Investments Flashcards
Certificate of Deposit
- Interest accrues and compounds monthly but is not paid out until the CD is matured or sold.
- Tax is due on the accrued interest (phantom income)
- Early withdrawal penatly before maturity date
Money Market Funds vs Accounts
MM Funds are not insured for the exam (they are by SIPC) and MM Accounts are insured by FDIC.
Have securities with an average maturity of 90 days consisting of T-Bills, negotiable CDs, and prime commercial paper.
Treasury Bills v Treasury Notes v Treasury Bonds
T-Bills
- Maturity of 1 year or less (issued 3, 6, and 12 month)
- Issued at a discount from face value
- Taxable in the year interest is received
- Issues of $100 to $1,000,000
- Risk free rate of return (no risk)
T-Notes
- Maturity of 1-10 years
- Issues of $1,000 to $100,000
- has RIP risk
- Interest paid semiannually
T-Bonds
- Maturity of 10-30 years
- Issues of $1,000 to $1,000,000
- has RIP risk
- Callable at 15 years
- Interest paid semiannually
Commercial Paper
Short-term (maturity of 270 days or less) unsecured promissory notes from large, financially strong companies.
$100,000 denominations
Normally sold at a discount and rated by quality
Bankers Acceptance
Finance imports and exports
Exporter wants assurance of payment when good arrive.
Maturity is 9 months or less
Eurodollars
A deposit in any foreign bank denominated in US Dollars
Yankee Bonds
Foreign bonds that are issued in the US in US Dollars by foreign banks and companies.
Need to be registered with the SEC.
Accrued Interest If a bond is bought or sold between interest payments
Buyer must compensate the seller for the interest “earned” since the last interest payment.
Whatever amount is accrued, that is paid to the previous bondholder and not taxable to the current holder and reduces basis.
OID (Original Issue Discount)
Discounted from Par value when a bond is issued. Many are zero-coupon bonds.
Discount must be accreted over the life of the bond. Each year the portion of the discount that is earned is included as taxable interest income and basis is increased.
Need to report income even if no income has been received (phantom income).
Muni Bond OID income must be straight line and is not subject to federal tax (non-taxable interest income).
No capital gain or loss if held to maturity.
Treasury STRIPS
Treasury issues its own zero-coupon bonds.
These are direct obligations of the Federal Government.
Discount on STRIPS is treated as taxable income, earned annually.
Interest not subject to state or local tax.
Most often purchased by pension plans
Treasury Inflation-Protected Securities (TIPS)
These are marketable securities to protect against inflation.
Face value is adjusted semiannually to keep pace with inflation, measured by CPI over 6-month intervals.
TIPS are issued with a stated coupon rate but the payments rise as the face value of the TIP rises. Higher inflation = higher face value
Sold in $1,000 denominations
Investor is taxed annually on the interest plus appreciation in face value. Income only collectible when bond is matured or sold. Basis is raised with phantom income. Income is taxable in the year it is accrued. Decrease will reduce the interest income, can be deduction if there is excess.
Interest not subject to state or local tax.
Series E, HH, and I Bonds
EE are fixed, I are half based on inflation.
Interest is not taxable until redemption, unless elected to tax. Interest accrues monthly and compounds semiannually.
HH bonds are not available after 2004.
Savings bonds need to help for at least 1 year before sold. Three month-interest-penalty applies if selling the bond before 5 years from issue.
Guarantee that the bond value will double in 20 years. (Guaranteed to reach face value)
Interest not subject to state or local tax.
Government National Mortgage Association (GNMA) - Ginnie Mae
This buys VA, FHA, and Farmer mortgages and pools them. Then passes through as interests in the pool.
Direct guarantee of the US Government but not issued by the Treasury so taxable federally and at the state level.
$25,000 issues.
No default risk but Interest rate and a lot Reinvestment rate risk. (more than normal bonds)
Payments are interest and a return of principal.
Other Mortgage Backed Agency Securities
Not fully backed by the US Gov. The US Gov backs these implicitly through lines of credit.
Federal Home Loan Bank (FHLB)
Federal National Mortgage Association (FNMA) - this is a profit making corporation - Fannie Mae
Federal Home Loan Mortgage Corporation (FHLMC) - private company - Freddie Mac
Pass-through securities.
Increasing interest rate decreases the value.
Mortgage Bonds (Corporate)
Considered the safest among long-term corporate issues. Backed by specific real property owned by the issuing company.
Property can be sold if issuer defaults.
Collateralized Mortgage Obligations
CMOs were developed to eliminate risk of varying amounts of principal repayment from homeowners. Rated AAA
Mortgage payments are taken as a “cash flow” basis. Based on the expected flow of cash, separate classes called tranches are created.
CMOs are multiclass pass-through securities with tranches A to Z with A tranches receiving payments faster and Z getting a higher yield because they have the longest duration.
Debenture vs Indenture
Debenture: Corporate debt obligation backed by the integrity of the issuer. (No collateral)
Indenture: Formal agreement between an issuer of bonds and trustee. Contract provides for appointment of trustee.
Rating Agencies
S&P and Moody’s
S&P rating is AAA, AA, A, BBB - Investment Grade
S&P rating is BB, B, below - Speculative Grade (junk bonds)
Moody - Aaa, Aa, A, Baa - Investment Grade
Moody - Ba, and below - Speculative Grade (junk bonds)
High-yield corporate bonds have a rating of BB or lower and pay a higher interest rate to compensate for its greater risk. Usually never correct on the exam.
Convertible Bonds Formula
Hybrid debt securities. Have a bond part and securities part. An investor sacrifices yield to have the option to convert the bond.
Formula for bond is normal as follows.
Formula for bond conversion value is:
Conversion Value (CV) = (Par value of bond/Conversion Price)*Current Market Price
Every convertible bond has a floor value. It cannot be lower than the greater of:
Its value as a bond
Its conversion value
Callable Bonds and Put Bonds
Issuers have a right to redeem the bond at a predetermined price prior to maturity (at least 10 years). Issuer is likely to call the bond if interest rates have dropped - they can then issue at a lower rate.
Put bond lets the holder of the bond to sell the bond back to the issuer. Issuer must redeem the bond at a specific date for its principal amount. If interest rates rise, bondholder could sell the bond back.
Yield is sacrificed in both to have this option.
Open End Funds - Mutual Fund
Continues to sell funds to investors after the IPO, continuously offers shares
The capitalization is constantly changing as new investors buy new shares and other redeem their shares back to the company
Investors redeem shares with the fund itself, not through an exchange
Shares are non-negotiable, redeemable securities
Each day fund computes its NAV
Sales charge added for underwriters on top of NAV, “no load” there is no sales charge
Sold interday at the end of the day
Closed End Funds
Issue stock once and then the books are closed, no new shares are issued, sells a fixed number of shares
Shares trade on a public exchange and are valued like any other negotiable security and may be greater or less than the NAV
May hold illiquid securities
Investors cannot redeem their shares, need to sell in the market
UIT - Unit Investment Trusts
Investment company that has no day-to-day portfolio management
Typically this is a unmanaged security portfolio created by a sponsor and handled by independent trustees
Passive investment as its assets are not traded but frozen, no new securities are purchased and existing securities are rarely sold
Trust collects income and eventually, the repayment of principal
Trust is self-liquidating because funds received are distributed to unit holders
Sponsor makes a market for investors selling units and buyers of used units with units generally redeemed at the NAV
UIT will typically make a one-time IPO offering a specified amount of units
Can trade on secondary markets
Issue units, not shares
ETFs - Exchange Traded Funds
Security that represents a basket or index of stocks or bonds
Can be open-end, closed-end, or UIT
Traded on a stock exchange and traded intraday
Allow investors to diversify by buying one vehicle
Usually more tax efficient than traditional open-ended mutual funds
Annual Reporting for Corporations
Annual report needs to be written for shareholders
10Qs needed quarterly from corporate to the SEC
10Ks needed annually from corporate to the SEC
Preferred Stock
Hybrid security
Sold at a par value with a stated dividend rate
Usually perpetual in length (infinite duration)
Interest rate changes often change the price of preferred stock more than debt
Cumulative or noncumulative dividends: cumulative missed dividends have to be paid back first where noncumulative do not have to be paid back
Usually for corporate treasurer with extra cash - if the corporation buys preferred stock then 50% of the dividends are excluded from taxation
Index Funds
Invest in stocks and/or bonds that are parts of indexes
Emphasize tax efficiency through minimal turnover
Hedge Funds
Aggressively managed investment portfolio using advanced strategies to generate high returns
Operate as private investment partnerships that require a very large initial investment
Investments are often illiquid and usually require a year commitment
Need to be an accredited investor and a sophisticated investor to invest
Not required to register with the SEC unless you have over $100M AUM
Accredited Investor
- Net worth of $1 Million (excluding value of primary residence)
- Single earning $200k annually
- Couple earning $300k annually
Limited Partnerships
Can be real estate, oil, gas, etc.
Sometimes with blind pool, actual properties have not been added yet
Need to look to general partner past performance
Guaranteed Investment Contracts (GICs)
Similar to CDs, issued by commercial banks
Guaranteed interest rate (no interest rate risk)
Value fluctuates with financial strength of issuer
Real Estate Investment Investor Managed Sections
Unimproved Land: Cannot generate income or depreciation, only hope is appreciation, can have negative cash flow
Improved Land: Includes rental income
Intrinsic Value
NOI / Cap Rate
REIT - Real Estate Investment Trust
REITs are portfolio investments subject to tax like a stock (similar to closed-end investment company) and managed by board of directors
Good way to get diversification in an otherwise illiquid market, REITs are liquid and marketable - actively traded on markets
Equity REITs - Invest mainly in income producing properties like office buildings and hotels and own the property (can be leveraged and good inflation hedge)
Mortgage REITs - Make loans to develop property (cannot be leveraged and not a good inflation hedge)
REITs need to have 75% of their income from real estate investments, 15% can come from securities
REITs need to distribute 90% of their income or else all of it is taxable. If 90% is distributed then only the amount not distributed is taxable.
Investor gets a 20% deduction of the pass-through income
RELPs - Real Estate Limited Partnerships
Non-publicly traded and subject to passive income loss rules
Generally not marketable and not liquid
Managed by a general partner
REMICs - Real Estate Mortgage Investment Conduits
Invests exclusively in real estate mortgages
More flexible than CMOs, where CMOs provide timing flexibility, REMICs provide timing and risk flexibility
Entity is taxed as a pass-through entity
Volatility and Time impact on option value
Volatility will keep the premium high even if close to the end of the option period because of variability in stock price
Time always gives a way for the price to change
Call Options and Warrants General Info
Options - Expire in 9 months
Put - Right to sell
Call - Right to buy
Warrants - Issued with no intrinsic value
Warrants - Issue new outstanding stock when exercised
LEAPS - Long-Term Equity Anticipation Securiites
Long term options
Maturities range from 2 years to longer
Lets buyers hedge long term movements
Great to hedge indices
Futures Contract Info
Spot price (price currently)
Open interest (number of futures contracts trading on a day)
Daily limit (max price increase or decrease to settlement price)
Commodity, financial, and currency futures
Can deliver or offset by buying opposite position
Collectibles, Natural Resources, and Precious Metals
Collectibles are rare objects and usually rise in value in inflationary periods
Trading is difficult because of the little amount of buyers/sellers
Negatively correlated with financial assets - good diversification
All gain taxed at LTCG 28%
Natural Resources add diversification because of the negative correlation to the stock market
Highly responsive to price changes with elastic products
Precious metals are an inflation hedge
Treated as collectibles for tax reasons
Can be simpler to invest in than real gold
Qualified Purchaser for Nonaccredited investors
and
Sophisticated Investor
Qualified purchaser owns at least $5M in investments
Sophisticated investor knows his stuff
Total Risk and Systematic Risk Measurement
Total Risk = Standard Deviation
Systematic Risk = Beta
Devaluation and Revaluation of Currency
Devaluation is the devalue of a country’s currency
Revaluation is a increase in the value of a country’s currency
International Investing Diversification
International investing adds diversification
Emerging markets are less correlated to US markets than international
International markets are less efficient because there are less analysts
Liquidity vs Marketability
Liquidity means a security can be sold without delay and without a substantial change in price. This describes both transaction speed and stability of price.
Recent maturing CDs, laddered CDs, Money Market mutual funds and life insurance cash value are liquid
Open-end funds, ETFs, closed-end funds, and brokered CDs are not liquid because they have possible loss in principle
Marketability refers to only speed.
Savings, checking, Money Market Accounts, CDs, and mutual funds are redeemed rather than marketable (marketability refers to people trading usually)
REITs, closed-end funds, ETFs, and brokered CDs are marketable
Investment Manager Use
Client needs investment manager if they cannot handle it on their own
Country vs Political Risk
Risk associated within a certain country due to changing economic or political circumstances
Normal vs Lognormal Distribution
Normal is the bell curve
Period returns and leverage $
Lognormal is skewed (positive is to the left)
Ending portfolio value $ with no margin
Correlation Coefficient
Standardized version of covariance
Range of +1 (perfectly correlated) to -1 (perfectly negatively correlated)
Corr = COV / (std. dev 1 * std. dev 2)
Covariance
Extent to which two stocks are correlated to each other
Unlimited amounts of possibilities
COV = correlation coefficient * std. dev 1 * st.d dev 2
Standard Deviation
Measures variability used in a nondiversified portfolio measuring total risk.
Beta
Measures volatility of returns in a diversified portfolio and is a measure of systematic risk.
B = (correlation coefficient * std. dev i) / std. dev m
Coefficient of Variation
Measures of relative variability used to compare investments.
CV = Standard deviation / mean return
This is risk per unit of return, higher the result the greater the relative risk
Standard Deviation Bell Curve Amounts
1x: 68%
2x: 95%
3x: 99%
Standard Deviation of a portfolio (formula shortcut)
Take the weighted average standard deviation
If the correlation coefficient is less than 1, then the answer is the next lowest value of the weighted average
Risk-Adjusted Return
Divide a funds realized return by its beta coefficient
Coefficient of Determination
R squared shows how much of the change in value can be predicted by the market and how much is not.
This is the square of the correlation coefficient, if it is above 60% then it is diversified
Calculating Geometric Return (Time-Weighted)
Return is 10%, 15%, -10%, and 17%
(1.1)(1.15)(.9)*(1.17) = 1.332 (FV)
PV = -1
N = 4
PMT = 0
I = 7.43%
Not affected by cash flows (eliminates additional and withdrawals and their timing)
Used to assess fund manager performance
Purely evaluate fund performance
Dollar-Weighted Return (IRR)
Mistake is that reinvestment rate is constant.
Measures change in total dollar value treating additions and withdrawals as part of the return along with income and capital gains and losses.
Same as IRR/NPV
Used to compare absolute dollar returns.
Total Return and Risk-Adjusted Return
Total Return: Annual return including appreciation or loss and dividends or interest.
Risk-Adjusted Return: Return has been altered to account for different in risk.
Holding Period Weaknesses
HPR fails to consider timing.
Overstates return greater than 1 year and understates returns under 1 year.
IRR and NPV
IRR is the discount rate at which the present value of the future cash flows equals the cost of the investment.
When NPV is 0, the discount rate is the IRR.
If NPV is over 0, IRR is greater and under 0 is less.
Over 0 is good, under is bad
YTM with zero-coupon bonds and reinvestment risk
Always compound semi-annually even with zero coupons.
Zero’s always avoid reinvestment rate risk.
YTM assumes that all coupons are reinvested at the same rate.
Current Yield
CY = Annual interest / Current bond price
If specified that they want “current” TEY or something else, then do this:
annual coupon / current value
Duration reveals
Investors can compare the volatility of bonds with equal coupons but different terms.
Risk averse seek low duration, high risk seek high duration when interest rates drop and short duration when interest rates increase.
Measures sensitivity of bond prices to change in interest rates
Immunization
When you match duration with your investment time horizon
This eliminates interest rate risk and reinvestment rate risk
Passive investment strategy
Capitalized Earnings
Earnings divided by cap rate
Only good for large companies that have stable earnings, growth, and risk
Zero Growth Model
D / Required Return
Good for no growth in dividends like preferred stock
Constant Growth Model - DDM
P = D1 / R - G
If market lowers the R then value of stock will rise
If market increases the R then value of stock will fall
If investors expect higher G then stock will rise
Dividend Discount Shortcut Method (2 stages of growth)
Shortcut #1
1st growth rate is lower than the second
Do the DDM for the second growth rate
Choose the next lowest option from the rate found
Shortcut #2
1st growth rate is higher than the second
Do the DDM for the second growth rate
Choose the next highest option from the rate found
Price/Earnings Ratio
Current Market Price
DDM does not work with no dividends
Current Market Price = Earnings * P/E ratio
Price/FCF
Instead of using the DDM, use this model exactly the same way
ROE formula
EPS formula
ROE = EPS / Book value per share
EPS = ROE * Book value per share
Dividend Payout formula
Dividends paid per share / EPS
Modern Portfolio Theory (MPT)
Seeks to estimate the relationship between risk and return. Assumes the investor is compensated for assuming risk. Involves determining the relationships between securities that comprise the portfolio to add diversification.
- Security Valuation
- Asset Allocation
- Portfolio Optimization
- Performance Measurement
Capital Market Line (CML)
Expresses macro aspect of MPT and CAPM. Specifies relationship between risk and return for a diversified portfolio (not individual positions or undiversified portfolios as those would fall under the CML).
Tangent to the efficient frontier at the optimal risky portfolio (all risky assets that are available). Most portfolios are allocated between optimal risky portfolio and risk free portfolio (T-Bills are risk free) with 100% risk free portfolio being 100% T-Bills
Represents highest return for a given pool of risk and becomes the new efficient frontier with risk free assets.
Shows variability between all possible portfolios.
CML shows: expected return on diversified portfolio and diversified portfolio should be on CML
Efficient Frontier
Markowitz approach was to look at combinations of risky assets that would give the lowest risk for a given level of return or the highest return for a given level of risk.
Efficient portfolios would fall on the efficient frontier, inefficient would be under and unattainable would be over.
Most important factor is risk.
Does not include Beta
Risk Tolerance or Indifference Curves
With the efficient frontier everyone would have their own indifference curve that would be tangent to the efficient frontier (not intersect).
More risk averse people would have a steep indifference curve with risk tolerant investors having a flatter indifference curve.
These show how much more return is needed to take on more risk.
Security Market Line - SML
Second part of CAPM looks at the relationship between risk and return for an individual asset or at the micro level. Does not matter whether it is diversified or not.
Security markets in equilibrium are on the SML. Expected return should be equal to the required rate of return.
If above, then that stock is undervalued because it gets a higher return for its level of risk. People would buy and it would increase value and drop return to the SML.
If below, the stock is overvalued because it gets a lower return for its level of risk. People would sell, decrease value, and move to SML.
Above the SML has less risk per return and below has more risk per return.
CAPM; Market Risk Premium; Stock Risk Premium
Finds required rate of return
R = Rf + (Rm-Rf)*B
MRP = Rm - Rf
SRP = (Rm - Rf)*B
Efficient Market Hypothesis
Suggests that investors cannot beat the market consistently on a risk-adjusted basis. Passive is the best.
Contends that security pricing reflects all known information and enables a stocks price to change quickly.
Day to day prices change randomly in a random walk over time. Patterns are unpredictable.
Any active strategy is pointless.
Anomalies
These cannot be explained easily and operate in contrast to the EMH
PE Effect: Low P/E stocks do better than high P/E stocks
Small-Firm Effect: Small firms do better than large
January effect: stocks drop in Dec and do better in Jan
Neglected-Firm effect: neglected firms do better than known firms
Value Line Phenomenon: stocks rated well by the value line survey do better than those rated 5
Fundamental Analysis
Examining balance sheets and income statements to forecast future stock price movements. Current and past company records are used to see future trends.
Top-Down vs Bottom-Up Method
Top Down:
Start with economy, then sector, then stock
Bottom Up: Start with stock and move up
Ratio Analysis; Liquidity; Activity Ratio; Profitability Ratio
Ratio: Studies relationships between financial ratios and trends in ratios
Liquidity: looks at current ratio to see if a firm is good
Activity: how quickly a firm converts its activities into cash, faster is better
Profitability: Ratios compare two or more financial variables relative of a firms income earning performance
Technical Analysis
Looks as charts to project price trends and mostly short-term. Not concerned with specific finances.
Looks at trends over time
Charting; Resistance; Support
Charting involves looking at price movements to predict buys or sells
Resistance is the upper level, once hit there should be sellers who sell, if its breaks through then it should keep going up
Support is the lower level, once there buyers will come in to buy, if it breaks through should keep going down
Sentiment Indicators; Dow Theory; Barron’s Confidence; Other Indicators
Sentiment: Look at the mood of investors and go the opposite
Dow: Use the DOW as a way to look at the total market movements and make trades off that (active)
Barron’s: Difference in good and bad bond return differences. When investors are scared they go into high yield which increases value and drops yield, gap gets bigger from that to bad bonds; vice verse
Others
Investment Policy Statement
Objectives are return and risk
Constraints are liquidity, time, and tax
Muni Bond Allocation
Gross: Interest paid before expenses
Net: Interest paid after expenses
Stock Splits
If it is 3/2 then divide the 3/2 to get 1.5 and multiple by the number of shares to get the new amounts.
Reverse splits work in the opposite way.
Wash Sale Rule
No deduction is allowed for a loss from the sell of a security if within 30 days before or after the sale you buy a substantially identical security. If that happens it is added to the basis of the new buy.
Different accounts or spouses still count for this.
Bond with different terms is not identical.
Ex-Dividend Date
Date of record is the first business day after the ex-dividend date
Corporation pays the dividend to the person who owns the stock the on the ex-dividend date. So…
Need to buy the stock the day before the ex-dividend date (2 days before record date) to get the dividend.
Be sure to think about business days and holidays for the test.
Sharpe Ratio
Sharpe = (Rp - Rf) / Std. Dev
Treynor Ratio
Treynor = (Rp - Rf) / Beta
Jensen Ratio (alpha)
Alpha = Rp - (Rf + (Rm - Rf)*B)
Choosing the right performance measure
If the coefficient of determination (correlation coefficient squared) is greater than 60, then use the highest alpha. If alpha is not available then use the highest Treynor.
If the coefficient of determination is lower than 60, use the highest Sharpe.
If the R^2s are mixed then use the highest Sharpe ratio.
Information Ratio
IR = (Rp - Rb) / Std. Dev
Return of the portfolio is subtracted from the benchmark return and divided by the std. dev to get the returns above the benchmark. This shows how consistent a fund manager is. Sometimes std. dev is called tracking error for this.
Excess Return v Active Return
Sharpe ratio compares excess return over the risk free rate
Information ratio compares excess return over a benchmark that a fund manager is responsible for
Different types of probability distributions
Normal, lognormal, triangular, uniform
And many others
Market Timing
Buying and selling securities based on short-term price patterns and asset values
Bond Swaps
Selling a bond and replacing it with another
Executed to change maturities or quality
Investors with bond losses usually swap for higher yielding bonds and tax loss harvesting
Stock Option Collar
Long the stock
Short call (out of the money)
Long put (out of the money)
Hedge against stock declining
Floating Rate Note Collar
This specifies a max and min interest rate that will be paid
Floating rate note is a debt instrument with a variable interest rate and interest adjustments are made periodically. Tied to money market or T-Bill and mature in 5 years
Provide protection against higher interest rates but pay lower yields than fixed rate notes
Dollar Cost Averaging
Invest equal amount at each time period (protects more against down moves)
To find average dividend amount invested by price at each period to get number of shares then divide entire amount by the number of shares for average basis
Passive
Dividend Reinvestment Plans (DRIPs)
Stockholders choose to automatically reinvest dividends into additional shares
No cash is received but dividends are fully taxable (phantom income)
No sales commissions for purchasing additional shares
Bond Portfolio Strategies
Ladder: bonds are purchased with different maturities spread out equally, as one matures another is bought
Bullet: all the bonds are set for one date, intermediate duration
Barbell: half in short term and half in long term
Investing on Margin
Regulation T is 50% for initial (set by the Federal Reserve Board by 1934 exchange commission)
FINRA and exchanges set 25% for maintenance margin (ongoing requirement to keep it
Allowable Securities to Trade on Margin
Margin-able Securities:
- securities listed on stock exchange (stocks, etfs, etc)
- NASDAQ issues
Securities not allowable under margin:
- mutual funds
- options
These would need to pay full amount because no margin is available
Maintenance Margin Formula
Margin Requirement = (1-initial margin %) / (1-maintenance margin %) * purchase price
If price drops questions:
Find current total value (shares * new price)
Equity required (current value * maintenance margin %)
Actual equity (current value - amount borrowed)
Equity required - actual equity = maintenance call
Short Selling
You borrow stock and sell it today and buy it at a later date to cover the trade (profit if fund drops in value)
Need margin to sell because of borrowing
Net proceeds plus margin are held by broker
No funds are immediately received by short seller
No time limit on short sell
Dividends declared must be covered by short seller (expense)
Option Straddle
Don’t know which direction but think price will be volatile
Buy a put and a call on same price for same expiration
If price moves in either direction more than 2 premiums combined then you make money
Protective Put
Long on a position (own it)
Buy a put
Insurance on decline but costs a premium
Currency Futures
Contracts of future delivery of currencies, corporations do this to lock in a price
If US man is doing business in Japan then:
- if the yen revalues then the return will be greater
- if the yen devalues then the return will be lower
In this case they would be long the yen so you would short a yen future to hedge
Active Investing
Particular investors possess some advantage relative to others.
Believe that markets are not efficient and that a particular strategy can earn superior returns.
Strategic Asset Allocation
This is done once every few years.
Simulations are done to generate projected outcomes for a series for each mix of securities and most optimal path is chosen.
Long-run or strategix asset mix.
Passive
Application of Life Cycle Analysis
As someone approaches retirement, they become more risk averse.
With age investors lose the opportunity to recover from large losses.
Overriding consideration is the client’s stage of life with asset allocation beingly largely tied to age.
Client Risk Tolerance and Issues that Arise when determining
Problems that arise when trying to figure out risk tolerance:
- Client may not know
- Different tools and surverys say different things
- As ages and level of wealth changes, risk tolerance changes
- As experience changes, risk tolerance changes
Risk Tolerance Characteristics
High Risk Tolerance:
- High debt
- Low levels of insurance
- Changes jobs often (not secure)
- Quick decisions
- High wealth for age
- Optimistic
- Handles stress
- Experienced
Low Risk Tolerance:
- No debt
- High levels of insurance
- Stable income or job
- Deliberate with choices
- Low level of wealth for age
- Pessimistic
- Does not handle stress well
- Inexperienced
Risk Tolerance
Risk Propensity
Risk Recognition
Risk Capacity
Tolerance: Amount of risk a client is comfortable to assume or accept. How much can you take and still sleep at night. Emotional
Propensity: Client willingness to take risk
Recongition: How much risk the client “thinks” there is
Capacity: How much risk you need to achieve your goals
If client takes less risk than they need to achieve goals there will be a shortfall and if they take more risk than they need they take uneccessary risk
Asset Allocation Rebalancing
Rebalancing is performed to reestablish intial asset mix.
When is it needed:
- Change in wealth
- Change in liquidity needs
- Change in legal environment
- Change in time horizon (goals)
- Change in tax
- Change in needs
Tactical Asset Allocation
Performed routinely in asset management.
Changes in asset mix are based off predictions concerning returns. As predictions of expected returns change, the asset allocation mix actually held in the portfolio change accordingly.
Market timing approach meant to increase exposure when expected returns are expected to be good.
Strategies with Concentrated Portoflios
Sell and recognize LTCG at favorable rates
Setting up hedge with the current position like long puts or collars
Arbitrage Pricing Theory (APT)
Pricing of securities cannot differ for any significant length of time.
Securities movements are not explained by risk and return but rather the result of arbitrage as investors seek to take advantage of perceived differences in prices.
Factors:
- Unexpected inflation
- Unexpected changes in levels of industrial production
- Unanticipated shifts in risk premium
- Unanticipated changes in structure of yields
If any of these factors are expected to happen, then the value of that change is 0
Black Scholes and Binomial Options Valuation Strategies
Options valuation stratgies
Black-Scholes uses five variables to value an option (call or put)
- Price of underlying stock
- Exercise price
- Time remaining
- Volatility of the stock
- Interest rates
Essentially an increase in any of these increases the option value (direct relationship) except for stock price (put only) and exercise price (call only)
Binomial option valuation
Assumes a stocks price can move to 2 possible values at expiration and either increase or decrease. Those values will be discounted back using the risk free rate.
If this theory is correct then the investor has formed a riskless portfolio or a perfect hedge.
Stocks expected rate of return (GGM)
R = (D1 / P) + G
Are bonds subject to PRIME risk?
In a way yes, they are subject to market and exchange rate risk
Best way to get a foreign stock
ADR
When to use clients required rate of return vs CAPM in case studies?
Case Study Tips
If they give you the clients required rate of return, use that unless told to use CAPM
Be sure to look at the wording like current for TEY they want the current ratio rate of the current value of the bond
When would an issuing corporation call its bonds?
When the bonds are trading at a premium because that means the interest rates are lower than the current rate of the bonds.
Accrued interest if acquired halfway through the year.
Amount payable to you is taxable to you and amount held by another is taxable to them.
Amount taxable to another that you need to give them decreases your basis by that much.
T-bills facts
Not sold at par
Sold on a discounted yield basis
Sold in denominations of $100
Sold by competitive bids
Are I Bond inflation adjustment subject to tax each year?
Determined by the holder but usually no one elects to be taxed on it.
Who claims savings bond interest deduction?
Guardian of the student, student has to be their dependent. For grandparent to deduct the interest the student must be a dependent of the grandparent.
How do HH savings bonds pay interest?
Pay it semi-annually by check.
How do Treasury Bonds and CD’s differ?
CD’s are insured up to $250k and are more short term so if there are not a lot of funds that can we worked with.
Treasury bonds are subject to more RIP risk.
Do ADRs give foreign tax credits?
Yes
Do ADRs satisfy the requirements for qualified foreign corporation to get the qualified dividend tax rates?
Most but not all!
Do ETFs have costs to buy them?
Yes with commissions and bid-ask spreads.
ETFs do not have sales loads.
What to look for when giving advice on specific funds
When you see high-yield bonds think about their income level, if low then think about it
If the answer feels weird, lots of aggressive growth, real estate stuff, stuff that is very correlated, probably not correct
Monthly income on a rental situation
Calculate NOI but subtract financing and depreciation costs.
How to avoid interest rate risk but keep cash flow with inflation?
Have balanced fund (40/60) or so or split annuity with immediate and growth
Most likely place for a mortgage reit?
SEP or qualified plan to defer income
What funds can ALWAYS be bought at NAV?
No-load mutual funds (open end companies)
Reports that need to be filed with the SEC?
10Qs and 10Ks
How much is 1 put?
100 shares
What is not a security under the 1933 Securities Act?
Futures contracts
If the client has a lot of US equity and is concerned with a large US equity downturn
Invest in negatively correlated items like collectibles and natural resources
Futures Contracts
If you are long - you want a short hedge (sell futures and protect against lower prices))
If you are short - you want a long hedge (buy futures and protect against higher prices)
If the Yen went from 100 Yen to $1 to 80 Yen to $1 did the Yen revalue or devalue?
Revalued because it takes less Yen to buy the same dollar.
The dollar devalued because it buys less Yen for the same dollar.
If you are doing business abroad you want the currency of the country you are doing business in to revalue, you are long that currency. To hedge you sell the country’s currency to protect against devaluation. Short hedge
Disadvantage of investing internationally
Double country taxation is a potential disadvantage.
Does emerging markets or international have a lower correlation with US equities?
Emerging markets
Do US Treasury securities have credit, default, or marketability risk?
NO but they do have RIP risk
No marketability risk because you can just sell them
How is a portfolio changed if a new position is added that has a negative correlation to the other?
It will decrease the covariance
Standard deviation can remain the same but correlation coefficient can decrease the covariance
Holding period return less tax
Whatever the gain is don’t forget to take out the tax looking at the capital gain tax on the gain
Don’t forget the capital gain tax bracket amounts 0%, 15%, 20% based on income that we are given
Tax Exempt vs Equivalent Yield
When asked for the best bond choice or return they are asking for tax exempt yield. So multiply each of the taxable bonds by the tax to equalize all of the tax-exempt yields and choose the highest yield.
If asked for best return on a tax-equivalent basis then divide the muni bond by 1-the tax rate
Tax Equivalent yield you divide
Tax Exempt yield (best return) you multiply
Tax Equivalent Yield
= return / (1-tax rate)
Tax Exempt Yield
= return * (1-tax rate)
If given a bunch of percent return back to back like year 1: 10%; year 2: 12%; year 3: -4%
And they are asking for return
They are looking for geometric or time-weighted return
If asking for a return and given a stocks starting, ending, time period info
They want you to find the I of the problem (using calculator) and that is your return.
To make it real then do the real return process
If they want holding period return they will specifically ask for that
How to find interest on a margin account that is compounding quarterly at 12% if $10,000 is on margin and it is held for a year
N = 4
I = 12/4 = 3%
PV = 10,000
PMT = 0
FV = $11,255 - $10,000 = $1,255 of interest
Zero coupon bonds
Compound semiannually
How to match two different duration bonds to get immunize the portfolio
Change the ratio up to get as close to your target as possible
If interest rates are increasing, which bonds should you choose?
Low duration because bonds will decrease OR you could short long-term bonds
Shorting works if interest rates are increasing
Which stocks have the highest dividend payouts?
Utility stocks
What is a stock’s yield?
Dividend / Price
Someone with a relatively steep indifference curve
Probably has a moderate risk tolerance
Are negative correlated assets required to reduce the risk of portfolios?
NO, they just have to be less than 1
Important variables in creating the efficient frontier
Risk, return, and standard deviation (therefore covariance)
Difference between CML and Efficient Frontier
CML is looking at diversified portfolios added with T-bills and looks at relationship between risk and return as you take more risky assets on
Efficient frontier is looking at adding only risky assets together to decrease the risk while keeping the return high so correlation coefficient plays a big role here because it matters that stocks are not perfectly correlated
CML, Efficient Frontier and SML X and Y Basis
CML and Efficient Frontier, Y is Return and X is risk
SML, Y is return and X is Beta
MPT expresses a risk-return relationship between what?
CML
Most important factor for Markowitz Efficient Frontier
RISK
Sinking Fund Provision
Purpose is to reduce default risk
Sinking fund may allow the issuer to retire a portion of debt each year until entire issue matures (but not mandatory)
Periodic payments required to source the sinking fund are generally the same each period
If a college grad got a new job and new inheritance, what should be the least of his worries?
Should not worry about making too much income because he is in a low tax bracket and can take the income
Federal reserve regulates the use of leverage on which investments?
Common stock
SEC prohibits use of leverage on Mutual Funds
Are options marginable securities?
NO, full amount of the option cost must be paid in cash
Wealthy people are just as common as poor to buy high and sell low, what can they do to stop that?
Use hedges or insurance to smooth out market volatility
What is true about APT?
Expected value of each factor is zero
What is not true about no-load funds?
They have no management expenses - that is NOT true
No load funds DO:
- have no sales charges
- sold or redeemed at NAV
- continuous offering and redemption
- have management expenses
Gross profit percentage of funds
(Income plus growth or appreciation) / basis
What should a moderate-high risk tolerance investor choose that is young?
Growth mutual fund or annuity?
Choose growth mutual fund, not enough info is given on the annuity and the mutual fund seems to fit the person well giving them moderate-high levels of growth and risk
Can an IRA hold annuities
YES
Is a bond portfolio subject to market risk?
Yes, they are subject to PRIME risk because that is systematic risk (not diversifiable)
When a Corp needs funds in a year should they invest in preferred stock or T-bills
Always look at the time it is needed. Because it is needed in a year it does not make sense to buy something that could substantially change in value over a year. T-bill with a max length of 1 year is a better option
In what ways are T-bills different from T-bonds?
Maturities
Risk levels
Callability
Interest paid
They are not different in terms of taxation
In declining interest rates, what fund should have the highest total return between a long-term corporate bond or zero coupon bond?
Because the corporate bond is specified as long-term then that makes it a more legit answer
A zero coupon would be a better answer if time was mentioned but because it was not then the long-term is better.
What funds provides leverage and hedge against inflation?
Equity REITS
Mortgage REITs do not provide this
Which stock is most likely to pay a dividend?
Stock with the highest dividend yield
Current tax equivalent yield
Find current yield which is (coupon/current price)
and then take this yield and divide it by 1-tax rate to find the tax equivalent yield
Grandpa wants to fund a 529 for his 7 year old grandson, which fund to use?
- Growth fund
- S&P 500 fund
- GNMA fund
- Emerging markets
- Target-date fund
He is young so he could take some risk. The growth and S&P 500 fund are too similar so the target-date seems best.
Mrs. Jackson needs $50k a year and recently inherited $500k from her husband. SS will give her $1,200 a month. How should she invest it?
- Balanced portfolio of stocks and bonds
- Growth mutual fund
- FDIC insured earning 5% (5 year CD)
- 30 year treasury bond with a 7% current yield
30 year t bond because it gets her very close to the amount she needs and is safe
Getting a floating rate note collar
If you get a 5%-9% collar on the SOFR you will receive payments if it’s above 9% and pay if it’s below 5%
What risk do CDs have?
Reinvestment rate and purchasing power risk. Non-negotiable CDs do not have inflation rate risk.
They don’t have market risk because not really affected by market.
Joe bought a $1k bond for $900 with a 5% coupon. He sold it after one year when it was paying him a current yield of 4%. What was his HPR?
$50/4% = $1,250
$1,250-900+50/900 = 44.44%
Stanley have his assets CDs so what risk are his assets subject to?
- Purchasing power
- Reinvestment
- Interest rate risk
- Market risk
Purchasing power and reinvestment rate risk. Since these are not negotiable CDs they are not subject to interest rate or market risk.
OID
Discount is accreted and you pay tax on the interest phantom income earned. That increases the basis.
With munis the OID accrection is tax free. Upon sale or redemption, any gain attributed to the OID is tax exempt. For other bonds that would be taxable (capital gain) but for Munis that is not taxable.
What is not included in a mutual fund’s prospectus?
Return projections
LEAPS
If sold after holding for a year then it is LTCG.
If exercised and you acquire shares then that is not a taxable event. When you exercise that is when the timer starts for the holding period of the stock. If you exercise and sell the stock within 1 year it is STCG.
Exercised vs Sold (DIFFERENCE)
Warrants
Offered as a sweetener with debentures.
Short $100k and buy to cover for $55k and pay $2k in dividends to the holder, what is your gain?
$45k - $2k = $43k of gain
Standard Deviation Problems
Correlation coefficient is 1 then weighted average
If less than 1 then find weighted average and next lowest
If negative then find something close to 0
If 0 then plug into the formula its easy
If it is 90% one variable then choose a standard deviation close to that number.
What does a negative beta do?
Moves opposite to the market.
Does duration look at credit risk?
NO, only cash flow
Is immunization passive?
YES
If a new client who is very risk averse comes to you and you look at his indifference curve, what should you do?
- Have him complete a risk questionnaire
- Decline him
- Gather more data
- Educate him on allocation scenarios and the risk he needs to satisfy his return requirements.
Educate him. You already got his risk info to make the curve but now you need to educate him.
If multiple R^2s above and below 60 what do you choose?
Highest Sharpe
Which Sharpe, Treynor, or Alpha to use?
Look at R^2 and if you do not see that look for what they tell you.
If diversified then go off greater than 60 rule and if not diversified then go off lower than 60 rule.
Index funds are diversified but sector funds are NOT.
Which of the following are true statements regarding T-Bills?
- They are riskless
- They can mature in 3 months
- They are callable
- They can be sold up to $1M
- They are sold by competitive bids
All except that they are callable is true.
They are issued in 3, 6, and 12 month increments.
Can more than 15% for a REIT come from securities like GNMAs?
NO only up to 15%
What is the daily limit in a futures contract?
The max permissible price increase or decrease relative to the settlement price the previous day.
Systematic risk is known as what?
Non-diversifiable risk.
Does sending the remaining balance of an account terminate the relationship?
Yes
Your new client is a half hour late and as he arrives he is already complaining about the drive. As you start to explain your work he tells you that he had a planner who lost his money over the past 10 years, and he needs a new planner who can assure him that he will not lose his money. What do you do?
- Don’t take him
- Explain to him that his expectations are unrealistic
- Educate him on risk vs reward
- Accept him and recommend MM
You should educate him on risk and reward. Just because he is a difficult client does not mean you should decline him and your go to should be education clients.
Bob consults with you on investments and opens a JT account with his wife. He unexpectedly calls you to break up the account into two separate accounts because they are separating. He informs you which stocks to go into his account and then tells you to place the remainder in her account, you realize he is keeping the better stocks. What do you do?
- Follow his advice
- Consult Bob’s wife before
- Consult your compliance department
- Terminate the relationship
- Tell Bob you need to meet with them both before doing anything
Because the account is a JT account, both of them are your clients. You need to talk to them both to figure this thing out.
Harry bought ten bonds (XYZs 8.00s 10/1/35) on July 1st, 2015, at a market price of 105 ($10,500). The transaction cost was $100 and he paid his broker $10,800 for the bonds. His broker reported $400 on a 1099-INT as taxable interest. How much is Harry’s taxable interest?
Harry’s taxable interest would be $200. Because the bonds pay out in October that means he will have held it for 3/6 months before the payment (July, August, September). So $200 of the interest is his and the other amount is paid to the previous holder and decreases his basis. Further, he paid $10,800, had $100 of fees, so the other $200 was the interest to get him to $10,500.
Which of the following are not subject to phantom income?
- STRIPs
- TIPs
- OID tax-exempt bonds
OID tax-exempt bonds are not subject to phantom income because the OID portion is tax exempt income.
On sale or redemption, any gain attributed to the OID is tax-exempt.
Tax-exempt zeros are not subject to phantom income.
Which of the following are marketable?
- CDs
- MM Funds
- Treasury bonds
- Blue chip stock
- T-Bills
Treasury bonds, blue chip stocks, and T-Bills are all marketable but CDs (negotiable CDs would be) and MM funds are not marketable.
CDs, MM accounts, and T-Bills are liquid
Treasury bonds, blue chip stocks, and T-Bills are marketable.
Brokered CDs would be marketable.
Index funds are best for an investor who believes in which of the following?
- Strong form
- Semi-strong form
- Weak form
- Modern portfolio theory
Strong form
Duration questions
Usually it is the next lowest one from what makes sense, think 10% is 3-4% coupon and think 15%-20% for 6-8% coupons.
Are Money market funds marketable?
NO
What avoids reinvestment rate risk? Interest rate risk?
Zeros avoid reinvestment rate risk.
CDs (not brokered) avoid interest rate risk.
Immunization portfolios avoid both reinvestment and interest rate risks.
