Investments Flashcards
How do Negotiable CD work, what are some insurances and what is the risk?
Issued by American banks
Can be bought and sold on the open markets
$250k fdic insured per individual
Deposit plus interest
Carry interest rate risk
Money market deposit account fdic limit per person
$250k
Money market mutual funds(mmfs)
Open-end investment companies offer mmfs.
Not fdic insured
Some offer insurance
Interest can be taxable or exempt
Taxable hold tbills, negotiable cds, and prime commercial paper.
Average maturity is 90 days
Tax-exempt contain short-term municipal securities
Treasury bills are
Short-term, 1 year or less.
Issued at a discount from face value
Commercial paper is
Short-term, 270 days or less
Unsecured promissory note by large well known and financial strong companies
Denominations of $100k
Usually sold at a discount and is rated by a rating service for quality
What is a bankers acceptance?
Instrument used to finance imports and exports transactions
Basically an assurance of payment
Bearer securities held 9 month or less
Trades at a discount
What are eurodollars?
A deposit in any foreign bank that is denominated in dollars
What is a yankee bond?
Dollar-denominated bonds issued in the US by foreign banks/corporations
The bonds are issued in the US when market conditions are more favorable than on the Eurobond market or in domestic markets overseas
Discount bond example
A $1000 par bond is quoted at 90 and is selling at a discount of 10 points ($100) from par. A bond point is $10
The yield ladder
Discount bonds-yields higher than $500
Remember YMCACMY
Yield to call
10%+gain yield to Maturity
10% Current yield
5%/$50 Annual coupon (nominal yield)
ABOVE THE LINE
BELOW THE LINE
2.5% Current yield
2.5%+losses yield to Maturity
Yield to call
Yields lower than coupon ($2000)
Premium bond
When is a corporation most likely to call it’s bond
When bonds are selling at a premium, newly issued bonds are offered with lower coupons. The company can recapitalize with lower coupon bonds.
When interest rates are expected to drop, should a corporation call a bond
Just because interest rates drop (1%) 8% to 7% doesn’t mean that’s lower than the company’s coupon rate
Nominal yield is the coupon rate
Coupon rate is the nominal rate
Bonds earn interest daily, if selling
The buyer must compensate for the accrued interest from the last interest date due to the “Regular Way” settlement date of the trade is calculated
The buyer pays this accrued interest in addition to the quoted amount and commission
The buyer will be reimbursed for this amount when the issuer makes the next payment
For the test all bond trades are assumed to be “with accrued” or “plus accrued.”
Accrued interest bond example
Remember bond pay in arrears
On july 1 Harry purchased 10 bonds for 8% interest 10/1/2029 at 105. Commission was $100. He pays $10,800. On Oct 1 he will be paid $400. He already paid $200 of the $400
He will report $400 on schedule b (form 1099-int) and subtract $200 as accrued interest
Things to look for on Accrued interest
Calculate the bond payment to determine 1099
How much is the accrued interest? Subtract that from the 1099 and the cost of the bond ie basis
Original issue discount (OID) from par when it is issued
Many OIDs are zero coupon bonds
No interest until maturity
The discount must be accredited over the bond life
Interest is included in interest income(phantom income) and the bond basis increases
Muni bond OID- interest is not taxable during or after maturity
T bill characteristics
Maturities 3, 6 12 months
Issued $100 to $1 million (discount yield basis)
Risk- none/safest (benchmark for risk free rate)
Default risk: none
Callable NA
No coupon interest(interest is the discount)
Subject to taxation on federal level, not state and local
Auction:weekly
Treasury notes characteristic
Maturities 1-10 years
Issued $1000 to more than $100000 at par
Risk- reinvestment, interest rate, purchasing power (RIP)
Default risk: none
Callable Not callable
Interest paid semiannually
Subject to taxation on federal level, not state and local
Auction:monthly
Treasury bond details
Maturities 10-30 years
Issued $1000 to more than $1million at par
Risk- reinvestment, interest rate, purchasing power (RIP)
Default risk: none
Callable 15 years* priory to maturity
Interest paid semiannually
Subject to taxation on federal level, not state and local
Auction:quarterly
Treasury bond that is callable
Are not callable for at least 15 years from the first day of the delivery month, or if not callable, have a maturity of at least 15 years from the first day of the delivery month. The invoice price equals the future settlement price times a conversion factor plus accrued interest
The conversion factor is the price of the delivered bond ($1 par value) to yield 6%
Treasury bonds are not riskless
Reinvestment risk, interest rate risk and purchasing power (inflation) risk RIPI
Treasury STRIPS (Separate Trading of Registered Interest and Principal of Securities)
Zero coupon bond issued by treasury
Investors acquire a direct obligation of the federal govt
The discount on STIRPS is treated as taxable income, earned annually
Treasury Inflation Protection (TIPS)
Tips offer inflation protection. Marketable security. The face value (principle) of tips is adjusted SEMIANNUALLY to keep up with inflation as measured by CPI over a 6 month period
TIPS are offered with lower stated coupon rate compared to conventional treasuries. The amount of semiannual interest rises as the face amount is adjusted higher with inflation. Higher inflation equates to a higher face amount of the bond (fixed percent but not fixed amount) semiannual interest payments.
TIPs are sold in $1000 denominations
TIP Example
$1000, 10 year TIP has a fixed rate of 3.625
If CPI rises ANNUALLY by 6.5%, the principle is adjusted to $1032.5 (1st semiannually) and the first interest payment is $18.13. The second interest payment would be ($1032.5.03625/2)=$18.71. The principal at the end of the year is 1065. The second year interest would be ($1065.03625/2)=$19.30
Taxation of a TIP
Federal tax but no state or local tax
Interest and appreciation are taxed
(appreciation is phantom) because nothing is received and Taxes are paid this raises the basis
If inflation goes down then it will reduce interest income to the semiannual interest and if there is excess, the excess will be an ordinary deduction
TIP increase basis in bond
The inflation adjustment increases the basis of the bond, the interest payment does not increase the basis of the bond. The interest received is taxable interest
EE bonds
Interest is based on the 10 year treasury note.
Nonmarketable
Fixed rate applies to 30 year life of the bond but only 20 years but adds a 10 year extended maturity period.
Denominations as low as $50. New issue rates are adjusted may 1 and Nov 1.
Interest accrues monthly and is compounded semi annually
Must be held for 1 year
There is a three month interest penalty for bonds held less than 5 years
Treasury guarantees the bond value will double after 20 years
It will continue to earn the fixed rate unless a new rate or structure is announced. If the bond doesn’t double then the treasury will make a one-time adjustment at maturity
Series EE bond taxation
Not taxed federally until bonds are redeemed or reach final maturity
The owner has the option to have the interest taxed each year
Interest is not subject to state and local taxes
Hh bonds
Exchanging from bonds at $500. Not available after 2004 but still may be out there
HH bonds are taxed yearly
I bonds or inflation-indexed accrual securities of the gov’t
Sold at face value
Accumulate interest monthly
Compounded every six months on the bond issue
$50 is the minimum
No guaranteed interest unlike EE bonds
Interest rate is fixed rate plus inflation adjustment
Inflation is traced ever 6 months based on CPI
Rate is announced by treasury May 1 and Nov 1
The owner determines tax. Owners typically def tax and rarely choose to recognize tax
Govt national mortgage association (gnma)
Buys fha, va, farmer home admin insured mortgages and places them into mortgage pools
Issue pass through certificates (min $25k) representing interests in the pool
Since they are not issued by the fed they are taxed federally, state and local
Direct guarantee by the US gov’t
Default:none
Interest rate risk: fixed interest, so interest rate risk if prices fall and interest rates rise
Reinvestment risk: reduced certainty of monthly payments because homeowners repaying their mortgages sooner when interest rates fall (prepayment)
Yield on GNMA
Should be aware that payments received is interest and return of principal (no par at maturity) decline in NAV. People can move in an increasing interest environment paying off their loan
Federal home loan Bank(FHLB)
Federal National Mortgage Association (FNHA) Fannie Mae is a profit making corporation
Federal Home loan mortgage corporation (FHLMC) is a privatized company issue Freddie Mac
The US govt does not directly back these issues. They are backed implicitly through lines of credit
Gnma is not subject to default risk
Fnma is subject to default risk because it is a for-profit corporation. Likely that treasury would step in if default was a concern
GO (general obligation) bonds
Are typically the safest munibond. Think bridges and roads. Can levy taxes
Revenue bond
Backed by specific source of revenue like a new stadium to pay back the bond holders
It is not pledged of the full faith and credit of the issuer (toll roads, hospitals, dorm rooms)
Greater risk equates to higher yields
Every munibond wants AAA
If insured they virtually have a rating of AAA
Credit rating agencies are
AMBAC, MBIA and BAM
Mortgage bonds (corporate)
Considered the safest among long-term corporate issues because the bonds are back by real property and can sell property if the issuer defaults
Collateralized Mortgage Obligations (CMOs)
Based on the expected cash flow to be received over the life of the pool, separate classes of securities called tranches are created
The tranches are separated into a to z. Represents fast pay, slow play (z). Z bears no coupon but receives cash flow from collateral from the remaining after the tranch is satisfied
Tranche Z has the following
Longest duration of all the classes (like 0)
It receives interest and principal after all other tranches have been liquidated
Since it has the longest duration it will have the highest interest rate risk
Since it is last to be paid it has the highest yield
What is debenture?
Corporate debt obligation back only by the insurer (corp)
Indenture debt agreement/deed of trust
A formal agreement, also called a deed of trust, between issuer of bonds and trustee
Appoints a trustee to act on behalf of bondholders
Form of bond (coupon or zero)
Amount of issue
Property pledged
Protective covenant, including provisions for sinking fund
Working capital and current ratio
Redemption rights
Default risk
A creditor may seize collateral and sell to recoup the principal (credit risk)
No government issued bond has this. Govt bonds have rip sans zero coupon bonds
High yield bond or junk bond rating
BB or lower and pays higher yield for the risk
Seldom the correct answer
Convertible bonds
Conversion depends on the price of the security depends on the value of the stock and the interest rate the bond pays
Bond conversion value calculation
Cv=(par/CP)*Ps
CP=conversion price
Ps=current market price of underlying stock
PAR=par value, presume zero
Floor value for convertible security
Every CVPs has a floor
A CVB will NOT SELL for less than the LARGER of the following
-its value as a bond
-its convertible value
Convertible bond securities sacrifice
An investor sacrifices yield to hold the convertible bond (the market price)
Financial distressed individuals are recommended to move their funds from CD to investment grade bonds. 3 months go by
They will state they haven’t had the time because risk adverse investors will put off making the required changes
Someone who wants to change from a conservative investor may
Morph into an aggressive investor
When solving for intrinsic and convertible bond values
Use Par, not market price of bond
Calculate current yield
Coupon payment/bond price= current yield
Describe feature of GNMAs
Payments include interest and principal
The amount received each month may vary
The yield can be somewhat variable
Certs guaranteed by us govt
If mortgage rates decrease, prepayment may increase
Describe I Bonds
Series I bonds earn interest for 30 years
Accrue earning based on fixed rate of return and the semiannual inflation rate
Tax credit applies to both EE and I
The difference between the purchase price and the redemption value is taxable interest
Common stock when it comes to creditors
Most junior security
Secured/unsecured, owners of bonds, preferred stock take precedence
Capitalization or cap refers to the market value of the corporation
Large cap stocks-cap exceeding $10 billion
Mid cap stocks- cap exceeding $10 billion (large) and $2 billion (small)
Small cap anything less than $2 billion
Micro cap- cap less than $300 million
10Qs and 10ks
Quarterly reports from corporations to the SEC
And
Annual reports from corporations to the SEC
Corporate annual report
Sent to shareholders annually speaking of the prior year’s results
Provides information to independent auditors
Preferred stock is a hybrid vehicle comprised of equity and debt
Usually used at $25 par or $100 par with a stated dividend.
Pays a fixed dividend rate
Duration is perpetual or infinite
Because of this interest rate change has a deeper impact then bonds
Preferred stock cumulative or non- commutative
Cumulative-when dividend payments are missed shares will be paid to preferred before any payment to common shareholders as well. Non-cumulative-payments don’t need to be made up
Preferred stock investors
The typical purchaser of a preferred share is corporate treasurer with excess funds on hand. If the treasurer buys bonds, all the interest is taxable however, the corporation buys preferred stock, 50% of the dividend received or generally excluded from taxation.
A corporation can take advantage of 50% or more dividend exclusion
Preferred stocks can be callable
like bonds
American Depository Receipt ADRs
ADRs are receipts of foreign shares held in a US bank vault
Entitle share holder to dividends
In USD, dividend in USD, declared in country of origin’s currency
ADR holders cannot vote for board of directors of the company
ADRs additional information on taxes if foreign issuer incurs tax on dividend
Then investor is taxed but investor may receive a corresponding tax credit
UITs are
A basket of funds that are not purchased and are rarely sold
The trust/sponsor makes a market for the security for the unit holders, not shareholders
Generally redeemed at NAV
Open-ended Mutual funds are
Redeemable
Continuously issued
Non negotiable
Not tradable
Just because someone has a high risk tolerance
Doesn’t mean they are very aggressive
A couple making good money in their 40s what should their portfolio be. They are worried about taxes and AMT
They should get a global fund and S&P
Hedge funds
Used to be unregulated by SEC.
Now if AUM is $100 million more they must register and provide the sec certain information pertaining to their trading
Net worth- residents needs to be over $1 million or earn a minimum amount of money
Blind-pool limited partnerships
The objective is known but actual property to be included is not
The performance of the general partner in past partnership is a major consideration
Can be used for various real estate acquisitions or oil and gas programs
Guaranteed investment contracts (GICs)
Similar to CD by commercial banks but issued by insurance companies. Term is 2-5 years
Bear a guaranteed interest rate
Unlike bonds, GIC do not fluctuate with the interest rate, their value does. Demands on financial strength of the issuer
Popular investment for defined benefit plans. Insurance company assumes the interest rate risk of gics
Real estate and inflation
Can be an effective hedge
Real estate has a low correlation with US stocks
This potential diversification is Reason for including real estate in a portfolio
Real estate investor differences in land for investment
Unimproved land is a passive investment. Unimproved land cannot generate income and depreciation. It’s return as potential price appreciation. In fact, it can produce negative cash flow due to insurance upkeep, etc..
Improve land typically generates income from rentals. Income properties include residential rental, commercial and industrial properties. Intrinsic value of real estate property can be computed using an operating income computation.
Net Operating Income (NIO) Calculation
NOI is critical in real estate analysis
Gross rental receipts
+non-rental income (vending machines, laundromat equipment, late fees)
=Potential gross income (PGI)
-vacancy and collection losses
=effective gross income
-operating expenses (excluding interest and depreciation)
= net operating income property, cash flow
Operating expenses for operating income is the following
Operating expenses include only actual cash, expenses depreciation and amortization expenses are not operating expenses. Also not included debt service, interest,
expense, on mortgage financing that property. Financing is non-operating function.
The focus of operating expenses, the properties cash flow not the investors cash flow. Once the NOI has been computed, it must be divided by the capitalization rate to arrive at a properties, intrinsic value, the appropriate captors of function of manufacturers, including the type location, age of property and the quality of the properties tenants
Intrinsic value on an investment property using NOI and cap rate
intrinsic value=NOI $143,600/capitalization rate (cap) 12%=$1,196,666
Reits are similar to a closed-end
The reit invests in real estate, short-term construction loans, and mortgages
With publicly traded reits the investor achieves diversification and marketability
Trust shares are either traded on an exchange or traded over the counter
Non-public REits
Are not liquid or marketable
Equity reits invest
Mainly income producing properties ie office buildings, hotels, shopping center then lease the property out
Use a modest amount of leverage to finance the properties
Too much leverage and not enough occupancy can reduce dividends and NAC
Mortgage reits investment gets money from
Lending out funds to develop property or finance construction
Construction loans can earn high interest rates but with high interest rates comes more risk
Higher default risk
These instruments are particularly vulnerable to purchasing power risk
75% of REIT’s in one must come from
Real estate investments. 15% can come from securities like gnmas
If REIT distributes 90% or more of it’s investment income it only pays taxes on the undistributed amount
If it fails to distribute 90% it pays taxes on the whole net amount of income is taxable
Since TCJA, shareholders may deduct 20% of the pass-through income from reits.
The top effective rate will now be 29.6%
Reits are prohibited from investing in in
Limited partnerships
Limited partnerships are often tax shelters
Real estate limited partnerships
Relps are non-publicly traded and are illiquid. Has a thin secondary market
They last between 10-20 year or until the property is liquidated
Relps are subject to the passive loss rules
Real estate mortgage investment conduits (remics)
Limited life, self-liquidating equity that invests in mortgages or security backed by real mortgages. Like CMO but the trenches but unlike CMOs (AAA rated) they can both separate mortgages from maturity but risk classes
REMICs MAY replace CMOs
REMIC is set up as a corporation, how is it taxed
As a pass-through income, the set of a corporation is ignored
Current yield on mutual fund
What you are paid by the capital gain dividend by investment amount
Who would be likely to buy a preferred stock?
A pension plan for the income, A C Corporation with extra cash because at least 50% is not taxable and a person in a 12% bracket because they most likely won’t pay taxes
What account would buy a reit in?
Qualified account due to substantial taxable income
High yield doesn’t necessarily mean
Junk bonds
Mutual funds are open-end investment companies
They continue to sell shares after initial offering. Capitalization is always changing due to buying and selling. Each day the fund company computes Net Asset Value. Mfs are marked to market and divided by outstanding shares
No loads, customer pays NaV
Redemptions are always NaV
Closed-end funds
Are publicly traded. They issue stock once then the books are closed, meaning no new shares are issued. Traded on an exchange and valued like any other security.
Closed end funds may hold illiquid securities. Illiquid stocks are not sold by investors
Shares are purchased directly with the issuer
Open-end fund and no-load balanced mutual fund
Intrinsic value of an option
The minimum price an option will command. Difference between market price and option price
Time premium of an option
The amount the market price of an option exceeds its intrinsic value
What is an Exercise price for options?
Is the price the stock can be purchased or sold when exercising an option
What is Premium for an option?
Is the price/cost of an option. As the option approaches its expiration date, the market price of the option (the premium) approaches its intrinsic value
Intrinsic value on an option formula
IV=Exercise price- market price
Option value based on time-to-expiration versus volatility(speculative)
The time value of an option may be the most importance element when market and exercise is equal. The greater the volatility, the greater the price of an option because the increase potential for the stock to move up or down
Call option taxation (9 months or less)
At the time of purchase, the premium paid is a capital expenditure (basis)
If call lapses and premium is received it’s a short-term gain rate(ordinary income rate)
If the call is exercised and security was held more than 12 months then long term gain. The premiums are added to the sale price-basis to get to taxable amount
Taxation for holder of an option(bought)
If expired, it produces a short-term loss.
Long-term equity anticipation securities (LEAPs)
Maturity of 2 years and beyond
S&P 500 index option is a useful hedge for money managers
Warrants compared to options
An option to purchase within a specified time period a stated number of shares at a specified price
Warrants are created by corporations/options are created by individuals on exchanges
Warrants maturity is several years/options are typically 9 months
Warrants terms are not standardized/options are
Warrants are issued with no intrinsic value
Future contracts in commodities
Spot price-current market price of the commodity in the cash market
Open interest-the number of future contracts trading for a commodity
Daily limit-the max permissible price increase or decrease relative to settlement price of the previous day
Future trading consists of
Commodity futures, currency futures, financial futures
Initial margin/deposit is good faith amount.
With future contracts if markets move against an investor and the value drops by more than the difference between good faith and maintenance margin
A margin call by the broker will require the investor to additional cash to restore margin
A futures contract can be settled by delivery or offset (typical)
Delivery means settlement (delivery of pork bellies)
Offset means the buyers will sell their position and sellers buy their position sometime prior to delivery (the reverse what was done originally)
Business may buy futures
To hedge against certain business risks
Future contracts are speculative and very risky
Collectibles can diversify a portfolio
Typically go up during inflation
No market, limited buyers and sellers
Long-term capital gain rate is 28%
Natural resources/commodies
May offer advantage of diversification
Most of these assets are negatively correlated with the stock market, rising when financial assets decline
If the supply or demand of a commodity is elastic it is highly responsive to price changes
Precious metals are believed to be an inflation hedge
You can buy gold through bullion, gold mining stocks, futures, coins, and gold securities
Precious metals are treated as collectibles tax wise-28% capital gains
Private placement Reg D
Not publicly offered
Can be offered to a maximum of 35 non-accredited investors (sophisticated) and must sign an investment letter. If they cannot evaluate on their own they need an attorney or cpa to evaluate (the evaluator signs)
And an unlimited amount accredited, over $1 million net worth excluding primary residence, $200k income for single, $300k for married. 321
Full disclosure is required through a offering memorandum
Future contract is not a security
It is regulated by Commodity Futures Trading Commission and not by the SEC
A futures contract is a formal agreement between buyer and seller that operates through the commodity exchange
A person who is hurt by 25% reduction has done nothing since with new money. He watched tv during the next downturn with $200k on the sideline. What will he do?
Nothing, he is paralyzed by all the negative reporting. He cannot make a decision
A person in their 40s is worried about recessions. She has 75% of her portfolio in US stocks. What would you suggest to diversify?
Fine art/collectibles and a natural resource fund are negatively correlated with the stock market. Global fun would overlap her US stock position
She may enjoy the art, may suit her lifestyle
Index option is correlated
Put options may expire
A person that owns an orange crop and is afraid prices will drop with an oversupply of fruit coming from another country
When they own OJ they are long OJ( they don’t have the oj yet.)
Owner would hedge against lower prices in the future by going short (selling a contract) of orange juice at today’s prices for delivery tomorrow (when prices may be lower)
This would hedge against the other countries oj prices
Read the
F’ing question
Intrinsic value has nothing to do with premium paid
Market price-strike price
Time value and intrinsic value
Time value is market price-(strike+premium)
Intrinsic is market price-strike price
Investment risk is
Uncertainty that the realized return will not equate to expected return
Systematic risk involves risk that is inescapable
It’s non-diversifiable risk. Remember PRIME
PURCHASING POWER RISK (inflation)
Reinvestment risk(new security has Lower yield)
Interest rate risk (the risk that a change to interest rates will cause fixed income securities to fall)
Market risk (as it is, cannot be avoided if in market)
Exchange rate risk( risk with changes in currency)
Country risk or political risk
The risk or uncertainty of returns caused by the possibility of major changes in the political or economic environment of a country
Closely related to exchange rate risk
Systemic risk is different than systematic risk
Systemic risk is a risk to a particular company could collapse an entire sector/economy. Think Enron or Silicon Valley Bank
Unsystematic risk can be avoided. What are unsystematic risks
Business risk( risk related to firm’s operations) Doesn’t adapt to technology
financial risk (credit or default risk) (risk related to how the firm finances its assets. Forced to close because it’s can’t service its debt
Total risk
Is expressed by standard deviation while systematic risk is expressed by beta 1
Total risk is the combination of systematic and unsystematic risk that a portfolio presents
Unsystematic risk can be diversified
By buying low or zero or negative uncorrelated securities
Systematic risk cannot be minimized by owning more securities
One may argue there is no-risk free investment. If a client invest for the short-term what risk does this person have
Reinvestment risk because the client could miss out on the possibility to reinvest at the rate equal to that of which he could have initially locked in
Think GNMA because interest and principal is getting paid out. The reinvestment could be a lower yield
Non-diversifiable risk is systematic risk. It is associated with
S&P index. Carries systematic risk
Political or sovereign risk
Is the risk a foreign govt will default on its loans or fail to honor business commitments because of change in national policy
Global funds count as investing internally
Buying an eft is not because it doesn’t specify what kind of etf
Liquidity implies that a security or commodity can be sold or purchased
without delay and without substantial change in price absent of new information. Liquidity refers to transaction speed and stability in price
Marketability refers to the speed of the transaction. Marketability is necessary but not the only condition for liquidity
Assets generally considered liquid
Cash, CD maturing shorly, life insurance cash value, money market fund (hold the buck)
Government bond fund and growth fund are longer settlements and could fluctuate
Negotiable CDs, etfs, closed end funds
What financial instruments are redeemed?
Savings, checking, money market, and mutual funds
True marketability implies
Trading amongst buyers and sellers
Reits, closed-end funds, etfs, and brokered cds are considered marketable
Mean is the middle point between two extremes
The arithmetic mean is the sum of each of the values being considered divided by the total number of values
Distribution of returns
Normal distribution applies when referring range of returns (%)
Any portfolio can produce negative or positive returns
If you are considering the possible ending portfolio value ($) as of some future date, a lognormal distribution applies because an unleveraged portfolio can never be worth less than zero
Normal distribution when referring to investments
The mean value, center, is the most likely return
The return is symmetrical about the mean
It is more likely to be close to the mean than far away
Period return %
Leveraged ($)
Lognormal distribution
The upper limit is unlimited but values cannot fall below zero
Distribution is positively skewed with most values near the lower limit
Mean will be the right of the highest point of the curve
Ending portfolio value ($)
No margin
Correlation coefficient (infinite possibilities) and covariance (falls between a specific range) both express
The extent to which the movements of securities in the same portfolio are similar or not
The correlation is the standardized version of covariance (infinite). What’s the correlation range and meanings?
+1 perfectly correlated
-1 perfectly negatively correlated
To determine the correlation coefficient of the returns in a portfolio on the exam
THE STANDARD DEVIATION of each securities return and covariance between returns on the securities are needed
Using covariance (COV) formula
COVij=PijOiOj
Standard deviation of Stock I is .10
Standard deviation of Stock j is .20
What is the covariance if correlation between the two stocks is .6 Pij
.6.10.20=0.012
Using the correlation coefficient (Pij) formula
Pij=COVij/Oi*Oj
.012/(.10*.2)=0.6
Perfectly negative correlated security -1 has what risk
Systematic but risk is completely eliminated and standard deviation is 0
Perfectly positively correlated +1
has maximum risk
Only when Pij (correlation) is +1 is the standard deviation O of the portfolio equal to the weighted average of standard deviations of two assets
Coefficient of Variation (CV) is
A measure of RELATIVE variability used to compare investments with widely varying rates of returns and standard deviations
Standard deviation O alone may not express whether one stock carries more risk relative to return of another
To create a relative measure of variability
Divide standard deviation by the mean of each stock
Standard deviation vs BETA
Both used to express risk of a security
Standard Deviation O measures variability of returns used in NONDIVERSIFIED portfolios and is a measure of total risk
BETA measures volatility of returns used in a DIVERSIFIED portfolio and is a measure of systematic risk (undiversifiable risk)
Standard deviation of a nondiversified portfolio is
Variability and total risk
Beta of a diversified portfolio is
Volatility and systematic risk
Standard deviation O and mean of a single investment calculation
Number E+
Number E+
Number- E+
Gold 7(X) for mean
Gold 8(Sx X) for standard deviation O
Applying standard deviation O
Standard deviation O is the absolute measure of variability of results around average or mean of those results
In a normal bell curve distributions
68% fall within 1 standard deviation
95% fall within 2 standard deviations
99% fall within 3 standard deviations
Portfolio weighted standard deviation
The risk and return of a portfolio maybe determined by multiplying the risk and return for each stock and adding them together
Portfolio weighted standard deviation example
Take two securities
Weighted A 40% and B60%
Expected return for A is 10% B is 14%
(.40.10)+(.60.14)=12.4 (return of portfolio.
Risk is standard deviation. What would be the risk if the portfolio was weighted the same
Average of the given risk
If the correlation coefficient of an equal weighted portfolio is less than 1,
the risk must be lower
When standard deviation is given for an equal weighted portfolio and correlation coefficient is less then one
Choose the number next of average number
Coefficient variation formula measuring risk
CV=SD/average(mean)
The lower the number the lower the risk per unit
Coefficient variance is a measure or risk
A negative correlation will make beta negative
And reduce the portfolio risk
The formula for beta includes the correlation coefficient
When it comes to USD and movement of another security
When foreign currency goes up and USD remains the same
USD is revalued
Foreign currency is devalued
Exchange rate formula when trading USD for foreign security and buying foreign stock
Initial investment $10k usd in pesos. Peso value on security is 29-so 10k buys 290000 pesos. Increases by 20% 348000 peso. Need to exchange back. So divid by new price of 30. Equates to $11,600
Beta calculation when measuring a security
Price movement * BETA
Geometric mean is also called time-weighted return
Reflects compound returns over more than one time period. Often used when finding an average numbers presented by %
Superior measure of change of wealth over multiple periods
Calculating geometric mean
- Add 1 to the percentage and make it a number
- Times the returns in step 1
- The results of step 2 become FV
- -1 is always PV
- N is the number of YEARS of the investment
- Use financial calculator to solve for I
Main point of time-weighted return/geometric mean is to
Evaluate performance of a portfolio
Unlike IRR it is not affected by cash flows
Time weighted return is
The measurement of investment performance (income and price changes) as a % of capital at work
It effectively eliminates effects of additions and withdrawals and their timing that distorts dollar-weighted average
Overall performance
Dollar-weighted return is
Measures change in total dollar value, treating additional and withdrawals of capital as part of the return, along with income and capital gains
SAME AS iRR and NPV
Money managers/advisors use what to measure performance
Time-weighted return
IRR rate is constant and does not account for reinvestment risk
This is the biggest mistake made with dollar weighted return or IRR
Holding period return or HPR is total return over the period from the purchase to end period divided by the basis. What is the weakness in this process?
Fails to consider timing of when cash flows occurred. If time period is great than 1 year, the hpr overstates the true annualized return. Under a year it understates the return
Buying stock on margin creates a scenario where
The downside risk is greater than the upside gain for the same rate of return. Margin magnifies the downside risk
Yield to maturity is
The effective yield of the bond. YTM is compounded rate of return someone will receive from a bond at the current market price if held to maturity
YTM takes into account market price/capital gains and losses if held to maturity
When calculating YTM always use semiannually even with zero coupon bonds
Reinvestment risk
YTM assumes an investor invests at the same rate as what they started. If the investment is at a different rate then the realized rate will be different than YTM
Zero coupon bonds and reinvestment risk
Zero coupon bonds eliminates reinvestment rate risk because there are no interest payment to be reinvested
Still carries interest rate risk and inflation risk
Current yield is calculated
Annual coupon/current price
Taxable equivalent yield is calculated
Tey=tax-exempt yield/1-tax rate
Tax-exempt yield=tey*(1-tax rate)
Taxable equivalents yield examples
Municipal bond issues in state 5.2% (tax free) this is the base
Municipal bond out of state (.064 1-.06)=6.02
Treasury 7%1-.24=5.35%
Corporate 7.8%*1-(.24+.06 state tax)=5.46
Current yield if demand increases causing the bond value to increase
Current yield will decrease
Required rate of return calculation
1.101.31.851.2=1.459
Take 1.48 FV
PV is -1
N5
Bond duration calculation. Formula provided on the test. What does y, c, t stand for
Y- current yield on a comparative bond
C-annual coupon
T-years to maturity
Duration is inversely related to
Yield to maturity-market interest rate increase bond duration decreases
Current yield-remember coupon and yield are interest rates inversely related
Years to maturity-duration and years to maturity are positively related-remember time is on top and rules us all
What does Duration reveal?
Compares the price volatility of bonds with equal coupons but different terms
Risk adverse investors prefer shorter duration
Aggressive investors should prefer bonds with long duration when they anticipate interest rates will decline and should consider short duration when they anticipate interest will rise
A High bond rate, its duration is shorter than a similar maturity with a smaller coupon
High coupon(interest)=low duration(inversely related)
Smaller coupon(interest) =high duration (inversely related)
Bond immunization
A bond portfolio with an average duration of the time horizon needed or wanted
By matching duration of the bond to time horizon you can offset these risks:
Interest rate risk and reinvestment risk
Zero coupon bonds have a duration of what?
Equal to their maturities
Because they have new coupon, their price fluctuate more than those coupons for the same maturities
Change in bond price calculation is
🔺P=change in price
D=duration
🔺Y change in interest rates inversely related
Bond price volatility, guidelines
When the coupon is smaller, the relative place fluctuation is greater
When the term to maturities longer, the relative price fluctuation is great
When the market interest rate is lower, the relative price fluctuation is greater
Zero growth model calculation
Price equals dividend divided by required rate of term
Constant growth model calculation
Price equals dividend times 1+ growth rate of dividend divided by required rate of return minus growth rate of dividends
A stocks expected rate of return that has a dividend
Expected rate of return equals dividend times 1+ growth rate of divided by price plus growth
Dividend discount model is
-If the market lowers the require rate of transfer stock, the value of the common stock will rise
-The opposite higher require rate of return or lower dividend lower the value of the common stock
-If investors expect that growth and dividends will be higher as a result of favorable development for the firm the value of the common rise
Current market price calculation
Current market price equals earnings times PE ratio
Price – free cash flow calculation
Intrinsic value equals free cash flow times 1 plus growth divided by rate minus growth
Return on equity equation ROE is
ROE equals earnings available for common EPS earnings per share divided by common equity (net worth, or book value)
Dividend payout ratio equation is
Dividend payment equals common dividend paid divided by earnings available for common EPS or EPS equals ROE per share times book value or net worth per share
What factor does not go into figuring the intrinsic value using the dividen model
Gross earnings of the company
Beta is used to calculate the required rate of return R equals RF plus RM minus Rs.
Be handy
What would least be affected by an interest rate change?
Short duration not coupon rate
How do you figure common equity?
ROE return on equity equals EPS divided by book value
How do you figure dividend payout ratio?
Common dividends paid divided by EPS
How do you figure stocks yield?
Stocks yield equals dividend divided by closing price
Modern portfolio theory enables someone to classify, estimate and maybe control the nature and amount of return and risk. It involves four steps
Security valuation
Asset allocation decision
Portfolio optimization
Performance measurements
Risk equals
Standard deviation
Capital (Marco) market line is the macro version of
Modern portfolio theory
Modern asset allocation is
The risk return and covariance of assets are important input variables in creating portfolios
Security (micro) line is micro is used to value what?
Any asset, whether it is a single security or a portfolio.
Security market line calculation is also required rate of return. What is it? Also capital pricing model or CAPM
Ri=rf+(rm-rf)Bi
Market risk premium calculation is
(Erm-rf)=market risk premium
Stock risk premium calculation is
Erm-rf)B=stock risk premium calculation
If a securities market security market, all assets plot along the SML security market line
They expect your return for any asset should be equal to its required rate of return
A stock above the security market line and a stock below the security market line is what?
Security above the security market line is undervalued and the security below the market security market line is overvalued
Efficient market hypothesis suggests investors cannot outperform the market. Price changes are unpredictable (random walk). What are three forms of EMH
Strong form-fully reflect all information, no one has an edge. Beneficiary for passive investors
Semi-strong form-all publicly know information is fully reflected. Only edge is insider trading
Weak form-reflects historical prices. Technical analysis does not produce better results but fundamentals may produce better results
The EMH suggest that financial planner should direct their activity selecting securities based on what?
Risk-return profile
Well recognized anomalies-pe effect
Stocks with low Pe ratios perform better than stocks with high PE ratios
Well recognized anomalies-small firm effect
Stocks of small firms, outperform stocks of large firms. A small firm is one with total market value in the lowest 20% of all stocks.
Well recognized anomalies-January effect
Stocks client at the end of the year and rebound in January, especially in the last five trading days
Well recognized anomalies-neglected firm effect
Stocks of firms, not commonly studied by analyst outperformed stocks of firms that receive considerable attention from analyst
Well recognized anomalies-value line phenomenon
Stocks rated 1 of (the top ranking) by the value line investment survey outperform those ranked 5 by the survey.
Anomalies would most likely not happen with EMH
PE effect
SML graph if stock is above the line
Carries less risk than below the line based on risk adjusted return
Risk adjusted return is return/beta
Market containing all information including insider information, public or private information
Strong market
Risk is the most fundamental distinguishing factor in the efficient frontier
Complementing factors are return covariance, correlation
Fundamental analysis is
Economics is research of such factors as interest rates, gross domestic product, inflation, employment, and inventory as tools in order to predict the direction of economy
In investing, the fundamental analysis exam as the balance sheet income forecast future stock, price movement fundamental analysis consider current and past company records in predicting future trends
Activity ratio is
How fast a company can turn its inventory or assets into sales to sales or cash. In general, the faster company can convert assets into cash or sales the more effectively the firm is being run.
Profitability ratios are
Ratios that compare to more financial variables, providing a relative measure of firms income earning performance
Sediment indicator are
Measures the bullshit bars, moved to investor many technical analyst look at these indicators as contrarian so if people are bullish, the technical anal will be bearish and vice versa
Other examples include court sales by specialist, mutual fund, cash positions, and the amount of margin debt
Stock splits are
An adjustment of par value of an outstanding stock
Par value is reduced and the number of common shares is increased
The reason for a stock split is to make ownership more affordable
Reverse split
Opposite of stock split. Price is too low for institutional investors or the stock is about to be delisted
Sharp ratio is
The Measure expressed as the ratio of the excess return of the portfolio to a standard deviation
Sp=(Rp-Rf)/Op
This number calculated is meaningless unless it’s compared to the market or other mutual funds
Sharp ratio is defined as and what is the calculation?
The Measure expressed as the ratio of the excess return of the portfolio to a standard deviation
Sp=(Rp-Rf)/Op
This number calculated is meaningless unless it’s compared to the market or other mutual funds
Treynor ratio is
This ratio is the excess return of the portfolio to its beta
Tp=(Rp-rf)/Beta
Rp
Rm
Rf
B
Return of portfolio
Return of market
Risk free return
Beta-Beta is the systematic risk of the asset, not the market’s systematic risk
Treynor ratio has a high number
Compared to other assets. Buy that.
Treynor is meaningless unless compared against the market or other mutual funds
Jensen ratio is
An index that is commonly referred to as alpha.
Alpha is the portfolio return-the expected return
Alpha fishp=rp-(rf+(rm-rf)B)
R2 or r squared is
The square of the correlation coefficient, which explains the movement in one variable explained by the movement of another variable
R2 or Rsquared reveals
It’s the movement that is explained in the s&p 500
Index funds/diversified fund will have a R2 very close to 100%
Sector funds will have very low R2 (5-25%)
The keys to selecting the most appropriate performance measure are the following chart
Correlation coefficient is .75
R2=.75*.75=0.563
Lowe than 60 chose shape ratio
Information ratio is
Portfolio returns from an investment manager or fund manager compared to a benchmark. The higher, the IR the more consistent manager is and consistency is an ideal trait.
Information ratio calculation is
IR(info rate)=Rp-Rb(expected value)/O
Rp is asset return
Rb is the benchmark asset
What are the differences between the sharp ratio and the information ratio?
Sharp ratio compares the excess return of an asset against the risk, free asset. Information ratio compares active return to the most relevant equity or debt to the benchmark index.
Return to notes the return over the risk free asset will active return to note the return over the benchmark
Ratios help an analyst or client when
having multiple ratios for the same industry, not multiple industries
The Dow theory contradicts
Modern portfolio theory and EMH, it looks for trends
Probability distributions have more than a dozen recognized distributions, some examples are
Triangular, lognormal, normal, and uniform
Floating rate note collar
A floating rate, no collar specifies, a maximum and minimum rate of interest that will be paid on a floating rate note a floating rate note is a debt instrument with a variable interest rate interest adjustments are made periodically. They are tied to a money market in instrument such as T bills, they usually mature in five years, they provide holders with production against higher interest rates, but pay lower yields than fixed rate notes of the same maturity. An example of a float would be buying a 5 to 9% collar on so far secured overnight financing rate a client would get paid if the price went over nine, but would have to make payments if it went below 5%.
Bullets for bond portfolio strategy
An investor purchases, intermediate duration bonds, and does not acquire a long duration, short, duration bonds
Barbell bond portfolio strategies
Half the portfolio is in short term and half the portfolio is in long-term here requires periodic rebalancing the portfolio if the portfolio needs to be restructured due to changing interest rates, only one group of bonds needs to be sold
Maintenance margin (FINRA requirement)formula
Margin requirements=(1-intial margin percentage)/1-maintenance margin percentage)*purchase price
Risk capacity is
Risk capacity is the amount of risk that an investor must take in order to reach financial goals
Control of volatility through beta
Choose stocks with low betas or diversify the portfolio to reduce its weighted beta
CAPM compared to CML
CML the risk of the portfolio
CAPM (Security market line) is the specification of the relationship between risk and return for an individual security
Arbitrage pricing theory (APT) is
Security returns are the results of arbitrage as investors seek to take advantage of perceived differences in prices
Unexpected inflation
Unexpected change in level of production
Unexpected shifts in risk premium
Unanticipated changes in structured yields
Arbitrage pricing theory focuses on
Using many factors to explain the rate of return
If factor is zero, the factor has no impact on return
Apt focuses on unexpected changes or unanticipated shifts
The black-schooled option valuation using five factors for a non-dividend producing stock. What are they?
The price of the underlying stock. The exercise price strike price of the option.
The time remaining to the expiration option.
The interest rate.
The volatility of the underlying stock.
Markowitz model ie the efficient frontier uses beta or standard deviation?
Standard deviation
Covariance, correlation coefficient and return
An upward movement in the yield curve shows that interest rates have increased. What does that do to duration?
Lowers duration, inverse relationship
Zero coupon duration is equal to what?
Maturity
To calculate gross profit you must do the following
Income+gain/basis
Holding period return calculation can only be calculated at what time?
Any
A company most likely to pay dividends
One that’s earnings are less than the dividend/earnings
Yield times price to get dividend
Current yield and tax rate
Coupon/current price
Take calculation/1-tax rate
What is investment income?
Investment income includes interest, non-qualified, dividends, royalties, and short term gains
