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CFP Exam Prep > Investment Planning > Flashcards

Investment Planning Flashcards

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1
Q

What are the risks for corporate and muni bonds?

HINT: is it DRIP, RIP, or IP?

A

DRIP

D-Default Risk
R- Reinvestment Risk
I- Interest Rate Risk
P- Purchasing Power

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2
Q

What are the risks for government bonds?

HINT: Is it DRIP, RIP, or IP?

A

RIP

R- Reinvestment Risk
I- Interest Rate Risk
P- Purchasing Power

(there’s no default risk, as it’s guaranteed by the gov’t)

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3
Q

What are the risks for CDs?

HINT: is it DRIP, RIP, or IP?

A

R- Reinvestment Risk
P- Purchasing Power

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4
Q

What are brokered CDs, and what are the risks for them (DRIP, RIP, or IP)?

A

CD’s sold through brokerage firm (vs. savings institution); risks include…

R- Reinvestment Risk
I- Interest Rate Risk
P- Purchasing Power

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5
Q

What are OID Bonds, and how are they taxed?

A

Original Issue Discount Bonds

-Discounted from par value at the time of purchase.
-Each year, the portion of the discount that has been earned is included as taxable interest income (PHANTOM INCOME), and the bond’s basis is increased.

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6
Q

What are STRIPS, how are they taxed, and who usually purchases them?

A

STRIPS are zero-coupon bonds issued by the US Treasury (thus they are a direct obligation of the US government); the discount on STRIPS is treated as taxable
(PHANTOM) income, earned annually.

NOTE: they are not subject to reinvestment risk since there is no coupon.

They are usually purchased by tax-deferred entities (pensions, IRAs, annuities).

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7
Q

Treasury Bills, Notes, Bonds

A

Bills: mature in 3-12 months; quoted in terms of discounted yield

Notes: intermediate debt (1-10 years)

Bonds: long-term debt (10-30 years)

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8
Q

What are TIPS, and how are they taxed?

A

TIPS are marketable with a face value adjusted semi-annually based on inflation (using CPI as a gauge). The higher the inflation, the higher the face value and semi-annual interest payment.

TIPS are taxed annually on the interest payment plus appreciation in face value (but only federal tax applies).

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9
Q

All about EE Bonds

A

EE Bonds

-Nonmarketable, non-transferable, non-negotiable.
-Issued at face value and in electronic form only.
-Earn fixed interest rates (for 30 yr period)
-Treasury guarantees that the bond’s value will double after 20 years.
-Interest is not subject to federal tax until bonds are redeemed or reach final maturity. NOTE: the owner may have interest taxed each year.
-No state or local taxes.

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10
Q

EEs in UTMA custodial account
vs
EE Educational Bonds

A

EEs in UTMA: owned by child; taxed as ordinary income at redemption.

EE Education Bonds: owned by adult (usu. parent); tax-free if parent’s AGI is less than phaseout at redemption.

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11
Q

EE and I bonds and use for educational expenses

A

Both can be used for education expenses and tax exempt, but only if…

-EE are educational bonds owned by parents (and parents’ AGI is below phaseout); thus, must be held outside of an UGMA/UTMA account
-Certain requirements are met for I bonds.

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12
Q

HH Bonds
-What’s unique?
-How often do they pay interest?

A

HH bonds are no longer issued. You could previously exchange EE bonds for HH bonds. Taxable gain is paid when the bonds are cashed in.

Recommending HH bonds should be a wrong answer on the test.

HH bonds pay interest semi-annually.

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13
Q

I Bonds (aka II Bonds)

A

-Nonmarketable, non-transferable, non-negotiable, cannot be pledged as collateral.
-Issued at face value.
-Interest is compounded every 6 months.
-Provide no guaranteed rate of earnings.
-Interest is composed of fixed base rate plus inflation adjustment (based on CPI).
-Taxed the same as EE bonds.

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14
Q

Which muni has less risk: general obligation or revenue bonds?

A

General obligation (GO)- backed by full faith, credit, and taxing power of issuer (whereas revenue depends on revenue source, which is not pledged).

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15
Q

Collateralized Mortgage Obligations (CMOs) and Real Estate Mortgage Investment Conduit (REMIC) are synonymous for the exam!

A

They do not pass through payments in exactly the same (uneven) form as received.

They create separate classes of securities (tranches) from A to Z, where A is fast pay, M is medium pay, Y is slow pay, and Z is a no-coupon tranche (like a zero) that receives cash flow from the collateral remaining after the other tranches are satisfied.

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16
Q

What is a GNMA?

A

Government National Mortgage Association
(Ginnie Mae)

-Direct guarantee of US gov’t
-Risks: RI (reinvestment and interest rate)
-Purchase a pool of FHA/VA guaranteed mortgages.
-Each payment represents both interest and return of principal.

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17
Q

FNMA and FHLMC

A

FNMA: Fannie Mae
FHLMC: Freddie Mac

Neither are guaranteed; they have been taken over by the fed government and are in conservatorship

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18
Q

How to Calculate a Security’s Intrinsic Value

A

PV of its expected cash flows

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19
Q

Call Premium

A

Represents the amount over par paid to the bondholder whose bond is called.

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20
Q

In the event a corporation is liquidated, what is the order of precedence in who will get their claims paid?

A

Secured and unsecured creditors and owners of bonds and preferred stock all take precedence over claims from common stockholders.

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21
Q

What are some of the unique attributes of preferred stock?

A

-Hybrid security (resembles both equity and debt)
-Pays a fixed dividend rate
-Is often perpetual
-Typically purchased by a corporate treasurer with excess funds (note: in most instances, 50% of the dividends received are excluded from taxation)
-Can be callable (like bonds)

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22
Q

What’s unique about Unit Investment Trusts?

A

-passive investment
-no day-to-day portfolio performance
-self-liquidating
-can trade on the secondary market
-payments can be income and/or return of principal
-most commonly used for muni bond portfolios

NOTE: there’s no continuous trading or redemption; think of them as shares that can be sold back to a sponsor

Think of UITs as the “grandfather of mutual funds” (with no captain).

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23
Q

Which of the following does not apply to mutual fund shares?
a) nonnegotiable
b) redeemable
c) tradeable
d) continuously issued

A

(b) Tradeable
(shares are redeemable but not tradeable)

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24
Q

The Investment Company Act of 1940 defines the following as investment companies…

A

Mutual Funds
Open-end funds
Closed-end funds
UIT companies
Variable annuity companies

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25
Q

Attributes of Guaranteed Investment Contracts (GICs)

A

-similar to CDs
-issued by insurance companies
-guaranteed interest rate
-unlike bonds, value does not fluctuate with the interest rate (i.e. limited interest rate risk)
-popular investments for defined benefit plans

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26
Q

How do you calculate Net Operating Income (NOI) in a real estate analysis?

A

Gross Rental Receipts
+Non-Rental Income (ex: laundry income)
=Potential Gross Income
-Vacancy and Collection Losses
=Effective Gross Income
-Operating Expenses (no interest or deprec)
=NOI

Note: property financing is not an operating function!

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27
Q

How do you calculate a property’s intrinsic value (or purchase price)?

A

Intrinsic Value or Purchase Price=
(Annual NOI)/(Capitalization Rate)

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28
Q

What might be a good option for holding a mortgage REIT as an investment?

A

A retirement plan, such as a SEP, since the REIT produces what would otherwise be taxable income.

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29
Q

How do REITs differ from Real Estate Limited Partnerships (RELPS)?

A

-REIT is a portfolio investment subject to taxes (like a stock would be); RELPS are subject to passive loss rules
-REITs are actively traded on securities markets; RELPs are generally illiquid.
-REITs are managed by a board of directors.

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30
Q

Is an EFT best described as a fund that is open-end, closed-end, or both?

A

Both

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31
Q

What’s unique about an immunized bond portfolio?

A

The duration of the portfolio is made equal to a pre-selected time horizon .

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32
Q

Formula for Intrinsic Value (IV) of a Call

A

IV= MP-EP

where MP is Market Price and EP is Exercise Price

NOTE: if EP is greater than MP, the IV is ZERO (IV cannot be negative!).

Think “Call ME Up” (i.e. Market - Exercise)

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33
Q

What to know about a call?
-Gives the right to…
-Investors who buy them are (bullish/bearish)?
-Call writers are (bullish/bearish)?

A

-Gives the right to Buy specific # of shares at a specific price for a specific period of time.

-Investors who buy them are bullish.

-Call writers are bearish.

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34
Q

Difference between a covered call and a naked call?

A

For a covered call, the stock is already owned by the call writer.

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35
Q

What to know about a put?
-Gives the right to…
-Investors who buy them are (bullish/bearish).
-Put writers are (bullish/bearish).

A

-Gives the right to sell specific # of shares at a specific price for a specific period of time.

-Investors who buy them are bearish.

-Put writers are bullish on the price of the underlying stock.

Think “Put EM Down” (i.e. Exercise - Market)

36
Q

Formula for Intrinsic Value (IV) of a Put

A

IV= EP-MP

where MP is Market Price and EP is Exercise Price

NOTE: if MP is greater than EP, the IV is ZERO (IV cannot be negative!).

37
Q

What is a protective put?

A

Buying/owning a stock AND buying/owning a put for the same stock. The put protects against a decline in the value of the stock.

38
Q

What is a straddle, and when would someone buy one?

A

A straddle or combination (buying a put and a call) is appropriate when someone feels that there will be movement (in one direction or another) in the price of the underlying security, but they aren’t sure in which direction.

The buyer will profit as long as either side goes into the money at an amount greater than the combined premium for the put and call.

39
Q

The Black Scholes Option Valuation Model uses what 5 variables to value the option of a non-dividend-paying stock?

A

-price of underlying stock
-exercise price of option
-time remaining until option expires
-interest rate
-volatility of underlying stock

NOTE: all of these variables have a direct (up) relationship for calls except exercise price (inverse).

40
Q

Taxation of Call Options
-At time of purchase
-To the writer (due to lapse; due to exercise)
-To the holder

A

-At time of purchase: nondeductible capital expenditure

-To the writer (due to lapse): premium received is short-term gain

-To the writer (due to exercise): premium received is added to sale price (LTCG if underlying security held more than 12 months; otherwise STCG)

HINT: Write love letters and Exercise are two things needed for a Long Term relationship!

-To the holder: if option is not exercised, it is considered sold and produces a ST loss

41
Q

Differences between warrants and calls: warrants are…
-issued by…
-have maturities of…
-have what kind of terms?

A

-issued by corporations (calls are by individuals or exchanges)

-have maturities of several years (calls generally expire in 9 months)

-have what kind of terms? Non-standardized (calls are standardized)

42
Q

Fur futures contracts, think in the following terms:
-Long Position wants to _____ the commodity/financial.
-Short Position wants to _____ the commodity/financial.

A

-Long Position wants to BUY the commodity/financial.
-Short Position wants to SELL the commodity/financial.

43
Q

Definition of an accredited investor:
-Net worth of _____
-One person with annual earned income of _____ or a couple with a joint earned income of _____.

A

-Net worth of $1 million (excluding primary residence)

-One person with annual earned income of $200,000 or a couple with a joint earned income of $300,000.

HINT: Remember the 1-2-3 test…$1 million-$200k-$300k

44
Q

Private Placements
-considered a public offering?
-exempt from registration?
-can be sold to a max of _____ non-accredited investors and _____ accredited investors.
-is disclosure required?

A

-considered a public offering? NO
-exempt from registration? YES
-can be sold to a max of 35 non-accredited investors and unlimited number of accredited investors.
-is disclosure required? YES

45
Q

What type of risk is diversifiable?

A

Unsystematic Risk

46
Q

What type of risk is non-diversifiable, inescapable, cannot be minimized by owning more securities, and is part of the overall market?

A

Systematic Risk

47
Q

Components of Systematic Risk (HINT: they can be tested, or PRIMED)

A

Purchasing Power Risk (aka inflation risk)
Reinvestment Rate Risk
Interest Rate Risk (#1 for bonds)
Market Risk
Exchange Rate Risk
Default Risk (aka credit risk)

48
Q

What type of risk is due to a loss of power through inflation?

A

Purchasing Power Risk

49
Q

Which risk deals with investing at a lower interest rate than the original investment instrument?

A

Re-investment risk

50
Q

Which risk deals with the potential fall of the market value of fixed income securities?

A

Interest Rate Risk
(i.e. rise in interest rates causes market value of bonds to fall)

51
Q

Which risk deals with the potential changes in the value of currencies?

A

Exchange Rate Risk

52
Q

_____ risk is represented by standard deviation, whereas _____ risk is represented by beta.

A

Total Risk: represented by standard deviation; measures variability of returns for a nondiversified portfolio

Systematic Risk: represented by beta; measures volatility of returns in a diversified portfolio.

53
Q

Standard Deviation vs Beta

A

Std Dev:
-measures variability of returns
-used in nondiversified p’folio
-measure of total risk

Beta:
-measures volatility of returns
-used in diversified p’folio
-measure of systematic risk

54
Q

What is the difference between liquidity and marketability?
-Liquidity describes _____ and _____.
-Marketability describes _____.

A

Liquidity: speed and stability
Marketability: speed only

55
Q

Devaluation vs Revaluation

A

Devaluation: lowering of value of currency relative to currencies of other nations (i.e. takes more of US currency to buy another currency)

Revaluation: increase in currency’s value relative to currencies of other nations (i.e. takes less of US currency to buy another currency)

NOTE: currency price moves in the opposite direction of what these words imply.

56
Q

Normal vs. Lognormal Distribution
-Which is symmetrical?
-Which is for values that don’t fall below zero?
-Which is for period returns?
-Which is for ending portfolio value?

A

Symmetrical: NORMAL

Doesn’t fall below zero: LOGNORMAL

Period Returns (can be below zero): NORMAL

End P’folio Value: LOGNORMAL

57
Q

Correlation Coefficient:

-Falls between _____ and _____.
-_____ represents max risk.
-_____ represents the risk has been completely eliminated.

A

Correlation Coefficient:

Falls between -1.0 and +1.0.

(+1.0) represents max risk.

(-1.0) represents the risk has been completely eliminated.

58
Q

What does standard deviation reveal?

A

The absolute measure of the variability of results around the average/mean of those results.

59
Q

What is a Z score for standard deviation, and how is it used?

A

Z= # of standard deviations away from the mean

Z=1 (1 std deviation away from mean in either direction)

Z=1 (68% of time)
Z=2 (95% of time)
Z=3 (99% of time)

60
Q

What does beta reveal?

A

The measure of volatility of a particular security’s (or portfolio’s) rate of return or price relative to the volatility of the market as a whole.

Remember: beta can be negative!

61
Q

Assets are marketable if they can be bought or sold; they are not marketable if they must be redeemed through the issuer rather than through other investors.

A

Examples of Marketable: REITs, closed-end funds, ETFs, brokered CDs

Examples of Redeemable: savings, checking, money markets, mutual funds

62
Q

Bond Duration Definition

A

The PV of the cash flows are used as the weights in calculating the weighted average maturity.

Enables investors to compart price volatility of bonds with equal coupons but different terms.

63
Q

Hint for solving for Bond Duration on the exam…

A

Don’t pick the maturity or the answer closest to it; pick the next lowest answer (Especially if the number of years of cash flow is higher).

Exception: If the cash flow period (in years) is lower (ex: 2 years), the duration should be closer to the bond maturity.

64
Q

Factors affecting bond duration:
-Current Yield (interest)
-Annual Coupon (interest)
-Years to Maturity (TOP)

How is duration related to each? Use the hints above

A

Factors affecting bond duration:
-Current Yield (INterest): duration is INversely related to YTM
-Annual Coupon (INterest): duration is INversely related to coupon rate
-Years to Maturity (TOP): time is on TOP…P for positively related.

65
Q

Bond Immunization:
-Used as a _____ investment strategy.
-Sets the _____ of the portfolio equal to a pre-selected time horizon.
-Goal is to protect the bond portfolio from _____ and _____.

A

Passive Strategy

Duration

Protect from interest rate fluctuations and reinvestment rate risk.

66
Q

Zero Coupon Bonds
-Duration = ?
-What will their prices do compared to coupon bonds with the same maturities?

A

-Duration = Maturities

-What will their prices do compared to coupon bonds with the same maturities? Fluctuate more.

67
Q

If interest rates are expected to rise, (shorten/lengthen) duration. If interest rates are expected to fall, (shorten/lengthen) duration

A

Rise: shorten (UPS- when rising UP, Shorten)

Fall: lengthen (FALLEN- when FALLing, LENgthen)

68
Q

Current Market Price Formula

A

Current Market Price = Earnings x P/E ratio

69
Q

ROE Formula

A

ROE= Earnings avail. for common (EPS) / Common Equity (net worth or book value)

70
Q

Arbitrage Pricing Theory
-Focuses on _____ or _____
-If a factor is zero, it has _____ impact on the return.

A

unexpected or unanticipated factors

no

71
Q

The farther the duration is from the goal, the (more/less) interest rate risk is present.

A

More

72
Q

Efficient Frontier & Optimal Portfolio

Each investor has a set of indifference curves (representing risk tolerance). The point where the indifference curve is _____ to the efficient frontier is the investor’s optimal portfolio.

Risk averse: indifference curve is _____

Less Risk Averse: indifference curve is _____

A

Tangent

Very steep

Relatively flat

73
Q

Capital Asset Pricing Model (CAPM)

-Attempts to determine what return a customer should demand for the level of risk they are taking.

-Lays foundation that more risk should equal more reward.

A

Capital Asset Pricing Model (CAPM)
(continued)

Capital Market Line (CML): Macro Level- Relationship between risk and return on a portfolio.

Security Market Line (SML): Micro Level- Relationship for an individual asset.

74
Q

Security Market Line Formula
(aka required rate of return)

r=rf + (rm-rf)*B, where

(rm-rf)= _____ and

(rm-rf)*B = _____

A

(rm-rf)= market risk premium

(rm-rf)*B = stock risk premium

75
Q

Efficient Market Hypothesis:

-Security pricing reflects _____
-Day-to-day prices will follow a _____ over time
-Favors a _____ investment strategy

A

-Security pricing reflects all known info
-Day-to-day prices will follow a “random walk” over time
-Favors a passive investment strategy

76
Q

Three Forms of EMH

A

Strong Form: All public and private info is reflected in market; fundamental nor tech analysis will produce superior results

Semi-Strong Form: all public info is reflected in market; only inside info may produce superior results

Weak Form: historical price data is reflected in market; fundamental analysis may produce superior results

77
Q

Fundamental vs. Technical Analysis

A

Fundamental: Financials and other company info (such as operating results)
(Hint: F=Financials)

Technical: various forces at work in the marketplace and their effect on stock prices
(Hint: T=price Trends)

78
Q

Tax Implication of Sale of Mutual Fund Shares

Basis of mutual funds may be determined by three methods:

A

FIFO: First In First Out

Specific Shares: the seller selects which shares

Average Cost Method: Divide total cost of shares by number of shares held

79
Q

Definitions:
Ex-Dividend Date
Date of Record

A

Ex-Dividend Date: Usually 1-2 days before the date of record; this is when an investor who purchases the stock will not receive the dividend.

Date of Record: The date on which the investor must be a registered shareholder to receive the dividend.

The stock usually must be purchased 2 days before the date of record.

80
Q

Wash Sale: no loss deduction is allowed if sale is within _____ days before and _____ days after the sale of substantially identical securities.

Penalty: How is the basis adjusted?

A

30 days before and 30 days after the sale

Penalty: basis is increased by the amount of the disallowed loss

81
Q

Sharpe Ratio:
-Risk is measured in terms of _____
-Contains what kind(s) of risk?
-Look for what in R-squared?

A

-Risk: standard deviation
-Contains: systematic and unsystematic
-Look for low R-squared

82
Q

Treynor Ratio:
-Risk is measured in terms of _____
-Contains what kind(s) of risk?
-Look for what in R-squared?

A

-Risk: Beta
-Contains: systematic
-Look for high R-squared (above 60)

83
Q

Jensen Ratio
-also known as _____
-Risk is measured in terms of _____
-Contains what kind(s) of risk?
-Look for what in R-squared?
-Measures the contribution of _____

A

-aka Alpha
-Risk: Beta
-Contains: systematic
-Look for high R-squared (above 60)
-contribution of portfolio manager

84
Q

What is R-squared?

A

Square of the correlation coefficient

Represents the % of a funds movements that are explained by movements in the S&P 500.

85
Q

Dollar-Weighted Returns (IRR) vs. Time-Weighted Returns

Which allows for manager-to-manager comparisons?

Which allows for comparing absolute dollar amounts with financial goals?

A

Comparing managers:
TWR (uses percentages)

Comparing dollar amounts:
DWR/IRR (uses cash flow)

CFP Exam Prep (11 decks)

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