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
Q
What is the Investment Company Act of 1940?
A
- Authorized SEC to regulate investment companies
- Three types: Open, Closed, Unit Investment Trusts
26
Q
What is the Investment Advisers Act of 1940?
A
- Required investment advisors to register with the SEC or state
27
Q
What is the Securities and Investors Protection Act of 1970?
A
- Established SIPC to protect investors for losses resulting from brokerage firm failure.
- DOES NOT protect them from incompetence or bad investment decisions
28
Q
What is the Insider Trading and Securities Fraud Enforcement Act of 1988?
A
- Defines an insider as anyone with info that is not available to the public
- Insiders cannot trade on that information
29
Q
What are the types of Money Market Secrities? Describe each:
A
- 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
Q
What is an Investment Policy Statement?
A
- 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
Q
How do you remember the components of an IPS?
A
“The IPS establishes RR TTLLU”
Objectives:
- Risk Tolerance - important so universe of investment alternatives can be narrowed
- Return Requirements - can be specific to a goal
Constraints:
- Taxes - taxable, tax-deferred or tax-free account
- Timeline (horizon) - ties to risk tolerance
- Liquidity - ties to time horizon
- Legal - if assets held in a custodial account or trust
- Unique Circumstances - to the client
32
Q
Which stock market indexes are value-weighted and which are price-weighted?
A
- 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
Q
What are the four basic premises of Traditional Finance?
A
-
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
Q
What are the assumptions in Behavioral Finance?
A
- 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
Q
- What is the Affect Heuristic?
- What is Anchoring?
A
- Judging a company based on non-financial issues
- 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
Q
- What is the Availability Heuristic?
- What is Bounded Rationality?
- What is Confirmation Bias?
A
- Relying upon knowledge that is readily available in his/her memory (recent events)
- 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
- filter info and focus on info that supports their opinions (don’t get a 2nd chance to make a first impression)
37
Q
- What is Cognitive Dissonance
- What is the DIsposition Effect?
- What is Familiarity Bias?
A
- misinterpret info that is contrary to existing opinion or only pay attention to info that supports an existing opinion
- 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
- they tend to over/underestimate risk of investments they are unfamiliar/familiar
38
Q
- Gambler’s Fallacy
- Herding
- Hindsight Bias
A
- they have an incorrect understanding of probabilites which lead to faulty predictions
- Follow the masses
- Looking back assuming they can predict future as readily as they can the past
39
Q
- Illusion of Control Bias
- Overconfidence Bias
- Overreaction
- Prospect Theory
- Similarity Heuristic
A
- people tend to overestimate their ability to control events
- they list mostly to themselves
- towards receipt of news or info
- People value gains and losses differently; loss averse; asymmetric attitude towards gains and losses
- decisions made on situations that have apparent similarity but may have different outcomes
40
Q
- Naive Diversification
- Representativeness
- Familiarity
A
- investing in every option available
- thinking a good company is a good investment with no analysis
- invest in what is familiar, e.g. employer
