Investment Planning - Fundamentals of Investments Flashcards
1
Q
What are the two forms of stock underwriting?
A
Best Efforts:
- Underwriter agrees to sell as much of offering as possible
- Risk is with the firm, unsold shares returned to the company
Firm Commitment:
- Underwriter agrees to buy entire issuance of stock from the company
- Underwriter can earn a spread between price stock is bought from company and what it is sold to the public
- Risk resides with underwriter that an issuance may not sell
2
Q
What is a prospectus?
A
- Outlines the risks, mgmt team, business operations, fees and expenses
- must be issued prior to selling shares to investors
3
Q
What is a Red Herring?
A
Preliminary prospectus issued BEFORE SEC approval, used to determine investor’s interest in a security
4
Q
What is the difference between a 10K and 10Q?
A
10K:
- Annual report of financial statements filed with the SEC
- Audited
10Q:
- Quarterly report filed with SEC
- not audited
5
Q
What is contained in a stock’s annual report?
A
- Message from Chairman of the Board on progress in last year and outlook for upcoming year.
- sent directly to shareholders
6
Q
Describe liquidity vs. marketability:
A
Liquidity: How quickly something can be turned into cash with little or no price concession; generally short-term investments (stocks, bonds, mutual funds NOT considered liquid because investor could suffer price concessions)
Marketability: Exists when there is a ready-made market for something; e.g. real estate is marketable, but not very liquid.
7
Q
What is a market order?
A
- Timing and speed of execution more important than price
- Not appropriate for thinly traded stocks
8
Q
What is a limit oder?
A
- price of trade execution more important than timing
- Most appropriate for stocks that are extremely volatile and are not frequently traded
9
Q
What is a Stop Order?
A
- Price hits a certain level and turns to a market order
- Primary risk: investor may receive significantly less than anticipated if market is moving quickly
10
Q
What is a Stop-Limit or Stop-Loss Limit Order?
A
- Investor sets two prices:
- First price is stop-loss price, once reached turns into limit order
- Second price is the limit price; an investor will not sell below that price
- Risk: if market moves quickly, order may not fill
- Appropriate for investors with a significant gain in a stock, but who may not want to sell during a period of significant volatility based on short-term news
11
Q
Describe Short-selling:
A
- Selling first at a higher price, in hopes of purchasing stock back at a lower price
- investor makes a profit when asset’s price decreases in value
- must have a margin account to protect against any price appreciation of the stock
- no time limit on maintaining a short position
- Dividends paid by a corporation must be covered by short seller
12
Q
Describe Initial Margin:
A
- The amount of equity an investor must contribute to enter a margin transaction
- Regulation T
- set by Federal Reserve
- initial margin = 50%
- Can be more restrictive based on volatility of stock
- Assume 50% margin requirement on exam unless otherwise stated in question
13
Q
What is Maintenance Margin?
A
The minimum amount of equity required before a margin call.
14
Q
What is Margin Position?
A
The current equity position of the investor.
Margin Position = Equity / FMV
Equity = Stock Price - Loan
15
Q
At what price does an investor receive a margin call price?
A
- Margin Call = Loan Price / (1 - Maintenance Margin Price)
- MEMORIZE! not on exam formula sheet
16
Q
How much equity must an investor contribute to satisfy a margin call?
A
Investor must contribute equity to restore position to the maintenance margin. see pages 4 and 5 for sample problems.
17
Q
Describe Value Line research reports:
A
- Ranks stocks
- Scale of 1 - 5
- 1 is the highest rating for timeliness and safety, signal to buy
- 5 is the lowest rating, signal to sell
18
Q
Describe Morningstar research reports:
A
- Primarily ranks mutual funds, but also stocks and bonds using 1 - 5 stars
- 1 star represents the lowest ranking
- 5 stars represents highest ranking
19
Q
What is the Ex-dividend date?
A
- The date the stock trades without the dividend
- One business day before the date of record
- if you buy on or after the ex-date you WILL NOT receive dividend
- if you sell on the ex-dividend date, you WILL receive dividend
20
Q
What is the Date of Record?
A
- The date on which you must be a registered shareholder to receive the dividend.
- One business day AFTER the ex-date
- Must purchase stock two business days PRIOR to date of record to receive dividend
21
Q
Describe Cash Dividends:
A
- Qualified dividends receive capital gains treatment
- taxed upon receipt
22
Q
Are stock dividends taxable?
A
Not taxable until the stock is sold.
23
Q
What is the Securities Act of 1933?
A
- Regulates the issuance of NEW securities (Primary Market)
- Requires new issues are accompanied with a prospectus before being purchased
24
Q
What is the Securities Act of 1934?
A
- Regulates secondary market and trading of securities
- Created the SEC to enforce compliance with security regulations and laws
25
What is the Investment Company Act of 1940?
* Authorized SEC to regulate investment companies
* Three types: Open, Closed, Unit Investment Trusts
26
What is the Investment Advisers Act of 1940?
* Required investment advisors to register with the SEC or state
27
What is the Securities and Investors Protection Act of 1970?
* Established SIPC to protect investors for losses resulting from brokerage firm failure.
* DOES NOT protect them from incompetence or bad investment decisions
28
What is the Insider Trading and Securities Fraud Enforcement Act of 1988?
* Defines an insider as anyone with info that is not available to the public
* Insiders cannot trade on that information
29
What are the types of Money Market Secrities? Describe each:
* Treasury Bills
* Issued with maturities up to 52 weeks
* $100 increments through Treasury Direct up to $5 Million per auction. Larger amounts available through a competitive bid
* Commercial Paper
* Short-term loans between corporations
* 270 days or less, no SEC registration reqs
* $100K denomination, sold at discount
* Bankers Acceptance
* Facilitates Imports/Exports
* 9 months or less
* Can be held to maturity or traded
* Eurodollars
* Deposits in foreign banks denominated in U.S. Dollars
30
What is an Investment Policy Statement?
* Primary goal is to understand an investor's attitude toward risk so that an appropriate portfolio allocation can be developed
* Establishes:
* A client's objectives
* Limitations on investment manager
* Used to measure investment manager's performance
* DOES NOT include investment selection
* Risk tolerance used as critical step
31
How do you remember the components of an IPS?
"The IPS establishes RR TTLLU"
Objectives:
* **_R_**isk Tolerance - important so universe of investment alternatives can be narrowed
* **_R_**eturn Requirements - can be specific to a goal
Constraints:
* **_T_**axes - taxable, tax-deferred or tax-free account
* **_T_**imeline (horizon) - ties to risk tolerance
* **_L_**iquidity - ties to time horizon
* **_L_**egal - if assets held in a custodial account or trust
* **_U_**nique Circumstances - to the client
32
Which stock market indexes are value-weighted and which are price-weighted?
* Dow Jones Industrial Avg:
* simple price-weighted average
* S&P 500
* value-weighted
* Russell 2000
* value-weighted
* Smallest market cap stocks in Russell 2000
* Wilshire 5000
* value-weighted
* Broadest index of over 6500 stocks
* EAFE
* value-weighted
* tracks stocks in Europe, Australia, Asia and the Far East
33
What are the four basic premises of Traditional Finance?
* **Investors are Rational**
* Investor decisions are logical, centered on a clearly defined goal free from emotion/irrationality, take into account all available info
* **Markets are Efficient**
* At any given time, a stocks price reflects all relevant info and trade at "fair value"
* **The Mean-Variance Portfolio Theory Governs**
* Investors choose portfolios by viewing and evaluating mean returns and variance for their entire portfolios
* **Returns are Determined by Risk**
* The CAPM is the basic theory that links return and risk for all assets by combining a risk-free asset with risky assets from an efficient market
34
What are the assumptions in Behavioral Finance?
* Investors are "normal"
* They want normal; but may commit cognitive errors and be misled by emotions
* Markets are Not Efficient
* Deviations from fundamental value create opportunities to buy at a discount, sell at a premium
* The Behavioral Portfolio Theory Governs
* Investors segregae their money into "mental accounting layers" when people "compartmentalize" certain goals in different categories based on risk instead of looking at their entire portfolio as a whole
* Risk Alone Does Not Determine Returns
* Behavioral Asset Pricing Model; uses Beta, book to market ratios, market cap ratios, stock momentum, etc.
35
1. What is the Affect Heuristic?
2. What is Anchoring?
1. Judging a company based on non-financial issues
2. Attaching thoughts to a reference point even though there may be no logical relevance or not pertinent to the issue at question; AKA conservatism or belief perserverance.
36
1. What is the Availability Heuristic?
2. What is Bounded Rationality?
3. What is Confirmation Bias?
1. Relying upon knowledge that is readily available in his/her memory (recent events)
2. rationality limited by the available info, tractability of the decision problem, cognitive limits and time available to make decisions; "Satisficers" seeking a satisfactory solution rather than an optimal one; consequence is having additional info does not lead to an improvement in decision making due to inability to consider significant amounts of information
3. filter info and focus on info that supports their opinions (don't get a 2nd chance to make a first impression)
37
1. What is Cognitive Dissonance
2. What is the DIsposition Effect?
3. What is Familiarity Bias?
1. misinterpret info that is contrary to existing opinion or only pay attention to info that supports an existing opinion
2. AKA Regret Avoidance or "faulty framing"; they don't mark their stocks to market prices, they create mental accounts and continue to mark their value to purchase prices even after market prices have changed
3. they tend to over/underestimate risk of investments they are unfamiliar/familiar
38
1. Gambler's Fallacy
2. Herding
3. Hindsight Bias
1. they have an incorrect understanding of probabilites which lead to faulty predictions
2. Follow the masses
3. Looking back assuming they can predict future as readily as they can the past
39
1. Illusion of Control Bias
2. Overconfidence Bias
3. Overreaction
4. Prospect Theory
5. Similarity Heuristic
1. people tend to overestimate their ability to control events
2. they list mostly to themselves
3. towards receipt of news or info
4. People value gains and losses differently; loss averse; asymmetric attitude towards gains and losses
5. decisions made on situations that have apparent similarity but may have different outcomes
40
1. Naive Diversification
2. Representativeness
3. Familiarity
1. investing in every option available
2. thinking a good company is a good investment with no analysis
3. invest in what is familiar, e.g. employer
