Investments Flashcards
2 Forms of Underwriting
1) Best Efforts: underwriter agrees to sell as much as possible. Risk resides with the firm - any shares not sold are returned to the company.
2) Firm Commitment: underwriter agrees to buy the entire issuance of stock. Risk resides with the underwriter
10K & 10Q
- 10K: annual report of financial statements filed with SEC. 10K is audited.
- 10Q: quarterly report “ “ 10Q is NOT audited.
Types of Orders
1) Market Order: timing and speed of execution more important than price. Appropriate for stocks that are not thinly traded (illiquid).
2) Limit Order: price at which trade is executed is more important than timing. Appropriate for thinly traded (infrequently, volatile) stocks.
3) Stop Order: price hits a certain level and turns into a Market Order.
4) Stop-Loss Limit Order: investor sets two prices - stop-loss price & limit price. Once the first price, the stop-loss, is reached, the order turns to a Limit Order. The investor, then, will not go beyond the second price set, the limit price.
Thinly Traded
Securities that are not easily sold; require a significant price change to sell; illiquid; trade with low volume; greater risk
Short-Selling
Sell at a higher price in hopes of purchasing back the stock at a lower price. Sell high & buy low.
Margin Definitions
- Initial Margin: amount of equity must contribute for a margin transaction. Margin requirement - 50%.
(Ex. 60% in cash, 40% borrowed) - Maintenance Margin: minimum amount of equity required before a margin call
- Margin Position: represents the current equity position of the investment
Margin Call Price
Demand for additional capital/securities when investor’s equity in a margin account falls below the required minimum.
Formula to determine price investor will receive a margin call:
Margin Call = Loan/(1-Maintenance Margin)
*MEMORIZE - not provided for exam
Research Reports - MorningStar & Value Line
- Morningstar: ranks Mutual Funds. Ranking 1-5 stars.
1 = low ranking, 5 = highest ranking - Value Line: ranks Stocks. Ranking 1-5 for timeliness and safety.
1 = highest ranking (buy), 5 = lowest (sell)
Dividend Dates
- Dividends declared by the Board of Directors. Paid quarterly.
- Ex-Dividend Date: date stock trades without the dividend.
If you sell stock on this date, then you’ll receive a dividend.
If you buy stock, there’s no dividend. - Date of Record: date you must be a shareholder to receive a dividend.
One business day after the Ex-Dividend Date. - TO receive dividend, investor must purchase stock prior to Ex-Dividend Date or 2 business days prior to Date of Record.
- Cash Dividend = Cap Gain treatment; taxable upon receipt
- Stock Dividends: taxable once stock is sold
Stock Split
Increase number of shares & reducing the price of them.
2-for-1 split: 100 shares at $50 per shares -> 200 shares at $50
3-for-2 split: 100 shares at $60 per share -> 150 shares at $40
Essentially, more shares & decr. price per share
- Shares x Stock Split (3/2) –> Bigger #
- $ Price / Stock Split (3/2) –> Smaller $
Security Regulations (*Exam Tip: know this flashcard)
- Securities Act of 1933: Regulates the issuance of new securities - Primary Market (Primary Market deals with company’s who directly originate stocks. This is when they are first being offered to the public - IPO - and also company’s second offerings). Requires new issues are accompanied by a prospectus for new securities before purchase.
- Securities Exchange Act of 1934: Regulates Secondary Market & trading. (Secondary Market is what we know to be the “stock market”. Every exchange is apart of it. Trading is between investors only and does not directly involve the companies originate the stocks (ex. Amazon). Trading on the secondary market is with already originated stocks that are being exchanged between investors). Created the SEC - enforce compliance & security regulations.
- Investment Company Act of 1940: Authorized SEC to regulate managed investment companies, variable life products, and UIT’s.
- Investment Advisors Act of 1940: Requires investment advisors to register with SEC/state. Regulates the actions of investment advisors.
- Securities Investors Protection Act of 1970: Established SIPC to protect investors for losses from brokerage firm failure. Protects accounts regardless of citizenship
- Insider Trading and Securities Fraud Enforcement Act of 1988: Defines an insider as anyone with information that is not available to the public; cannot trade on that info
Mutual Fund vs ETF
Mutual Fund (index fund):
- sales occur directly between investors and the fund (unlike ETFs which are traded on the Secondary Market)
- typically, actively managed (although they CAN track indexes like ETFs although, more commonly are actively managed)
- more expensive than ETF’s (because they are actively managed, more associated trading costs or fees)
- commonly managed by financial institutions such as Vanguard, or BlackRock, either directly or through a brokerage firm
- can be purchased in fractional shares. Although, require full purchase price is required and can’t be shorted.
- only purchase once at the end of each day
ETFs:
- Secondary Market trading: trade freely on the open market throughout the day between others investors like a stock
- more passively managed
- track indexes
- more cost-effective since trade on exchanges like share of stock
- CAN be purchased on margin or shorted (whereas index funds require the full purchase price and can’t be shorted)
Closed vs Open-End Funds vs UIT’s
*All 3 based on NAV
Closed-End: actively managed; issues a fixed number of shares through an IPO to raise capital for its investments
- shares can then trade on Secondary Market but no new shares will be created
- many muni bonds are closed-end
- Usually sold at either a premium or discount to NAV
Open-End: (almost synonymous for MFs)
- usually passively managed; consists of well-diversified portfolio; can issue new shares
- NOT traded on secondary market. Rather, are only traded directly from the company that issues
Unit-Investment Trusts (UITs): an investment company that buys or holds a group of securities and makes them available to investors as redeemable units.
- Holds most muni bonds until maturity
- Passively managed by a portfolio manager
- NO additions to investments once the trust has been structured
- Portfolio is self-liquidating
- Shares are NOT traded on the open market
12b-1 Fees (MF’s)
- Fees charged based on daily fund assets and used for marketing expenses & distribution costs.
- an aside: MF commissions are paid using either a front load or a back load
Key Documents
1) Prospectus: Must be issues by an investment company prior to selling shares. Outline the business operations, mgmt team, fees, and risks of stock.
2) Red Herring: Preliminary prospectus used to determine investors’ interest in the security
3) Annual Report: Sent directly to shareholders. Contains message from Chairman of the Board on progress of past year & outlook for coming year.
Money Market Securities (*Exam Tip: know definitions carefully)
1) Treasury Bills (T-Bills): debt obligations of the US Gov issued in varying maturities of 1yr or less (52 weeks). Denominations in $100 increments via Treasury Direct up to $5M per auction.
2) Commercial Paper: Short-term loans between corporations. Maturities of 270 days or less. Denominations of $100,000 and are sold at a discount. Do NOT have to register with SEC.
3) Bankers Acceptance: Maturities 9 months or less. Facilitates imports & exports. Can be held until maturity or traded.
4) Eurodollars: deposits in foreign banks that are denominated in US Dollars
Investment Policy Statement
IPS establishes ULLTTRR:
Unique circumstances
Liability
Legal
Taxes
Time horizon
Risk tolerance
Return
Market Average & Indices (5)
- Dow Jones Industrial Average (DIJA): price-weighted average index. Does NOT incorporate market cap. ONLY Price-Weighted Index
- S&P 500: value-weighted index. Incorporates market cap of individual stocks.
- Russell 2000: value-weighted index of the smallest market cap in the Russell 3000
- Wilshire 5000: value-weighted index. Measures performance of over 3,000 stocks.
- EAFE: value-weighted index. Tracks stocks in Europe, Australia, Asia, & Far East
Price-weighted Average vs Value-weighted Index
- Price-weighted: each company apart of the index has its stock value weighted into the average based upon its price per share. Index = avg. of all share prices of all companies
- Value-weighted: each company apart of the index is weighted according to its market cap; its weight is proportional to its value
Behavioral Finance:
4 Basic Premises:
1) Investors are Rational
2) Markets are Efficient
3) The Mean-Variance Portfolio Theory Governs
4) Returns are Determined by Risk
NPV & IRR
NPV is a better method for evaluating projects than the IRR method. The NPV method:
- Employs more realistic reinvestment rate assumptions.
- Is a better indicator of profitability and shareholder wealth.
Volatility/maturity of Investments
- Treasury bills are short duration and backed by the full faith and credit of the United States gov. Treasury bills have 4, 8, 13, 17, 26 and 52-week durations. They are least volatile.
- Commercial Paper is a money market instrument with a 270-day maturity.
- Bankers Acceptances are money market instruments durations less than or equal to 9 months.
- Treasury notes have maturities of 2,3,5,7, or 10 years.
- Agency issues are not backed by the full faith of the federal government (though in practicality they may be) and are slightly more volatile and pay a higher yield.
Standard Deviation
- Measures total risk of undiversified portfolios
(Could ask, “What is riskiest asset?” Really, asking which asset has highest std. dev.) - The higher the standard deviation, the higher the riskiness.
- Normal Distribution: 68% (1), 95% (2), 99% (3)
CFP exam: - calculate std dev
- use to determine probability of returns
Coefficient of Variation
- Determines the probability of actually experiencing a return close to the average return.
- The higher the CV, the riskier an investment
Fomula: CV = Std Dev/Avg. Return
Kurtosis
Variation of returns. If there is little variation (Treasuries), distribution will have high peak (positive Kurtosis).
- Leptokurtic: high peak & fat tails (higher chance of extreme events)
- Platykurtic: low peak and thin tails (lower chance of extreme events)
Monte Carlo Simulation
A spreadsheet simulation that returns probability of events occurring based upon assumptions
Covariance & Correlation (Coefficient)
Both:
- Measure movement of one security relative to that of another;
- relative measures
Covariance
Measures the relative risk of two securities
- How price movements between the two are related.
*COV formula provided
Correlation Coefficient
- Correlation ranges from -1 to +1.
+1: two assets are perfectly positively correlated to each other
0: the assets are completely uncorrelated
- Risk is reduced anytime correlation < 1.
Max Diversification Benefits are when correlation = -1
Beta
- Measures volatility of a diversified portfolio
- An individual security’s volatility relative to that of the market.
- Measures systematic/market risk. (Std Dev measures total risk)
- Market Beta = 1 mirrors the market
- Beta > 1: stock fluctuates more than the market; greater risk
- Beta < 1: stock fluctuates less than the market; less risk
- Beta = 0 no systematic risk
*CFP Provided formula
Coefficient of Determination or R-Squared (r^2)
Beta & Coeff of Determination VS
Std Dev & Coeff of Variation, Covariance, and Correlation Coeff
- % return due to the market. (r-squared = % of systematic risk)
- The higher % r-squared, the higher the % of systematic risk & smaller % of unsystematic risk
- Indicates how well diversified portfolio is & if Beta is appropriate to measure risk.
If r-squared > .70, then portfolio is diversified;
- Beta: Treynor & Jensen’s Alpha
(70% of the risk is systematic; 30% unsystematic)
If r-squared < .70, then portfolio is undiversified;
- Std. Dev: Sharpe
**Exam Tip: if not given r-squared, then choose Sharpe!
Portfolio Risk
Utilizes the:
a) Std Dev (Coeff of Variation, Covariance, Correlation Coeff)
b) COV/Correlation Coeff
c) weight of the securities in a portfolio
*CFP Provided
Systematic & Unsystematic Risk
- Systematic: lowest level of risk one could expect in a fully diversified portfolio. Inherent in the “system”. Non-diversifiable, market risk
(as result of unknown element of securities). - Unsystematic: exists in a specified firm or investment that can be eliminated through diversification. Diversifiable, unique, company-specific risk.
Systematic Risks are PRIME
PRIME:
Purchase Power Risk: inflation decr amt of goods that can be purchased
Reinvestment Rate Risk: not being able to reinvest at same ROR (bonds)
Interest Rate Risk: inverse relationship of int rate and equities/bonds
Market Risk:
Exchange Rate Risk: change in rate impacts international securities
Unsystematic Risks - ABCDEFG
Accounting Risk: risk that an audit firm is too closely tied to mgmt
Business Risk: inherent risk of industry in which they operate
Country Risk: doing business in a particular country
Default Risk: risk of company defaulting
Executive Risk: moral and ethical character of mgmt
Financial Risk: debt vs equity of firm, % of debt
Government Regulation Risk: risk of tariffs or restrictions being placed
Efficient Frontier
The curve which illustrates the best possible returns that could be expected from all possible portfolios\
-Std Dev x-axis
- Expected return y-axis
Indifference Curve
A curve based on the highest level of return given an acceptable level of risk. Represents how much return an investor needs to take on risk. Essentially, this tells how much return the investor requires in order to take on risk.
- If investor risk averse: significant return is required to take on a little risk. Hence, they will have a very steep indifference curve
Efficient Portfolio
Occurs when an investor’s indifference curve is tangent to the Efficient Frontier
*studying graph rather than definitions probably more helpful
Capital Market Line (CML)
- Displayed on the Efficient Frontier. Specifies relationship between risk & return in all possible portfolios.
- *Exam Tip: Measure of risk = Std. Dev.
*NOT need to know formula
Capital Asset Pricing Model (CAPM) or Security Market Line (SML)
CML = Efficient Frontier
SML = CAPM
The SML is a line drawn on a chart representing CAPM showing systematic risk of a given security. (x-axis risk (Beta) & y-axis (expected return) determines whether investment product would offer favorable expected return compare to level of risk
- Undervalued (above line). Jensen’s Alpha positive
- Overvalued (below line). Jensen’s Alpha negative.
- *Exam Tip: asked to calculate Expected Return or Required ROR
*KNOW & practice Q’s w/formula
Market Risk Premium
- How much an investor should be compensated to take on a market portfolio vs. a risk-free asset
- MRP = (rm - rf);
- rm = return of market
- rf = risk free rate of return
*MEMORIZE formula
Portfolio Performance Measures
1) Information Ratio: *don’t study
2) Treynor Index: relative - needs to be compared to another Treynor ratio. Based on assumption of well-diversified portfolio, unsystematic risk is already close to zero.
- Used when portfolio is DIVERSIFIED
- Beta is used to measure risk (diversified)
- Measures return achieved relative to amt of systematic risk
- Does NOT measure portfolio performance vs. market’s performance
3) Sharpe Index: relative - needs to be compared to another Sharpe ratio.
- Used when portfolio is UNDIVERSIFIED
- Measures risk premiums of the portfolio relative to the total amount of risk in the portfolio
**Exam Tip: if not given r-squared, then select Sharpe!
- Does NOT measure portfolio performance vs. market’s performance
4) Jensen Model or Jensen’s Alpha: significantly different from Treynor & Sharpe. It is a model of absolute performance
- Determines portfolio performance relative to market performance.
- Determines difference between realize, actual, and required returns
- Alpha: indicates level of portfolio’s performance
- Indications:
Positive (+) Alpha = Good; portfolio had more return than expected
Alpha = 0: portfolio return was equal to expected return
Negative (-) Alpha: Bad; portfolio had less return than expected
Treynor vs Sharpe Index
- Treynor & Sharpe very similar. A higher ratio result is better because it means that more return is provided for each unit of risk.
- The higher the ratio, the better because that means more return provided for each unit of risk.
- Both relative performance measures
- In poorly diversified portfolios, two portfolios are significantly different.
- In well diversified portfolios, results are identical
Yield Summary
*Exam Tip: often Q on relationship between Coupon, Current Yield, YTM, and YTC
*Exam Tip: “If out shopping and see a Discount, CALL mom!”
Net Operating Income
*CFP Exam Tip: Take net income and add back depreciation and financing activities
Options
A derivative security. The value of an option is derived from the value of another underlying asset. One option contract controls 100 shares of the underlying asset. Two types of options:
- Call Option: the right to buy a specified number of shares at a specified price (strike price) within a specified period of time.
- Put Option: the right to sell “ “
**EXAM TIP: if asked about maximizing gains..
if the price rises, “Buying a Call” is the right answer.
if price falls, then “Buying a Put”
Invest in Options for 3 reasons - hedging, speculation, or income
*See image attached
Option Premium
Option Premium: consists of the intrinsic value & a time premium.
- Call Intrinsic Value: Stock Price - Strike Price
- Put Intrinsic Value: Strike Price - Stock Price
- Time Value = Premium - Intrinsic Value
*EXAM TIP: intrinsic value cannot be < zero.
*For problems, assume 1 call/put option = 100 shares (unless specified)
**BE CAREFUL on calculations if problem states individuals is “SELLING” an option rather than “BUYING”.
Investors normally BUY options. SO be on lookout if wording says “SELL”. If selling option, then will be opposite of gain/loss would be for a “BUY”. (ex. pg 122).
