Investment Planning (17%) Flashcards

Question 1

Q

What is Unsystematic Risk?

Answer

A

Known as diversifiable risk, may alslo be referred to a non-systematic risk.

Business Risk - refers to the nature of the firm’s operations (i.e., possibility of loss due to new technology)
Financial Risk - Refers to how the firm finances its assets (i.e., the possibility of loss due to heavy debt financing)

Question 2

Q

What is Systematic Risk?

Answer

A

Also known as non-diversifiable risk. This part of risk is inescapable because no matter how well an investor diversifies, the risk of the overall market cannot be avoided.

Beta is measure of systematic risk or volatility of the market. If the beta is 1.2 then your portfolio has 20% more risk/volatility than the market. Systematic risk can be further defined by measuring the R-squared. You get to R-squared by squaring the correlation of a stock/portfolio relative to its benchmark. R-squared equals systematic risk.

Ex: The fund has a correlation of 0.87 with the Russell 2000, and squaring the correlation would give us an R-squared of 0.76, meaning there is 76% systematic risk and 24% unsystematic risk.

Total Risk is measured by Standard Deviation or variability of returns from the mean.

Question 3

Q

What are the Types of Systematic Risk?

Answer

A

Purchasing Power Risk - Loss of purchacing power through inflation.
Reinvestment Risk - Risk that proceeds available for reinvestment must be reinvested at a lower interest rate than the instrument that generated the proceeds.
Interest Rate Risk - The risk that a change in interest rates will cause the market value of the fixed income security to fall.
Market Risk - Risk of the overall market
Exchange Rate Risk - Risk associated with changed in the value of the currency.

Study Hint

Remember P.R.I.M.E.

Question 4

Q

FDIC Insured Amounts

(per bank/per type of account)

Answer

A

Individual: $250k

Joint: $250K

Trust (per beneficiary): $250k

IRA/Keogh: $250k

Question 5

Q

The Yield Ladder

Answer

A

Discounted Bonds

^{(Yields Higher than coupon)}

Yield to Call
Yield to Maturity
Current Yield
Nominal Yield (Annual Coupon Rate)
____________________
Current Yield
Yield to Maturity
Yield to Call
Yields lower than coupon
Premium Bonds

Premium Bonds

^{(yields lower than coupon)}

Question 6

Q

What are the provisions of EE Bonds?

Answer

A

Non-marketable, non-transferrable, can’t be used for collateral
Sold at face value
Interest rate based on 10 yr Treasury note yields
Fixed interest rate that is in effect at the time of purchase
Subject to federal taxation when redeemed, unless used as education bonds
Not subject to state or local taxes

Question 7

Q

What are the provisions of I bonds?

Answer

A

Non-marketable, non-transferrable, can’t be used for collateral
Sold at face value
Interest rate is composed of two parts
1. A fixed base rate (remains the same for the life of the bond)
2. An inflation adjustment (adjusted every 6 months)
Subject to federal taxation when redeemed (unless used as education bonds)
Not subject to state or local taxation

Question 8

Q

What are the Types of Municipal Securities?

Answer

A

General Obligation Bonds: Backed by the full faith, credit and taxing power of the issuer. GO Bonds ae generally considered the safest types of municipal credit.
Revenue Bonds: Backed by a specific sources of revenue to which the full faith and credit of the issuer is NOT pledged. Because revenue bonds are backed by a single source of funds (like toll roads, hospitals, power plants, etc.), they have a greater credit risk than GO Bonds. As such, they trade at higher yields.
Insured Municipal Bonds: The insurers pay timely interest and principal when the issuer is in default. Municipal bond insurers are AMBAC and MBIA.

Question 9

Q

What do Indenture Agreement Cover?

Answer

A

Form of bond
Amount of Issue
Property Pledged
Protective covenant, including any provision for a sinking fund
Working capital and current ratio
Redemption Rights

Question 10

Q

What are the Risks of Corporate and Municipal Bonds?

Answer

A

Default: A creditor may seize the collateral and sell it to recoup the principal
Reinvestment: As payments are received from an investment, interest rates may fall. When the funds are reinvested the investor receives a lower yield.
Interest Rate: Rising interest rates may cause bond prices to fall
Purchasing Power: Inflation may lower the value of bond interest payments and principal repayment, thereby forcing bond prices to fall.

Study Hint

Remember: D.R.I.P.

Question 11

Q

What are the Risks of Government Bonds?

Answer

A

RIP only! No default or credit risk.

Question 12

Q

What are the market values to define

Market Capitalizations of Companies?

Answer

A

Large: > $10 billion
Mid: $2-10 billion
Small: < $2 billion
Micro: < $300 million

Question 13

Q

American Depository Receipt (ADR)

Answer

A

Prices of ADRs quoted in US dollars
Dividends paid in US dollars
Dividends declared in foreign currency

Attain diversification and risk reduction due to lower correlation of foreign securities with US securities.

Question 14

Q

What is the NOI calculation for

Improved Land/Real Estate?

Answer

A

Improved land is normally income producing. Income properties include residential rental, commercial and industrial properties. The intrinsic value of a real estate property can be computed using a net operating income (NOI) calculation.

Gross Rental Receipts

+ Non-rental income (laundry, etc.)

Potential Gross Income (PGI)

Vacancy and collection losses

- Operating Expenses (excludes interest and depreciation)

= Net Operating Income (NOI)

Question 15

Q

What are General Definitions for Options?

Answer

A

Intrinsic Value is the minimum price the option will command as an option. It is the difference betwen the market price and exercise price of the stock.
Exercise Price (strike is the price at which the stock can be purchased or sold on exercise of the 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 intrinsic value
Time Premium is the amount the market prices of an option exceeds its intrinsic value.

Study Hint

IV + TV = Premium

Question 16

Q

What is the Taxabilty of Call Options?

Answer

A

At the time of purchase: non-deductible capital expenditure

To the writer due to lapse: Premium paid is a short-term gain
To the writer due to exercise: Premium paid is added to sale price (can be long term gain if underlying security was held more than 12 months, otherwise short term). Covered Call.
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.

Question 17

Q

Define Hedging Strategies - Straddles, Collar,

Protective Put

Answer

A

Straddle: Buying a put and buying a call - the buyer does NOT own the stock

Collar: Selling a call (out-of-the-money) at one strike price and buying a put at a lower strike price; investor OWNS the stock

Protective Put: Buying a stock (or already owning it) and a put for the stock serving as insurance against the decline in the underlying stock. (Hint: A good answer for the exam.)

Question 18

Q

Compare Warrants vs. Call Options

Answer

A

Warrants are issued by corporations, whereas Calls are issued by individuals.
Warrants typically have maturities of several years.
Warrant terms are not standardized. Call options are standardized.

Question 19

Q

What are the Positions of Futures Contracts?

Answer

A

Long Commodity Position - If a farmer is long a commodity (for example, corn) he needs a short hedge and will sell a futures contract.
Short Commodity Position: If Kellogs is short a commodity (for example, corn), they need a long hedge and will buy a futures contract.

Question 20

Q

Compare Reg D Accredited vs. Non-accredited Investors

Answer

A

Accredited (Unlimited)

Net worth of $1 million or
Individual with income of $200,000 or
Couple with income of $300,000

Non-Accredited

Issue sold to a maximum of 35 investors
Must use a purchaser representative if not “sophisticated”

Question 21

Q

Coefficient of Determination

R²

Answer

A

The square of the correlation coefficient measuring 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 that are explained by the movements in the S&P500. Index funds/diversified funds based on the S&P500 will have R² of very close to 100%, while sector funds (not diversified) will have very low R² (typically 5% - 25%).

Question 22

Q

Risk Level Quantification

Compare Standard Deviation vs. Beta

Answer

A

Standard Deviation: Measures variability of returns used in a non-diversified portfolio and is a measure of total risk (Systematic Risk + Unsystematic Risk = Standard Deviation).
Beta: An index of volatility used in a diversified portolio and is a measure of systematic risk.

Question 23

Q

Geometric Return

vs.

Internal Rate of Return (IRR)

Answer

A

Geometric Return or Time-Weighted Return - Evaluates the performance of a portfolio manager.

IRR or Dollar Weighted Return - Compares absolute dollar amounts.

Question 24

Q

“Real” vs. Nominal Rate of Returns

Answer

A

Real: The inflation adjusted interest rate

Nominal: Actual returns not adjusted for inflation.

The “real” rate is defined as the nominal rate of return adjusted for inflation.

Question 25

Q

Define Holding Period Return (HPR)

Answer

A

The total return (income plus price appreciation and dividends less margin interest) over the entire period divided by the out of pocket cost of the investment.

Question 26

Q

Taxable Equivalent Yield (TEY)

Answer

A

To make the returns on municipal bonds comparable to those of taxable bonds, the TEY can be calculated.

TEY = Tax Exempt Yield / (1-Marginal Tax Rate)

OR

TEY x (1-Marginal Tax Rate) = Tax Exempt Yield

Question 27

Q

Duration

(Principles to Remember)

Answer

A

First thing to do is to think if there were two bonds with similar varibales and then the variable below is different. How would the duration react.

Years to Maturity (Remember duration and maturity are positively related)

Annual Coupon (Remember duration is inversely related to coupon rate)

YTM, the current yield on comparative bonds (duration is inversely related)

How to Remember: Coupon and yield are interest rates - inversely related.

Ex: A bond’s coupon rate is a key factor in calculation duration. If we have two bonds that are identical with the exception on their coupon rates, the bond with the higher coupon rate will pay back its original costs faster than the bond with a lower yield. The higher the coupon rate, the lower the duration, and the lower the interest rate risk so it has an inverse relationship.

Question 28

Q

Zero Coupon Bonds

Answer

A

Duration equal to Maturity
No coupon interest, yet produces “phantom” income
No reinvestment rate risk
Sold at deep discounts to par
Fluctuate more than coupon bond with the same maturities

Question 29

Q

Rules for using Duration to Manage Bond Portfolios

Answer

A

If interest rates are expected to rise, shorten duration. (interest rates up, shorten duration. Remember: UPS - UP for up, and S for shorten.)
If interest rates are expected to fall, lengthen duration. Buy low coupon bonds with long maturities. Interest rates fall → lengthen duration. Remember: FALLEN - FAL for fall and LEN for Lengthen.

Question 30

Q

Conclusions to Fluctuations in Bond Prices

Answer

A

The smaller the coupon, the greater the relative price fluctuation
The longer the term to maturity, the greater the price fluctuation
The lower the market interest rate, the greater the relative price fluctuation

Question 31

Q

Define Convexity

Answer

A

The degree which duration changes as the yield-to-maturity (YTM) changes.
Largest for low coupon bonds, long-maturity bonds and low-YTM bonds
allows to improve the duration approximation for bond price changes.

Question 32

Q

What is Return on Equity (ROE)

Answer

A

ROE = Earnings Available for Common (EPS)

Common Equity (net worth or book value)

Question 33

Q

How to Calculate Dividend Payout Ratio

Answer

A

Dividend Payout Ratio =

Common Dividends Paid

Earnings Available for Common (EPS)

Question 34

Q

What are three types of

Efficient Market Hypothesis (EMH)

Answer

A

Strong Form: Asserts that stock prices fully reflect all information, public and private.

Not even access to inside info can be expected to result in superior investment performance over time.
Neither fundamental analysis nor technical analysis can produce superior results over time on a risk-adjusted basis.

Semi-strong form: Asserts that all publicly known information is reflected in stock prices.

Neither technical analysis nor fundamental analysis can produce superior results over time on a risk-adjusted basis.
Only an investor with access to inside information may consistently achieve superior results (but such access is illegal)

Weak form: Suggests that historical price data is already reflected in current stock prices and is of no value in predicting future price changes.

Technical analysis will not produce superior results.
Fundamental Analysis may produce superior results.

Question 35

Q

Types of Indexes / Benchmarks

Answer

A

Dow Jones: 30 industrial stocks, price weighted
S&P 500: broader measure of NYSE activity, value weighted
Russell 2000: 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.
Value Line: ±1700 stocks, equally weighted
NASDAQ: Broadest measure of OTC trading, value weighted
Europe, Australia and Far East (EAFE): Equity performance of the major foreign markets, value weighted.
Lehman Brothers Aggregate Bond: More than 5000 US Government, corporate and mortgage backed and asset backed bonds.

Question 36

Q

Tax Basis of a Mutual Fund

Answer

A

First-in, First-out method treats shares acquired first as being sold first.
Specific ID requires the seller to identify the shares of the fund that are sold. Specific ID allows the investor to create gain, neutralize gain or create a loss (Most flexible).
Average Cost allows the investor to divide the total cost of all shares held by the number of shares sheld.

Question 37

Q

Steps to Risk-Adjusted Measures of Performance

(Sharpe)

Answer

A

Step 1 - Look for a low R² (less than 60), or a non-diversified portfolio.

Step 2 - Look for the highest Sharpe number.

Question 38

Q

Steps to Risk Adjusted Measures of Performance

Jensen (Alpha) / Treynor

Answer

A

Step 1 - Look for high R² (60+) or a diversified portfolio.

Step 2 - Look for the highest positive Alpha. If no Alpha is given, then look for the highest Treynor.

Question 39

Q

What is a Margin (Maintenance) Call?

Answer

A

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 it’s 30%, take 2/3 and then choose the next highest number.

Question 40

Q

Examples of Passive Investment Strategies

Answer

A

Buy & Hold (EMH)
Dollar Cost Averaging
Index Investing
Strategic Asset Allocation (revised every few years)

Question 41

Q

Examples of Active Investment Strategies

Answer

A

Market Timing
Tactical Asset Allocation
Technical Analysis

Question 42

Q

Arbitrage Pricing Theory

(APT) Keys

Answer

A

Unexpected Inflation
Unexpected changes in industrial production
Unanticipated shifts in risk premium
Unanticipated changes in structure of yields.

Question 43

Q

Portfolio construction using the CAPM

Answer

A

Portfolio Construction:

When constructing a portfolio so that the portfolio standard deviation is minimized, investors seek to assemble a portfolio of securities that have low correlation coefficients with each other.
When using the CAPM formula to determine the required return for an individual security, investors should prefer that the security have a high correlation coefficient with the market against which it is measured.

The reason is that the security’s return is a function of the market’s return.
For beta to accurately predict the security’s risk premium there must be a strong relationship between the security’s price movements and the market’s price movements (the benchmark which it is being compared to).
If the relationship is not strong, then the required return computed using the CAPM formula will not fall on the SML. It will be above or below the line, causing an error in the estimated return.

Question 44

Q

What is Sharpe Ratio?

Relative measure of risk (must be used in comparing one fund’s risk-adjusted return to another.

Question 45

Q

What is Treynor?

Question 46

Q

What is Alpha?

Absolute measure of risk-adjusted performance

Answer

A

The excess return of the manager over the portfolio benchmark. Alpha is th Return of the Portfolio - CAPM

Question 47

Q

What is Beta?

Question 48

Q

What is Beta β?

Answer

A

Beta measures systematic risk. Beta measures a security’s or portfolio’s performance (asset’s risk and return) in relation to the movements in the market. Beta is a relative measure used for comparison and does not show a security’s individual behavior.

A beta value of 1 show that the security is performing in line with the market’s performance and a beta of less than 1 show that security’s performance is less volatile than the market. A beta of more than 1 show that a security’s performance more volatile than the benchmark.

The formula for beta has been recently added to the CFP Certification.

Examination’s formula sheet:

Acronym to remember it: “S_imR_im.” Beta is calculated by taking the standard deviation of the individual asset (S_i) divided by the standard deviation of the market (S_m) and multiplying by the correlation coefficient between the two (R_im)—remember that “R” stands for correlation coefficient (“ρ ” in the formula).

Keep ρ & β because they are not in the Greek letter options in Brainscape.

Question 49

Q

Beta and Coefficients?

Answer

A

Measures the volatility of a stock (or portfolio) relative to the market (a benchmark), so the greater the correlation the more accurate beta becomes.
Since R-squared measures systematic risk, it can be used to determine beta reliability, generally you are looking for an R-squared of 70 or higher in order for beta to be considered reliable.

Question 50

Q

Testing Hierarchy of BATS

Answer

A

Beta - Make sure Beta is reliability (if R-squared is given, need 0.70 or higher)
Alpha - If Beta is reliable, then use alpha as first choice (since it is an absolute value)
Treynor - If Alpha is not available, then use Treynor
Sharpe - If these are not available or if beta is not reliable (R² below 70) use Sharpe.

Question 51

Q

What are the three Monetary Policy Tools by the Fed?

Answer

A

Open Market Operations
Discount Rate Changes
Reserve Requirement Changes

Question 52

Q

What are Expansionary Monetary Policy Tools?

Answer

A

Open Market Operations - Purchase Government Securities

Fed creates dollars to buy securities on the open market
Dollares transferred from the Fed to the Public and Banks

Discount Rate - Lower Discount Rate

Encourages banks to borrow from the Fed to lend to their customers

Reserve Requirements - Lower Reserve Requirements

Allows banks to expand lending

Question 53

Q

What are Contractionary Monetary Policies?

Answer

A

Open Market Operations - Sell Government Securities

Fed sells securities on the open market
Dollars transferred from the Public and Banks to the Fed

Discount Rate - Raise Discount Rate

Discourages banks to borrow from the Fed to lend to their customers

Reserve Requirements - Raise Reserve Requirements

Discourages banks from expand lending

Question 54

Q

What is the formula for measuring GDP?

Answer

A

The GDP equation is GDP = C + I + G + NE (consumption, investment, government spending, and net exports).

Question 55

Q

What is Kurtosis?

Answer

A

Kurtosis is the characteristics of a bell cureve that has lots of returns clustered around the mean (lots of small surprises) but some extremely large positive or negative returns (few large surprises)

Question 56

Q

What is skewness?

Answer

A

Skewness represented by a bell curve that looks off-center, with flat or skinny tails at on or both ends. A positively skewed distribution has a large hump to the left and a long right tail; a negatively skewed distribution has a large hump to the right and a long left tail. Investment reuturns generally are postitively skewed.

Question 57

Q

Covariance, Correlation Coefficient and Coefficient of Determination Pyramid.

Answer

A

Covaraiance

Can be any number

Correlation Coefficient or (R)

Between -1 and +1

Coefficient of Determinatin or (R-squared)

Found by squaring the Correlation Coefficient

Question 58

Q

What is the Coefficient of Variation Formula?

Answer

A

CV = Standard Deviation / Mean or CV = σ / x

Question 59

Q

Coefficient of Variation

Answer

A

Coefficient of Variation: Hint is to choose the lower number

A. The coefficient of variation is a way to compare the relative variation of two or more securities.

The security with the lowest CV generally should be chosen when given a question that requires choosing from two or more securities.

2. The CV communicates the extent to which an investor can depend on the security being able to achieve its expected mean return. The lower the CV, the greater the reliability.

The CV can be considered another method of computing a risk-adjusted return, since both risk and return measures are used in the equation.
The CV equation is not given on the CFP Certification Examination formula sheet. You must memorize the formula.
a. The formula for coefficient of variation is as follows:

CV = σ₁ / x₁ or S₁/ Mean₁

To Solve a question on the Test:

b. For any of the formulas, use simple numbers and change one of the variables if you forget which way is preferable, example with the CV:
(1) Mean return is 10% for both investments, one has a standard

deviation of 10 (Choice A), the other 20 (Choice B), so

(2) 10/10 = 1, and 20/10 = 2, so you would choose the lower

number. Both give you the same return, but your chances of

achieving that return are greater with Choice A—so with CV

choose the lower number.

Example. Asset A has a mean return of 10% and a standard deviation of 6%. Asset B has a mean return of 12% and a standard deviation of 9%.

Which one provides the least amount of risk per unit of return? Asset A has a CV of 0.60 (6/10). Asset B has a CV of 0.75 (9/12).

Question 60

Q

Covariance and Correlation Coefficient

Answer

A

They communicate the same informaiton. They both measure the strength of the relationship between the returns of two securities.

The only reason Covariance may be needed is as an input into the formula for Standard Deviation of a portfolio.

You may be given the correlation coefficient and the standard deviation of two assets and then be asked to compute the covariance using the following formula COV_ij= ρ_ijσ_iσ_jand you would divide each side by σ_iσ_j to get COV_ij / σ_iσ_j= ρ_{ij or}R_ij

Question 61

Q

Similarities of Covariance and Correlation Coefficient?

Answer

A

Both measures only linear relationship between two variables, i.e. when the correlation coefficient is zero, covariance is also zero. Further, the two measures are unaffected by the change in location.

Question 62

Q

Differences of Covariance and Correlation Coefficient?

Answer

A

A measure used to indicate the extent to which two random variables change in tandem is known as covariance. A measure used to represent how strongly two random variables are related known as correlation.
Covariance is nothing but a measure of correlation. On the contrary, correlation refers to the scaled form of covariance.
The value of correlation takes place between -1 and +1. Conversely, the value of covariance lies between -∞ and +∞.
Covariance is affected by the change in scale, i.e. if all the value of one variable is multiplied by a constant and all the value of another variable are multiplied, by a similar or different constant, then the covariance is changed. As against this, correlation is not influenced by the change in scale.
Correlation is dimensionless, i.e. it is a unit-free measure of the relationship between variables. Unlike covariance, where the value is obtained by the product of the units of the two variables.

Question 63

Q

Definition of Covariance?

Answer

A

Covariance is a statistical term, defined as a systematic relationship between a pair of random variables wherein a change in one variable reciprocated by an equivalent change in another variable.

Covariance can take any value between -∞ to +∞, wherein the negative value is an indicator of negative relationship whereas a positive value represents the positive relationship. Further, it ascertains the linear relationship between variables. Therefore, when the value is zero, it indicates no relationship. In addition to this, when all the observations of the either variable are same, the covariance will be zero.

In Covariance, when we change the unit of observation on any or both the two variables, then there is no change in the strength of the relationship between two variables but the value of covariance is changed.

Question 64

Q

Definition of Correlation Coefficient?

Answer

A

Correlation is described as a measure in statistics, which determines the degree to which two or more random variables move in tandem. During the study of two variables, if it has been observed that the movement in one variable, is reciprocated by an equivalent movement another variable, in some way or the other, then the variables are said to be correlated.

Correlation is of two types, i.e. positive correlation or negative correlation. The variables are said to be positively or directly correlated when the two variables move in the same direction. On the contrary, when the two variables move in opposite direction, the correlation is negative or inverse.

The value of correlation lies between -1 to +1, wherein values close to +1 represents strong positive correlation and values close to -1 is an indicator of strong negative correlation. There are four measures of correlation:

Scatter diagram
Product-moment correlation coefficient
Rank correlation coefficient
Coefficient of concurrent deviations

Answer 62

A

The Coefficient of Determination is the Correlation Coefficient squared or R²

Answer 63

A

Coefficient of determination is the square of the correlation coefficient; hence the term “R²” or “R-squared.”

The coefficient of determination (R- squared) generally is used to show the percentage of change of an individual security or mutual fund that can be attributed to the market index against which the R² is measured.
“R-squared” gives you the amount of systematic risk, and the balance is unsystematic risk.
You should be prepared for questions that may give you “R” when you need “R-squared” and vice versa, also be prepared for them to refer to R-squared as the coefficient of determination, not R-squared.
It is easy on your calculator to calculate one when you know the other.

Answer 64

A

Do not use the formula. Use your calculator. You can calculate the Standard Deviation and the Mean by using the Sigma Key.

Answer 65

A

A portfolio’s standard deviation cannot be computed by taking a weighted average of the standard deviations of the assets in the portfolio

Except when the correlation coefficient is a perfectly positive +1.0;
The formula must be used in all other cases.

Answer 66

A

First Enter Standard Deviation (SD or σ) asset and hit “INPUT”

Then enter Weighting of SD and hit “Σ+”

Then enter SD of next asset and hit “INPUT”

Then enter Weighting of SD and hit “Σ+”

Then keep going until all securities are entered

Then hit “shift” “6” key for answer

Answer 67

A

The standard deviations and the covariance are input using whole numbers instead of decimals when calculating.

Answer 68

A

P/E effect => low P/E outperforms high P/E stocks
Small Firm effect => small firms outperform large firms
January effect => sell in Dec and buy in Jan
Un-excellent/excellent effect => excellent firms outperform
Neglected Firm Effect => firms followed by few analysts outperform - may be extension of small firm effect
Value Line Phenomenon => Stocks ranked 1 outperform those ranked 5
Book Value / Market Value Effect => high book value to market value outperforms

Answer 69

A

The random walk theory suggests that stock price changes have the same distribution and are independent of each other, so the past movement or trend of a stock price or market cannot be used to predict its future movement. In short, this is the idea that stocks take a random and unpredictable path.

Price movements are not predictable, rather they are random.

Answer 70

A

Hint: G R I I

G DP Changes

R isk Premiums

I nterest Rates (Yield Curves)

I nflation

Answer 71

A

Beta becuase it is one security we are comparing. We use Systematic Risk not Total Risk (Systematic & Unsystematic) like CML.

The SML is the MICRO component that demonstrates the risk or return for individual stocks using Beta.

Think S from SML is S from Systematic

Answer 72

A

Standard Deviation is CML. CML is a tangent to Efficient Frontier Curve and it measures total risk, not just systematic but also unsystematic risk.

The CML is the MACRO component that determines the risk or return for efficient portfolios using standard deviation.

Answer 73

A

Ex Dividend is two days before Record Date and one business day after the trade date. Not entitled to Dividend on Ex Dividend date or after.

Must purchase stock on day before the Ex Dividend date to be eligible for dividend.

See table.

Answer 74

A

If a stock’s intrinsic value, computed using the DDM, is lower than the current market price of the stock, the stock is overvalued and either should not be purchased or should be sold.
If the intrinsic value is higher than the current market price, the stock is undervalued and should be purchased.

Answer 75

A

Zero growth: aka as dividend into perpetuity, used to value preferred stocks.

Formula is V = D_o / r

V or P₀= Value of Price at time 0

D₀ = Dividend at time 0

r = discount rate

Answer 76

A

Fair value: V = D_o (1 + g) / r - g -or- V = D₁ / r - g

Expected Return: E_r = (D₁ / P) + g

V = Intrinsic Value

D_o = Dividend Amount

r = Interest Rate or cost of capital

g = Growth

D₁ = D_o (1 + g) or Estimated value of dividend next year

E_r = Expected Return

Answer 77

A

What is r? The Required Return

Formula for r:

r_i = r_f + (r_m − r_f)β_i

r_f = risk free rate

r_m = market rate

What is g? Sustainable growth rate

Formula for g:

g = Retention Rate (RR) x Return on Equity (ROE)

Answer 78

A

Geometric Average Returns

Answer 79

A

Internal Rate of Retun (IRR)

Answer 80

A

Net present value (NPV) is the present value of future cash flows using an appropriate discount rate, and then subtracting the investment’s cost.

For example, assume a given project requires an initial capital investment of $15,000. The project is anticipated to generate revenues of $3,500, $9,400 and $15,100 in the next three years, respectively, and the company’s hurdle rate is 7%.

The present value of the anticipated income is:

$3,500 / (1 + 0.07) ^ 1) + $9,400 / (1 + 0.07) ^ 2 + $15,100 / (1 + 0.07) ^ 3, or $23,807.

The NPV of this project can be determined by simply subtracting the initial capital investment from the discounted revenue:

$23,807 - $15,000 = $8,807.

Answer 81

A

Positive NPV means:

A positive NPV means the investor will earn a return higher than the discount rate used, and the investment should be purchased

Zero NPV means:

A zero NPV means the investor will earn the same return as the discount rate used, and the investment should be purchased

Negative NPV means:

A negative NPV means the investor will earn a return lower than the discount rate used, and the investment should be rejected

Answer 82

A

liquidity (current ratio which is current assets/current liabilities)
1. quick ratio is current assets minus inventory/current liabilities
activity (inventory turnover)
profitability (EBITDA, ROE, return on capital)
1. focus on these
leverage (debt to equity)
financial statement

Answer 83

A

is imputed annually even though no cash interest payment is received.
taxable investors may want to use zeros only in tax-deferred accounts.
has interest compounded semiannually—remember to use semiannual compounding with all bonds, including zeros, unless specifically told otherwise

Answer 84

A

Treasury bills are any bills from 4 weeks to 1 year

Treasury Notes are any notes from 1 year to 10 years

Treasury Bonds are any bonds from 10 years to 30 years

Answer 85

A

A convertible bond is a type of debt security that can be converted into a predetermined amount of the underlying company’s equity at certain times during the bond’s life, usually at the discretion of the bondholder. Convertible bonds are a flexible financing option for companies and are particularly useful for companies with high risk/reward profiles.

Answer 86

A

Know how mortgage-backed securities work, including CMOs and Ginnie Maes (GNMAs).
CMOs—“A” tranche paid off first (least risky, more certainty when the principal will be repaid), “Z” tranche paid off last (most risky).
GNMAs are the only mortgage-backed security explicitly backed by the full faith and credit of the U.S. government. Due to the credit crisis, we now have the government backing Fannie Mae (FNMA) and Freddie Mac, but this is subject to change in the future.
Be comfortable with how mortgage-backed securities work, monthly payments consist of interest and can also have return of principal.

Answer 87

A

Interest rate remains fixed during term of security;
1. semiannual interest payment is based on the inflation-adjusted principal at the time the interest is paid.
Principal amount is adjusted for inflation semi-annually, but inflation adjusted principal is not paid until maturity.
1. Annual adjustment is subject to federal tax even though no cash is received (similar to zero coupon bond).
2. Annual adjustment can be up (inflation) or down (deflation), but investor will get at least par value back at maturity.
Inflation index used is the CPI–U index (all urban consumers).
Effective duration of a TIP is about half the duration of a similar maturity coupon bond.

Answer 88

A

Series I Bonds - similar to TIPS

Similarities between TIPS and I Bonds
1. Both offer protection from purchasing power risk.
2. Both have no default risk, because they are U.S. Treasury guaranteed.
3. Both reduce interest rate risk because of the inflation adjustments.
Features of Savings Bonds

Answer 89

A

Both are priced in U.S. dollars
Eurodollar bonds are sold by U.S. firms outside the U.S. (such as GE issuing a bond in London)
Yankee bonds are issued by foreign firms and sold in the U.S., (such as British Airways selling a bond in the U.S.).

Answer 90

A

They provide fixed periodic cash flow (coupons for bonds, dividends for preferred stock).
No voting power concerning the management of the company is conveyed to the holders.
There is no sharing in the net profits of the company.
Issues may be called (bonds) or redeemed (preferred stock).
Both may be convertible to common shares.
Sinking funds may be associated with each type of issue.
Holders of both take precedence over common stockholders in the event of bankruptcy.

Answer 91

A

The dividends of preferred stock are not tax deductible by the issuer.
The dividend exclusion rule available to corporations holding preferred stock of domestic corporations is applicable to preferred stock dividends but is not applicable to bond interest.
The failure of preferred stock to meet a dividend payment does not trigger corporate bankruptcy.
Accounting treatment differs.
Dividends of preferred stock are paid quarterly; interest on bonds is paid semiannually.

Answer 92

A

Invesely related

Answer 93

A

Think of the Y M C A and drop the A.

C Y = Current Yield

YTM = Yield to Maturity

YTC = Yield to Call

Next - Think of a see-saw. Put Y M C on right side of Fulcrum

If we have a bond selling at a discount then we pull the see-saw down and the it goes Y< M < C but each one is higher than the next.

If we have a bond selling at a premium, then we push the see-saw up and the goes Y > M > C, but each one is lower than the next

Answer 94

A

Inversely related like with price.

Why?

Think of starting duration at it’s fulcrum and then raising and lowering interst rates. What does that do to duration?

What happens to the fulcrum point with higher coupons? The fulcrum point will then shift to the left (meaning lower duration).

What happens to the fulcrum point with lower coupons? The fulcrum point will then shift to the right (meaning higher duration).

Answer 95

A

Directly related.

Why?

Think of starting duration at it’s fulcrum and then shortening maturities and lengthening maturities. What does that do to duration?

The shorter the maturity, the lower the duration.

The longer the maturity, the higher the duration.

Answer 96

A

Immunization is the process of matching the duration (not maturity) of a bond or a bond portfolio to the time horizon of a cash need.

a. A single zero-coupon bond with a duration (and maturity in the case of a zero) equal to the time until a child starts college immunizes against the cost of a college education.
b. A portfolio of bonds with a duration equal to the year pension payments are required to be made to retirees immunizes the pension plan against the liability due at that time.
c. Immunization offsets both interest rate risk and reinvestment rate risk.
d. For testing purposes 10-year bonds have an approximate duration of 7—this will give you a ballpark figure to work with.
e. Don’t fight this even if you do not completely understand it. For testing purposes, match duration to your time horizon; if you match maturity you will get the answer wrong.

Answer 97

A

For expected changes in rates of less than 1%, duration alone does a good job of explaining the expected change in bond price.
For changes in rates exceeding 1%, convexity must be considered.
The following graphic shows how convexity affects bond prices.
When rates fall, convexity causes the price increase to be greater than duration alone would indicate.

Answer 98

A

All I have to do is memorize one. Then all the others are opposites.

Calls are “in the money” when the Spot (Current Market Price) is greater than the Strike Price (Exercise Price)

Then they have to be “out of the money” when Strike is less than Spot.

Answer 99

A

A Short Hedge is when you are LONG the commodity.

For example, a wheat farmer (who is long wheat) would then short wheat futures as a hedge (against lower prices).

The opposite goes for a Long Hedge.

Example, a baker (who is short wheat - because he has to buy it in the open market) would then buy wheat futures as a hedge (against higher prices).

Answer 100

A

a. is used as a valuation tool in many aspects of finance beyond the pricing of exchange-traded puts and calls.
b. The variables that affect the price of an option in the Black-Scholes model are the following:
(1) The current price of the stock
(2) The time (in years) to the expiration date
(3) The standard deviation of the stock’s annual return
(4) The annual risk-free rate of interest with a term equal to the option’s expiration date
(5) The exercise price (strike price)

The value of a call option will rise with increases in each of the five factors, except exercise price.

Call Option Price Increases in Value if

Market Price = Increases

Time = Increases

Volatility = Increases

Risk-Free Rate = Increases

Exercise Price = Decreases

Answer 101

A

V = NOI / Cap Rate

Answer 102

A

Be prepared for bond questions to be presented in different ways. For example, the question may say that an investor purchased a 20-year bond five years ago. In this case, the number of years until maturity would be 15 (30 compounding periods with semi-annual compounding). Or a bond may be presented as having a call premium of 5%. So, you would take the $1,000 face amount; increase it by 5% to arrive at a call price of $1,050. Don’t let these nuances throw you.

Answer 103

A

Present Value of An Annuity Due (PVAD) is solved in BEG Mode

We are usually solving for something in the future (BEG)

Think of PVAD B or pvad b the d and b look alike.

Answer 104

A

Present Value of An Oridnary Annuity (PVAO) is solved in END Mode

We are usually solving for something in the past (END)

Think of PVOA - The O A an E for END are all vowels.

Answer 105

A

1 SD = 68%

2 SD = 95%

3 SD = 99%

Answer 106

A

Skewness is a measure of the assymmetry of a distribution. The qualitative interpretation of the skew is complicated and unintuitive. Skew does not refer to the direction the curve appears to be leaning; in fact, the opposite is true.

Negagive Skewness has a large hump to the right and a long left tail.

Positive skewness has a large hump to to left and a long tail to the right.

Answer 107

A

Kurtosis is the characteristic of a bell curve that has lots of returns clustered around the mean (lots of small surprises) but some extremely large positive or negative returns (few large surprises). So, kurtosis results in a bell curve that has a higher peak and fatter tails than a normal distribution. Many equity returns have a high degree of kurtosis.

Answer 108

A

A serial payment is a payment that accounts for inflation for each payment period. We would draw a graph showing each year payment adjusted by (Inflation/Rate -1 x 100) to illustrate this concept.

Answer 109

A

The Weak Form of the EMH argues that all new public information (earnings reports, financial statements, etc) and private information (new products, upcoming earnings, legal issues) may or may not be available to investors, and that only historical price information is. It suggests that all information is not incorporated in the current stock price. It’s used as an argument against technical analysis, and suggests that past price performance does not give predictive power on an underlying’s future price. In other words, a historical price chart can’t help predict an underlying’s future price.

Ex. Just because Transocean’s (ticker symbol RIG) stock price is at a 30 day low doesn’t mean the stock is more likely to go up or down in the future.

Fundamental Analysis ONLY works in the WEAK FORM

Answer 110

A

The Semi-Strong Form of the EMH argues that, in addition to the historical price data available in the weak form of EMH, public information about a company is available to investors and is incorporated into the current price of the stock. As information becomes publicly available, traders price the underlying immediately to reflect the new information. It’s used as an argument against fundamental analysis, and suggests that any public information does not give predictive power on an underlying’s future price. This means that performing fundamental analysis or watching the news can’t give traders a better ability to predict an underlying’s future price.

Ex. When a company releases earnings, we can watch the stock price change as the market digest the earnings information in after-hours trading.

Answer 111

A

The Strong Form of the EMH argues that, in addition to the information in the weak and semi-strong forms, even non-public insider knowledge is factored into the current price of the stock. Even if the information is not available to investors, and is only known to corporate directors, the current stock price still reflects it. This means that even knowing insider information cannot improve price prediction leading to “abnormal profit over time.”

Ex. Private information that only a company’s CEO knows, like a new equity offering or revenue numbers, is encapsulated in stock prices.

Answer 112

A

The EMH argues that stock prices incorporate relevant market information arriving at fair prices.

Weak form EMH argues that stock prices incorporate past public information. (Technical)

Semi-strong form argues that stock prices incorporate all current public information. (Technical + Fundamental)

Strong form argues that stock prices incorporate all information including private insider knowledge. (Technical + Fundemental + Insider)

Answer 113

A

When you own foreign securities, you want the home currency to decline against the foreign currency so that you can convert foreign currency into more US dollars.

Example:

For example, let’s say your foreign investment portfolio generated a 12% rate of return last year, but your home currency lost 10% of its value. In this case, your net return will be enhanced when you convert your profits to U.S. dollars, since a declining dollar makes international investments more attractive.

Answer 114

A

Mental accounting is creating different categories for assets, and treating one dollar differently from another.

Answer 115

A

Anchoring is the tendency to hold onto certain beliefs even when faced with new information that should alter those beliefs.

Answer 116

A

Confirmation bias is when investors search for and rely on information that supports their decisions, and essentially ignore information that contradicts or conflicts with their decision.

Answer 117

A

Framing is looking at how a concept is presented to an individual, which can then influence their behavior.

Answer 118

A

Endowment is valuing something that one owns more than assets that are not owned.

Answer 119

A

Self-attribution describes the tendency of individuals to take credit for their successes, and to blame others for their failures.

Answer 120

A

Recency Bias is placing too much emphasis on recent events, rather than looking at the long-term objective and time frame.

Answer 121

A

Hindsight bias is looking back in the past and believing that events that took place were more predictable than they really were.

Answer 122

A

Luxury goods tend to have elastic demands and necessities tend to have inelastic demands.

Supply and demand is inelastic if the ratio of the percentage change in quantity divided by the percentage change in price is less than one. (Necessity Goods)

Supply and demand is elastic if the ratio is greater than one. (Luxury Goods)

Answer 123

A

A Yankee bond is a bond issued by a foreign corporation in the United States, and denominated in U.S. dollars.

Answer 124

A

A Eurodollar bond is a bond issued overseas by a U.S. corporation and denominated in U.S. dollars.

Answer 125

A

With currencies in order to make money you want your currency to weaken (devaluation) and the other currency to strengthen (revaluation).

Answer 126

A

An investor who purchases a put option makes a profit only if the market price of the stock is lower than the exercise (strike) price of the option.

Until the market price drops below the strike price, the option is said to be out-of-the-money.

It is in-the-money when the market price drops below the strike price.

Answer 127

A

If you believe interest rates are going to fall, you would want to lengthen (increase) durations, and low coupon bonds have a higher (longer) duration than high coupon bonds.

this is lower coupon bonds at the same term as higher coupon bonds. Lower bonds pay back less money so the duration is longer. Higher coupon bonds pay back more money so duration is shorter. Ex: 7 year bond with 2% interest vs. 10% interest.

Answer 128

A

A market maker is a dealer who buys and sells OTC securities for his or her own account.

Answer 129

A

Equity REITs own property and receive all income from the property rentals, making them more like a stock fund.

Mortgage REITs own the mortgages used to finance RE properties, making them more like a bond fund.

Equity REITs are more volatile than mortgage REITs, and they provide more capital gain opportunity then do mortgage REITs.

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Investment Planning (17%) Flashcards

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