Investments Flashcards
What is Unsystematic Risk?
Unsystematic Risk = Non-market risk
Known as Diversifiable Risk, may also be referred to a Non-systematic Risk.
Business Risk: Refers to the nature of the firm’s operations (i.e., possibility of loss due to new technology)
Financial Risk: Refers to how the firm finances its assets (i.e., the possibility of loss due to heavy debt financing)
What is Systematic Risk?
Systematic Risk = market risk
Also known as Non-Diversifiable Risk.
This part of risk is inescapable because no matter how well an investor diversifies, the risk of the overall market cannot be avoided.
Systematic Risk: Factors That Make Up Systematic Risk
Remember P.R.I.M.E.
Purchasing Power Risk: Loss of purchasing power through inflation.
Reinvestment Risk: Risk that proceeds available for reinvestment must be reinvested at a lower interest rate than the instrument that generated the proceeds.
Interest Rate Risk: The risk that a change in interest rates will cause the market value of the fixed income security to fall.
Market Risk: Risk of the overall market (the asset class market: equity, bond, etc.)
Exchange Rate Risk: Risk associated with changed in the value of the currency.
FDIC Insurance: Amounts
FDIC Insurance for each account type
Individual: $250k
Joint (per owner): $250K
Trust (per beneficiary): $250k
IRA/Keogh: $250k
Yield Ladder
Discounted Bonds (Yields Higher than coupon)
Yield to Call
Yield to Maturity
Current Yield
Nominal Yield (Annual Coupon Rate)
Current Yield
Yield to Maturity
Yield to Call Premium Bonds (yields lower than coupon)
EE Bonds: Structure
- Federal government bond
- taxed at Federal only when REDEEMED, unless for education, parents only) or at MATURITY
- Non-marketable, Non-transferrable, can’t be used for collateral
- Sold at Face Value
- Interest Rate based on 10 yr Treasury Note Yields
- Fixed Interest Rate that is in effect at the time of purchase
- Not subject to state or local taxes, only pay Federal tax
- Only PARENTS can get education expenses tax free, not grandparents/others
I (inflation) Bonds: Structure
- Federal government bond (taxed at Federal only when REDEEMED, tax free for education)
- Non-marketable, non-transferrable, can’t be used for collateral
- Sold at Face Value
Interest Rate is composed of two parts:
- Fixed Base Rate (remains the same for the life of the bond)
- Inflation Adjustment (adjusted every 6 months)
Muni Bonds: Types
General Obligation Bonds (GO Bonds): Backed by the full faith, credit and taxing power of the issuer. GO Bonds are generally considered the safest types of municipal credit.
Revenue Bonds: Backed by a specific sources of revenue to which the full faith and credit of the issuer is NOT pledged. Because revenue bonds are backed by a single source of funds (like toll roads, hospitals, power plants, etc.), they have a greater credit risk than GO Bonds. As such, they trade at higher yields.
Insured Municipal Bonds: The insurers pay timely interest and principal when the issuer is in default. Municipal bond insurers are AMBAC and MBIA.
Bonds: Indenture Agreements
Indenture Agreement Structure
- Structure/Form of Bond
- Amount of Issue
- Property Pledged (collateral)
- Protective covenant, including any provision for a sinking fund
- Financial requirements: Working Capital and Current Ratio
- Redemption Rights
Bonds: Risks
Default: A creditor may seize the collateral and sell it to recoup the principal.
- U.S. government bonds have NO default risk.
Reinvestment: As payments are received from an investment, interest rates may fall. When the funds are reinvested the investor receives a lower yield.
Interest Rate: Rising interest rates may cause bond prices to fall
Purchasing Power: Inflation may lower the value of bond interest payments and principal repayment, thereby forcing bond prices to fall.
Market Cap Definitions
Large: > $10 billion
Mid: $2-10 billion
Small: < $2 billion
Micro: < $300 million
American Depository Receipt (ADR)
- Prices of ADRs quoted in US dollars
- Dividends paid in US dollars
- Dividends declared in foreign currency
- Attain diversification and risk reduction due to lower correlation of foreign securities with US securities.
Real Estate: Net Operating Income (NOI)
Improved land is normally income producing.
Income properties include residential rental, commercial and industrial properties. The intrinsic value of a real estate property can be computed using a Net Operating Income (NOI) calculation.
NOI = GOVO
Gross Rental Income
+ Other Non-Rental Income
- Vacancy/Collection Losses
- Operating Expenses
= Net Operating Income (NOI)
Gross Rental Receipts plus Non-rental Income (laundry, etc.) equals Potential Gross Income (PGI) minus Vacancy and collection losses minus Operating Expenses (excludes interest and depreciation) = Net Operating Income (NOI)
Intrinsic Value = NOI /Cap Rate %
Options: Definitions
Intrinsic Value is the minimum price the option will command as an option. It is the difference between the market price and exercise price of the stock.
Exercise Price is the price at which the stock can be purchased or sold on exercise of the option.
Premium is the market price of an option. As the option approaches its expiration date the market price of the option (Premium) approaches its Intrinsic Value Time. Premium is the amount the market prices of an option exceeds its intrinsic value.
Premium = Intrinsic Value + Time Value
Options: Taxes
Taxability of Call Options
At the Time of Purchase: Non-deductible Capital Expenditure
To the Writer Due to Lapse: Premium received is a short-term gain
To the Writer Due to Exercise: Premium received is added to sale price (can be long term gain if underlying security was held more than 12 months, otherwise short term). Covered Call.
To the Holder: If the option expires worthless, then the option is considered sold and it is a short-term loss. The option period is 9 months or less.
Options: Hedging strategies
Protective Put: Buying a stock (or already owning it) and a Put for the stock serving as insurance against the decline in the underlying stock. (Hint: A good answer for the exam)
Straddle: Buying a Put and Buying a Call - The buyer does NOT own the stock.
Collar: Selling a Call (out-of-the-money) at one strike price and buying a Put at a lower strike price; investor OWNS the stock. Lock in price with put option paid by the premium from writing the call.
Warrants vs. Call Options
Warrants are issued by corporations, whereas Calls are issued by individuals.
Warrants typically have maturities of several years.
Warrant terms are not standardized. Call options are standardized.
Futures Contracts: Hedging Positions
Long Commodity Position: If a farmer is long a commodity (for example, corn) he needs a short hedge and will sell a futures contract.
Short Commodity Position: If Kellog’s is short a commodity (for example, corn), they need a long hedge and will buy a futures contract.
Reg D: Accredited vs. Non-Accredited Investors
Accredited (Unlimited): (1-2-3)
- Net worth of $1 million or,
- Individual with income of $200,000 or,
- Couple with income of $300,000
Non-Accredited
- Issue sold to a maximum of 35 investors
- Must use a purchaser representative if not “sophisticated”
Coefficient of Determination R2
R = correlation
R2 - coefficient of determination
The square of the correlation coefficient measuring the proportion of the variation in one variable explained by the movement of the other variable.
How is R2 used on the exam?
It describes the percentage of a fund’s movement that are explained by the movements in the S&P 500.
Index funds/diversified funds based on the S&P 500 will have R2 of very close to 100%, while sector funds (not diversified) will have very low R2 (typically 5% - 25%).
