Investments Flashcards
CDs carry interest rate risk
Treasury bills – one year or less
Commercial paper – short term, unsecured, promissory note issued by large financially, strong company (270 days or less)
Bankers acceptance
Before a foreign exporter will ship goods to US, they want assurance of payment. Bankers acceptances are bearer securities, and can be held to maturity. (nine months or less)
Euro dollar
Deposit in any foreign bank that is denominated in dollars
Yankee bond
Dollar denominated bonds issued in US by foreign banks and corporations. Must be registered with SEC.
Commission gets added to bonds basis
Original issue discount (OID)
Typically zero coupon bonds, but issued far below par value.
No interest until maturity
Each year portion of discount hat has been earned is included in taxable interest income and bonds basis is increased. Zero coupon bond holders must report interest income although bond pays no interest before maturity (phantom income)
Treasury notes and bonds have reinvestment, interest rate, and purchasing power risk (RIP)
Treasury bills, notes, and bonds all are subject to federal income tax, exempt from state and local income tax
Treasury issues it’s own zero-coupon bonds, called STRIPS
They are a direct obligation of the federal government
STRiPS do not distribute interest in form of coupon payment. Interest is accrued and phantom income.
TIPS
Min denominations of 1,000
Interest rate is fixed
Interest payments vary as the principal is adjusted for inflation
Obligations of federal government
EE bonds
Fixed rate based on 10 yr treasury
Guaranteed to reach face value in 20 yes but can earn interest for 30 yrs
Only subject to federal tax
GNMA
(Government national mortgage association) (Ginnie Mae)
Prepayment risk!
These are guarantee of US govt but not issued by the treasury
Fed state and locally taxed
Minimum sold is 25,000
Rates increase causes NAV of GNMA to decrease. Also principals being paid off can cause value to lower
Reports
10k- required to be filed with SEC. Annually
10q- required to be filed with SEC. Quarterly
Prospectus- for potential buyers of new stock issue
Red herring - preliminary prospectus
Preferred stock
Pays a fixed dividend rate.
Can be cumulative or non cumulative.
Cumulative- if dividend payments are missed, it will pay dividends in full before common shareholders.
Non cumulative- missed dividends do not have to be made up
No maturity date but can be callable
C corps will likely buy to get 50% of dividends excluded from taxation
ADR
A way for Americans to buy foreign shares in the US. An ADR is a receipt for the shares of a foreign based corp held in US vault.
Dividends are paid in US dollars, but declared in currency of country of origin
Hedge funds
Aggressively managed portfolio that uses long short, leveraging and derivative positions.
Open to a limited number of investors and require large minimum investment.
Often illiquid and require money in fund for at least one year.
Laws require a majority of investors to be accredited (must earn minimum amount of money annually, or have a net worth of more than 1 million. Primary residence does not count toward 1 million.)
GICS do not have interest rate risk
Guaranteed Investment Contract like a CD generally purchased by institutional companies
Net operating Income
Any income, less vacancy, less operating expenses = NOI
*do not do anything with any mortgage info they give you or depreciation info. It is not included in calculation
**if they ask for monthly income, that factors in mortgage payments
Put option
Gives owner right to sell a specific number of shares at a set price. Investors buy puts when they are bearish. Writers (sellers) of the put are bullish on price. They believe it won’t decrease and options won’t be exercised
In the money and out of the money for PUTS
When market price is less than the exercise price, a put is in the money.
When market price is greater than the exercise price, about is out of the money.
Call
Contract that gives holder the right to purchase a specific number of shares at a set price. Investors buy cars when they are bullish. Call writers (sellers) premium income. If an individual writes a covered call, a call is written on stock already owned by the call writer.
In the money and out of money for CALLS
When market price is greater than the exercise price, a call is in the money. When the market price is less than exercise price, a put is out of the money.
Intrinsic value of a put = exercise price - market price
Intrinsic value of a call = market price - exercise price
Warrants vs calls
Warrants are issued by corporations. Calls are created by individuals on exchanges.
Warrants generally have maturities of several years. Calls usually expire within 9 months
Warrants are issued with no intrinsic value
Collectibles long term capital gain rate is 28%
Real Property (1250) LT gains are taxed at capital gains rate. A special 25% depreciation recapture is applied when the property is sold. (This is just on the amount that was taken for depreciation.
Private placement (regulation D)
Is an issue offered privately that can be sold to a maximum of 35 nine accredited investors and an unlimited amount of accredited investors. This issue would be exempt from registration.
Accredited investor - individual with net worth $1 million, one individual with an annual income of 200,000, or a couple with joint income of 300,000
(remember 123 rule 100,000,000/200,000/300,000)
1 million excludes primary residence volume
Systematic risk
PRIME
Purchasing power risk, reinvestment, right risk, interest rate risk, market risk, exchange rate risk
- S&P index would carry a systematic risk
Unsystematic risk is diversifiable risk, and can be largely eliminated
Business risk and financial risk
Future Contracts
Farmer may sell a contract on corn if he wants to hedge against lower crop prices in the future. He will make a short hedge if worries prices will be lower in the future.
Food processor may hedge to guard against increase in commodity’s price at the time of delivery. The processor wants to buy the crop at today’s price to hedge against higher price in the future. (This is the processors going long)
Total risk is expressed by standard deviation while systematic risk is expressed by Beta.
Revaluation
Generally means an increase in the currencies value
Devaluating is the lowering of the value of currency relative to currencies of other nations
Life insurance cash value is considered to be liquid. So is open ended money market mutual funds.
Savings, checking, money market accounts, and mutual funds are redeemed rather than marketable. Treasury bonds, and common stock are marketable.
Correlation coefficient, and covariance, both express the extent of which movements of stocks in the same portfolio are similar or not
+1 = perfectly positively correlated
-1 = perfectly negatively correlated
When correlation coefficient of an equally weighted portfolio is less than one, the risk must be lower than the average risk.
Coefficient of variation is the standard deviation, divided by the average return
The higher the coefficient of variation, the riskier the stock
Standard deviation and beta are used to express risk of security
Standard deviation measures variability of returns used in a non-diversified portfolio, and it’s a measure of total risk
Beta measures volatility of returns, used in a diversified portfolio and is a measure of systematic risk
Standard deviation
This is the bell curve chart. The mean is at the center.
1 standard deviation = 68%
2 standard deviations = 95%
3 standard deviations = 99%.
Correlation coefficient example
Correlation coefficient is .5
Fund A mean = 10% and risk = 20%
Fund B mean = 8% and risk = 12%
Portfolio is equally weighted. What is standard deviation?
Add the risks 20% +12%, then divide by two = 16%. Since the correlation coefficient is less than one, choose the next Lowest answer under 16%. if the correlation coefficient were exactly 1, the portfolio standard deviation would’ve been exactly 16.
Beta
Volatility of assets or portfolios rate of return compared to market. The market constant beta is 1.0.
1.5 beta is a stock with 50% more volatility than market
.75 beta is only 75% as volatile as market
Beta can be negative. Negative beta can lower volatility of portfolio
Risk adjusted return
Divide individual funds realized return by its beta coefficient.
Reinvestment rate risk
GNMA have greatest reinvestment risk because payments include interest and return of principal.
Zeros and STRIPS have lowest since there are no coupon payments to reinvest
Geometric return
Used to reflect compound returns over more than one time period.
- Add to returns (25% becomes 1.25, -12 become .88)
- Multiply returns 1.25x.88
- That result is your FV
- -1 is always your PV
- N is the the number of years of investment
- Solve for I
Time weighted returns, such as geometric, allows investors to compare managers. This is not possible with dollar weighted returns
Time weighted return is normal
Holding period return
Income plus price appreciation and dividends less margin interest.
If time period is over 1yr, then HPR overstates annualized returns. If under 1 yr, it understates.
HPR
Sell price factoring in interest - cost basis factoring in any interest - any margin / initial investment
When calculating yield to maturity, always use semi annual compounding, even with zero coupon bond
Zero-coupon bonds
One advantage is the elimination of reinvestment rate risk, because there are no interest payments to be reinvested. Zeros still carry interest rate and inflation risk.
Current yield
Current Yield = annual interest in dollars / bonds current price
Taxable equivalent yield (TEY)
Taxable equivalent yield = tax exempt yield / 1 - tax rate
Treasury securities are exempt from state and local tax
Duration is inversely related to Yield to maturity and annual coupon. When market interest rates increase, duration decreases.
Duration and maturity are positively related.
(Remember time is on top, positively related)
Duration
Enables investors to compare the price volatility of bonds with equal coupons, but different terms
Most important measure of how risky bones are because it measures are sensitivity to interest rate changes
Interest rate risk is neutralized if duration is equal to the preselected investment horizon
Zero-coupon bonds are most volatile if interest rates move quickly. The duration of the zero coupon bond is the same as its maturity.
Remember UPS
If interest rates go UP, Shorten duration
Remember fallen
If interest rates FALL, LENgthen duration
Convexity
Expresses degree to which duration changes as a bonds yield to maturity changes.
Convexity is the largest for low coupon bonds, long maturity bonds, and low yield to maturity bonds.
Constant Growth Model
Dividend (1+ Growth Rate of dividend)/Required rate of return - growth rate of dividends
*If constant growth model is higher than price, then the stock is undervalued.
*This model assumes dividends grow at a constant rate over time.
When intrinsic value is lower than the MV of stock, the investor earns a lower rate of return than he requires.
If dividend changes over time use TVM calculation.
Step #1 - Find PV. Input FV, Interest, and N. Do this for each year, then total the years PV.
Step #2 - Use constant growth model. D(1+G)/r-g
*D=the last dividend you figured from step 1.
Step #3 - discount this value back to PV. Then add that and step #1 value together
USE shortcut!!! not this..
Dividend discount model shortcuts
shortcut #1 - If the FIRST growth rate is lower than the second growth rate, then do the discount model equation using the second growth rate (the highest). Once you have that figure, pick the answer that is the next lowest.
shortcut #2 - If the FIRST growth rate is higher than the second growth rate, then do the discount model equation using the second growth rate (the lowest). Once you have that figure, pick the answer that is the next highest.
***Always use the second growth rate. If it gets lower, pick the next lowest answer. If it gets higher, pick the next highest growth rate.
Yield curve shows market rates of interest for bonds of different maturities with similar credit ratings.
Current market price = Earnings x P/E ratio
if PE Ratio is more than price, it is undervalued.
Return On Equity (ROE)
Earnings available for common (EPS) / Common Equity (net worth or book value)
*preferred dividends don’t factor in
Dividend payout ratio
Common dividend paid/ EPS
Short selling involves borrowing a security who’s price you think is going to fall and then selling it on the market. your plan is to then buy the same stock at a lower price and pocket the difference after repaying the loan
If stock goes up you have to buy stock on open market to close position. The stock could rise to infinity.
Utility stocks typically have a high dividend payout ratio
Change in interest rate formula
-Duration(change on interest/current interest rate)
Capital Market Line
Specifies relationship between risk and return on a portfolio rather than on one investment
Individual securities or an efficient portfolios fall below the CML . Diversified portfolios should fall somewhere along the CML.
It can’t be used to evaluate a single security
Modern asset allocation by Harry Markowitz
Risk, return, and covariance of assets are important input variables in creating portfolios
Risk adverse investor will have a steep indifference curve which demands a significant amount of return to take on more risk. Someone who is less risk adverse would have a relatively flat indifference curve
Market risk premium
Return of market - risk free rate
Stock risk premium
(Return of market - risk free rate)Beta
Security market line (SML)
If security is above line, it’s undervalued. It offers more expected return than investor requires.
If under line, it’s overvalued
Efficient market hypothesis
EMH justifies passive investing
Strong form -fully reflect all public and private info. Neither fundamental or technical analysis produces superior results over time.
Semi strong form - reflects, publicly known information. Neither technical analysis nor fundamental analysis produces superior results. Only an investor with the inside info could achieve superior results (illegal).
Week form - suggests historical price data is already reflected in current prices and is of no value in predicting future price changes. Technical analysis will not produce superior results. Fundamental analysis may produce superior results.
Fundamental analysis
Factors such as interest rates, gross, domestic product, inflation, unemployment, and inventories are used to predict the direction of the economy
Top-Down method
Investor first looks at trends in the general economy, then select industries, and then companies that shod benefit from those trends
Bottom-up method
Client searches for individual stock with outstanding performance before considering the impact of economic trends. This approach assumes the individual company will do well, even if the industry doesn’t.
Current ratio
Assets/liabilities
Assets - bonds count. IRA’s do not count
Liabilities - only use taxes payable when the material indicates the taxes are due or if it says the taxes are payable. Always use credit card debt even if the credit cards are paid off monthly.
Technical Analysis
Most technical analysis looks at short or immediate term outlook. It is not concerned with any specific financial position of a company, unlike fundamental analysis.
Bar charts, resistance/support levels, ect
Resistance
Price ceiling. If stock breaks through, it’s considered bullish.
Support
Price floor, if stock breaks through, it’s considered Bearish
Wilshire 5000
Broadest measure of the market but value-weighted.
Date of record comes after ex dividend date.
You must purchase before the ex dividend date to get dividend
Sharpe ratio
Ratio of the excess return of the portfolio to it standard deviation. This number is meaningless unless it’s compared to the market or other mutual funds.
Treynor ratio
This measure is expressed as a ratio of the excess return of the portfolio to its beta.
Uses beta so portfolio must be diversified (using systematic risk only)
Jensen ratio
AKA Alpha.
Uses beta so portfolio must be diversified (using systematic risk only)
Calculates the portfolio return actually attained and subtract it from what the return should’ve been based on the risk assumed. Positive number signifies that the return exceeded what was expected.
R-squared (correlation coefficient squared)
Is the percentage of a funds movements that is explained by movements in the S&P 500.
If R-squared is higher than 60, look for highest alpha (Jensen). If alpha/Jensen isn’t option, look for highest Treynor.
If R-squared less than 60, look for highest sharpe number.
Information ratio
Measures portfolio managers ability to generate returns higher than benchmark.
Rp-Rb/standard deviation
Rp=asset return Rb=return on benchmark asset
Immunization
A portfolio is immunized if duration of portfolio is = to pre-selected time horizon of portfolio
Barbell strategy
Buying half very short term and half very long term bonds
Margin
Regulation T sets initial margin at 50%. Exchanges and FINRA set the next level, normally 25%.
Only actively traded securities are marginable not mutual funds or options.
Margins requirement= (1-margin %) / (1-maintenance margin %). x purchase price of stock
Margins
If bought 200 shares at $150 on margin. Initial margin requirement is $15,000. Maintenance margin is 25%. What is maintenance call if stock drops to $90.
200 shares x $90. =$18,000
25% x $18,000 = $4,500 equity required
$18,000-15,000= -$3,000 actual equity
$1,500 maintenance call
Long vs short position
Long position means you own it. Short position is generally a sale of a stock you do not own
Risk capacity
Amount of risk an investor “must” take to reach their goals
Arbitrage Pricing Theory (APT)
The security’s movement and return are not explained by a relationship between risk and return. They suggest four main reasons: unexpected inflation, unexpected changes in level of industrial production, unanticipated shifts in risk premium, and unanticipated changes in structure of yields.
When arbitrage pricing theory expect value is zero, the factor has no effect. It was expected.
Black Scholes option value model
Valuation of options. An increase in exercise price of call decreases the calls value. Increase in exercise price of put increases the puts value. (Direct relationship)
Interest rate risk
Danger that bond could lose value
Naked call
Similar to short selling. In short selling you borrow the stock your selling in naked calls, you are selling the right to buy the security at a fixed price. You are aiming to make a profit from collected premium
Out of the money
Stock price 39. Call price is 40. Intrinsic value is zero. There is no intrinsic value when you can buy the stock at a lower price than the call prize.
Dividends reinvested get input as 0 in the IRR calculation. This then gets added to basis and is treated as phantom income. Dividends taken as cash are just a positive cash flow.
Carryforward loss
Only $3,000 can be deducted on the 1041 estate tax return in the year of death. Any remaining losses are lost after year of death.
