Investments Flashcards
CD’s and MMF’s
CD’s are insured up to $250k
MMF’s are not insured
Banker’s Acceptance, Eurodollar & Yankee Bonds
Bankers Acceptance: Used to finance import and export transactions
Eurodollar: Deposit in a foreign bank denominated in US Dollars
Yankee Bonds: Dollar denominated bonds issued in U.S. by foreign banks and corps
Yields on Premium vs. Discount bonds
Premium: (high side of teeter totter) Coupon, Current, YTM, YTC (low side)
Discount: (High side) YTC, YTM, Current Coupon (low side)
nominal = coupon rate (semi annual payment though)
OID
Discount bonds, usually zero coupon, which they generate no income each year but the income that was to be generated that year due to the discount is taxed to them as phantom income
Treasuries
TBills: 3, 6 & 12 months. $100 to $1mil (safest) Rfr. No interest paid. Weekly auction
TNotes: 1-10 years. $1,000 to $100,000. Reinvestment risk, purchasing power. Semiannual interest. Monthly auction
Tbonds: 10-30 years. 1,000 to $100,000. Reinvestment risk, purchasing power. Semiannual interest. Quarterly auction
TIPS and STRIPS
TIPS: Adjust the principle semiannually to keep pace with inflation. Adjustment is based on current CPI
STRIPS: The interest (phantom income) on zero coupon bonds is taxable income earned annually but is a direct obligation of the government
Series EE, HH and I bonds
All non-marketable. Cannot be held in UTMA/UGMA accounts
EE: 30 year term, issued at face value, fixed interest rates, owner has the option of having interest taxed each year or at final maturity. Interest not subject to state/local taxes
HH: Only available by exchanging at least $500 of EE bonds. Semiannual interest payment by check
I: Inflation indexed. Sold at face value. Owner has the option of having interest taxed each year or at final maturity.
GNMA & Other Agency Securities
GNMA: Mortgage pools that offer individual interest in the pool. They are a direct guarantee of the U.S. government, but not issued by the treasury. Each payment is part interest and repayment of principal.
Risks for this include: Interest rate (prices fall when interest rates rise) and reinvestment (premature payments by homeowner)
Other Agencies: Government does not directly back their securities
Muni Bonds
GO bonds: are the safest type of municipal credit
Rev Bonds: Back by a specific revenue source and not pledged
CMO’s
Tranches of mortgages get paid based on their rank from A to Z. A is fast paying to Z is slow paying but highest yield
Bond Risks
Ratings Agency rate bonds only for Credit Risk
Muni and Corporate: DRIP
Default, Reinvestment, Interest Rate, Purchasing Power
Government: RIP
Reinvestment, Interest Rate, Purchasing Power
Rating Agencies
Standard & Poor’s:
AAA, AA, A, BBB (investment grade)
BB and below (junk)
Moody’s:
Aaa, Aa, A, Baa (investment grade)
Ba and below (junk)
Bond Conversion Equation
Conversion Value = (Par Value / Conversion Price) * Current Market Price
Convertible bonds sacrifice yield for the conversion factor
Callable and Putable Bonds
Callable: Issuer has right to redeem at a predetermined price at a date prior to maturity. Would if interest rates have dropped since bond was issued
Putable: Permits holder to sell bond back to issuer at par value at specific time. Would if interest rates have risen since bond was issued
Stocks Caps
Large: > 10 billion
Mid: >2 billion < 10bilion
Small: < 2 billion
Micro: < 300 million
Corporate Reports
Annual Report: Sent annually to shareholders to explain previous years results
10Q: Quarterly report from corporate to SEC
10K: Annual report from corporate to SEC
Preferred Stock and ADRs
Preferred Stock: Has a fixed dividend rate, dividend can either be cumulative or non, duration is infinite and thus making them riskier than bonds
Corporations typically buy preferred shares because 50% of the dividends received are excluded from taxes
ADRs: Shares of forgeign based shares bought in the US. It is paid in USD, but declared in foreign currency
Dividend Tax Rates
Single:
0%: < 41,675
15%: 41,675 to 459,750
20%: > 459,750
Joint:
0%: < 83,350
15%: 83,350 to 517,200
20%: > 517,200
ETFs
Low management fees, open or close end fund and are generally tax efficient
UIT (Unit Investment Trust)
No day to day portfolio management (passive investment), unit holders not shareholders and units are redeemed at NAV
Mutual Funds
Open-end fund, shares are purchased by new shareholders and redeemed back to company. Redemption is at NAV, shares are marked to market daily and the fund passes through capital gains
Closed-end companies
Issue shares once and then books are closed. Shares trade on an exchange and sold on market or negotiated not redeemed
Hedge Fund
Aggressively managed private investment partnership open to a limited number of investors. May be unregulated and are usually illiquid
GICs
Like a CD, but issued by insurance companies. 2-5 years in length with guaranteed interest rate, value fluctuates but interest rate does not.
Real Estate
Unimproved land is a passive investment, can only appreciate not generate income.
Improved land generates income from rentals. Intrinsic value of property is computed using NOI
NOI, Cap Rate & Intrinsic Value
NOI calculation:
Gross Rental receipts
+Non-Retnal Income
= Potential Gross Income (PGI)
-Vancany and collection losses
-Operating Expenses (excluding interest & depreciation)
=NOI
Intrinsic Value = NOI / Cap Rate
REITs, RELPs, REMICs
REIT: Similar to close end fund, invests in real estate, construction loans and mortgages but is liquid. Equity REITs are income producing, mortgage REITs loan money to develop property (vulnerable to default and purchasing power risk). Taxed like a stock
RELPs: Managed by GP, generally not marketable, subject to passive loss rules
REMICs: Provide more flexibility than CMOs and may eventually replace them
Options Intrinsic Value
Put:
Intrinsic Value = Exercise Price - Market Price
If EP > MP then put is in the money
If EP < MP then IV is 0 and out of the money *cannot be negative
Call:
Intrinsic Value = Market Price - Exercise Price
If MP > EP then call is in the money
If MP < EP then IV is 0 and out of the money *cannot be negative
Call Option Taxation 9 months or less
Writer:
Option Lapses = short term gain for premium received (same for a put option)
Option exercised = premium received added to sale price, can be long term gain if covered call and security was held for > 12 months
Holder:
Option not exercised = short term loss
Warrants
Option to purchase stated number of shares for a specified time period.
- Issued by corporations
- Maturities of years (calls only up to 9 months)
- Non standardizes terms
- No intrinsic value
Tangible Assets
Stamps, coins, oriental rugs and antiques. typically rise in inflationary periods
Long Term Cap Gain Rate: 28%
Private Placement (Regulation D)
Max 35 non-accredited investors. Unlimited accredited investors.
Accredited = 1-2-3 Test. 1 mil net worth (excluding primary residence), 200k annual income (single), 300K annual income (joint)
Futures
3 main types: Financial, Commodity and Foreign Currency
Delivery: means settlement
Offset: buyers sell their positions and sellers buy their positions prior to delivery
Long position: Person who wants to buy commodity
Short: Person who wants to sell the commodity
Speculating is very risky in futures, but companies may use futures to hedge or mitigate risk
Spot: Current market price
Open interest: Number of contracts trading on a given day
Daily limit: maximum permissible price increase or decrease relative to settlement price on previous day
Systematic Risks
Purchasing Power Risk: rise of prices and services erode purchasing power of fixed income through inflation
Reinvestment Rate Risk: Proceeds will be invested at a lower interest rate than the security that generated the proceeds. Uncertainty about the rate future income can be invested at
Interest Rate Risk: Change in interest rates will cause market value of fixed income security to fall. Relationship of bond prices and required rate of return
Market Risk: Risk of the overall market
Exchange Rate Risk: Uncertainty of the price at which one country’s currency can be converted into anothers.
- Devaluation: lowering the value of a currency relative to
another currency
- Revaluation: Increase in the value of a currency relative to
another currency
Systematic risk is expressed by Beta
Unsystematic Risks
Business Risk: Nature of firms operations
Financial Risk: How firm finances its assets
Can be reduced through diversification
Total Risk
Total risk is expressed by standard deviation. It is a makeup of systematic and unsystematic risk.
International Investing
Lower correlation of foreign securities with US securities
Liquidity and Marketability
Liquidity: Security can be bought or sold without delay and without substantial price change
Marketability: Speed of a transaction
Mean and Distribution of Returns
Mean: Middle point between two extremes
Normal Distribution: Mean = most likely return, and is centered in bell curve (68, 95, 99)
Lognormal Distribution: Upper limit is unlimited but lower cant go below 0, distribution is positively skewed with most values near lower limit, mean is to the right of highest point
Correlation Coefficient and Covariance Formulas
Correlation Coefficient: Ranges from +1 (perfectly correlated and move together) to -1(negatively correlated and move opposite). Symbol is Pii.
Pii= COVii / (STdev1*STdev2) use whole numbers for STdev’s
Covariance: COVii = PiiSTdev1STdev2
Coefficient of Variation
= Standard Deviation / Mean
Standard Deviation vs Beta
St. Dev: Measures the variability of returns, used in non diversified portfolio to measure total risk
Beta: Measures volatility of returns used in a diversified portfolio to measure systematic risk
Bi (beta) = [Pii * STdev(stock)] / STdev(market)
Calculator Calculations for Mean, Standard Deviation
2nd Stat: Enter returns for stock under each year
2nd Data: down to X = mean, Sx= St Dev
Standard Deviation of a Portfolio
(Sum of STdev’s of all funds ) / # funds (use whole number not percentages)
then look for the next lowest answer
Weighted Beta
Stock 1 Beta * Stock 1 weighting = Stock 1 weighted beta
Stock 2 Beta * Stock 2 weighting = Stock 2 weighted beta
Sum those answers together
Risk-adjusted return
Funds Annual Return / Beta
Geometric vs Arithmetic Mean Return
Geometric: Time Weighted Return
(1+ return1) * (1+ return2) * (1 + return3) = FV for financial calculator. PV = sum of money, N= # of returns. Solve for I/Y
Arithmetic = Sum of all returns / # of returns. Not a good use of measuring returns
Dollar Weighted = IRR and NPV
Real Rate of Return
[(1+after tax return) / (1+inflation rate)] - 1 then multiply by 100
Returns
Nominal: Actual returns produced over a given time without account for inflation
Total: Annual return including appreciation or loss and dividends/interest
Risk Adjusted: Return has been altered to account for differences in risk among variables of the same type
Holding Period: (Sale price + Dividends&Interest - Purchase Price) / Purchase Price
Margin HPR: [(Sale Price * Total Shares) - (Borrowed Funds + Interest) - Purchase Price of Shares Client Paid For] / Purchase Price of Shares Client Paid For
IRR
Use CF on calculator. Note: that if dividend hits on the same year as sale, net out the proceeds in that year.
YTM
When calculating YTC, use semiannual compounding (2 p/y)
PV= Current MP
I/Y = Solve for
N = # Years xP/Y
FV = Par
PMT = (Coupon Rate * Par) / 2
YTC
When calculating YTC, use semiannual compounding (2 p/y)
PV= Current MP
I/Y = Solve for
N = # Years until callable x P/Y
FV = Call Price
PMT = (Coupon Rate * Par) / 2
Current Yield
(Coupon Rate * Par) / Current Price
Taxable Equivalent Yield
Tax exempt yield / (1 - Tax Rate)
Duration
Measure of how long it will take recoup the price paid by cash flows. Compares price volatility with equal coupons but different term lengths.
Interest rates expected to rise: Buy high coupon short maturity (shorten duration)
Interest rates expected to fall: Buy low coupon long maturities (lengthen duration)
Duration = (1 + y) / y
y = current yield on comparative bonds
Portfolio Immunization
Passive investment strategy where the portfolio duration is equal to a preselected time horizon
Zero Coupon Bonds
Their Duration equals their maturity. Their prices fluctuate more than those of coupon bonds with same maturities
Changes in Bond Prices Formula
Change in Price / Price
also = -Duration (change in interest rates / [1 + YTM])
Bond Volatility
Smaller Coupon: greater price fluctuation. Convexity is largest
Longer maturity: greater price fluctuation. Convexity is largest
Market interest rate is lower: greater price fluctuation
Low yield to maturity: Convexity is largest
Dividend Growth Models
Zero Growth:
Price = Dividend / Required Rate of Return
Constant Growth Model:
Price = [Dividend * (1 + Growth Rate)] / (Required Rate of Return - Growth Rate)
(Also same as Price to Free Cash Flow Fomula, Dividend is replaced by FCF per share)
Dividend Discount Model (Shortcuts):
Solve for constant growth using the 2nd dividend growth rate.
Price = [Dividend * (1 + 2nd Growth Rate)] / (Required Rate of Return - 2nd Growth Rate)
If 1st Growth Rate < 2nd Growth Rate, select the next lowest answer than the price solved for.
If 1st Growth Rate > 2nd Growth Rate, select the next highest answer than the price solved for.
Yield Curve
Normal: Higher yield for longer maturities
Inverted: Lower yield for longer maturities
Price to Earning
P/E:
Price = Earnings * P/E ratio
Return on Equity
ROE (per share) = EPS / Bookvalue or net worth (per share)
Dividend Payout ratio:
Common dividends paid / EPS
Modern Portfolio Theory
Seeks to quantify the relationship between risk and return. Four Basic Steps.
- Security Valuation: Describe universe of assets by expected return and risk
- Asset Allocation Decisions: Determining how assets are to be distributed among classes
- Portfolio Optimization: Reconciling risk and return in selecting the securities to be included
- Performance Measurement: Dividing each stock’s performance into systematic and unsystematic risk
Capital Market Line
Expresses macro aspect of MPT. The straight line CML is tangent to Markowitz Efficient Frontier, optimal portfolio’s align.
It reveals:
- Expected return on fully diversified portfolio
- Diversified portfolio should fall somewhere on the CML
- Individual securities or inefficient portfolios fall below the CML
- Cannot be used to evaluate performance of a single security or not fully diversified portfolio
- Risk free rate/return is 100% T-Bills
Efficient Frontier
Markowitz’s approach to portfolio selection, investors should evaluate portfolios based on their expected returns and risk (standard deviation). There are many optimal portfolios along the indifference curve. Indifference curves cannot intersect, where they are tangent is the optimal portfolio for that investor
Lowest level of risk for a given level of expected return
Highest expected return for a given level of risk.
Any points above the efficient frontier are not feasible or unattainable.
Any points below are attainable but inefficient.
Risk averse have steep curved lines, less risk averse have flatter lines
Security Market Line
At a micro level, its the relationship between risk and return for an individual security.
It uses the CAPM to solve for the required rate of return.
Rr= Rfr + (return market - Rfr) * Beta
Return market - Rfr = Market Risk Premium
(Return market - Rfr)*Beta = Stock Risk Premium
If markets are in equilibrium, the expected return should equal the required return
Efficient Market Hypothesis
Strong Form: All past, public and private info is included. Nothing can provided superior results
Semi Strong Form: All past and current public info is included. Neither fundamental or technical analysis can produce superior results
Weak Form: Past/historical Info is included, but fundamental analysis could produce superior results, but technical cannot.
Anomalies
Perform in contrast to what is expected in totally efficient:
P/E Effect: Low P/E ratio stocks perform better than high P/E ratio stocks
Small Firm Effect: Small firm stocks outperform large firm stocks
January Effect: Stocks decline at the end of the year and rebound in January
Neglected-firm Effect: Not commonly studied firms stocks outperform heavily studied firms
Liquidity Ratios
Current Ratio: Current Assets / Current Liabilities
CA: Cash, Marketable Securities, AR and Inventory
CL: AP, Credit Card Debt and Taxes Payable
Technical Analysis
Use charts or computer programs to identify and project prices.
- Dow Theory: Aggregate measure of securities prices, shows direction of the overall market
- Barron’s Confidence Index: differential between returns of bonds and bonds of lesser quality will forecast future price movements
- Advance/Decline Line, Moving Average, IA opinions, Odd lot theory
Charting: Believe stock prices move in patterns. Plot market variables, stock prices and moving averages.
Resistance: Price ceiling which shows persistent selling of a security. Sellers enter the market to push price lower. If stock breaks through resistance level, usually mean prices will go higher and outcome is considered bullish
Support: Level where security tends to stop falling, due to more demand then supply. Temporary price floor, price at which security or index bottomed at the past. If price drops past support level, outcome is considered bearish
Benchmarks
Dow Jones: 30 individual stocks. Price weighted
S&P: Largest stocks on the NYSE
Russell 2000: Smallest 2000 stocks in Russell 3000 index. Cap weighted
Wilshire 5000: Broadest measure of activity in overall stock market
Value Line: 1,700 stocks equally weighted on NYSE, AMEX and OTC
NASDAQ: Broadest measure of OTC trading. Cap weighted
EAFE: Compares performance of U.S. and international equity markets
Monte Carlo Simulation
1,000 trials based on inputs put into the system to determine the most possible outcomes. Results are shown in a histogram
Tax Implication for Sale of Mutual Fund Shares
3 Methods:
FIFO
Specific Lot
Average Cost
Stock Splits
Split: Amount owned in $’s stays the same, # of shares increases and cost per share decreases
Reverse Split: mount owned in $’s stays the same, # of shares decreases and cost per share increases
Wash Sale
Cannot repurchase the same security within 30 days of selling it for a loss. If you do no deduction will be allowed for the loss.
Purchase Date, Ex-Dividend Date and Date of Record
Purchase Date: Day order was placed and filled
Ex-Dividend Date: Stock must be purchased before this date in order to qualify for the dividend
Date of Record: 1st business day after the ex-dividend date. Shows the date the trades are settled.
*Watch out for holidays and weekends they like to test those
Sharpe Ratio
Excess return of a portfolio to its standard deviation.
Sharpe = (Return portfolio - Rfr) / STdev portfolio
It’s meaningless unless compared to the market or other MF’s. You want the highest risk adjusted return when comparing to market or other MF’s
Treynor Ratio
Excess return of a portfolio to the Beta of the asset (not the market beta). Risk adjusted return
Treynor = (Return portfolio - Rfr) / STdev portfolio
You want the highest risk adjusted return when comparing to market or other MF’s
Jensen Ratio
Alpha. Measures the contribution of the portfolio manager.
Alpha = Return portfolio - CAPM
Using R2 to determine the right performance measure
R2 = square of the correlation coefficient (correlation coefficient * correlation coefficient)
R2 < 60: Non-diversified portfolio, look for highest Sharpe ratio. Sharpe is measured in STdev, contains systematic and unsystematic risk
R2 > 60: Look for highest Alpha (Jensen), if that is not a choice choose highest Treynor
Information Ratio
Active return of a portfolio over it’s benchmark.
IR = (Return portfolio - Return benchmark) / Tracking error
Passive Investing
Indexing, weights portfolio to match a broad based index
Swaps and Collars
Bond Swap: Selling a bond and replacing it with another
Stock option collar: Hedging strategy. Stock owner, sells a call at one strike price (out of the money) and buy a put at a lower strike (out of the money)
Floating rate note collar: Protect holders against higher interest rates but pay lower yields than fixed rate notes of same maturity
Bond Portfolio Strategies
Ladder: Bonds are purchased with different maturity dates, when each one matures another long term bond is purchased
Bullet: Immediate duration bonds purchased and dont acquire short duration or long duration bondds
Barbells: half short term duration bonds and half long duration bonds. Requires periodic rebalancing
Margin
Initial Margin: Reg T set requirement of 50%
Maintenance Margin:
[(1 - Initial Margin Requirment) / (1- Maintenance Margin requirement)] * Purchase price of stock
Short Selling, Option Straddles & Currency Futures
Short Selling:
-Investor thinks that the price will security will decline but they do not own the stock
Straddle: Buying a put and buying a call on the same security, because investor feels there will be movement of the security
Protective Put: Owning a security and buying a put on it
Currency Futures: Establish long position on a currency to lock in a price and avoid the risk
Risk Tolerance vs Risk Capacity
Tolerance: Amount of risk that an individual is comfortable assuming
Capacity: amount of risk an investor must take in order to reach financial goals.
Asset Allocation
Tactical: Market timing approach
Passive: Buy & Hold, Immunization, Laddered, Indexed Porftolio, Barbell, Dollar cost averaging
Rebalancing is done for change in wealth, liquidity requirements, legal/regulatory, time horizon, tax circumstances, or needs/circumstances
Asset Pricing Models
CAPM: See previous cards
Arbitrage Pricing Theory: Premise is that pricing of securities cannot differ for an significant length of time. Investors seek to take advantage of price differences because of unexpected inflation, changes in industrial production levels, shifts in risk premium, and changes in the structure of yields
Black-Scholes
Used to value options.
Increase in the exercise price of a call, decreases the call’s value
Increase in the exercise price of a put, increases the put’s value
Binomial Option Pricing
Model assumes price of an option can be two possible values at the option expiration
