Investments Flashcards
systematic risk
what is it and what types are there
- influences that cannot be diversified away (i.e., impacts all companies at the same time; not necessarily to the same degree)
- measured by beta
-
Types: PRIME
- purchasing power
- reinvestment risk
- interest rate
- market risk
- exchange rate
unsystematic risk
what is it and what types are there
- may affect all businesses but not at the same time
-
Types: ABCDEFG
- accounting risk (e.g., fraudulent activity in accounting)
- business risk
- country risk (e.g., firm has invested heavily in China)
- default risk
- executive (decisions)
- financial risk (how they’re financed)
- government regulations
what does standard deviation measure?
- total risk
- absolute measure
- measures variation around an average
Formula:
- r(t) = the return
- r(absolute) = absolute value of the average
what the standard deviation probabilities?
- 68% of the time, the return will fall within 1 standard deviation (+ or -)
- 95% of the time, the return will fall within 2 standard deviations (+ or -)
- 99% of the time, the return will fall within 3 standard deviations (+ or -)
what is the ideal beta and what does it mean if beat is more or less than that
- Ideal = 1
- E.g., If you have a beta of 1.5, that means your portfolio is 50% more volatile, so it will go up by 50% less and down by 50% more
- market goes down 10%, portfolio goes down 15%
- market goes up 10%, portfolio goes up 5%
what does beta measure?
- systematic risk
- how our asset returns relate to the market return
- beta = the slope of the line if you were to plot market returns vs the portfolio return
*
call option & what is long/short position
- Holder has the right (but not the obligation) to buy
- long position = buyer (the right to buy)
- short position = seller (agrees to sell to the person with the long position and gets the premium either way)
put option & what is long/short position
- Holder has the right (but not the obligation) to sell
- long position = seller (right to sell)
- short position = buyer (agrees to buy from the long position and gets the premium either way)
in the money / out of the money / at the money
how does premium factor in?
- in the money - holder will make money if they exercise the option
- out of the money - holder will not make money if they exercise the option
- at the money - holder would break even if they exercised the option
disregards the premium because not everyone would have paid the same premium
how to value stock options
premium = fundamental (intrinsic value) + time value
fundamental (intrinsic value)
- How much the option is in the money
- for call = stock price - strike price
- for put = strike price - stock price
- Cannot be < 0 because if it wasn’t in the money, you wouldn’t exercise it
futures contracts
- long position = buyer
- short position = seller
- legally binding obligation to make (seller) and take (buyer) delivery on specified date
- highly leveraged (bought on margin)
futures hedgers vs speculators
- hedgers = producers/processors; protecting their interests by locking in a price
- speculators = investors trying to profit on expected price swings
Regulation T
initial margin requirement set by the federal reserve; must be at least 50%
formula to determine at what price an investor would receive a margin call
1 - (loan / maintenance margin)
what are the main rating agencies for mutual funds and stocks?
- Value Line: ranks stocks only; 1-5 and 1 is the best
- Morningstar: ranks mutual funds and stocks 1-5 and 5 is the best
Ex-dividend date
what is it and what happens if you buy on that date
business day prior to date of record; if you buy on or after you don’t get the dividend so the price typically falls this day
what is a qualified dividend and how is it treated for tax?
- Cash
- paid by US company or qualifying foreign company
- held >60 days during 121 period beginning before ex-dividend date
- Taxed as capital gains
- Stock
- not taxable to shareholder
Securities Act of 1933 vs 1934 vs Investment Company Act 1940 vs Securities Investors Protection Act of 1970
- 1933 - regulates primary market
- 1934 - regulates secondary market; created SEC
- 1940 - authorized SEC to regulate investment companies
- 1970 - protect from brokerage firm failures (up to $500K)
types of money market securities
- CDs
- T-Bills < 1 yr ($100 denominations)
- commercial paper (maturity <270 days; denominations $100K)
- Bankers acceptance (maturity < 9 mos; facilitates imports/exports)
- eurodollars (deposits in foreign bank denominated in USD)
investment policy statement
- establishes:
- objectives: return, risk tolerance
- constraints: time horizon, liquidity, taxes, laws (e.g., if in trust), unique circumstances (e.g., special needs child)
- limits on investment manager
market indices (Dow vs S&P)
-
Dow - simple price weighted average of 30 stocks
- doesn’t incorporate market cap
-
S&P - value weighted index
- incorporates market cap of individual stocks
- Russell 2000 - value weighted for small cap
- Wilshire 5000 - value weighted on all stocks
coefficient of variation
symbol, formula, what it measures, when to use, what # you want
- Symbol: CV
- Formula: CV = standard deviation / mean expected average return
- What it measures: risk relative to return
- When to use: when comparing two assets with different average returns
- Do you want lower or higher #?: lower = less risky
correlation coefficient
symbol, formula, ranges, what # you want
- symbol: r
- formula: r = COV / (standard deviation of stock 1 x standard deviation stock 2 etc)
- ranges: from -1 to 1
-
what # you want: diversification benefits come whenever correlation is <1
- Note: negative is better but NOT necessary
coefficient of determination
symbol, what it measures, when to use it
- symbol: r2
- what it measures: tells you how much of your return is systematic risk
-
when to use it: must be ≥70% to use beta as a benchmark
- note: index that has the highest r2 is the best one to use as a benchmark
coefficient of variation vs correlation coefficient vs coefficient of determination
-
coefficient of variation (CV)
- measures risk relative to return
-
correlation coefficient (r)
- ranges from -1 to 1
- diversification benefits come whenever correlation is <1
-
coefficient of determination (r2)
- tells you how much of your return is systematic risk
- must be ≥70% to use beta as a benchmark
modern portfolio theory
- the acceptance by an investor of a given level of risk while maximizing their return objectives
efficient frontier
what is it and what does it mean to be above or below
- curve that illustrates the best possible returns to expect from all possible portfolios
- along the frontier are efficient
- below frontier is inefficient
- above frontier is unattainable
indifference curve
what is it and what does slope indicate
- curve illustrating how much return is required for each level of risk
- Indifferent because investor is indifferent toward where on that line we land)
- steeper = more risk adverse
capital market line
- the line that runs along the mid-ish point of the efficient frontier;
- not commonly tested
capital asset pricing model
- calculates relationship between risk and return of an individual security using beta as it’s risk measurement
-
ri = rf + (rm - rf)Bi (on formula sheet)
- B = beta of the individual security
- risk premium = (rm - rf)
security market line
- relationship between risk and return as defined by the CAPM (ri) if you were to graph a line based on beta and return
- on line, beta of 1 = rm
Treynor vs Sharpe vs Jenson’s vs Info Ratio
-
Treynor - measures return relative to systematic risk (i.e., beta)
- doesn’t measure manager performance
- only use if r2 ≥ 0.7
-
Sharpe - measures return relative to total risk
- doesn’t measure manager’s performance
-
Jenson’s Alpha - absolute measure of risk
- measures return of portfolio minus CAPM (fish symbol on formula sheet)
- = good (i.e., out-performed the market)
- = bad
- only use if r2 ≥ 0.7
-
information ratio (IR on formula sheet) - relative measure of consistency of excess return
- rb = return of benchmark
- standard deviation A = tracking error of active return
arbitrage pricing theory
how does our return vary based on multiple factors across the market, not just risk (e.g., inflation)
holding period return
- HPR = made / paid (on formula sheet to calculate HPR for returns)
- no consideration for how long investment was held
- simple rate of return, not compounded
- e.g., bought share for $20 on initial margin of 60%, charged 10% margin interest then sold stock for $30
- paid
- margin = (20 x 0.6) = $12
- loan interest = (20*0.4*0.1) = $0.80
- made = 30 - 20 = $10
- HPR = (10 - 0.80) / 12 = 76.67%
- paid
Net Present Value
- PV of future cash flows minus upfront costs
- Positive NPV = invest
- Negative NPV = don’t invest
- Calculate: Use CFj to enter cash flows, provided rate (required rate of return aka discount rate), and # periods to solve for NPV
Internal Rate of Return
- what interest rate will make the NPV = 0 i.e. what % do i need to earn to break even
- calculate: enter CFs just like NPV, N for the number of periods, solve for IRR/YR
time weighted vs dollar weighted return
- time weighted: used for mutual funds; based on the cash flows from the security perspective
- dollar weighted: used for investors; based on cash flows from the investor’s perspective
intrinsic value
what is it an when can you use it
- V on the formula sheet
- D1 is the dividend after 1 year (not today)
- discount dividend model aka value of a stock after 1 year
- Only works if dividends are growing at a constant rate
expected rate of return
r on formula sheet
if > than required rate of return, you would buy that stock
how to calculate intrinsic value when dividends aren’t growing at a constant rate
- Step 1: Calculate intrinsic value for any time period where dividends are growing constantly
- Step 2: Use CFj to calculate NPV up until the time that dividends start growing constantly, including NPV of the constant growth above
- E.g.: Dividends paid
- Yr 1 = 2; Yr 2 = 2.5; Yr 3 = 3
- after Yr 3, start growing at 8%
- required rate = 10%
- Step 1: V = (3*1.08)/(10%-8%) = 3.24/0.02 = 162 (that is added to CF3)
- Step 2: Calculate NPV
- 0 → CFj → 2 → CFj → 2.5 → CFj → 165 → CFj → 10 → I/YR → orange → NPV = 127.85
PE Ratio
PE = stock price / earnings per share
Dividend payout ratio vs retention ratio
- dividend payout ratio = common stock dividends / earnings per share
- retention = 1 - dividend payout ratio
ROE
ROE = earnings (or net income) per share / stockholders equity per share
dividend yield
dividend yield = dividend / stock price
efficient market hypothesis and forms
- random walk theory = the behavior of stock prices closely resembles a random walk
- prices reflect the information available at that time
-
forms:
- weak - prices reflect historical info/prices, so technical analysis wont help investors outperform market
- semi-strong = price reflects historical info and public info, so technical and fundamental analysis won’t help
- strong = price reflects historical info, public info, and private info (i.e., insider trading), so only option is to diversify
technical vs fundamental analysis
- technical: historical prices
- fundamental: analyzing individual company reports (10-K)
Series E and EE Bonds
- sold at FV
- non-marketable and nontransferable
- accrue interest but don’t pay it periodically
Series I Bonds
- inflation protected based on a fixed rate + variable coupon rate
- like E/EE bonds, do not pay interest periodically but accrue it
Treasury bills vs notes vs bonds
- bills = initial maturity < 1 year
- notes = initial maturity 2-10 years
- bonds = initial maturity > 10 years
TIPS
- Treasury Inflation Protected Securities
- principal adjusts for inflation and coupon (fixed rate) applies to new principal
STRIPS
- US treasury security
- separate trading of coupon payments and principal
- e.g., 10 year bond will have 21 strips, 20 for the coupon payments and 1 for the principal
- essentially creates many zero coupon bonds
secured bonds
types
-
mortgage bonds: backed by a pool of mortgages
- risk of default and prepayment
- Collateral Trust Bonds: backed by an asset the company owns
-
CMOs (collateralized mortgage obligations):
- investors divided into tranches (short term, long term)
- intended to mitigate prepayment risk
what securities are backed by the full faith and credit of US government?
GNMA (Ginnie Mae)
US Treasuries (bonds, notes, bills)
not backed: Fannie Mae, Freddie Mac, Sallie Mae, various federal banks
unsecured bonds
types
-
debentures (bonds) - unsecured debt not backed by a specific asset
- e.g., corporate bond
- subordinated debentures (bonds) - have a lower claim on assets than unsecured debt so more risky
- income bonds - stipulate that interest is only paid when specific level of income is obtained (rather than fixed coupon)
Municipal Bonds Types
- general obligation = backed by municipality; paid via taxes
- revenue = baked by revenue of project (e.g., toll road)
- private activity = partnership between gov. and private group (e.g., stadium); tax-preferred for AMT
- insured municipal = companies that issue insured municipal bonds and pay if default (AMBAC and MBIA)
Municipal bond taxation
NO tax (federal, state or local) if you live in the municipality
how are treasury securities taxed
- taxed at federal level but no state/local
- to get tax-equivalent yield (TEY) of a treasury security, would only consider state tax since federal already applies to it
current yield
current yield = annual payment / current price
annual payment = coupon interest
Yield to Maturity
what is it and how to calculate
- what is it: compounded rate of return if investor buys bond today and holds to maturity
-
how to calculate: using time value, solve for i based on all the payments to come (coupon rate /2) and the par value (FV)
- Note: when you get the result, need to multiply i by 2 because coupon payments are semi-annual
if a bond is selling at a premium, how does the coupon rate relate to:
current yield, YTM and YTC
Coupon > CY > YTM > YTC
if a bond is selling at a discount, how does the coupon rate relate to:
current yield, YTM and YTC
YTC > YTM > CY > Coupon
if a bond is selling at par, how does the coupon rate relate to:
current yield, YTM and YTC
Coupon Rate = CY = YTM = YTC
what happens to accrued interest when a bond is sold?
buyer pays the seller the accrued interest
buyer gets 1099 for the interest but can claim deduction for interest paid to seller
original issue discount (OID) bond
- zero coupon bond
- purchased at discount
- interest is reported as phantom interest each year
- tip: it’s good to keep these in a tax deferred account (IRA)
yield curve theories
Liquidity Preference Theory vs Market Segmentation Theory vs Expectations Theory vs Unbiased Expectations Theory
- theories that attempt to explain yield curve shape (Y-axis = yield; X-axis = time)
-
Liquidity Preference - investors are willing to accept a lower yield for shorter maturities b/c willing to pay for liquidity
- doesn’t explain inverted curves
- Market Segmentation - curve depends on supply and demand of given maturity
-
Expectations - curve reflects investor inflation expectations
- if they think inflation will rise, lenders will increase rates so longer term yields will be higher than short term
- unbiased expectations (UET) - rate for each year reflects both that year and years prior
duration
what does it measure, what higher # means, and what duration value do you want
- what it measures: bond’s price sensitivity to changes in interest rates
- what higher # means: higher = more sensitive
- what # you want: match duration to investment time horizon
how does duration relate to other variables
-
Inversely related to interest rate variables (coupon rate, YTM)
- e.g., lower coupon = higher duration = more volatile
-
directly related to time
- e.g., longer maturity = higher duration = more volatile
convexity
convexity is my friend so higher is better
if interest rates increase, what happens to bond values and what kind of duration do we want?
bond values decrease
we want a shorter duration because it won’t be as price sensitive
convertible bond value and conversion ratio
CV = (par value / conversion price) x stock price
conversion ratio = par value / conversion price
property valuation formula
value = net operating income / required rate of return
when calculating NOI, operating expenses exclude depreciation and interest because the value of the asset does not vary based on how someone pays for it
what is the lowest bond rating that can still be considered investment grade debt?
Moodys = Baa
S&P = BBB
investment company/fund types
-
closed
- fixed initial market cap
- shares trade on organized exchange
- may trade at premium or discount to NAV
-
open (mutual funds)
- unlimited initial market cap
- shares bought/redeemed directly from fund family
- shares trade at NAV
-
unit investment trust
- can be equity or fixed income
- self-liquidating
- passive investments
- sold in units, NOT shares
global vs international mutual funds
- global: includes US
- international: excludes US
fund expenses (share types)
-
A Shares
- front end load
- small 12b-1 fee
- no redemption fee
-
B Shares (rare)
- redemption fee
- max 12b-1 fee (1%)
- no front end load
- convert to A shares
-
C Shares
- no front end load
- usually small back end load
- max 12b-1 fee (1%)
Real Estate Investment Trusts (REITs)
- tax-exempt because they pass income to investors
- must distribute 90% of investment income to maintain tax-exempt status
- types:
- equity
- mortgage
- hybrid
American Depository Receipts (ADRs)
what are they and are they subject to exchange rate risk
- foreign stock held in domestic bank’s foreign branch
- trade on US exchange, denominated in US dollars
- DO NOT eliminate exchange rate risk because the US dollar denomination is still exchanged from a different currency
portfolio insurance
using a put option on an index to “lock in” portfolio gains
straddle
types and when to use them
-
Long
- buy a put and a call
- do when you expect volatility but you aren’t sure which direction
-
Short
- sell a put and a call
- do when you don’t expect volatility, you just want to keep the premiums
option pricing models
- Black/Scholes - used to value calls
- Put/Call Parity - used to value puts; based on value of call option
- Binomial pricing model - values options based on assumption that stock can only move two different directions
Black/Scholes variables
InVEST)
- INterest rate (specifically, risk-free rate)
- Volatility
- Exercise price (i.e.., strike price)
- Stock price
- Time
- Note: all have a direct relationship EXcept the EXercise price
Warrants
- long-term call options (usually 5-10 years)
- issued by corporations
- terms are not standardized (can be any strike price)
bond investment strategies
bond laddering, immunizing, bond-swap, bond-barbell
- Bond laddering - includes short term, intermediate and long term bonds
- Immunizing - uses duration rather than maturity as a measure of position for implementing the strategy
- Bond-swap - trade different and varied maturities to meet the objective of the portfolio
- Bond-barbell - involves both very long-term bonds and very short-term bonds for a portfolio, and very few intermediate-term bonds
what kind of bonds are most sensitive to interest rate changes?
if the term is equal, bonds with the lowest coupon will have the longest duration and therefore be the most sensitive to interest rate changes
Tactical asset allocation
active management portfolio strategy that re-balances the percentage of assets held in various categories to take advantage of market pricing anomalies or strong market sectors.
12b-1 fees vs commissions vs management fees
- 12b-1: used for marketing and distribution costs
- Commissions are paid using either a front load or a back load.
- management fees - pay for all other costs, such as legal, accounting and analysis
calculate how much a bond’s price will change if interest rates change by X amount
Use “change in p / p” formula on sheet where D = duration
what are treasure shares
shares a corporation as repurchased
ETFs vs Index Fund
when they can trade, can they use margin, can they be shorted, which most closely matches underlying stock value
- When can they trade?
- ETFs - any time during day
- Index - only at EOD
- Can they be purchased on margin?
- ETFs - yes
- Index - no
- Can they be shorted?
- ETFs - yes
- Index - no
- which value will be closest to the value of the underlying stock?
- ETFs because index funds will incur transaction costs, fund cash flows, and changes to the index
best efforts vs firm commitment
- forms of underwriting
-
Best efforts:
- firm takes all the risk
- underwriter agrees to sell as much as they can
- unsold shares returned to company
-
firm commitment
- underwriter takes all the risk
- underwriter buys entire issuance and tries to sell to public for more
red herring
- preliminary prospectus issued before SEC approval
- note: prospectus outlines risk, management team, fees, expenses, etc.
- used to determine investor interest in the security
market order
- market order - timing and speed more valuable than price (thinly traded stocks)
- limit order - price is most important (volatile stocks)
- stop order - when price hits certain level, turns into market order; if market is moving quickly, can end up sold for significantly less
- stop limit or stop-loss limit order - investor sets two prices: stop loss (turns it into limit order) and limit price (won’t sell below this price); risk that it won’t fill if market moves too quickly
anchoring
anchor thoughts to a preference even if no logical relevance
aka conservatism or belief perseverence
bounded rationality
seek satisfactory solution, not optimal one
cognitive dissonance
tendency to misinterpret info that is contrary to existing opinion or only pay attention to info that supports existing opinion
hindsight bias
assuming you can predict the future as readily as you can explain the past
prospect theory
value gains and losses differently ; base decisions on perceived gains rather than perceived losses (loss averse)
how to calculate standard deviation of portfolio
return1 → E+ → return2 → E+ → return3 → E+ → etc → ORANGE → Sx,Sy
what measure of risk do capital market line and security market line use
capital: standard deviation
security: beta
tools of technical analysis
- charting - plot historical prices to determine pattern
- market volume - how the market is trending indicates investor sentiment
- short interest - # shares sold indicates future demand
- odd lot trading - trading done by small investors (<100); do opposite of small investors
- dow theory - signals when bull or bear market ends (not when it will begin)
- breadth of the market - number of stocks that increase in value vs # stocks that decline
- january effect - january has better gains because of tax selling in Nov/Dec
- small firm effect - small caps tend to outperform large caps
- value line effect - value line’s highest ranked stocks outperform lowest ranked
- P/E effect - stocks with low P/E outperform those with high P/E
bond rating agencies
- Moody’s: Aaa-C
- investment grade = Aaa-Baa
- Standard & Poors: AAA-D
- investment grade = AAA-BBB
bond strategies
tax swap, barbell, laddered, bullets
- tax swap - sell bond with a gain and a loss to offset each other or sell bond with loss and buy a new bond
- barbell - own both ST and LT bonds
- laddered - own varying maturities
- bullets - little payments in interim then lump sum in future (e.g., zero-coupon, Treasuries)
Closed end vs open end investment companies and calculating NAV
-
Closed
- fixed # of shares and initial market cap
- shares then traded on organized exchanged
- may sell at premium or discount to NAV
-
Open
- unlimited # of shares
- shares bought and redeemed directly from fund family
- shares trade at NAV
- NAV = (assets - liabilities) / shares outstanding
