Investment Planning Flashcards
What’s the IV of an Option
What an option is worth, can’t EVER be less than zero
- it’s either nothing, or something
COME
- Call Option, Market - Exercise
•(CMV of stock - Exercise Price of Option)
POEM
- Put Option, Exercise - Market
“COME read my POEM”
What is the Time Value of an Option
The difference between an options Premium Price and it’s Intrinsic Value
Gets close to zero the closer an option is to expiring
What type of indicators are the changing of stock prices?
A leading indicator, according to the conditions of an efficient market
What are some differences between CAPM & Arbitrage Pricing Theory?
CAPM
- shows a linear relationship between risk and return
- suggests the only factor that explains returns is a stocks beta
APT (arbitrate pricing theory)
- suggests relationship between a stocks risk/return is not linear
- a stocks price depends on variables other than market returns and volatility of returns
What is the Coefficient of Variation?
CV is a relative measure of TOTAL RISK per unit of EXPECTED return
CV = stand. dev. / exp. return
What are the similarities/differences of Sharpe/Treynor ratio?
Similarities
- measure of risk adjusted performance
- bigger is better
- “like MPH” -> measures how far you go by how fast you are (120 mph > 60 mph)
Differences
- Sharpe -> TOTAL risk (standard deviation)
- Treynor -> systemic risk (beta)
In a diversified portfolio, both equations should yield the same result
What type of index is the DJIA?
Price weighted index
- takes sum of prices of securities in the index / predetermined divisor
- does not account for stock splits and dividends
30 stocks, mostly blue chip companies
What type of index is the S&P 500?
Cap Weighted Index
- automatically adjusts for splits and dividends
500 large cap stocks
Used as benchmark for large cap equity
What type of index is the Russell 2000?
Cap weighted
Benchmark for small cap companies
Subset of Russell 3000
- R3K -> benchmark for total US market
What type of index is the MSCI EAFE?
Cap weighted
Index for international securities
What type of index is the Wilshire 5000?
Cap weighted index
Measures the US broad market as a whole (total market)
5000 US Headquartered equity securities (similar to R3K)
What’s Alpha?
Measures risk adjust value added by a portfolio manager.
- average return - expected return (CAPM formula)
Uses beta
What is the information ratio?
Ratio of the expected return to risk as measured by standard deviation
Measures the consistency w/ which a manager beats a benchmark
“Bigger is better” (like sharpe/Treynor)
IR = (portfolio % - benchmark %) / SD of asset
What’s the tax equivalent yield equation?
TEY: Muni -> Corporate
• R% / (1 - tax bracket)
• “MDC” (muni divide corporate)
TEY: Corporate -> Muni
• R% * (1 - tax bracket)
* “CMM” (Corp multiply muni)
What are futures contracts?
Futures -> a contract between 2 parties to make/take delivery of a specific commodity/asset of a specified quantity at a future time/place/unit price
“The future is known” -> you know the time, place, price, asset, and other party
What is a long and short hedge for futures?
Short hedge
- short futures to hedge a long futures position
- you own the underlying asset and want to protect from falling price
ex) a farmer is long wheat, hedges with short position
Long hedge
- long futures to hedge a short position
- you don’t own the underlying
ex) furniture manufacturer uses wood to make chairs, is short wood; hedge their position w/ long futures contracts
What is the Black-Scholes option valuation model?
Estimates the price of European call option
- “the black-scholes Forrest is in Europe”
Assumes price of option will change on basis of movement of the underlying stock
What does it mean to be positively or negatively skewed?
Positively skewed
- tail skewed to the right (longer tail to right)
- peak to left
Negatively skewed
- tail to the left
- peak to right
What does kurtosis, leptokurtic, platykurtic mean?
Kurtosis
- measures weather a distribution is more or less peaked than normal distribution
Leptokurtic
- more peaked than normal distribution
- for investors who want to minimize volatility
Platykurtic
- less peaked than normal
- has large distributions from the mean
- “platypus’s love volatility”
How do you calculate standard deviation w/ returns of a stock on a calculator?
- %, (+/- if necessary), Σ+
- … (repeat as necessary)
- SHIFT, 8 (Sx, Sy)
How to calculate a portfolio beta for 4 stocks, the long way?
S1 - FMV, S1 β, product (fmv*β)
S2 - …
S3 - …
S4 - …
Add FMV together, add product together
Divide total product by total FMV = weighted portfolio beta
How to calculated portfolio beta for 4 stocks, the short way?
- S1 β, INPUT
- S1 FMV, Σ+
- … (repeat as needed)
- SHIFT, 6 (xw, β)
Can use either full FMV or shortened (5000 or 5 for $5000 fmv)
What is semi-variance?
The downside volatility of an investment
- the variability of returns below the average or expected return
The lower semi variance the lower the chance of the security incurring a substantial loss in value
What’s the equation for holding period return?
(Ending Value - beginning value +/- cash flows) / beginning value
OR
[(1 + %1)(1 + %N)…] - 1
What is the equation for Arithmetic Mean?
(%1 + … + %N) / N
Does NOT account for compounding interest
What’s the formula for the Geometric mean?
N-sq. root((1+%1)…(1+%N)) - 1
OR
N-sq. root(HPR +1) - 1
Accounts for avg compounding return OR the internal rate of return
What is the time weighted return and what does it measure?
It’s the geometric annual rate of return measured on the basis of the current year value of the asset
- measures the rate of return w/o considering the investors size or timing of funds
PREFERRED METHOD FOR ANALYZING THE PERFORMANCE OF A PORTFOLIO MANAGER
- “managers have TIME”
Reports the RoR of mutual funds
What’s the dollar weighted return and what does it measure?
It measures the compounded annual rate of return (IRR) that discounts a portfolios future value and cash flows to a present value
MEASURES THE ACTUAL PERFORMANCE OF AN INVESTOR RATHER THAN A PORTFOLIO MANAGER
- investors measure their DOLLARs
What’s the way to calculate the weighted average return of a portfolio (3 stocks), the long way?
- S1 market price, S1 %, S1 product (CMP*%)
- S2 …
- S3 …
- Add total market price, add total product
- total product / total market price = weight avg return
What’s the way to calculate the weighted avg return of a portfolio (3 stocks), the short way?
- S1 %, INPUT
- S1 market price, Σ+,
- … (repeat as needed)
- SHIFT, 6 (xw, β)
- it uses the same key to determine weighted beta
What’s the equation to determine the price at which a margin call will be triggered?
(CMP * Margin %) / (1 - Maintenance %)
ex) CMP of $25 with margin req of 50%, maintenance of 35%
(25 * 50%) / (1 - 35%) = 12.5/0.65 = $19.23
A margin call will be triggered at $19.23 or lower
OR -> [(1-margin %)/(1-maint.%)]*purch price
• .5/.65 = 0.7692 * $25 = $19.23
Ex) Stock price is $25; margin is 50%, maintenance is 35%; stock price drops to $15. How much $ will the investor have to deposit to meet the margin call?
Required Equity - Current Equity = Amount needed
1) Required Equity
• $15 current price * 35% maintenance = $5.25 required equity
2) Current Equity
• $15 price - $12.50 loan amount ($25*50%) = $2.50 current equity
3) Difference
• $5.25 - $2.50 = $2.75 amount required
- $2.75 will have to be multiplied to the amount of shares owned
What is portfolio immunization?
Bond portfolio duration is equal to the amount of years until the goal
Protects portfolio against reinvestment risk and interest rate risk
What should bond holders do when rates are projected to rise, or begin to rise?
Move from long term to short term bonds
- price of the long term bonds will decline, long term bonds are more susceptible to IR swings
What’s the conversion ratio of convertible bonds?
Par value / conversion price = conversion ratio
What’s the conversion value of convertible bonds?
Common stock price * conversion ratio = conversion value
If conversion value > par of convertible bond -> you should convert
What does CAPM assume about risk?
The only relevant thing about an asset is it’s systemic risk (beta)
Unsystematic risk is not relevant because rational investors will diversify it out of their portfolio
What is the definition of intrinsic value of a security?
The present value of expected future cash flows, discounted at an appropriate discount rate, taking the risk of the investment into consideration
What are some characteristics of closed end funds?
- trade in the secondary market
- shares are NOT redeemed by the company
- have fixed capitalizations (won’t offer new shares to raise capital)
- shares may trade at a premium/discount to NAV
How should investment goals relative to risk and return be stated?
Goals should be stated in terms of return AND risk
- level of risk will help determine the level of return that is feasible
What type of risk do zero coupon bonds have?
- purchasing power risk
- interest rate risk
- default risk IF issued by a corporation
- NOT subject to reinvestment risk (does not provide semi annual coupon payments)
How would a viatical sale qualify for favorable tax treatment?
If the insured has certification by a physician that they are terminally ill with a life expectancy less than 24 months
If they qualify, the sale of the proceeds are tax free
What’s the HPR of someone in the 15% tax bracket who buys stock for $40k, receives $1k in dividends, and sells for $60k?
($60k sale + $1k dividends) - $40k OG purchase = $21k profit
$21k profit * 0.85 (15%) = $17.850 after tax profit
$17,850 a-t p / $40k basis = 44.625% HPR
How many non-accredited investors may participate in a private placement?
Up to 35 non-accredited investors
How is bond price volatility related to time to maturity and coupons?
Price volatility is DIRECTLY related to time to maturity and INVERSELY related to coupons
How do you effectively immunize a bond portfolio and what does it due relative to performance for an investor?
To immunize a bond portfolio you match the duration with the investors investment time horizon
Immunizing a bond portfolio protects a clients bond portfolio yield from changes in interest rates
- cap losses are offset by gains on reinvestment income
Protects against IR risk and reinvestment risk
What are revenue bonds
Municipal bonds backed by funds generated from income producing projects
Have maturity schedules that reflect the life of the project
What’s the equation to determine the value of income producing property?
V = NOI / Cap. Rate
Or, more accurately
V = (Gross Income - (vacancy %*GI) - Expenses) / Cap rate
How do you accurately determine any long term and short term gain/loss on the sale of mutual fund shares?
Break it down by category (from L to R)
1) purchase date
2) sale date (determines holding period)
3) shares sold
4) total sale price (price @ sale * shares sold)
5) total purchase price (OG price * shares)
Subtract from the appropriate columns to determine long term/short term gain/loss, then add/subtract it together to determine net gain/loss per period
How do you determine the price change of a bond given the increase/decrease of interest rates?
((-D(Δy/1+y)) + 1) * FMV bond
Ex) $5000 bond w/ YTM of 2% & D of 16.68. What’s the price if rates increase .5%
((-16.68(.005/1.02)) + 1) * 5,000
(-.08180 + 1) * 5000
.9120 * 5000 = $4,591 will be the bonds FMV if rates increase .5%
What’s the easiest way to calculate HPR?
(FMV/share - OG Price/share +/- dividends) / OG Price/share
What’s the “P/E effect”?
Stocks with low P/E ratios tend to outperform stocks with high P/E ratios (undervalued)
What’s the strong form of EMH?
All public AND private information is included in market prices
Someone who tries to solicit inside info doesn’t believe all private info is in market prices and that markets aren’t efficient under strong form
What is the “weak form” version of EMH?
All historical price and volume information is included in stock prices, but you may be able to make gains by studying other publicly available info like annual and analyst reports (fundamental analysis)
What is financial risk?
The extent to which a company uses debt/leverage to finance its operations
How do you determine how much cash to add to a margin position if the stock drops below a certain amount?
1) CMV of Stock - OG Loan
— (CMV*Shares) - ((OG Price *margin %) * shares) = current equity
2) Current Equity - Required Equity
— Current Eq (step 1) - (CMV * Maint. %) = Cash Required
Ex) bought 100sh of X @ $60/sh. Margin of 50%, maint. Of 30%. How much $ is required if X drops to $40?
$4000 (40100) - $3000 ((60100)0.5) = 1k
$1000 - $1200 ((40*100)0.3) = $200 required
How do you determine the geometric return with a calculator?
PV = 1
FV = result of (1+%1)(1+%N)
N = # of returns
Solve for I/yr
How do you calculate the IV of a stock where the dividend adjusts for 3 years then increases at a level amount indefinitely after that?
1) calculate each future dividend until the growth rate stabilized
— D0 * % = D1
— D1 * % = D2
— D2 * % = D3
2) use the consistent growth dividend model to calculate the remaining IV of the stock beginning when the dividend rate stabilizes
— D3 * G% = D4
— D4 / (G% - R%) = IV
3) use uneven cash flow method to solve for NPV — CF0 = 0 — CF1 = D1 — CF2 = D2 — CF3 = D3 + IV from step 2 = $# — I/yr = investors required return — SOLVE FOR NPV
A bond AA rated w/ 15y maturity, $1000 par, and a 3.75% coupon is issued. 3y later IR on similar bonds falls to 3.25%. How can you calculate the new price on similar bonds and what is that price?
- 2 p/yr
- FV = 1000 (par)
- PMT = 18.75 (semi-Ann coupon)
- I/yr = 3.25 (new rate)
- N = 24 (12 shift N -> 3y into 15y bond)
- solve for PV -> $1049.36
What is the process to determine the value of a stock whos dividend is increasing at one rate for 3 years, then another rate annually after that?
1) determine the dividends for the three years
• D1 = D0 * growth %
• D2 = D1 * %
• D3 = D2 * %
2) use constant div growth model to determine IV when dividend growth stabilizes
• v = D3(1+g)/(r-g)
3) solve for NPV • CF0 = 0 • CF1 = D1 • CF2 = D2 • CF3 = D3 + IV from step 2 • I/yr = investors required return % • Solve for NPV
How do you determine the duration of a bond using the cash flow equation on a calculator?
4 steps
1) determine the YTM of the bond
2) break down cash flows (coupons per year + final pmt+par) and multiply them with the years
• ex) a coupon of 12.5% in y2 = 250 (1252)
3) use the CFYears results and enter them as cash flows, the YTM from step 1, and solve for NPV
• important -> CF0 is ALWAYS 0
4) divide NPV by current bond price
How do you determine HPR of a margin investment?
Determine
1) Ending Value
• FMV at sale * shares owned
2) Beginning value
• FMV @ purchase * shares owned
3) cash outflows
• dividends received or margin interest (beg Val * shares owned * margin interest)
4) initial loan
• beginning value * margin requirement %
5) use HPR equation
• (end Val - beg Val - cash outflows) / initial loan = HPR %
How do you determine the amount of gain to report in an installment sale?
Gain / sale price = gross profit percentage
GP% * payment = amount includable as a gain
If any gain is attributable to 1250 property (depreciable RE), the gain is recognized before any LTCG rates
• 1250 gain taxed @ 25%
What is the conversion value of a convertible bond?
The conversion value is
- conv ratio * CMV of stock
• conv ratio = par / conv price
Ex) what the conversion value of a bond, w/ $18 conversion price per share, whos stock is trading at $16.75?
• $1000 or / $18 conv price = 55.56 conv ratio
• 55.56 * 16.75 = $930.63 conversion value
Are utility stocks subject to interest rate risk?
Yes
What is the purpose of seed financing?
It’s funding for the purpose of R&D for an idea
“Plant the SEED for R&D”
What is the purpose of first-stage financing?
Financing for initial manufacturing and sales
“The FIRST STAGE is MANUFACTURING and SELLING”
What is start up financing?
Funding for product development and market for companies who haven’t sold products/services commercially
“To START UP you must MARKET”
What do you call a distribution that’s more leaked than normal?
Leptokurtic
- Investors want this one (it minimizes volatility)
Distributions are
- more peaked than a normal distribution
- observations are clustered around the mean
What distribution is less peaked than normal?
Platykurtic
Distributions are
- less peaked than normal
- more observations w/ large deviations from the mean
- “the PLATYpus loves volatility”
What are the mean, medium, and mode and what is their order for positively and negatively skewed distributions?
Mean
- sum of observations / # of observations
Median
- midpoint of values after they’ve been ordered from smallest to largest
Mode
- observation that appears with greatest frequency
Positively skewed dist (hump to left, tail to right)
• mode - median - mean
• “I’m POSITIVE that MODE goes FIRST”
Negatively skewed dist (hump to right, tail to left)
• mean - median - mode
• “NEGATIVE people are MEAN”
- MEDIAN IS ALWAYS IN THE MIDDLE
Where do closed end funds trade and at what price? are they redeemed? What’s their capitalization?
Closed End Funds
- trade on exchanges (secondary market), may trade at a premium/discount to NAV
- shares are NOT redeemed
- have a fixed capitalization
A distribution with a mean that’s less than its median is most likely…
Negatively skewed
What is the duration of a zero coupon bond?
It’s maturity date
How do you determine the duration of a bond portfolio?
Assume
• B1 - $5000 fmv, D - 5
• B2 - $3000 fmv, D - 8
• B3 - $2000 fmv, D - 12
Same as weighted beta
B1 - 5000 * 5 = $25,000
B2 - 3000 * 8 = $24,000
B3 - 2000 * 12 = $24,000
TTL - 10,000 - $73,000
73,000/10,000 = Duration of 7.3
What are the taxable equivalent yields for corporate, treasury, and municipal bonds?
Corporates & treasury’s
- % * (1 - tax bracket %)
Muni’s -> corporates
- % / (1-l - tax bracket %)
Muni’s (GO/Rev/Private activity)
- tax free, no equation
What would increased yields on invested assets for mutual life insurance companies?
Increase dividends paid on a whole life policy
Mutual IC’s is owned by policyholders who are in a smokier position to stockholders, and benefit from increased earnings
Variable policies CV’s are based on underlying investments
What are the features and benefits of group disability contracts?
- exclude part time EE’s
- offer lower premiums
- more strict definition of disability
- no enhanced benefit triggers
What should you do if a client has more insurance than necessary and wants to stop paying premiums?
Reduced paid up insurance
- reduces the face amount but policy remains in force with no further premiums due
How much coverage would a HO-6 policy have if the roof was damaged?
$0
Damage to the roof is not covered under a HO-6 policy (condo)
What happens if someone lied about having cancer in order to obtain a life insurance policy if it could be proven they lied?
The policy would be rescinded on the basis of fraud
What types of gains and losses are and aren’t taxable?
ARE taxable
- REALIZED gains/losses
ARENT taxable
- UNREALIZED gains/losses
What is the riskier choice between municipal GO bonds and municipal revenue bonds?
Revenue bonds are riskier (project could fail)
What is the most important indicator of a stocks marketability?
Number of shares traded (average daily trading volume)
What is the duration of a zero coupon bond?
Whatever it’s maturity date is
Ex) a zero maturing in 10 years has a duration of 10
How are gains and losses treated when a non natural person (Corp) owns an annuity?
Ordinary gains and ordinary losses
