Investments Flashcards

1
Q

Investment Policy Statement

A

written document provides general guidelines for investment manager

Includes:
- Objectives (risk & return)
- Constraints (time horizon, taxes, liquidity, legal considerations, unique needs/special circumstances)

does NOT identify specific investments

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2
Q

Holding Period Return HPR

A

return measure

HPR = (SP - PP +- CFs) / PP = made / paid

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3
Q

Arithmetic Mean

A

return measure

sum the returns & divide by n

more misleading w/ larger variations in return

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4
Q

Geometric Mean

A

return measure

compound ROR

will ALWAYS be less than or equal to arithmetic mean

use PV, FV, n, then solve for i

IRR, YTM, YTC, time-weighted return (use the security cash flows), & dollar-weighted return (use the investor’s cash flows) are ALL geometric mean calculations

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5
Q

Weighted Average

A

return measure

portfolio expected return, portfolio beta, & portfolio duration are all calculated as weighted averages

portfolio standard deviation is NOT a weighted average

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6
Q

Real Rate (inflation adjusted return)

A

return measure

use w/ education funding & retirement needs questions

Real Rate = [(1+nominal)/(1+inflation) - 1] x 100

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7
Q

Tax Adjusted

A

return measure

used to determine the after-tax ROR from an investment

After-Tax Return = Pre-Tax Return x (1 - Marginal Rate)

= corporate rate x (1 - tax rate)

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8
Q

Required Return

A

use CAPM to determine the required ROR on an investment given its systematic risk

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9
Q

Expected Return

A

use current price & expected future cash flows to calculate the expected return on an investment

RR < expected return = invest (asset undervalued)

RR = expected return = invest

RR < expected return = do NOT invest (asset overvalued)

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10
Q

Actual Return

A

use w/ Sharpe/Treynor/Jensen to determine risk-adjusted performance

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11
Q

Which measure should you use to evaluate a manager’s performance?

A

High r^2 = all three measures are reliable

Low r^2 = use Sharpe (bad beta!)

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12
Q

Sharpe Ratio

A

relative risk measure

excess return divided by total risk (SD)

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13
Q

Treynor Ratio

A

relative risk measure

excess return divided by systematic risk (beta)

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14
Q

Jensen’s Alpha

A

absolute risk measure

portfolio return minus CAPM (uses beta)

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15
Q

Information Ratio

A

ratio of a portfolio’s return in excess of the returns of a benchmark (such as an index) to the standard deviation of those excess returns (tracking error)

the ratio indicates the portfolio manager’s ability to consistently beat the index

the higher the IR the more consistent the manager is in generating excess returns

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16
Q

P/E Ratio

A

market price of the common stock divided by EPS

= expected price per share / EPS

how much investors are willing to pay for each dollar of earnings

growth stocks = high P/E ratios

value stocks = low P/E ratios

earnings are accounting based & thus do NOT reflect cash flow which is central to equity valuation

P/E ratios also tend to be lower during times of higher inflation

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17
Q

Earnings Per Share (EPS)

A

= (Net Income - Preferred Dividends) / # common shares outstanding

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18
Q

P/CF Ratio

A

market price of the common stock divided by cash flow

useful ratio for evaluating non-dividend paying firms

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19
Q

P/S Ratio

A

market price of the common stock divided by sales

useful ratio for evaluating non-dividend paying firms or firms w/ low or negative profits

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20
Q

PEG Ratio

A

stock’s P/E ratio divided by 3-5 year growth rate in earnings

PEG < 1.0 = stock may be undervalued; P/E ratio less than average growth in earnings

PEG > 1.0 = stock may be overvalued; P/E ratio greater than average growth in earnings

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21
Q

Yield Curve Theories - 3

A

attempt to explain the shape of the yield curve

  1. Expectations Theory
  2. Liquidity Preference Theory
  3. Market Segmentation Theory
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22
Q

Expectations Theory

A

expectations of inflation & the effect on future ST interest rates determine shape

could explain normal & inverted curves

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23
Q

Liquidity Preference Theory

A

investors accept lower yields for ST investments (price for liquidity) & require premiums for longer term maturities

explains only a normal curve

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24
Q

Market Segmentation Theory

A

the supply/demand for funds in ST & LT markets determine the shape of yield curve

could explain normal & inverted curves

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25
Efficient Market Hypothesis
efficient markets = asset prices reflect all relevant information 3 forms: 1. Weak Form 2. Semi-Strong Form 3. Strong Form
26
Weak Form - EMH
past prices & volume information reflected in asset prices investor CANNOT use TECHNICAL analysis to achieve risk-adjusted excess returns
27
Semi-Strong Form - EMH
all public information is reflected in asset prices; market prices rapidly adjust to new information investor CANNOT use TECHNICAL or FUNDAMENTAL analysis to achieve risk-adjusted excess returns
28
Strong Form - EMH
all public & private information is reflected in asset prices investor CANNOT achieve risk-adjusted excess returns indexed options only
29
Standard Deviation of a Portfolio vs Weighted Average of the SD of the assets that comprise the portfolio
the SD of a portfolio will ALWAYS be LESS THAN the weighted average of the SD of the assets that comprise the portfolio EXCEPTION = if the correlation b/t the assets is perfect positive (+1.0) then the portfolio SD will be EQUAL to the weighted average
30
Total Risk
Systematic + Unsystematic measured by SD
31
Systematic Risk
undiversifiable risk measured by beta PRIME purchasing power risk reinvestment rate risk interest rate risk market risk exchange rate risk
32
Unsystematic Risk
diversifiable ABCDEFG accounting risk business risk country risk default risk event/executive risk financial risk government/regulatory risk
33
Measures of Total Risk
standard deviation variance = SD^2 coefficient of variation = relative risk semi variance = measures downside risk (measures volatility of returns that fall below the mean)
34
Normal Distribution
68-95-99 68% of returns +-1 SD 95% of returns +-2 SD 99% of returns +-3 SD
35
Kurtosis
measure that indicates whether a distribution is more or less peaked than a normal distribution Leptokurtic = more peaked than normal; have flat tails Platykurtic = less peaked than normal
36
Measure of Systematic Risk
beta; appropriate measure of a well diversified portfolio market beta = 1 beta 1.5 = 50% more volatile than the market r^2 should be high to ensure reliability of beta r^2 > 0.70
37
Portfolio Risk
combines the individual risks of the securities along w/ their interactive risk SD of a two-asset portfolio formula on formula sheet COV = SDi x SDj x r
38
Long Call
pays the premium right to buy stock @ strike price bullish maximum loss = premium paid
39
Short Call
sells the option (receives premium) obligation to sell underlying asset at strike price bearish maximum gain = amount of premium received
40
Long Put
pays the premium right to sell at strike price bearish maximum loss = premium paid
41
Short Put
sells the option (receives premium) obligation to buy at strike price bullish maximum gain = premium received
42
Black Scholes Option Pricing Model
attempts to price a call option interest rate volatility exercise price stock price time *ONLY the EXERCISE PRICE (STRIKE PRICE) is inversely related to the value of a call option
43
Flat Market
better for option seller (writer, short position) collects premium & hopes stock price movement will NOT negate the profit
44
Volatile Market
better for option buyer (if speculating) must be enough movement in the price of the underlying asset for the option buyer to recover the premium & make a profit
45
Protective Strategy
short stock long call
46
Portfolio Insurance Protective Strategy
long stock long put
47
Short Straddle
income strategy sell call sell put not expecting volatility
48
Long Straddle
buy call buy put expecting volatility unsure of which direction
49
Collar
protects gain in appreciated stock long stock, short call, long put concentrated stock positions lack diversification, selling a large amount of the position in one tax year can push the taxpayer up to a higher tax bracket or initiate the net investment income tax a collar strategy can be used to spread the sale over multiple tax years while protecting the gain
50
Covered Call
income strategy long stock short call
51
LEAPs
Long Term Equity Anticipation Securities similar to exchange traded puts & calls but w/ expirations extending out to 3 years
52
Warrants
like a call option issued by a company; much longer expiration & NOT standardized (call options have shorter maturities & ARE standardized) often included in a new debt offering to make the bond more attractive to investors
53
Stock Rights
rights granted to existing shareholders to purchase new shares of a new stock issue before it is offered to the public this allows shareholders to maintain their existing proportionate share of the company following a new equity offering
54
Duration (Macaulay)
Time-Weighted Payback weighted average maturity of a bond's cash flows greater the duration, the more sensitive a bond's price is to interest rate changes
55
3 Variables to determine a bond's duration
1. coupon rate 2. YTM 3. time to maturity
56
Variables relationship to duration (Coupon, YTM, Time)
Coupon = INverse relationship (lower cpn, higher duration) YTM = INverse relationship Time = Direct relationship
57
Modified Duration
equals the value of Macaulay duration divided by 1 plus the YTM of the bond (1+y) modified duration gives us a linear approximation of the change in bond value that will result d/t changes in yield the estimated price change = -1 x modified duration x change in yield
58
Immunization
occurs at the point of duration at that point (in the life of the bond) interest rate risk & the reinvestment rate risk exactly offset one another
59
Duration of a zero coupon bond
equals its maturity the duration of a coupon paying bond < its maturity
60
Buying Stock on Margin
when the stock price falls below the trigger price (TP) the equity percentage has fallen below the required maintenance level & a margin call will result TP = Loan / (1 - MM)
61
Short Sales
"sell high, buy low" short seller is responsible for dividends paid during short sale period
62
Rate Anticipation Swap
if interest rates are expected to increase (decrease), reduce (increase) duration of portfolio you would swap long (short) duration bonds for shorter (longer) duration bonds
63
Tax Swap
swap a bond (w/ a capital loss) for a similar bond be careful -- avoid wash sale rule
64
Pure Yield Pickup Swap
swap lower coupon bond for a higher coupon bond to pick up yield
65
Bond Ladder
portfolio of bonds w/ staggered maturities (ST to LT) maturing bonds are reinvested in LT bonds
66
Bond Barbell
portfolio consists of bonds w/ ST & LT maturities; few intermediate strategy requires periodic rebalancing
67
Bullet Strategy
bonds w/ similar maturities are focused around a point in time
68
Derivative
an asset whose value is derived from the value of an underlying asset examples = options, futures
69
Forward Contract
an agreement (initiated at one time) that involves the purchase or sale of an asset at a later time the price & quantity are specified at the inception of the contract forward contracts are traded OTC w/ contract terms negotiated b/t the parties
70
Futures Contract
a "forward-type" contract that trades on an exchange contract is standardized (terms, quantity, expiration date) LONG position agrees (today) to buy the asset in the future SHORT position agrees (today) to sell the asset in the future for hedging, take the position that is opposite to the current position Corn Farmer is long corn so hedge is to go short Frito Lay Inc is short corn so hedge is to go long
71
Option
long position buys the option (pays a premium) short position (writer) sells the option (receives the premium)
72
Intrinsic Value
how much the option is in-the-money cannot be negative, lowest value is zero
73
Option Value
= Intrinsic Value + Time Value
74
Modern Portfolio Theory
Markowitz identifies efficient portfolios (in terms of risk/return); efficient frontier inputs = asset volatility, security returns, & covariance of returns portfolios on frontier = efficient; under = attainable, not efficient; above = unattainable
75
Capital Market Line CML
x axis = risk; y axis = return CML connects w/ y axis at risk-free rate shows the risk & return trade-off b/t a risk free asset & a well-diversified risky portfolio uses portfolio SD as risk measure
76
CAPM
determines required ROR given an asset's systematic risk (beta)
77
SML
security market line graphical depiction of CAPM slope of SML = market risk premium = (Rm - Rf) slope becomes steeper if investors become more risk averse (i.e. require higher ROR to invest in the market instead of investing in risk free assets) SML shifts (no change in slope) when market interest rates change securities ABOVE SML = undervalued; return higher than expected given level of risk securities BELOW SML = overvalued; return lower than expected given level of risk uses beta as the risk measure
78
Coefficient of Variation
SD divided by expected return (total risk per unit of return)
79
Correlation
ranges from -1.0 to +1.0 maximum risk reduction occurs at perfect negative -1.0 no risk reduction occurs at perfect positive +1.0 a correlation of zero indicates that the assets move independently of one another
80
Covariance
measure of how much two assets move together
81
Coefficient of Determination
known as r^2 tells us the percentage variation in portfolio returns that is explained by the variation in the benchmark returns
82
Stock Valuation
intrinsic value (PV) of future CFs generated by the security constant growth model assumes constant growth (g) NOTE: the required ROR (r) from CAPM > g P0 = D1 / (r - g)
83
Relationship b/t valuation model & P/E ratio:
P0 / E = (D/E) / (r - g) = Div Payout / (r - g)
84
Technical Analysis
relies on movements in stock price to predict future stock price movement using charts, moving averages & other tools, technical analysists use volume & stock price data to identify trends that will be useful in making profitable buy & sell decisions
85
Fundamental Analysis
examines internal data (from financial statements) & external economic factors (industry characteristics & market variables) to assess the market & company conditions use ratio analysis, stock price multiples (P/E ratio) & discounted cash flow analysis to determine the intrinsic value of the company the intrinsic value can then be compared to current market prices to make a buy/sell decision
86
Bonds
FV = par value n = # of periods until maturity i = market rate of interest (YTM) per period PMT = coupon payment per period PV = bond value or price
87
Bond Valuation
enter FV, n, PMT, i, then solve for PV
88
Yield to Maturity YTM
expected ROR on a bond enter FV, PMT, PV (as negative #), n, then solve for "i" assumes reinvestment of coupon payments at the YTM rate
89
Yield to Call YTC
enter FV (call price), PMT, PV (as negative #), n (# periods until callable), then solve for "i" assumes reinvestment of coupon payments at the YTC rate
90
Current Yield CY
annual coupon interest / current bond price
91
Coupon Rate CR
annual interest rate
92
Premium Bond
CR > CY > YTM > YTC **alphabetical except for YTC CR comes before CY which comes before YTM
93
Par Bond
CR = CY = YTM YTC equal if same callable price
94
Discount Bond
CR < CY < YTM < YTC
95
Primary Bond Risks (3)
1. Interest rate risk (interest rates increase) 2. Reinvestment rate risk (interest rates decrease) 3. Default risk, purchasing power risk
96
Real Estate Valuation
Value = NOI / capitalization rate NOI = gross income - vacancy, operating expenses, property taxes do NOT subtract depreciation, income taxes, mortgage payments/interest from total revenue to calculate NOI NOI = Net operating income
97
Investment Company
corporation that is governed by the Investment Company Act of 1940 investment company pools funds from many investors & invests those funds in a portfolio of securities, typically combinations of stocks & bonds
98
Closed-End Fund
think stocks fixed capitalization shares trade in secondary market on an organized exchange price determined by supply & demand for the shares shares tend to trade at a discount or premium relative to NAV
99
Open-End Fund
think mutual funds capitalization NOT fixed allowed to issue unlimited # of shares shares bought & sold through the investment company; trade at NAV
100
NAV Formula
NAV = (Market value of assets in fund - Outstanding liabilities) / Number of shares outstanding
101
Exchange Traded Fund ETF
investment fund that trades on an organized exchange most designed to track an index generally trade at prices close to NAV like the shares of a closed-end company ETF shares trade throughout the day like an open-end fund the capitalization of an ETF is NOT fixed ETFs generally are tax efficient & have low costs
102
Unit Investment Trust UIT
unmanaged portfolio of stocks & bonds trust has finite life; self-liquidating may have income &/or capital appreciation objectives "units" (NOT SHARES) are sold to investors
103
Common Stock
stockholders are owners of the firm return to stockholders dependent on success of the firm & generally takes the form of dividends &/or stock price appreciation
104
Preferred Stock
characteristics of both common stock & bonds preferred dividend is fixed percentage of par value preferred dividends paid prior to common dividends many corporations invest in preferred stock corporate investors tend to like the fixed nature of preferred dividends at least 50% of dividends received by a corporation (common & preferred) are excluded from taxation
105
Dividends
determined by BOD stock price falls on ex-dividend date (1 business day before record date) cash dividends are taxable (even if in DRIP) stock dividends (generally not taxable) similar to stock split (# of shares increase, stock price falls)
106
Municipal Bonds
exempt from federal income taxes General Obligation (GO) = backed by full faith, credit, & taxing power of the issuer Revenue Bonds = more risky; only the revenues generated by the project (ex toll bridge) are used to service the debt Private Activity Bonds = issued by local or state government to finance the project of a private nature (ex stadium); the interest is a tax preference for the ATM
107
Comparing municipal securities (exempt from federal taxation) to corporate bonds (subject to federal taxation)
calculate the taxable equivalent yield (TEY) investors in higher tax brackets benefit more from the tax advantage of municipal bonds TEY = muni rate / (1 - tax rate)
108
Convertible Bond
conversion value = (Par / conversion price) x stock price
109
MBS (Mortgage Backed Securities)
an asset-backed security that represents a claim on the cash flows generated from a pool of underlying mortgages examples = GNMA, FNMA, FHLMC securities investors receive their pro rata share of interest & principal subject to prepayment risk, interest rate risk, purchasing power risk, & default risk (except GNMA)
110
REMICs
investment vehicles that hold mortgages issue securities that represent interest in the underlying mortgages example = CMO (collateralized mortgage obligation)
111
CMOs
mortgage derivatives backed by residential mortgages different investment classes (tranches) have different maturities & risks interest payments & all principal payments flow to tranche #1 (A) until it matures Tranche #1 (A) has shortest maturity, least risk, lowest expected return Z-tranche = longest maturity
112
REITs
securitized real estate 3 types = equity, mortgage, hybrid must distribute at least 90% of its taxable income to shareholders annually at least 75% of gross income must be real estate related
113
Monte Carlo Simulation
uses inputs to construct financial models generates a large # of random samples from a specified probability distribution useful in determining likely outcomes
114
American Depositary Receipt ADR
security issued by a domestic bank, represents shares of foreign stocks (deposited in a foreign custodian bank) face exchange risk even though they are denominated in U.S. dollars as well as dividends etc
115
Yankee Bonds
U.S. dollar-denominated bonds issued in U.S. by foreign firms/governments investors are NOT exposed to foreign currency risk
116
Foriegn/International Funds
open-end & closed-end funds (& ETFs) that invest solely in international stocks & bonds
117
Global Funds
hold international & domestic assets
118
Treasury STRIPS
zero coupon bonds created from coupon interest & principal payments that are "stripped" from Treasury notes & bonds STRIPS have considerable interest rate risk but NO reinvestment rate risk
119
Series EE Bonds
non-marketable redeemable after 12 months (w/ 3 months interest penalty); no interest penalty for redemption after 5 years no inflation adjustment interest = accrues, paid at redemption subject to federal taxation, can be deferred until redemption; may be excluded from federal taxation when used for education
120
Series HH Bonds
no longer issued (as of 2004) acquired by exchanging EE bonds for HH bonds; non-marketable, redeem w/ U.S. Treasury no inflation adjustment interest paid semiannually semiannual interest subject to federal taxation in year they occur
121
Series I Bonds
non-marketable; redeemable after 12 months (w/ 3 months interest penalty); no interest penalty for redemption after 5 years inflation adjustment = fixed rate plus variable semiannual inflation adjustment interest = accrues, paid at redemption subject to federal taxation, can be deferred until redemption; may be excluded from federal taxation when used for education
122
TIPS
marketable (can be sold in secondary market) inflation adjustment = principal increases (decreases) w/ inflation (deflation) interest paid semiannually semiannual interest payments & principal increases subject to federal taxation in year they occur (avoid annual tax by holding in qualified accounts such as IRAs)