Investment Planning Flashcards
Financial Markets
Provide for the exchange of capital and credit in the economy
Money Markets
Concentrate on short term debt instruments
Capital Markets
Trade in long term debt and equity instruments
Include Stock market, bond market, commodities and foreign exchange
2 types- primary and secondary
Primary Capital Markets
New Securities issued and sold for the first time
Registered with the SEC and sold through IPO
Issuing firm receives proceeds
Regulated through Securities Act of 1933
Secondary Capital Market
Where previously issued securities trade among investors
Issuing company is not directly involved
2 forms- Organized - i.e. NYSE
Over the counter - NASDAQ
Regulated by Securities Act of 1934 (this also created the SEC)
Holding Period Return Formula
HPR=(Pe-Pb +D)/Pb or Profit/cost
Pe= Ending Value
Pb= Initial Value
D= income generated or lost. Includes dividends call/put premiums, and loses for margin interest
Not time indexed and assumes dividends were not reinvested
Time Weighted Returns (TWRR)
Global standard for fund performance
Based solely on the appreciation or depreciation of the portfolio from period to period
Dollar Weighted Return (DWRR)
Appropriate for a specific client with their own particular cash flows
accounts for when (and at what price level) investments are made and when withdrawals occur
Investment Risk
Experiencing an outcome different than the outcome that was expected
Total risk = systemic risk + Unsystemic risk
measured by standard deviation
Systemic Risk
Can not be eliminated through diversification
PRIME
Purchasing power
Reinvestment
Interest rate
Market
Exchange rate
Quantified by the β (beta) statistic
Unsystemic Risk
Can be eliminated through diversification
Also called specific risk
Business
Financial
Default or credit
Regulatory
Sovereignty
Risk and Return
The Greater the expected risk, the greater the expected return
Risk
Realizing an outcome different than then expected outcome
Measured by standard deviation
The greater the Standard deviation, the greater the variance around the expected return
Investments with greater standard deviation require a greater expected return
Investors are paid for Risk
Investment Options - Low to High Risk
Treasury Bills (T-Bills)
CDs
Government Bonds
Corporate Bonds
Preferred Stock
Common Stock
Options & Futures
Factors that Influence Risk Capacity
Time Horizon
Liquidity Needs
Total Investable Assets
Distribution Curve
A Normal distribution curve is used in probability analysis of expected returns around an average return
Standard Deviation and Variance
+/- 1 = 68%
+/- 2 = 95%
+/- 3 = 99%
Skewness
The extent to which a distribution curve is not symmetrical
- positively skewed distributions have many outliers in the upper (right tail)
Negatively skewed distributions have many outliers in the lower (left tail)
Stock Market tends to be positively skewed
Kurtosis
When a distribution is more or less peaked that a normal distribution
Mesokurtic
Normal distribution (peakedness)
Leptokurtic
More Peaked than noramal
Platykurtic
Less peaked than normal
Efficient Market Theory (EMT)
Stock Markets are efficient and therefore all stock prices reflect all relevant information and are priced in equilibrium
3 forms- strong, semi strong, weak
strong- always true
semi strong- always true except insider information
Weak- insider information and fundamental analysis can beat markets
Anomalies that EMT does not explain
Low P/E effect
Small Firm Effect
Neglected Firm Effect
January Effect
Value Line Effect
Random Walk
Stock Movement is utterly unpredictable and lacks any pattern that can be exploited by an investor
Efficient Frontier
Identifies optimal amount of return given a unit of risk
uses standard deviation to measure risk
below curve is inefficient
above curve is impossible
curve is plotted based on risk tolerance
risk adverse clients have a steep curve
Risk tolerant have a flat curve
Sharpe Ratio
Measures Risk adjusted performance of portfolio in terms of standard deviation
Only use if R^2 < .70
comparative value
Sharpe Ratio Formula
Sp= (Rp-Rf)/σp
Sp- Sharpe Ratio
Rp- Return of the portfolio
Rf- Risk free rate of return
σp- standard deviation of the portfolio being measured
Treynor Ratio
Measures risk adjusted performance of a portfolio manager
Only use if R^2 > .7
Comparative to similar investments
Higher Treynor = higher risk adjusted return
Treynor Ratio Formula
Tp = (Rp-Rf)/βp
Tp=Trenor ratio
Rp- return of the portfolio
Rf= Risk free rate of return
βp= Beta of the portfolio being measured
Capital Asset Pricing Model (CAPM)
Foudation for all other modern portfolio theory (MPT)
Quantify expected returns given market returns and a beta to the market
used to plot security market line (sml)
Alpha = actual return - CAPM
Capital Asset Pricing Model Formula
Ri = Rf+ (Rm-Rf)βi
Ri= expected return of invesment
Rf= Risk free rate of return
Rm = expected return for the market
βi= beta of the investment
(Rm-Rf) = also called the market risk premium
(Rm-Rf)βi = also called stock premium
Jensen Performance index (alpha)
A measure used to evaluate the benefit of a portfolio manager
quantifies risk adjusted rate of return
R^2 > .70
Alpha is an absolute value
α > 0 - good, better then expected performance
α < 0 - bad, worse than expected performance
α = 0 - Good, Expected performance
Jensen Performance index Formula
αp = Rp - [Rf+(Rm-Rf)βp]
αp- Jensen
Rp- Return of the portfolio
Rf- Risk free rate of return
Rm- Return of the market
βp - beta of the portfolio
The Yield Curve
Under normal circumstances the short term rates are lower than the long term rates
Inversion in the yield curve indicates a looming recession
Depends on business cycle and Fed Policy
Fed Policy has a larger effect on short term rates
Anticipated economic conditions have larger impact on long term rates
Valuation of Bonds
Valuation is a function of
The bonds coupon payment
the market rate of interest for comparable bond
amount of time remaining to maturity
maturity value (assume $1,000 unless stated otherwise)
Calculating Valuation of Bonds
PMT- Coupon Payment
i- Market Rate of interest
n- Time Remaining (assume semi annual payments)
FV- Maturity Value
PV (solve) - Present value of bond
Bond and Yield Pricing
Normal Yield- Stated yield of coupon yield
Current Yield - the annual income paid divided by current market bond price
Yield to maturity and yield to call can be calculated - yield to worst is the lower of the two
Duration
Always in years
The weighted average of the present value of the future cash flows of a bond portfolio
the time to recoup your money or a bond investment
Change in Bond Prices
Inverse relationship between interest rates and bond prices.
as rates decrease bond prices increase
as rates increase bond prices decrease
longer duration and lower coupon lead to more sensitivity to rate changes
shorter duration and higher coupon lead to less sensitivity in rate changes
Margin Call (federal Minimums)
Initial margin requirements = 50%
minimum maintenance requirements = 25%
Broker can be more restrictive but not less
Margin Call Price Formula
(1-initial margin %)/(1-maintence margin %) * initial purchase price
Stock Options “Players”
Buyer- aka the holder or the long
Seller- aka the writer or the short
Buyer of Options: Call Contracts
The right to purchase shares at a specific price before a specific date
Options: Buyer of put contracts
The right to sell shares at a specific price
Options: Premium
The dollars/share the buyer pays to enter the contract
Represents the maximum the seller can make and the maximum the buyer can lose
Options Clearing Corporation’s (OCC) Job
Guarantees the performance of both parties
eliminates counterparty risk
Options Grid
Buy Sell
Call
Put
Buy Sell
Call Bull Bear
(Going up) (going down)
Put Bear Bull
(going down) (going up)
2 Variables make up options premiums
Intrinsic Value
Time Premium
Neither can even be less than 0
Stock Options: Intrinsic Value Variable
Market Price of the Stock
Exercise price of option contract
Stock Option: Time Premium Variables
Risk free rate of return
Time till expiration
Variability of stock (as measured by standard deviation)
It is greatest at creation and then declines
Intrinsic Value formula for call options
COME
Call Option = Market value - Exercise price
Intrinsic Value Formula for Put Options
POEM
Put Option = Exercise price - Market value
Covered call writing
Long the underlying stock- Short the call
Only considered covered if you own enough shares to cover all contracts sold
Used to generate income for a portfolio
Naked Call writing
Does not own the underlying stock
writer bears unlimited risk
Protective put
Long the Stock- Long the put
This is the essence of portfolio insurance
Protective call
Short the stock- Long the call
Used to protect a short position in the stock
Covered Put
Short the Stock - Short the Put
Writer uses the sock put to cover their short position
Collar (zero cost collar)
Long the stock - Long the Put - short the call
The put is used to protect against a stock price decrease and the call premium is used to offset the cost of the put
Straddle
Long a put and a call on the stock with the same expiration date and strike price
Used to capitalize on volatility regardless of direction
Spread
Involves purchasing and selling the same type of contract
Benefits from stability
Futures contracts
An Agreement to buy or sell a specific amount of a commodity. currency, or financial instrument at a particular price on a stipulated future date
Spot Price
What the current market value of the item is in today’s market
Futures hedging, long and short
Long position- anyone who owns something (farmer growing corn is long corn)
Short position - Anyone who has to buy something is said to be short (a construction company that needs to build is short lumber)
Short Hedge: Futures contracts
If you are long you need a short hedge
selling a futures contract establishes a short hedge
Long Hedge: Futures contracts
Anyone who is short needs a long hedge
Buying a futures contract establishes a long hedge
Futures vs. Forwards contracts
Futures are standardized and go through a clearing house (no counterparty risk)
Forwards can take any form the parties agree to (not standardized) and do not go through a clearing house (carry counterparty risk)
Net Present Value (NPV) vs. Internal Rate of Return (IRR)
NPV- Present value of cash flow, absolute sum, and can be used where there are cash flow changes
Positive of 0 NPV = accept the project
IRR- Discount rate (5) that makes NPV of cash flow to zero, relative measure, can not be used for changing cash flows.
Accept project when IRR exceeds the required rate of return
Wash Sale Time Period
61 days
30 days before the sale
the day of the sale
30 days after the sale
Wash Sale; where do losses go?
Losses are added to basis and will be allowed when underlying stock is sold and not repurchased
Wash Sale; common triggers
Convertible Bonds for the same stock
purchasing a call option that can be exercised into the same stock that was sold for a loss
