Investment Planning (17%) Flashcards
Money Markets
Short-Term Debt Instruments
Primary Market
New Securities issued to the public
Securities Act of 1933
Secondary Market
Previously issued securities are traded among investors (issuing company is not directly involved).
Securities Act of 1934 (also created SEC)
Exchange (NYSE) vs. OTC (Nasdaq)
IPO
Initial Public Offering
Holding Period Return (formula)
(Ending Value - Initial Value) + Income Generated / Initial Value
aka: Profit / Cost
Assumes Dividends are NOT reinvested
Time-Weighted Return (TWRR) (forumula)
Appreciation or Depreciation of a portfolio from period-to-period.
(((1+R1)(1+R2)(1+R3))1/Rn) - 1
e.g.: [(1+.2)(1-.05)(1+.1)]1/3)-1
Or
N=3, PV=-1; FV=(1+.2)(1-.05)(1+.1)
Solve for I/YR.
Dollar-Weighted Return (DWRR) (formula)
aka. Geometric Mean & Money-Weighted Return
e.g.: returns of 20%, -10%, 5%
Timing of a specific client’s cash flows.
Use Cfj function
Total Risk
Systematic Risk + Unsystematic Risk
Measured by Standard Deviation
Systematic Risk (PRIME)
Can NOT be eliminated through diversification.
Measured by Beta.
PRIME:
Purchasing Power Risk
Reinvestment Risk
Interest Rate Risk
Market Risk
Exchange Rate Risk
Unsystematic Risk
aka. Firm-Specific Risk
(BFDRS)
Can be eliminated through diversification
Business Risk
Financial Risk
Default or Credit Risk
Regulation Risk
Sovereignty Risk
Rank Investments by level of risk
Most Risky:
Options & Futures
Common Stock
Preferred Stock
Corporate Bonds
Government Bonds
CDs
T-Bills
Bond Ratings
Investment grade Moody’s Standard & Poor’s Fitch
Strongest
Aaa AAA AAA
Aa1 AA+ AA+
Aa2 AA AA
Aa3 AA- AA-
A1 A+ A+
A2 A A
A3 A- A-
Baa1 BBB+ BBB+
Baa2 BBB BBB
Baa3 BBB- BBB-
Non-investment-grade Moody’s Standard & Poor’s Fitch
Ba1 BB+ BB+
Ba2 BB BB
Ba3 BB- BB-
B1 B+ B+
B2 B B
B3 B- B-
Caa1 CCC+ CCC+
Skewness
Positively skewed means right tail (bulb to the left)
Negatively skewed means left tail (bulb to the right)
Kurtosis
A distribution is more or less peaked than normal.
Normal is Mesokurtic
Slender is Leptokurtic
Broad is Platykurtic
Efficient Market Theory (EMT)
Efficient Market Hypothesis (EMH)
Strong; Semi-Strong; Weak
Inside Information - Semi-Strong and Weak
Fundamental Analysis - Weak
Technical Analysis - None
‘Random Walk” utterly unpredictable movement of stocks, lacking any pattern that can be exploited by an investor.
Efficient Frontier
A curve identifying the optimal return given risk taken.
Uses Standard Deviation
All points on curve are equally efficient.
Below the curve is inefficient
Above the curve is impossible
Sharpe Ratio
Risk-adjusted performance of a portfolio in terms of standard deviation.
Formula: Sp = Rp - Rf / σ
Use only when R2 < 0.70
Comparative to other Sharpe Ratio calculations
Higher the Sharpe Ratio the Higher the Risk-adjusted rate of return
Treynor Ratio
Risk-adjusted performance of a portfolio manager.
Formula: Rp - Rf / β
Use when R2 > 0.70
a Relative calculation
Higher the Treynor, the higher the risk-adjusted rate of return
Jensen’s Alpha
Evaluates the benefit of a portfolio manager
R2 > 0.70
Formula: Rp - [Rf+(Rm - Rf) * β]
An absolute calculation
Alpha = 0 matches the SML
Capital Asset Pricing Model (CAPM)
Foundation for all Modern Portfolio Theory (MPT).
Formula: Rf + (Rm - Rf) * β
(Rm - Rf) = Market Risk Premium and Equity Risk Premium.
(Rm - Rf) * β = Stock Risk Premium
Calculates expected return given: I. market return and ii. Beta
Calculates Security Market Line (SML)
Quantifies investor’s required rate of return.
With CAPM (which is the expected return) you subtract from Actual Return to get Alpha.
Upward Sloping Yield Curve
Normal / Positive
Short-term rates are lower than long-term rates
Flat Yield Curve
Rates of short-term paper and long-term paper are similar
Downward Sloping Yield Curve
Inverted / Negative
Rates on short-term paper are HIGHER than the rates of longer-term paper
Intrinsic Value of Bonds
N = 2 * Years to Maturity
i = 1/2 * rate
PMT = 1/2 (due to 2x year pmts)
FV = Maturity Value
Solve for PV
Nominal Yield of a Bond
Stated or coupon yield
Current Yield of a Bond
annual income paid divided by the current market price of the bond
Duration of a Bond
Used to estimate sensitivity of a bond to changes in rates
Stated in Years.
Zero-Coupon bonds duration equals years to maturity
Higher coupon results in lower duration.
1% change in rates equals % change in bond price equal to duration
A linear estimate of sensitivity to changes in rates
Yield to Worst
Yield to lower of YTM and YTC.
It’s the appropriate yield to make an investment decision on.
Bonds
Duration
Duration Formula
Change in Portfolio / Portfolio = -D [Change in rate / 1+ YTM]
Multi-Stage Dividend Discount Model
Step 1: Calculate the end-of-year dividend for 3 years at dividend growth rate.
Step 2: Formula: V = Div from final year in step 1 * 1+interest rate growth of dividend / (r - g)
g = growth
r = req’d rate of return
Margin
Pledging securities in your brokerage account for a loan from your brokerage firm
Margin Call Formula
[(1 - Initial Margin) / (1 - Maintenance Margin)] x Purchase Price of the Stock
1-50% / 1-25% x $10
Maintenance Margin
25% - set by feds. Min rate. Firms can use higher number like 35% or more.
Stock Option Premium Intrinsic Value
Intrinsic Value for Call Options (COME) Call Option = Market Value - Exercise Price
Intrinsic Value for Put Options (POEM) Put Option = Exercise Price - Market Value
Remember, the lowest level that intrinsic value will ever be is $0!
Market Price of underlying stock
Exercise price of the option contract
Stock Option Premium Time Premium
-Risk-free rate of return
-Time to expiration
-Variability (standard deviation)
Time premium is greatest at creation of contract and approaches zero at expiration of the contract
Stock Option Intrinsic Value
Call Options and Put Options
NEVER less than zero
Call Options (COME) - Call Option = Market Value - Exercise Price
Put Options (POEM) - Exercise Price - Market Price
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 the portfolio
Naked Call Writing
Does not own the underlying stock - short the call
Writer bears UNLIMITED risk
Protective Put
Long the stock - Long the put
Used to protect a short position in the stock
Covered Put
Short the stock - Short a put
Writer uses the stock put to cover their short stock 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 same underlying stock with the same expiration date and strike price.
Used to capitalize on volatility regardless of the direction.
Spread
Involves purchasing and selling the same type of contract
Benefit from stability (i.e., minimum moves in the underlying stock’s price)
A Future’s Contract
an agreement to buy or sell a specific amount of a commodity, a currency, or a 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.
Short Hedge (futures contract)
Anyone who is long needs a short hedge.
Selling a futures contract establishes a short hedge.
Long Hedge (futures contract)
Anyone who is short needs a long hedge
Buying a futures contract establishes a long hedge
Net Present Value (NPV)
Used to evaluate cash flows associated with capital projects and capital expenditures
Use: CFo; CF1; Nj
If zero or positive - investor should take the investment b/c it will match or beat required rate of return
Internal Rate of Return (IRR)
Compare the computed rate to the required rate of return.
Calculated using TVM keys (N, PV, FV, PMT, and i%)
Wash Sales
Realize a loss on sale of a security and acquire a substantially identical security w/in 61-days.
Loss is disallowed.
Disallowed loss is added to basis of new securities purchased.
Current Ratio
Current Assets / Current Liabilities
Quick Ratio
Current Assets - Inventories / Current Liabilities
Working Capital
Current Assets - Current Liabilities
Inventory Turnover
COGS / Average Inventory
Gross Profit Margin
Gross Profit / Sales
Return on Assets (ROA)
Earnings after Tax / Total Assets
Return on Equity (ROE)
Earnings after Tax / Equity
