Investments Flashcards
Systematic Risk (nondiversifiable risk)
Purchasing power risk Reinvestment rate risk Interest rate risk Market risk Exchange rate risk
Systematic risk is inescapable because no matter how well you’re invested, overall market cannot be avoided
Unsystematic risk (diversifiable risk or nonsystematic risk)
Business Risk
Financial Risk
Investors can construct a diversified portfolio and eliminate the unsystematic or diversifiable risk. After the unsystematic risk is eliminated, systematic risk remains
Unsystematic risk can be reduced through diversification by owning securities of companies in different industries with low positive (or zero, or negative) correlations
Yield Ladder
Discounted Bonds - Pay $500 for a $1,000 par bond
Yields higher than coupon
Y M C A C M Y
Yields lower than coupon
Premium Bonds -Pay $2,000 for $1,000 par bond
Current yield
Annual interest in dollars/Bonds market price
Bonds market (selling price)
=annual interest in dollars/current yield
HPR question example
Joe purchased a $1,000 par bond for $900 with a 5% coupon. He sold the bond after one year when it was paying him a current yield of 4%. What is Joe’s holding period return?
HPR = (1250 + 50) - 900/900 = 400/900 = 44.4%
Bonds market price = annual interest in dollars/ current yield = 50/.04 = 1,250
EE Bonds
Non-traded debt of the U.S. government, savings bonds are nonmarketable, nontransferable, and nonnegotiable and cannot be used for collateral. THEY ARE ISSUED AT FACE VALUE. Term is for 20 years. No more paper bonds are issued.
EEs in UTMA Account EE “Education” Bonds
- Owned by the child. -Normally owned by the parent
- Taxed at ordinary income at redemption. -Tax free if the parent’s AGI is less than the phaseout at redemption
Owner has the option of having interest taxed each year, althought most investors prefer not to.
Interest is not subject to state or local taxes
STRIPS
Treasuries version of a zero-coupon bond
Direct obligation of the federal government
Discount on STRIPS is treated as taxable (phantom) income, earned annualy. STRIPS product phantom income
TIPS
Investor taxed annually on the interest payment plus the appreciation in face value
Increase in value produces phantom income and is not collectable until sold or maturity
However, income is taxable in the year it is accrued
TIPS interest not subject to state or local taxes
HH Bonds
2 potential questions
Mrs Cain held her EE bonds until they no longer paid any interest (30 years), and in 2001 exchanged them to HH bonds.
Did she have to pay tax on the gains? No, it is deferred until she cashes in the HH bonds
DId this imrpove her cash flow? Yes, the HH bonds pay her interest semiannually
I bonds
Inflation- indexed accrual securities issues by the US government
Non-marketable, nontransferable, and nonnegotiable and cannot be used for collateral
Sold at face value
Interest compounded semi annually
2 parts:
A fixed base rate
Inflation adjustment additional amount(updated ever 6 months to keep up with CPI)
May qualify for education bond status
GNMA
Ginnie Mae securities purchase a pool of FHA/VA guaranteed mortgages. GNMAs are guaranteed by the federal government
FNMA/FHLMC
Federal National Mortgage (Fannie Mae) and Federal Home Loan (Freddie Mac) are NOT guaranteed
The have been taken over by the federal government
They are placed into conservatorship of the FHFA (Federal Housing Finance Agency)
You can get Fucked
CMOs (mortgage-backed pools)
Mortgage payments received are distributed on a “cash flow” basis.
Different tranches are created
Z tranche most likely tested.
Tranches: A (first pay), M (medium pay), Y(slow pay) plus a Z tranche that bears no coupon (most risk) but receives the cash flow from the collateral remaining after the other tranches are satisfied
Z Tranche carrier no coupon. It functions like a zero coupon bond. It produces no cash flow
Convertible Bond Formula
Must memorize
Conversion value = par/cp x Ps
CP=Conversion price
Ps = current market price of underlying stock
PAR= Par value of bond )typically, but not necessarily, $1,000)
Find out bond PV* FV typically 1000 Pmt is interest received x 2 Time will be years x 2 Interest will be yield /2 Solve for OV
Use conversion for stock price
Chose higher
Put bonds
Put bond permits the holder to sell the instrument back to the issuer. If effect, firm must redeem bond at a specified date for its principal amount (par). If, after put bonds were issued, interest rates were to rise and thereby drive the price of the bonds down, the investor should excercise the put option at the specified redemption date. In return for the put priviledge, a bond buyer sacrifices some yield (PUT DOWN)
Preferred stock
Maturity is infinite
Price flucations in preferred stock often exceed those of even long-term bonds
Typical purchaser of preferred shares is a corporate treasurer with excess funds. If treasurer were to purchase bonds, all of the interest is taxable. If the corporation’s treasuer buys preferred stock, than at least 50% of the dividends received are excluded from tax
ADRs
Prices are quoted in US dollars, and dividends are PAID in US dollars. Because the dividends are DECLARED in the foreign currency, some exchange-rate risk remains. Investors also get a foreign tax credit.
Fixed Unit Investment Trusts (UIT)
Typically an unmanaged security portfolio offered by a sponser and handled by independent trustee
Passive invesment because its assets are not traded, but frozen
No new securities are purchased, and securities originally purchased are rarely sold.
Guaranteed Investment Contracts (GICs)
Issued by insurnace companies
Issued for 2 to 5 years and bear a guaranteed rate of interest
GICs value does not fluctuate with interest rate changes, their value does, however, depend on financial strength of issuer (default risk)
Insurance company takes all market, credit, and interest rate risks on the GICs, but can profit if its returns exceed the guaranteed amount
Intrinsic Value question for property
Must use NOI (not cash flow) and divide it by cap rate to determine a property’s intrinsic value
If individual uses cash to purchase property and cap rate is given, woudl be equal to rate of return
REITs
Equity REITs
Invest in operating rental properties (for growth). Net income from property (rents less operating expenses) should exceed the REIT’s borrowing costs, producing income for shareholders
Mortgage REITs
Invest mainly in mortgages and construction loans. Interest earned on the mortgages and construction loans should exceed the REITs borrowing costs. These REITs are highly leveraged. They make their income from the “spread” between the lending rate and borrowing rate. Inflation is bad for mortgage REITs
Tax Rules to Achieve Conduit Status
At least 75% of REITs income must come from real estate investments (15% can come from securities, like GNMAs)
If REIT distributes a minimum of 90% of net investment income of more, it only pays tax on the undistributed portion.
If the REIT fails to distribute 90%, then all the net investment income is taxable to the REIT as an entity
REITs generally operate as pass-through arrangements, so distributions are ordinary dividends and may qualfy for QBI deduction of up to 20% of that income.
LEAPs (Long term Equity Anticipation)
Expiration ranges from 9 months to 3 years
Once LEAP is excercised, investor must hold the shares of the stock for more than 12 months in order to pay LTCG rate
Private Placement (Reg D)
Not subject to all of the registration requirements associated with public offerings, exempt from registration
Can be offered to 35 “non-accredited” investors and unlimited accreddited investors
Full disclosure must still be given to investors through an “offering memorandDum”
Accreddited investor is institutional investor, 1M of worth (excluding personal residence), 200k income or 300k jt income
1-2-3
Non accreddited investors (35) must be “sophisticated: Such investors sign an “investment letter”
If they cannot evalutate the issue on their own, the rule requires the use of a puchaser representative (a lawyer or accountant)
