Investments Flashcards
Original Issue Discount Bond (OID)
- Bond that is discounted from par at the time of issue
- Most are zero-coupon bond; pay no interest until maturity
- The phantom income is included as taxable interest income (ordinary) and increases the bonds basis
- OID’s of tax exempt bonds (Municipal OID) is not taxable on primary issuance
Brokered CD vs. CD
Brokered CD = traded on an exchange (subject to interest rate risk) vs. CD = cash and no interest rate risk
Treasury Bills, Notes, and Bonds (BNB)
Bills (short term): 3-12 months / issue at discount / $100 to $1 million
Notes (intermediate): 1-10 years / $1,000 to $100,000
Bonds (long term): 10-30 years/ $1,000 to $1 million
No Default Risk
Unsystematic Risk
Diversifiable or Non-Systematic Risk
everything not PRIME
Systematic Risk
Tradable Securities Systematic Risk:
- Purchasing Power Risk
- Reinvestment Risk
- Interest Rate Risk
- Market Risk
- Exchange Risk
Bond Systematic Risk:
- Defualt Risk - corporate only (credit risk)
- Reinvestment Risk
- Interest Rate Risk
- Purchasing Power Risk
Zero-Coupon Risk
- Interest Rate Risk
- Purchasing Power Risk
Systematic risk does not get diversified, it is stagnant
Zero Coupon Treasury Bond (STRIPS)
- Direct obligations of the federal government
- Produce phantom income taxable every year
- Discount is treated as taxable income
- Typically purchased in a tax deferred account due to the phantom income (pensions, IRA, etc.)
Treasury Inflation Protected Security (TIPS) Bond
- Taxed annually on interest payment + additional principal (phantom income)
- Not subject to state and local tax
- TIPS are not subject to Purchasing Power Risk (inflation adjusted) - Just RI
EE Bonds
- Non-tradable / Non-marketable / Non-transferable / Non-negotiable
- Can not be used as collateral
- Issued at face value
- Term = 20 years; if not redeemed at maturity, can still accrue interest for another 10 years (30 years total)
- No taxation until maturity or redeemed
have the option to receive and tax interest each year
HH Bonds (2 Potential Questions)
When transferring EE Bonds to HH Bond do you pay tax on the gain? No, it is deferred until maturity
Did transferring EE Bonds to HH Bonds help her cashflow? Yes - they pay interest semi-annually
I Bonds
- Inflation adjusted EE bonds
- Non-marketable / Non-transferable / Non-Negotiable
- Can not be pledged for collateral
- Sold at face value
- Interest rate consists of fixed rate + inflation adjusted component (every 6 months of bonds issue date)
- No guaranteed rate of earnings like the EE bonds
- May qualify for education bond status
Mortgage Backed Securties
GNMA: Ginnie Mae purchase FHA/VA loans. Guaranteed by federal goverment.
FNMA/FHLMC: Federal National Mortgage (Fannie Mae) and Federal Home Loan (Freddie Mac) are NOT guaranteed. They are in conservatorship of the FHFA.
Mortgage Backed Bonds (CMOs)
- CMO’s do not pass mortgage payments through to certificate holders in the same format as recieved
- Fast Pay (A Tranche), Medium Pay (M Tranche), Slow Pay (Y Tranche), and Z Tranche (no coupon)
- Z Tranche is zero coupon and gets what is left over - high risk (high duration)
Municipal Bond: General Obligation (GO)
- Backed by full faith and credit over municipality (taxing power)
- Issuer promises to raise taxes without any limit in order to pay off bond holders (least amount of risk)
*for all muni bonds, no federal taxes only SALT (unless you live in the state of issue)
Revenue Bonds
- Bond back by specific source of revenue (stadium project, toll road)
- Higher credit/default risk = higher yields
insured revenue bonds are safer than regular revenue bonds
What is in a bond indenture agreement?
- Form of bond
- Amount of issue
- protective covenant / provisions for a sinking fund
- redemption rights such as call, put, conversion
Convertible Debt
- Hybrid security but still considered debt
- Investor can choose to convert a specific amount of shares to common stock
- Market price is dependent on both values (stock and bond)
Bond Investment Value
Present value of expected cash flows (discounted by appropriate value)
Conversion Value = Par / Conversion Price (compare conversion value vs. present value)
Put vs. Callable Bond
Put Bonds: used when interest rates rise and investor wants to put bond back
Callable Bonds: used when interest rates fall and issuer wants to call back higher interest rate bond and issue lower interest rate bond
- Call premium is the amount over par that the investor is compensated with; punishes issuer for calling bond early
Corporation Liquidation Order
Secured Bondholder (creditor), Unsecured Bondholder, Preferred Stock, Common Stock
Preferred Stock
- Hybrid security resembling both an equity and fixed income component
- Ussally issued at par ($25 or $100) with a stated fixed dividend rate
- Maturity is infinite (no maturity date) = long long duration = high price fluctuation
- Corporations purchase due to 50% divided deduction
American Depository Receipt (ADR)
- Receipt of share of foreign corporation
- Held in US
- Issued in the US
- Prices in US dollars
- Dividends declared in foreign currency
- Dividends paid in US dollars
Exchange Traded Funds (ETF’s)
- Can be open or closed
- Type of index fund
Unit Investment Trust (UIT’s)
- Passive investment (unmanaged securities) - managed by a trustee
- The trust is self liquidating
- No reinvestment, just liquidation
- Generally redeemed but sometimes traded on a thin secondary market
- Not shares
Mutual Funds
- Open End
- Continuous offering (books are open) - redeemable
- Non-negotiable, Non-Marketable
Closed End Investment Company
- Books are closed / traded on an exchange (one time issuance)
- Value is based on supply and demand
- can trade at a premium or discount
Index Funds
- Tax efficiency (little turnover)
Real Estate
hedge against inflation and diversification due to correlations its common stocks
Unimproved
- negative cashflow
- invest for appreciation
Improved Land
- income producing
- Intrinsic Value computed using NOI
NOI Calculation
Gross Rental Receipts
+ Non-rental income (laundry machine, equipment, etc.)
- Vacancy and collection losses
- Operating expenses (do not include interest or depreciation)
= NOI
Intrinsic Value Calculation
- NOI / Cap Rate
Real Estate Investment Trust (REIT)
- Invest in real estate, short term construction loans, and mortgages
- generrally not redeemable and are negotiable/trade on an exchange
Equity REITS
- Invest for income and growth
- Net income exceeds investors borrowing costs
- Leveraged and nice inflation hedge due to owning the properties
Mortgage REITS
- Invest in real estate debt
- Interest exceeds borrowing costs
Income and Conduit Treatment
- At least 75% of REIT income must come from real estate investments (15% can come from securities like GNMA)
- 90% of net investment income must be distributed to only pay tax on undistributed portion unless pay tax on all net investment income
REIT Dividend Deduction
- REITS can deduct 20% of dividend income (not capital gains)
- Only taxable individual accounts
Call Option
Selling Call (Bearish) | Buying Call (Bullish)
Formula = MP - EP (can not be zero - in the money when positive)
- Time premium = intrinsic value - price of the option
Calls vs. Warrants
- Calls issued by individuals / warrants issued by corporation
- Calls have maturity of 9 months / warrants have longer maturities
- Calls dont create new stocks / warrants create new stock when exercise
- Calls are standardized / warrants are not standardized
Black - Scholes Option Valuation Model
5 Variables - must be non-dividend stock
- Direct Relationship
- Price of underlying stock
- Time remaining on the option
- Interest rate
- Volatility of the underlying stock
- Inverse Relationship
- Exercise Price
Put Options
Selling Put (Bullish) | Buying Put (Bearish)
Formula = EP - MP (dont go below zero)
Protective Put = long position in both the put and underlying stock
- Insurance
Taxation of Options
Holder (bought a call or put)
- Exercised or expires = short term gain or loss
Seller (sold a call or put)
- Expires = premium received is short term gain
- Exercised = premium received is added to sale price and takes the character of the transaction
Long-Term Equity Anticipation Securities (LEAPS)
Expiration can range from 9 months to 3 years
STCG LTCG |———|—————| Exercise 1 year +
Short Selling
Sell short when the investor is bearish
- Investor sells borrowed security
- Investor sells borrowed securities at high & waits for price to drop to then purchase again at a lower price to give back
- Must maintain a margin account
- Everything is held at the broker (not the investor) instruct broker to do this
- Dividends must be covered on a short sale
- Target stocks with high P/E (want a high price with little earning to tank)
Futures (Short/Long)
Short Position = if you are long the underlying good take the short position (farmer is long corn, short the price)
Long Position = if you are short the underlying good, take the long position (Kellogg’s needs wheat so is short, need to take long wheat)
Collectibles
- Return is mostly through price appreciation
- Can be inflation hedge
- Low correlation with functional market
- Own capital gains bracket = 28%
Liquidity vs. Marketability
Liquidity = security sold or purchased without delay without a change in price (speed & price)
Marketability = only refers to speed of transaction (exchange)
- Mutual funds are not marketable
Private Placement
Accredited Investor: $1,000,000 (net worth not including residence)or $200,000 income (S) or $300,000 income (MFJ)
- Not a public offering and exempt from registration
- Can be sold to a max 35 non-accredited investors and unlimited accredited investors
- Must provide full disclosure through offering memorandum
- Typically illiquid investments that require long holding periods
Other accredited investors:
- FINRA license or RIA; NOT CFP professionals
- 1 year of service at private investment fund
- LLC for investment purposes; family offices under $1b but more than $5m
- Spouse of accredited investor
Exchange Rate
Devaluation vs. Revaluation
- If the currency you are in can buy more of something = other currency was devalued against the currency you are in
- If dollar is going to be devalued = sell dollars and buy other currency
Covariance / Correlation Coefficient
Covariance and Correlation Coefficient both reflect how securities in a portfolio move together (or not)
- Covariance is infinite while Correlation Coefficient are expressed in a range from -1 to 1
+1= perfectly positively correlated / Securties move exactly together and no reduction to portfolio risk
- standard deviation of portfolio is weighted average
+1 - 0 = Risk of portfolio is less than the individual security
-1 = exactly opposite of one another / risk is completely eliminated / standard deviation is 0
test tip = do 50/50 weight with 1 correlation and step down from there to determine standard deviation of the portfolio
Standard Deviation Results
1 standard deviation = 68%
2 standard deviation = 95%
3 standard deviation = 99%
*Z score is just amount of standard deviations (Z score of 1 = 1 standard deviation)
Coefficient of Variation (CV) (formula not on sheet)
This is a measure of relative variability used to compare investments with widely varying rates of return and standard deviation
- Risk per unit of return
CV = standard deviation / return
can also use Sharpe; however, you want higher results rather then lower like CV
Standard Deviation vs. Beta
Standard Deviation
- measures variability of non-diversified portfolio
- measure of total risk
Beta
- measures volatility of returns in a diversified portfolio
- measures systematic risk
Beta of 1 = moves with market (market has beta of 1)
Beta of below 1 = fluctuates less than the market
Beta above 1 = fluctuates more than the market
Beta of 1.5 = 50% more volatile then market
Risk Adjusted Return
Risk adjusted return =. Average Return / Beta
Risk Tolerance vs. Risk Capacity
Risk Tolerance = amount of risk investor is comfortable to take
Risk Capacity = amount of risk investor must take to reach financial goals
Arithmetic Mean (Average)
(Compound Return / Effective Rate of Return)
Normal average calculation (formula sheet)
Geometric Mean (Time Weighted Return)
Mostly used to evaluate performance of investment manager
Ex. Up 30%, Up 50%, Down 20%
FV: 1.30 X 1.50 X .80 = 1.56
PV: -1
N: 3
I/Y: ?
when it is in dollars you can take the first number as PV and last as FV and calculate I/Y
Dollar Weighted Return (Internal Rate of Return)
- Accounts for cashflow - additions and withdrawals
- Manager to manager comparisons are not possible
Uneven Cashflow Analysis
- put the calculator in the correct holding period
- watch out for missed holding periods!
Holding Period Return
Income + Appreciation / Dividends - Margin / Price of Investment (out of pocket cost)
Bond Current Yield Formula
Current Yield (CY) = Annual Interest in Dollars / Bonds Market Price
Current yield is based on market value not basis
Reading a Bond Quote
$50,000 face value municipal bond at $95 = bought for 5% discount
Taxable Equivalent Yield (TEY)
- Municipal bond is exempt from federal income
- exempt from SALT if investors lives in that state (NY resident is exempt from all tax on NY municipal bond)
Bond Duration
Measures weighted average maturity of the bonds cash flow on a present value basis
Elements of Duration
- Intrest rates are inverse with duration
- annual coupon is inversely related with duration
- years to maturity are positively correlated with duration
Interest rates expected to rise = short duration | Interest rates expected to fall = long duration
Yield Curve
Normal Yield Curve = maturity increases / yields increase (need to be compensated for risk)
Inverted Yield Curve = short maturity has higher yield than long
Immunization (passive strategy)
Safeguard bond portfolio against interest rate volatility with matching the duration of the portfolio to pre-selected time horizon
Ex. 10 year time horizon = 12 year bond with 5% coupon
Change in Bond Price
For large interest rate changes, bonds should move with duration (ex. 1% interest rate change on 10 year duration bond = 10% change)
USE formula given on CFP formula sheet
Efficient Frontier
Not feasible and not attainable
————————————————- Attainable (best r/r)
Inefficient but attainable
Optimal portfolio = indifference curve meets efficient frontier
Capital Market Line (CML)
- uses standard deviation to measure total risk
- how can leverage increase returns
Security Market Line (SML)
Relationship between risk and return for individual assets diversified or undiversified
- uses the required return formula
- looks at risk as a function of beta
Market Risk Premium
(Rm - Rf)
- slope of the SML
Stock Risk Premium
(Rf - Rm) X B
Efficient Market Hypothesis (EMH) (Passive)
Investors can not expected to outperform the market consistently on a risk adjusted basis
- Random Walk Theory = day to day changes are random and unpredictable and if patterns form they are accidental
- Technical analysis is never helpful according to this theory (no charting)
Weak form = Fundemental analysis and insider information may help (no technical)
Semi-Strong form = only insider information may help (non technical or fundemental)
Strong form = Nothing helps, all information is reflected in the price
superior results over time are unlikely not immediately
Anomalies
Anomaly is an exception to the rule or model
- P/E effect / Small firm effect / Day of the week effect
Passive vs. Active Strategy
Passive Strategy
- buy-hold / long term strategic allocation, core satellite approach
Active Strategy
- tactical asset allocation, market timing , volume analysis
When does an investor get a dividend?
Purchase date ——— Ex-dividend date ———— Date of Record
- Watch out for holidays
- Date of record + 2
Performance Measures
High R2 = Jensen (alpha) or Treynor (greater than 60)
- Alpha is preferred
- Other words to look out for are diversified or systematic risk only
Low R^2 = Sharpe
- Look out for words such as non-diversified or unsystematic risk
R2 = coefficient of determination or the correlation confident ^2
- for the exam this is correlation with the S&P 500
if they are not all diversified use Sharpe
Information Ratio (IR)
High ratio mean a manager can achieve higher returns more efficiently than one with a low ratio by taking on additional risk
Return of portfolio - return of benchmark / tracking error
Margin Accounts
Regulation T = sets initial margin at 50% (SEC) | FINRA sets maintenance margin
1-IM / 1-MM * purchase price of stock
What is marginable?
- only certain ACTIVE securities are marginable
- options are not marginable
—————————————————————————————
New stock Price New Stock Price
X MM - Loan amount
= Required Equity = Current Equity
What Are No Load Funds?
They do not have management fees
