Investment Planning Flashcards
Stock Options
The BUYER of the contract has the right (or option) to…
The right to buy a call.
The right to sell a put.
Stock Options
Which option strategy is used when you own the shares and want to generate income?
Selling Covered Calls (or Covered Call Writing)
Only considered covered if you own enough shares to cover all contracts sold.
Stock Options
Which option strategy is used when the stock’s price is expected to have minimum movement?
Spread
Involves purchasing and selling the same type of contract. Example: Buy a call and Sell a call.
Stock Options
The SELLER of the contract has the obligation to…
The obligation to sell the call.
The obligation to buy the put.
Stock Options
Which option strategy is used when an investor has a concentrated stock position?
Collar
Investor buys a put (portfolio insurance) and also sells (or writes) a call option.
An investor who is already long the underlying stock buys an out-of-the-money put option while simultaneously writing an out-of-the-money call option. The put protects the trader in case the price of the stock drops. Writing the call produces income (which ideally should offset the cost of buying the put) and allows the trader to profit on the stock up to the strike price of the call, but not higher.
concentration = collar
Stock Options
Which option strategy describes an investor who does not own the stock and writes a call option?
Naked Call Writing
Seller bears unlimited risk because they don’t own the stock. If the market price of a stock moves against a put writer, it can fall to zero and that’s the end of it. If it moves against a call writer, the sky’s the limit as to how high the price could go.
Using FUTURES for hedging strategy
What type of hedge should you use if you do not own shares and think the price in the future will be higher than today?
Long hedge
Anyone who has to buy something is short, so they should buy a futures contract if they think the price will go up (they need a long hedge).
Example: A paper manufacturer needs to buy lumber from tree farmers and is concerned lumber prices may rise, so they should buy a futures contract to protect against rising lumber prices.
Using FUTURES for hedging strategy
What type of hedge should you use if you own shares and think the price in the future will be lower than today?
Short hedge
Anyone who owns something is long, so they should sell a futures contract to protect against falling prices (they need a short hedge).
Example: An investor is convinced that gold has peaked and it is likely to begin losing value in the next 6 to 12 months. He should sell a 12-month futures contract on gold.
Futures Contracts
Take a (long or short?) position if you think the price in the future will be higher than today.
Take a long position if you think the price in the future will be higher than today.
Stock Options
Which option strategy is used when you want to protect the stock you own from falling prices?
Protective Put
Investor owns the stock, and buys a put to protect their long position.
This is the very essence of portfolio insurance.
Futures Contracts
If an investor thinks their stock may begin losing value, should they buy or sell a futures contract?
Anyone who owns something is long, so they should sell a futures contract (they need a short hedge).
Example: An investor is convinced that gold has peaked and it is likely to begin losing value in the next 6 to 12 months. He should sell a 12-month futures contract on gold.
Stock Options
Which option strategy is used to capitalize on volatility regardless of direction.
Straddle
By purchasing a put and a call of the same underlying stock, same expiration and same strike price, the trader is able to catch the market’s move regardless of its direction. If the market moves up, the call is there; if the market moves down, the put is there.
Think of straddle the bull that has you go up and down, like volatility.
Futures Contracts
If a company needs to buy something and concerned prices may rise, should they buy or sell a futures contract?
Anyone who needs to buy something is short, so they should buy a futures contract (they need a long hedge).
Example: A paper manufacturer needs to buy lumber from tree farmers and is concerned lumber prices may rise, so they should buy a futures contract to protect against rising lumber prices.
Margin Call: calculating margin on a per share basis
What price must the stock fall below for the investor to receive a margin call?
[(1 - IM) ÷ (1 - MM)] x Initial Purchase Price
Assume Initial Margin (debt) = 50% and Maintenance Margin = 25%
If paying broker’s commission, add that amount to the initial stock purchase price
Margin Call
If the stock price falls, what amount must be deposited to cover the margin call?
Required equity: current stock price (price it fell to) x MM
Current equity: current stock price minus loan amount per share
Required equity minus current equity = deficit
Multiply the deficit by the number of shares.
Holding Period Return (HPR)
Profit ÷ Cost
Profit = what you sold the stock for, plus dividends, minus your investment, minus the margin loan, minus margin interest.
Cost = only include what you invested, no margin expenses. The maximum you can borrow on a margin account is 50%, so use that percentage if not provided. For example, if the price of the stock is $1000 but you purchased on margin, you would use a cost of $500 as that is all that you invested.
Inflation-adjusted Rate of Return (Real Interest Rate or Real Rate of Return)
[(1 + investment return) ÷ (1+ inflation rate) -1] x 100
With education funding, step 2 uses the EDUCATION inflation rate
Formula for Current Yield (Bond)
Annual coupon payment ÷ Bond’s market price
Formula for Taxable Equivalent Yield (TEY)
Tax-exempt bond rate ÷ (1 - investor’s marginal tax rate)
Tells you how much of a return a taxable bond would need to generate in order to equal the yield on a tax-exempt bond, like a muni bond.
Formula for Conversion Value of Bond
(PAR ÷ Conversion price) x Stock price
Conversion price: PAR ÷ Shares
Stock Options calculation
Intrinsic Value: CALL Options
IV for Call Option = Market value - Exercise price (COME)
For a Call, it is favorable when the MP > EP (In the money)
Stock Options calculation
Intrinsic Value: PUT Options
IV for Put Option = Exercise price - Market value (POEM)
For a Put, it is favorable when the EP > MP (In the money)
Calculation
Total Premium for stock option
Total Premium = Time Premium + Intrinsic Value
Time premium is greatest at the creation of the contract, and approaches $0 at the expiration.
Stock Options
Combining stock and option positions provides ____ for long options, and ____ for short options.
protection for long options
income for short options
Risk-adjusted return measurements
Sharpe Ratio
AKA “Reward to Variability”
Formula provided
- Used to compare two funds but only appropriate when r2 < 0.70
- Use standard deviation (Sharpe begins with S).
If you are provided the correlation coefficient, square it to calculate r2.
If uncertain about the reliability of r2 or the question does not provide it, go with Sharpe. “When in doubt, BE SHARPE”.
Risk-adjusted return measurements
Treynor Ratio
Formula provided
- Used to compare two funds but only appropriate when r2 > 0.70
- Use Beta (Beta is king!)
- The higher the Treynor ratio, the higher the risk-adjusted rate of return (more reward).
Treynor is used to compare specific sleeves in a portfolio, like small cap growth.
Risk-adjusted performance measurements
Jensen’s Alpha
Formula provided
- Measures how well a portfolio manager beat the market (excess return / seeking alpha).
- Only appropriate when r2 > 0.70
- Absolute measurement (whereas Treynor is relative)
Expected performance on excess return:
* Positive alpha = portfolio manager provided greater return than expected.
* Zero alpha = portfolio manager provided the exact return expected.
* Negative alpha = portfolio manager provided less return than expected.
Within the formula for alpha, you see the CAPM formula (Expected Return). The alpha formula could be simplified to rP (return of the portfolio) - Er.
Distribution of Returns (Skewness & Kurtosis)
Distribution curve for a three-month T-bill would best be described as…
Leptokurtic
3-month T-bills would be a good example as they are more predictable.
Slender bell curve, hence more peaked
Distribution of Returns (Skewness & Kurtosis)
Distribution curve for small cap returns would best be described as…
Platykurtic
Small caps historically have high variability, so they are less predictable.
Broad bell curve, hence less peaked.
Duration
The (higher or lower) the coupon, the more volatile the bond.
The lower the coupon, the more volatile the bond.
Generally, bonds with long maturities and low coupons have the longest durations. These bonds are more sensitive to a change in market interest rates and thus are more volatile in a changing rate environment. So, the longer the maturity, the more volatile the bond.
Duration is a linear estimate of sensitivity to a change in bond rates.
Duration
In a low interest rate environment, an investor would be well positioned to have (higher or lower) durations?
Lower durations
The lower the time to maturity and the higher the coupon, the shorter the duration (recoup your investment faster). An investor will participate fully in price depreciation as rates increase.
For income-producing bonds, duration will always be < maturity except with a zero-coupon bond. Zero-coupon’s duration = its maturity.
Duration is a linear estimate of sensitivity to a change in bond rates.
Duration
How do you immunize a bond portfolio?
By matching the duration of a fixed income portfolio to an investor’s time horizon.
Significantly reduces purchasing power and reinvestment rate risks for the assets.
Net Present Value (NPV) vs Internal Rate of Return (IRR)
If NPV calculation suggests investing in project A, while IRR calculation suggests investing in Project B, which should you select?
Select the investment with a higher positive NPV.
NPV: If zero or positive, good investment. If negative, bad investment. You should apply the investor’s required rate of return to NPV calculations. Calculated using uneven cash flows keys (CF0, CFj and Nj).
IRR: If the IRR exceeds the investor’s required rate of return, you should accept the project (undertake the investment).
Wash Sale
With stocks, what are two assets that would trigger “substantially identical” in pre-trade?
Convertible bond - converting to stock that was the same stock that was sold for a loss.
Purchase of a Call that can be exercised into the same stock that was sold for a loss.
What is the formula to determine if the company has the ability to meet its short-term obligations?
Current Assets ÷ Current Liabilities
You want a higher current ratio.
This is called the Current Ratio. It is a liquidity ratio
What is the formula to calculate the Quick Ratio?
(Current Assets - Inventories) ÷ Current Liabilities
What is the formula to determine if the company has the ability to meet its long-term obligations?
Total Debt ÷ Total Assets
You want a low debt ratio.
Debt Ratio
What is the formula to calculate gross profit margin?
Gross Profit ÷ Sales
What is the formula to calculate return on equity (ROE)?
EAT (or EPS) ÷ Equity (or Book Value per share)
Book value per share (BVPS) takes the ratio of a firm’s common equity divided by its number of shares outstanding. Book value of equity per share effectively indicates a firm’s net asset value (total assets - total liabilities) on a per-share basis.
Do not include preferred stock.
Which measure of risk is used in the Capital Market Line (CML)?
Standard Deviation
What types of risks cannot be eliminated through portfolio diversification?
Systematic Risk.
You cannot “beat the system” with diversification.
P-R-I-M-E:
* Purchasing Power Risk (inflation)
* Reinvestment Risk
* Interest Rate Risk
* Market Risk
* Exchange Rate Risk
Measured by Beta.
Economic Indicators
Average prime rate
Leading, Coincidence or Lagging?
Lagging indicator
Lagging indicators tend to follow or lag economic performance.
Economic Indicators
change in CPI
Leading, Coincidence or Lagging?
Lagging indicator
Lagging indicators tend to follow or lag economic performance.
Economic Indicators
Industrial production
Leading, Coincidence or Lagging?
Coincident indicator
Coincident indicators tend to change at the same time as the economy.
Economic Indicators
Manufacturing and trade sales
Leading, Coincidence or Lagging?
Coincident indicator
Coincident indicators tend to change at the same time as the economy.
Benchmarks
What is the appropriate performance benchmark for an investment portfolio primarily of cash?
3-month Treasury Bill
4, 13, and 26-week durations – used in Money Markets
Risk Allocation
What is the appropriate allocation for an investor who wants current income, investment stability, and capital preservation with a 3 to 5-year time horizon?
20 / 80
EQUITIES
Large cap: 15%
Int’l: 5%
Small cap: 0%
BONDS = 50%
CASH= 30%
Risk Allocation
What is the appropriate allocation for an investor who wants current income, investment stability, but also some growth opportunity with a 5-year time horizon?
50 / 50
EQUITIES
Large cap: 25%
Int’l: 10%
Small cap: 5%
BONDS = 50%
CASH= 10%
Risk Allocation
What is the appropriate allocation for an investor who wants current income, solid growth, relative stability, who can tolerate low levels of volatility with a 10-year time horizon?
60 / 40
EQUITIES
Large cap: 35%
Int’l: 15%
Small cap: 10%
BONDS = 35%
CASH= 5%
Risk Allocation
What is the appropriate allocation for an investor who is most concerned about growing their investments and can tolerate moderate levels of volatility with at least a 10-year time horizon?
80 / 20
EQUITIES
Large cap: 45%
Int’l: 20%
Small cap: 15%
BONDS = 15%
CASH= 5%
Risk Allocation
What is the appropriate allocation for an investor who is most concerned about growing their investments and can tolerate high levels of volatility with a 15 or more year time horizon?
95 / 5
EQUITIES
Large cap: 50%
Small cap: 25%
Int’l: 20%
CASH = 5%
BONDS = 0%
Efficient Market Hypothesis
Which form of the EMH is for an investor that evaluates a stock based on its intrinsic value using qualitative and quantitative information?
Weak form
Belief that you can beat the market using fundamental analysis or inside information.
Utilize active strategies, NOT technical analysis.
Efficient Market Hypothesis
Which form of the EMH is for an investor who believes that they can beat the market only through inside information?
Semi-strong form
Utilize active strategies, NOT technical analysis.
Efficient Market Hypothesis
Which form of the EMH is for an investor who believes in index funds?
Strong form
Fully believe in the strengths / efficiency of the markets.
Utilize passive strategies. They buy index funds.
The relationship between bond prices and yields is referred to as …
Convexity
Yield to Worst (YTW)
When provided par value and callable value, you need to calculate the Yield to Worst (YTW), which is the lower of YTM and YTC and the appropriate yield when considering investing in the bond. The reason for this is that the YTW is your worst-case scenario, so if the investor is satisfied by this, then their investment performance can only match or exceed their requirement.
You need to calculate the YTM and YTC and select the lower of the two.
Bond Ratings
Investment Grade
S&P/Fitch: AAA, AA, A, BBB (+/-)
Moody’s: Aaa, Aa, A, Baa(1, 2, 3)
Speculative Grade
S&P: BB, B, CC and below (+/-)
Moody’s: Ba, B, Caa and below
What statistical measure is used to quantify total risk?
Standard Deviation
The higher the standard deviation, the greater the risk, as you are moving away from the mean (average).
What are the 3 determinants of an option’s Time Premium?
- Risk-free rate of return
- Time to expiration
- Variability of the underlying stock (as measured by standard deviation)
The greater any or all of the three variables above, the greater the time premium.
Time premium is greatest at the creation of the contract and approaches $0 at the expiration of the contract.
Asset Class
High Yield Bonds & Emerging Market Bonds are risker than…
Riskier than government bonds but less risky than equities.
Asset Class
Gold
Over time, gold investments have shown a low correlation with investments in other asset classes.
Gold is a limited resource & cannot be inflated. As a result, it has historically remained a relatively stable purchasing power, whereas practically all currencies have lost purchasing power in the long run.
While the price of gold can be volatile in the short term, it has always maintained its value over the long term.
Beta
Beta is a measure of the volatility - or systematic (nondiversifiable) risk - of a security or portfolio compared to the market as a whole (i.e. S&P 500).
The market (or benchmark) is always assumed to have a Beta of 1.0. An investment around that will preform similarly to the market.
Stocks with Betas higher than 1.0 can be interpreted as more volatile than the S&P 500.
Stocks with Beta less than 1.0 are considered to be less volatile than the market, so when the market is down, the investment will be down less (defensive).
When examining several funds and calculating the correlation coefficient relative to the existing portfolio, when does diversification benefits begin?
Diversification begins anytime the correlation is something less than 1.
