Investment Planning Flashcards
This is the investment banker who agrees to lead the offering process for an IPO
originating house/lead underwriter
Other securities firms that agree to assist with marketing the IPO
syndicates
This underwriting agreement provides no guarantees from the investment bankers to the company going public - they will sell as many shares as possible
best efforts agreement
In this underwriting agreement, investment bankers guarantee the company that the entire issue will be purchased. The investment bankers absorb the loss if they fail to sell the entire issue.
First commitment
This is the right to increase the size of the offering
Green shoes
This is a sale of securities to the public by insiders or other affiliated persons
Secondary offering
Agents of sellers of securities who receive a commission for executing a transaction
brokers
Principals who buy and sell securities for their own accounts
dealers
This is the market for new issues
primary market
This is the market for previously issued securities
secondary market
The number of shares that are available for trading by investors
public float
How many shares is in a round lot?
100
An order to buy or sell at the current price
market order
An order to buy or sell at a specific price
limit order
An order that is good just for the day, if not executed, it expires at the end of the day
pay order
an order that will remain in effect until either it is executed or canceled
good-til-canceled order
An order to buy or sell if the price of a stock trades at or through a set price
Stop order
When an investor borrows a stock and sells it on an exchange
short position
Who sets the initial margin requirement?
The Fed
What is the current initial margin requirement?
50%
What is the margin call formula?
(1-initial margin %)/(1-maintenance margin %) x purchase price of stock
How much does the FDIC insure per bank account?
$250,000 per owner
These are short term debt issued by the U.S. government
Treasury bills
These are unsecured short-term promisory notes issued by large corporations with maturities up to 270 days
Commercial paper
This money market instrument allows lenders and banks to negotiate terms. It involves amounts larger than $100,000.
Negotiable CDs
These are short term drafts guaranteed by a bank and used to finance international trade by guaranteeing payment to the exporter of goods
Bankers’ acceptances
These are dollar denominated time deposits (6 months or less) made at foreign banks or at foreign branches of American banks
Eurodollar CDs
How is interest income taxed?
at ordinary income tax rates
How are qualified dividends taxed?
At long term capital gains rates
How long must a security be held to classify as long term?
More than 1 year
What is the maxium tax rate for collectibles?
28%
Gains and losses are netted with
Gains and losses of a similar type (ST or LT)
If a taxpayer has short term losses and long term gains
The losses are netted with the gain. If there is a net loss, up to $3,000 loss is allowed annually. If there is a net gain, it is taxed at long term rates.
If a taxpayer has short term gains and long term losses
The losses are netted with the gains. If there is a gain, it is taxed at the marginal tax rate. If there is a loss, up to $3,000 loss is allowed to be taken annually.
If a taxpayer has short term and long term gains
They are taxed separately at their respective rates
What is the medicare contribution tax
3.8% of the lesser of net investment income or the excess of the modified AGI over a specified threshold amount
When you sell a security at a loss and buy it back within 30 days of the sale, or purchase a security within 30 days prior to the sale, this is known as
wash sale
What is the penalty for a wash sale?
The loss is disallowed. It is added to the cost basis of the shares.
What are the three goals of the Fed and the U.S. Treasury?
- Full employment
- Stable prices (low inflation)
- Economic growth
When prices are falling in absolute terms
deflation
During periods of deflation, investments should center on
very-high quality debt instruments
What are three tools the Fed has?
- Setting reserve requirements of banks
- Setting the federal funds rate and the discount rate
- Buying and selling U.S. government securities in the open market
The rate at which banks borrow money from the Fed
discount rate
Rate at which banks can borrow from each other
federal funds rate
What actions mark expasionary policy for the Fed?
- lower reserve requirement
- lower discount rate
- purchase government securities
What actions mark contractionary policy for the Fed?
- Increase reserve requirement
- increase discount rate
- sell government securities
The diversifiable component of total risk
unsystematic risk
The risk associated with the nature of the business
business risk (unsystematic)
The possibility that a debt security will be called in by its issuer prior to maturity
call risk (unsystematic)
The risk that an enterprise’s financial condition will deteriorate, resulting in a downgrading of its debt
credit risk (unsystematic)
The risk that an enterprise’s financial conditions will deteriorate to the point where it will not meet its financial obligations
default risk (unsystematic)
The risk associated with the extent to which debt has been used to finance a company’s operations
financial risk (unsystematic)
The risk that an investment does not have an active market within which to trade the investment
Marketability risk (unsystematic)
The degree of uncertainty associated with the time it takes to sell an investment with a minimum of capital loss from the current market price.
Liquidity risk (unsystematic)
The risk associated with actions and decisions of the investment manager that could adversely impact one’s investment in the fund he or she is managing.
Investment manager risk (unsystematic)
The risk associated with the uncertainty of an adverse outcome due to the interpretation of tax laws and regulations
Tax risk (unsystematic)
The uncertainty caused by the possibility of adverse political events occurring in a country.
Political risk (unsystematic)
The nondiversifiable component of total risk (expressed as beta)
Systematic risk
The risk that future inflation will cause the purchasing power of cash flow from an investment to fall
purchasing power risk (systematic)
The risk that falling interest rates will cause the cash flow from an investment to fall when the principal or interest payments of that investment are reinvested at lower rates
Reinvestment risk (systematic)
The risk that a change in interest rates, especially rising rates, will cause the market value of a fixed-income security to fall
Interest rate risk (systematic)
The risk that changes in the overall market prices will cause changes in the market value of a specific security.
Market risk (systematic)
The risk that an appreciating home-country currency, compared to a foreign currency, will cause an investment in a foreign security denominated in the foreign currency to be worth less, in dollar terms, than what that investment would have been worth if the currency rates had remained stable
Exchange rate risk (systematic)
Risk from shocks that are generated and amplified within the financial system
Endogenous risk
The tendency of the returns of two assets over time to move in the same or in different directions
Covariance
The statistical measure of the strength of the relationship of the return of two assets
Correlation coefficient
The proportion of the total variation in returns of a security that is explained by the variation in returns of another security or of a benchmark index
Coefficient of determination
An investment’s risk per unit of expected return
Coefficient of variation
A measure of systematic risk. It measures a stock’s volatility.
Beta
This form of risk cannot be diversified away
Systematic
A well diversified portfolio can be formed by how many securities?
10 to 15
A well diversified portfolio can be achieved by how many mid to small cap stocks?
25 to 30
How many different mutual funds in different assets classes can create a diversified portfolio?
4 to 7
A distribution that has a hump to the left
positively skewed
A distribution that has a hump to the right
negatively skewed
Investment returns tend to be _______ skewed.
positively
A distribution that has a greater peak.
Leptokurtic
A distribution that has a lesser peak.
Platykurtic
This form of kurtosis has less variance.
Leptokurtic
This form of kurtosis has a wide variance in returns.
Platykurtic
Returns fall within one standard deviation of the mean ___% of the time.
68%
Returns fall withint two standard deviations of the mean ___% of the time.
95%
Returns fall within three standard deviations of the mean ___% of the time.
99%
Coefficient of variation equals
standard deviation / arithmetic mean
A statistical measure of the relative dispersion of data points around a mean.
Coefficient of variation
Is a higher or lower coefficient of variation better?
lower - less risk being taken to achieve the return
What is the problem with covariance?
It does not tell us magnitude
Correlation coefficient has a range between
-1 and 1
R represents the
correlation coefficient
A correlation coefficient of 1 means
the two assets have a perfectly positive relationship
A correlation coefficient of 0 means
the two assets have no relationship
A correlation coefficient of -1 means
the two assets have a perfectly negative relationship
Correlations tend to __________ in rising markets and ___________ in falling markets.
decrease, increase
A beta of 1.2 means that the assets has ____% of the volatility of the benchmark.
120%
In order for beta to be reliable, the stocks must have a coefficient of determination (R squared) of
70% or greater
market risk premium
return of the market - risk free rate
This provides an absolute measure of risk adjusted return
Jensen’s Alpha
A graph showing the relationship between systematic risk and the required return for an investment for any given level of risk. Determined by CAPM.
Security Market Line (SML)
A graph showing the relationship between the total risk and return for a portfolio of securities in which risky securities are combined with a risk-free asset.
Capital Market Line (CML)
A graph that represents various combinations of securities plotted so that a maximum expected return is shown for each incremental risk level
Efficient frontier
The portfolio that maximizes an investor’s expected return consistent with that investor’s given level or risk
Optimal portfolio
What are the seven assumptions of Markowitz Portfolio Theory?
- Investors are risk averse
- Investors make investment decisions based on expected return and risk only
- Investors have homogenous expectations
- One-period time horizon
- Free access to all relavent information
- No transaction costs
- Capital market is perfectly competitive
The optimal portfolio is located at the point where the investor’s ______________ and the _______________ are tangent.
indifference curve, efficient frontier
What is the formula for the capital market line?
expected return of the portfolio = risk free return + standard deviation of the portfolio x ([market return - risk free return]/standard deviation of the market)
If interest rates increase the SML will
shift up
If inflation is expected, the SML will
shift left
If investors are risk averse, the SML
has a steeper slope
A multi-factor model that is an alternative to CAPM. Posits that four major factors affect a stock’s return.
Arbitrage Pricing Theory
What are the four major factors that affect a stock’s return under Arbitrage Pricing Theory?
- Inflation
- Industrial production (changes in GDP)
- Risk premiums
- Yield curves (interest rates)
The identification of an asset mix that will provide the optimal balance between expected risk and return for a long investment horizon.
Strategic Asset Allocation
Focus on sector and securities. Periodically revising the asset mix, moving funds from one category that appears to be overvalued to one that appears undervalued.
Tactical Asset Allocation
Divide a portfolio into a core holding of stocks and bonds and a satellite portion. The satellite portion is used to take advantage of opportunities that add return, diversification, and/or reduce risk.
Core/satellite Asset Allocation
Changes the asset mix as the market changes.
Dynamic Asset Allocation
The idea that security prices adjust rapidly to the arrival of new information, and current security prices reflect all information about the security.
Efficient Market Hypothesis
What are the assumptions of the efficient market hypothesis (6)?
- Large number of competing participants
- Information is readily available
- Transaction costs are small
- An investor cannot outperform or underperform the market
- An investor can earn a return that is commensurate with the amount of risk assumed
- Even if a security is mispriced, one cannot predict the direction of the error in an efficient capital market
The idea that successive price changes in a stock are independent.
Random walk
Investors should not be able to achieve above-average returns consistently using trading rules based on historical information. Fundamental analysis can help investors spot information errors and potentially find undervalued securities.
Weak form efficient market hypothesis
Trading rules based upon information after it becomes publicly available should not result in consistently above-average returns. Fundamental analysis is of no value. The only way to beat the market is inside information.
Semi-strong form of the efficient market hypothesis
Stock prices fully reflect all public and private information. No group of investors should be able to consistently achieve above average returns. There is no way to outperform the market.
Strong form of the efficient market hypothesis
The anomaly that stock prices are lower in December than in January (especially for small-cap stocks)
January Effect
The anomaly that stocks with high dividend rates tend to outperform stocks paying lower dividend rates
Dividend-yield anomaly
The anomaly that stock prices tend to peak in value on Friday and decline in value on Monday
Weekend effect
The anomaly that low P/E stocks outperform high P/E stocks
Low P/E
The anomaly that small-cap stocks outperform large-cap stocks
Size (small firm) effect
The anomaly that stocks with high book to market prices outperform stocks with low book to market prices
BV/MV effect
The anomaly that it is profitable to buy stocks with few analysts
Neglected firm effect
The anomaly that stocks rated 1 in Value Line ourpeform stocks rated 5
Value Line effect
The idea that investors hate to take losses and will generally prefer to avoid losses than to achieve gains
Loss aversion
Investors may choose to invest or not invest based on a fear of missing out or of losing money
Fear of regret
People tend to be over optimistic about the market and believe they are above average
Overconfidence (Optimism Bias)
Investors make judgements based on stereotypes. They become overly pessimistic about investments that have performed poorly in the past and overly optimistic about investments that have done well.
Representativeness
Investors attempting to determine the potential success of a new investment by comparing it to an already understood category or previously held investment
Based-rate neglect (a form of Representativeness)
An investor failing to accurately consider the sample size of the data used to make a judgement
Sample-size neglect (a form of Representativeness)
Investors are influenced by the way an idea is presented.
Framing
Investors search for and rely on information that supports their decisions.
Confirmation bias (Rationalization)
Discomfort experienced when newly acquired information conflicts with preexisting understandings.
Cognitive Dissonance
Individuals only register information that appears to affirm an already chosen decision
Self perception (a form of Cognitive Dissonance)
Rationalizing actions that enable a person to adhere to the original course
Selective decision making (a form of Cognitive Dissonance)
