Investments Flashcards
Investment Policy Statement
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
Holding Period Return HPR
return measure
HPR = (SP - PP +- CFs) / PP = made / paid
Arithmetic Mean
return measure
sum the returns & divide by n
more misleading w/ larger variations in return
Geometric Mean
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
Weighted Average
return measure
portfolio expected return, portfolio beta, & portfolio duration are all calculated as weighted averages
portfolio standard deviation is NOT a weighted average
Real Rate (inflation adjusted return)
return measure
use w/ education funding & retirement needs questions
Real Rate = [(1+nominal)/(1+inflation) - 1] x 100
Tax Adjusted
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)
Required Return
use CAPM to determine the required ROR on an investment given its systematic risk
Expected Return
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)
Actual Return
use w/ Sharpe/Treynor/Jensen to determine risk-adjusted performance
Which measure should you use to evaluate a manager’s performance?
High r^2 = all three measures are reliable
Low r^2 = use Sharpe (bad beta!)
Sharpe Ratio
relative risk measure
excess return divided by total risk (SD)
Treynor Ratio
relative risk measure
excess return divided by systematic risk (beta)
Jensen’s Alpha
absolute risk measure
portfolio return minus CAPM (uses beta)
Information Ratio
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
P/E Ratio
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
Earnings Per Share (EPS)
= (Net Income - Preferred Dividends) / # common shares outstanding
P/CF Ratio
market price of the common stock divided by cash flow
useful ratio for evaluating non-dividend paying firms
P/S Ratio
market price of the common stock divided by sales
useful ratio for evaluating non-dividend paying firms or firms w/ low or negative profits
PEG Ratio
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
Yield Curve Theories - 3
attempt to explain the shape of the yield curve
- Expectations Theory
- Liquidity Preference Theory
- Market Segmentation Theory
Expectations Theory
expectations of inflation & the effect on future ST interest rates determine shape
could explain normal & inverted curves
Liquidity Preference Theory
investors accept lower yields for ST investments (price for liquidity) & require premiums for longer term maturities
explains only a normal curve
Market Segmentation Theory
the supply/demand for funds in ST & LT markets determine the shape of yield curve
could explain normal & inverted curves
Efficient Market Hypothesis
efficient markets = asset prices reflect all relevant information
3 forms:
1. Weak Form
2. Semi-Strong Form
3. Strong Form
Weak Form - EMH
past prices & volume information reflected in asset prices
investor CANNOT use TECHNICAL analysis to achieve risk-adjusted excess returns
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
Strong Form - EMH
all public & private information is reflected in asset prices
investor CANNOT achieve risk-adjusted excess returns
indexed options only
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
Total Risk
Systematic + Unsystematic
measured by SD
Systematic Risk
undiversifiable risk
measured by beta
PRIME
purchasing power risk
reinvestment rate risk
interest rate risk
market risk
exchange rate risk
Unsystematic Risk
diversifiable
ABCDEFG
accounting risk
business risk
country risk
default risk
event/executive risk
financial risk
government/regulatory risk
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)
Normal Distribution
68-95-99
68% of returns +-1 SD
95% of returns +-2 SD
99% of returns +-3 SD
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
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
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
Long Call
pays the premium
right to buy stock @ strike price
bullish
maximum loss = premium paid
Short Call
sells the option (receives premium)
obligation to sell underlying asset at strike price
bearish
maximum gain = amount of premium received
Long Put
pays the premium
right to sell at strike price
bearish
maximum loss = premium paid
Short Put
sells the option (receives premium)
obligation to buy at strike price
bullish
maximum gain = premium received
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
Flat Market
better for option seller (writer, short position)
collects premium & hopes stock price movement will NOT negate the profit
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
Protective Strategy
short stock
long call
Portfolio Insurance Protective Strategy
long stock
long put
Short Straddle
income strategy
sell call sell put
not expecting volatility
Long Straddle
buy call buy put
expecting volatility unsure of which direction
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
Covered Call
income strategy
long stock short call
LEAPs
Long Term Equity Anticipation Securities
similar to exchange traded puts & calls but w/ expirations extending out to 3 years
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
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
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
3 Variables to determine a bond’s duration
- coupon rate
- YTM
- time to maturity
Variables relationship to duration (Coupon, YTM, Time)
Coupon = INverse relationship (lower cpn, higher duration)
YTM = INverse relationship
Time = Direct relationship
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
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
Duration of a zero coupon bond
equals its maturity
the duration of a coupon paying bond < its maturity
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)
Short Sales
“sell high, buy low”
short seller is responsible for dividends paid during short sale period
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
Tax Swap
swap a bond (w/ a capital loss) for a similar bond
be careful – avoid wash sale rule
Pure Yield Pickup Swap
swap lower coupon bond for a higher coupon bond to pick up yield
Bond Ladder
portfolio of bonds w/ staggered maturities (ST to LT)
maturing bonds are reinvested in LT bonds
Bond Barbell
portfolio consists of bonds w/ ST & LT maturities; few intermediate
strategy requires periodic rebalancing
Bullet Strategy
bonds w/ similar maturities are focused around a point in time
Derivative
an asset whose value is derived from the value of an underlying asset
examples = options, futures
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
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
Option
long position buys the option (pays a premium)
short position (writer) sells the option (receives the premium)
Intrinsic Value
how much the option is in-the-money
cannot be negative, lowest value is zero
Option Value
= Intrinsic Value + Time Value
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
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
CAPM
determines required ROR given an asset’s systematic risk (beta)
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
Coefficient of Variation
SD divided by expected return (total risk per unit of return)
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
Covariance
measure of how much two assets move together
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
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)
Relationship b/t valuation model & P/E ratio:
P0 / E = (D/E) / (r - g) = Div Payout / (r - g)
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
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
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
Bond Valuation
enter FV, n, PMT, i, then solve for PV
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
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
Current Yield CY
annual coupon interest / current bond price
Coupon Rate CR
annual interest rate
Premium Bond
CR > CY > YTM > YTC
**alphabetical except for YTC
CR comes before CY which comes before YTM
Par Bond
CR = CY = YTM
YTC equal if same callable price
Discount Bond
CR < CY < YTM < YTC
Primary Bond Risks (3)
- Interest rate risk (interest rates increase)
- Reinvestment rate risk (interest rates decrease)
- Default risk, purchasing power risk
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
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
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
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
NAV Formula
NAV = (Market value of assets in fund - Outstanding liabilities) / Number of shares outstanding
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
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
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
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
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)
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
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)
Convertible Bond
conversion value = (Par / conversion price) x stock price
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)
REMICs
investment vehicles that hold mortgages
issue securities that represent interest in the underlying mortgages
example = CMO (collateralized mortgage obligation)
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
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
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
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
Yankee Bonds
U.S. dollar-denominated bonds issued in U.S. by foreign firms/governments
investors are NOT exposed to foreign currency risk
Foriegn/International Funds
open-end & closed-end funds (& ETFs) that invest solely in international stocks & bonds
Global Funds
hold international & domestic assets
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
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
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
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
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)
