Investment Planning Flashcards
What is Unsystematic (non-systematic) Risk?
Not System-wide
Diversifiable risk.
Business risk- nature of operation
Financial risk- how a firm finances its assets
What is Systematic Risk?
System-wide
Non-Diversifiable risk.
The risk of the overall market. This cannot be avoided.
Expressed by Beta.
What are the types of Systematic Risk?
PRIME
Purchasing Power Risk: Loss of purchasing power through inflation.
Reinvestment Risk: Risk that one would need to reinvest available proceeds at a lower interest rate that the instrument that generated the proceeds.
Interest Rate Risk: Risk that a change in interest rates will cause the market value of a fixed income security to fall.
Market Risk: Risk of the overall market
Exchange Rate Risk: Risk of changes in the value of currency.
FDIC Insured Amounts
Per Bank/Per TYPE of account
Individual: $250k
Joint (per OWNER): $250k
Trust (per beneficiary): $250k
IRA/Keogh: $250k
Yield Ladder
Discount Bonds:
Y (YTC)
M (YTM)
C (CY)
A (Annual Coupon)
C
M
Y
Premium Bonds:
EE Bonds:
- Issue price?
- How is interest rate derived?
- How does the interest accrue?
- How long must they be held?
- Is there any Treasury guarantees?
- Who can own one?
- How are they taxed?
- Non-marketable, non-transferable, cannot be used as collateral.
- Issued at face value.
- Interest rate is based on the 10-year Treasury note yields, and is fixed at the time of purchase. The fixed rate applies for the 30-year life of each bond, which is 20-years, but also adds a 10-year extended maturity period.
- Denominations are as low as $50.
- Interest Accrues monthly, and is compounded semi-annually.
- Savings bonds must be held one year, and there is a three-month interest penalty applied to bonds held less than 5 years.
-Treasury GUARANTEES the value will double after 20 years. - Subject to federal taxation when redeemed UNLESS USED FOR EDUCATION
- Not subject to state or local taxes.
- Must be owned by an adult at least 24 years old, typically a parent, and cannot be held in an UTMA/UGMA and still qualify for the interest exclusion.
- A Grandparent may claim the interest exclusion if the grandchild/student is a dependent of the grandparent.
The interest earned is not subject to Federal income tax until the bonds are redeemed or reach full maturity. The owner has the option of having the interest taxed each year.
HH Bonds
HH bonds were available only by exchanging at least $500 in Series EE bonds.
Pay interest semi-annually.
Non-marketable.
Interest is taxed yearly.
After 2004, no longer exchangable.
I Bonds:
- Issue price?
- How is interest rate derived?
- Who can own one?
- How are they taxed?
- Non-marketable, non-transferable, cannot be used as collateral.
- Sold at face value.
- INTEREST RATE is composed of two parts: A fixed base rate, and an inflation adjustment (adjusted very 6 months). Different from TIPS.
- Subject to federal taxation when redeemed UNLESS USED FOR EDUCATION.
- Not subject to state or local taxes.
- Taxed like EEs. The owner will generally choose whether to be taxed each year.
- Must be owned by an adult at least 24 years old, typically a parent, and cannot be held in an UTMA/UGMA and still qualify for the interest exclusion.
- A Grandparent may claim the interest exclusion if the grandchild/student is a dependent of the grandparent.
Types of Municipal Securities
GO Bonds: Backed by the full faith, credit, and taxing power of the issuer. Considered the safest type of muni credit.
Revenue Bonds: Backed by specific sources of revenue. Full faith and credit of the issuer are NOT pledged. Have a greater credit risk than GO bonds, but have higher yields.
Insured Muni Bonds are insured by AMBAC and MBIA
What do Indenture Agreements Cover? (6)
Form of Bond
Amount of Issue
Property Pledged
Protective covenant, including provisions for a sinking fund
Working Capital and Current Ratio
Redemption Rights (call or put)
What are the Risks of Corporate and Municipal Bonds?
DRIP
Default
Reinvestment
Interest Rate
Purchasing Power
What are the Risks of Government Bonds?
RIP
Reinvestment
Interest Rate
Purchasing Power
No Default
Market Caps of Companies
Large: > $10 billion
Mid: $2-10 billion
Small: < $2 billion
Micro: < $300 million
American Depository Receipt (ADR)
Receipt for buying shares of a foreign based corporation.
Instead of buying shares of a foreign-based company in overseas markets, Americans can buy foreign shares in the US in the form of an ADR.
Prices for ADRs are quoted in US dollars.
Dividends are declared in foreign currency, but are paid in USD.
Bankers Acceptance:
- Length of maturity?
- How does it trade?
Finances imports and exports.
Bearer securities that can be held till maturity.
9 month or less maturity, and trades at a discount to face value.
Before a foreign exporter will ship goods to the US, the exporter wants assurance of payment when the goods arrive.
Eurodollars
US dollar denominated deposit in ANY FOREIGN BANK.
Eurodollar Bond
A Eurodollar bond is a U.S.-dollar denominated bond issued by an overseas company and held in a foreign institution outside both the U.S. and the issuer’s home country.
Mercedes issues a usd bond in Canada.
Yankee Bond
US dollar denominated bonds issued in the US, BY FOREIGN BANKS AND CORPS.
These bonds are issued in the US when market conditions are more favorable than on the Euro markets.
What is the NOI calculation for improved land/real estate?
Improved land/real estate is normally income producing. The intrinsic value of a real estate property can be computed using the NOI computation:
Gross rental receipts
+ Nonrental income
= Potential Gross Income
- Vacancy and collection losses
- Operating expenses (cash expenses only. Excludes interest amortization, depreciation, or debt service)
= NOI
NOI / Cap rate = Intrinsic value
The focus of operating expenses is the properties cash flow, not the investors cash flow.
What are the general definitions of Options?
IV is the minimum price the option will command as an option. Market Price - Ex Price.
Ex Price is the price that the stock can be purchased or sold on the exercise of an option.
Premium is the market price of an option. As the option approaches its expiration date the market price of the option (premium) approaches its IV.
Time Premium is the amount the market price of an option exceeds its IV.
IV + TV = Premium
What is the Taxability of Call Options?
At the time of purchase: Non-deductible capital expenditure
To the writer due to lapse: Premium received is a short-term gain
To the writer due to exercise: Premium received is added to sale price (can be long term gain if underlying security was held more than 12 months, otherwise short term).
To the holder: if the option is NOT exercised, then the option is considered sold (it expires) and it is a short-term loss. The option period is 9 months or less.
Hedging Strategies - Straddles, Collar, Protective Put
Straddle: Buy a Put AND buy a Call. The buyer DOES NOT own the stock.
Collar: Sell a Call (out-of-the-money) at one strike price, and buy a Put at a lower strike price. Investor OWNS the stock.
Protective Put: Buy/Own a stock, and then buy a Put for the stock. This serves as insurance against a decline in the underlying stock and is a good answer on the exam.
Warrants vs. Call Options
Warrants are issued by corporations. Calls are issued by individuals.
Warrants typically have maturities of several years.
Warrant terms are not standardized. Call options are standardized.
What are the Hedging Positions of Futures Contracts?
Long (owner) commodity position: If a farmer is long a commodity, they need a SHORT hedge, and will SELL a futures contract. This will protect the farmer from the price of that commodity from falling and having to sell the commodity at a lower price. By selling the future short, the farmer locks in a higher price is the commodity was to devalue.
Short (buyer) commodity position: If a manufacturer is short a commodity (doesn’t own/needs), they need a LONG hedge, and will BUY a futures contract. This will protect the manufacturer from the price of the commodity from rising, and having to buy at a higher price. By buying a future long, the manufacturer locks in a lower price if the commodity was to revalue.
Reg D Accredited vs. Non-Accredited Investors
1, 2, 3, 35
Accredited (unlimited):
Net worth of $1 million
Ind. with income of $200,000
Couple with income of $300,000
Non-Accredited:
Issue sold to a max of 35 investors
Must use a purchaser representative if not “sophisticated”
Coefficient of Determination R²
The square of the correlation coefficient measures the proportion of the variation in one variable explained by the movement of the other variable.
How is R² used on the exam?
It describes the percentage of a fund’s movement thats explained by the movements in the S&P 500.
Diversified funds (Index Funds) based on the S&P 500 will have an R² of very close to 100%. Alpha (Jenson), Treynor.
Non-Diversified funds (Sector Funds) will have a very low R² (typically 5%-25%). Sharpe.
Standard Deviation Vs. Beta
Both Standard Deviation and Beta are used to express the risk of a security.
- Standard Deviation measures VARIABILITY of returns used in a NON-DIVERSIFIED portfolio and is a measure of TOTAL RISK.
- STD, Variability, Non-diversified, Total Risk, Low R², Sharpe.
- Beta measures VOLATILITY of returns used in a DIVERSIFIED portfolio and is a measure of SYSTEMATIC RISK (because it’s diversified, there’s no unsystematic risk remaining, just systematic).
- Beta, Volatility, Diversified, Systematic Risk, High R², Alpha (Jenson) Treynor.
Geometric Return vs. Internal Rate of Return (IRR)
Geometric Return (Time-Weighted Retun): Evaluates the performance of a portfolio manager. (GReat Tiger Woods).
IRR (Dollar-Weighted Return): Compares absolute dollar amounts. (IRRegular Dollars).
Real vs. Nominal Rate of Returns
Real: Inflation adjusted interest rate. This is the nominal rate of return, adjusted for inflation.
Nominal: Actual returns. Not adjusted for inflation.
Holding Period Return (HPR)
Total return (income + price appreciation and dividends - margin interest - initial cost) over the entire period, divided by the out of pocket cost of the investment.
Taxable Equivalent Yield (TEY)
Compares municipal bond returns to those of taxable bonds.
TEY = Tax-Exempt Yield / (1 - Marginal Tax Rate)
or
Tax-Exempt Yield = TEY x (1 - Marginal Tax Rate)
Tax-Exempt Yield is typically the yield on a Muni Bond
Duration (Principals to Remember)
Years to Maturity: Duration and Maturity are POSITIVELY related.
Annual Coupon/YTM: Duration is inversely related to both Annual coupon and YTM.
Coupon and Yield are Interest Rates - Inversely Related.
Zero Coupon Bonds:
- Duration?
- What is it? How does it function?
Duration is equal to Maturity.
Produces Phantom Income.
No reinvestment rate risk.
Sold at deep discount to par.
Fluctuates more than coupon bonds with the same maturities.
Using Duration to Manage Bond Portfolios
If interest rates are expected to rise, shorten duration. UPS = interest rates UP, Shorten duration. Shorten by buying short maturities, high coupon
If interest rates are expected to fall, lengthen duration. FALLEN = interest rates FALL, LENgthen duration. Lengthen by buying long maturities, low coupon
Small coupon, Small interest rate = Big fluctuation.
Big Maturity = Big fluctuation.
Conclusions to Fluctuations in Bond Prices
Smaller coupon, longer term to maturity, lower market interest rate = GREATER THE PRICE FLUCTUATION.
Convexity
The degree that duration changes as YTM changes.
Largest for low coupon, long maturity, low YTM bonds. This allows investors to improve the duration approximation for bond price changes.
What is ROE?
ROE = EPS / Net worth or Book value
Dividend Payout Ratio
Dividend Payout Ratio = Common Dividends Paid / EPS
This compares dividends paid to earnings available.
What are the three types of Efficient Market Hypothesis
EMH suggests that investors cannot expect to outperform the market consistently on a risk-adjusted basis. Security prices reflect all known information.
Strong Form: Stock prices fully reflect all information, public and private. NEITHER fundamental analysis nor technical analysis can produce superior results.
Semi-Strong Form: All PUBLICLY known information is reflected in stock prices. NEITHER technical analysis nor fundamental analysis can produce superior results over time. Only an investor with inside information may achieve superior results.
Weak Form: Suggests that HISTORICAL price data is already reflected in current stock prices. FUNDAMENTAL ANALYSIS may produce superior results.
Types of Indexes / Benchmarks
Dow Jones: 30 industrial stocks, PRICE weighted.
S&P 500: Large caps. Broader measure of NYSE activity. VALUE weighted.
Russell 2000: Small caps. Smallest 2000 stocks of the Russell 3000 index. VALUE weighted.
Wilshire 5000: Broadest measure of the activity and movement of the overall stock market. VALUE weighted.
NASDAQ: Broadest measure of OTC trading. VALUE weighted.
Europe, Australasia and Far East (EAFE): Equity performance of the major foreign markets. VALUE weighted.
Value Line: +/- 1700 stocks. EQUALLY weighted.
Barclays Aggregate Bond: More than 5000 US Government, Corporate, Muni, mortgage backed and asset backed bonds.
Tax Basis of a Mutual Fund
FIFO
Specific ID: seller must identify the shares of the fund to be sold. This allows the investor to create gain, neutralize gain, or create a loss (FLEXIBLE).
Average Cost: Allows the investor to divide the total cost of all shares held by the number of shares sold.
Steps to Risk-Adjusted Measures of Performance: SHARPE
Look for LOW R2 (less than 60), or a NON-DIVERSIFIED portfolio.
Look for the highest sharpe number.
Steps to Risk-Adjusted Measures of Performace: ALPHA (JENSON) / TREYNOR
Look for HIGH R2 (60+) or DIVERSIFIED portfolio.
Look for the highest Alpha (Jenson). Of Alpha is not given, look for the highest Treynor.
What is a Margin (Maintenance) Call?
The formula for calculating when an investor will receive a margin call is:
(1 - Initial Margin / 1 - Maintenance Margin %) x Purchase Price of Stock.
Shortcut: 2/3 of the purchase price if the minimum maintenance is 25%. If the minimum maintenance is 30%, take 2/3 of the purchase price and then choose the next highest number.
Examples of Passive Investment Strategies
Buy & Hold (EMH)
DCA
Indexing
Strategic Asset Allocation (revised every few years)
Examples of Active Investment Strategies
Market Timing
Tactical Asset Allocation
Technical Analysis
Arbitrage Pricing Theory (APT)
Pricing of securities in different markets cannot differ for any significant length of time.
Unexpected Inflation or changes in industrial production.
Unanticipated shifts in risk premium or changes in structure of yields.
If the expected value is zero, then the factor has no effect.
Eurobond
A Eurobond is a debt instrument that’s denominated in a currency other than the home currency of the country or market in which it is issued.
Negotiable CDs
Issued in exchange for a deposit of funds.
Marketable deposit, issuer must sell new CDs on demand.
At maturity, holder receives deposit plus interest.
CDs are negotiable in that they can be sold in the open market before maturity.
Carry interest rate risk.
Insured up to $250,000 by FDIC.
Are MMMFs insured by FDIC?
NO. Open-ended investment company issue MMMFs.
Average maturity is limited to 90 days.
Commercial Paper:
- What is it?
- Denominations?
- Maturity?
Short-term, unsecured promissory note issued by large well-known, financially strong companies.
Denominations of $100,000.
Maturity of 270 days or less.
Normally sold at a discount.
When is an issuing corporation most likely to call its bonds?
When the bonds are selling at a significant premium.
If the bonds are selling at a premium, newly issued bonds are offered with lower coupons. Declining interest rates do not necessarily mean that previously issued bonds are trading at a premium.
OID:
- How is is issued?
- How is the accretion incorporated/taxed?
Discounted from par value when issued.
Pay no interest until maturity, but the discount must be accreted over the life of the bond.
Each year the portion of the discount that has been earned is included as taxable interest income, and basis is increased.
Must report interest income although the bond pays no interest before maturity. PHANTOM INCOME.
Annual accretion on an OID Muni is considered to be non-taxable interest income. If held to maturity, no gain or loss.
T-Bills
3, 6, and 12 month maturities.
$100-$1,000,000 issues (Discount yield basis).
Safest.
Issued at Discount, so there is no coupon interest.
Subject to Federal income tax, exempt from state/local. Fed gets Fed.
Weekly Auction
Treasury Notes
1-10 Year Maturities.
$1,000-$100,000 issues at Par.
RIP
Not Callable.
Semi-annual interest.
Subject to Federal income tax, exempt from state/local. Fed gets Fed
Monthly Auction
Treasury Bonds
10-30 year Maturities.
$1,000-$1,000,000 issues are par.
RIP
Callable
Semi-annual interest
Subject to Federal income tax, exempt from state/local. Fed gets fed.
Quarterly Auction
Treasury STRIPS
Zero-coupon bond.
Direct obligation of the federal government.
The discount is treated as taxable income earned annually. This is Phantom Income taxed annually that is not actually paid out until maturity
TIPS
Protection against inflation.
Marketable.
Principal (Face Value) is adjusted semiannually to keep pace with inflation, measured by CPI over a 6 month period.
Fixed interest rate, variable principal depending on inflation.
Sold in $1,000 denominations.
Investor is taxed annually on the interest payment plus the appreciation in face value. The increase in face value due to the inflation protection is Phantom income, but the increase is not collected until maturity. FED ONLY.
Are Treasury securities Marketable?
Yes. Safest securities. Have a market.
GNMA
Pass-through security, with a direct guarantee of the Government.
Fed/State/Local taxation.
Minimum of $25,000
Each payment received represents both interest and return of principal. No par at maturity.
Muni Bond insurers
AMBAC- American Municipal Bond Assurance Corp
MBIA/National- Municipal Bond Insurance Association Corp.
BAM- Build America Mutual Insurance
Yield Ladder
Discounts:
Y (YTC)
M (YTM)
C (CY)
A (Annual Coupon)
C
M
Y
Premium Bonds:
CMOs
Because principal repayments vary as homeowners refinance their homes, the amount of principal repayment received by the investor changes every month.
CMOs were developed to eliminate these risks.
CMOs do not view mortgage pools as a means of passing through payments to certificate holders in exactly the same fashion as received. Instead, the payments received are looked at on a cash flow basis.
CMOs are multi class pass-through securities with Tranches.
Do CDs have less risk than Treasury Bonds and GNMA securities?
Yes. They are FDIC insured up to $250,000.
T or F: Treasuries are government securities and only have have RIP risks?
T. No Default risk. Only Reinvestment, Interest rate, and purchasing power risk.
Bond IV calculation:
Always 2 P/YR unless specified.
PMT is the semi-annual amount of the CURRENT bond.
I/YR is the % of the bond being compared.
N is # of years x P/YR.
Solve for PV.
FV is 1000.
Bond Conversion Value formula
CV = (Par / CP) x Current market price of stock.
(1000/40) x 50
STRIP vs. OID
STRIPs do not distribute interest in the form of a coupon payment. The interest is accrued and phantom income, payable at maturity.
With an OID tax exempt obligation, the bonds interest could be either accreted or paid. It could be an OID coupon bond, not a pure zero.
Are MMDAs FDIC Insured?
Yes.
EE Bonds in an UTMA
EE Bonds are taxed annually in an UTMA account. Have the Interest taxed each year to the kiddie. With the child’s standard deduction and low tax bracket, taxation will be minimal.
Preferred stock
Hybrid security, because it resembles both equity and debt.
Issued at $25 par or $100 par with a fixed stated dividend rate.
Because it is perpetual, duration is normally infinite. When interest rates change, price fluctuations often exceed those of bonds.
The typical purchaser is a corporate treasurer, C-Corp, or pension plan (for the income). If the treasurer buys bonds, all the interest is taxable. However, if the corporation buys preferred stock, 50% of the dividends received are generally excluded from taxation.
For preferred stock that pays annual dividends, if those dividends are to be qualified, the stockholder must own the stock for 90 days in a 180 day period that begins 90 days before the ex dividend date.
