Investments Flashcards
What is Unsystematic Risk?
Diversifiable (Non-systematic) Risk
* Business Risk: Nature of firm’s operation (possibility of loss due to new technology)
* Financial Risk: How firm finances its assets (possibility of loss due to heavy debt financing)
What is Systematic Risk?
Non-Diversifiable Risk → Risk is inescapable even if investor diversifies
What are Types of Systematic Risk?
Purchasing Power Risk: Loss of Purchasing Power through Inflation
Reinvestment Risk: Money available for reinvestment must be reinvested at lower interest rates than instruments that generated the proceeds
Interest Rate Risk: Change in interest rates will cause market value of fixed income security to fall
Market Risk: Risk of overall market
Exchange Rate Risk: Risk of Change in Value of Currency
FDIC Insured Account (per bank/per type of account):
- Individual (250K)
- Joint (250K per owner)
- Trust (250K per beneficiary)
- IRA/Keogh (250K)
The Yield Ladder
Discounted Bonds (Yields Higher than Coupon) → Yield to Call → Yield to Maturity → Current Yield → Nominal Yield (Annual Coupon Rate) → Current Yield → Yield to Maturity → Yield to call Premium Bonds (Yields Lower than Coupon)
What are the Provisions of EE (Type of US Savings) Bonds?
- Non-marketable, non-transferable, can’t be used for collateral
- Sold at Face Value
- Subject to Federal Taxation when redeemed, unless used as education bonds
- Not Subject to State or Local Taxes
- Interest Rate based on 10 yr Treasury Note Yields
- Fixed Interest Rate in effect at time of purchase
What are the Provisions of I (US Treasury) Bonds?
- Non-marketable, non-transferable, can’t be used for collateral
- Sold at Face Value
- Subject to Federal Taxation when redeemed, unless used as education bonds
- Not Subject to State or Local Taxes
- Interest Rate Has Two Parts:
1. Fixed Base Rate (Same for Bond Life)
2. Inflation Adjustment (Adjusted every 6 months)
What are the Types of Municipal Securities?
General Obligation Bonds: Backed by full faith, credit, and taxing power of issuer. Considered safest types of municipal credit.
Revenue Bonds: Backed by revenue which full credit of issuer is NOT pledged. Given single source of funds (railroads, hospitals, power plants, ect.), there is greater credit risk than GO bonds and therefore higher yield.
Insured Municipal Bonds: Insurers pay timely interest and principal when issuer is in default. Municipal bond insurers are AMBAC and MBIA.
What do Indenture Agreements Cover?
- Form of Bond
- Amount of Issue
- Property Pledged
- Protective Covenant, including any provision for a sinking fund.
- Working Capital and Current Ratio
- Redemption Rights
What are the Risks of Corporate and Municipal Bonds?
THINK – DRIP!
Default: Creditor may seize collateral and sell it to recoup principal
Reinvestment: As payments received from investment, interest rates may fall. When funds are reinvested, investor receives lower yield
Interest Rate: Rising interest rates may cause bond prices to fall
Purchasing Power: Inflation may lower value of bond interest payments and principal repayment, forcing bond prices to fall
What are the Risks of Government Bonds?
THINK – RIP! ONLY
* Reinvestment: As payments received from investment, interest rates may fall. When funds are reinvested, investor receives lower yield
* Interest Rate: Rising interest rates may cause bond prices to fall
* Purchasing Power: Inflation may lower value of bond interest payments and principal repayment, forcing bond prices to fall
What are Market values to define Market Capitalization of Companies?
Large: >10 Billion
Mid: 2-10 Billion
Small: <2 Billion
Micro: <300 Million
American Depository Receipt (ADR)
Bank-issued certificates representing shares in foreign companies for trade on the American Stock Exchange.
* Prices of ADRs quotes in US dollars
* Dividends paid in US dollars
* Dividends declared in foreign currency
* Attain diversification and risk reduction due to lower correlation with US securities
What is NOI Calculation for Improved Land/Real Estate?
Improved Land: Usually income producing
Improved Properties: Rental, commercial, and industrial
NOI = Intrinsic Value of Real Estate Property
NOI = Gross Rental Receipts + Non-Rental Income (Laundry, ect.)
NOI = Potential Gross Income (PGI) - Vacancy & Collection Losses - Operating Expenses (excludes interest + depreciation)
What are General Definitions for Options?
Intrinsic Value: Min price option will command. Difference between market price and exercise price of stock
Exercise Price: Price stock can be purchased or sold on exercise of option
Premium: Market price of an option. As option approaches expiration date, the premium approaches its Intrinsic Value Time. Premium is the amount market prices of an option exceed its intrinsic value. (IV+TV = Premium)
What is the Taxability of Call Options?
At the Time of Purchase: Non-deductible Capital Expenditure
To the Writer due to Lapse: Premium received is short-term gain
To Writer Due to Exercise: Premium received is added to sale price (can be long-term gain if underlying security was held more than 12 months, otherwise short-term COVERED CALL)
To the Holder: If option NOT exercised, option considered sold (it expires) and it is short-term loss. The option period is 9 months or less.
Define Hedging Strategies: Straddles, Collar, Protective Put
Straddle: Buying a put and CALL. Buyer does not own the stock.
Collar: Selling a call (out-of-the money) at one Strike price and buying a Put at lower strike price; Investor owns stock!
Protective Put: Buying a stock (or already owning it) and a put for the stock serving as insurance against decline.
Compare: Warrants vs. Call Options:
- Warrants issued by corporations, calls issued by individuals
- Warrants typically have maturities of several years
- Warrant terms are not standardized, call options are standardized.
What are Hedging Positions of Future Contracts
Long Commodity Position: Need short hedge and will sell futures
Short Commodity Position: Need long hedge and will buy futures
Compare: Reg D Accredited vs. Non-Accredited Investors
Accredited (unlimited):
* Net worth of 1 million or,
* Individual with income of 200K or,
* Couple with income of 300K
Non-Accredited:
* Issue sold to 35 investors max
* Must use purchaser representative if not “sophisticated”
Coefficient of Determination
Square of correlation coefficient measuring proportion of variance explained by movement of another variable.
R^2 on Exam: Describes percentage of fund’s movement explained by movements in S&P 500.
Index/Diversified funds based on S&P 500 have R^2 close to 100%, while sector funds will have very low R^2 (typically 5%-25%)
Risk Level Quantification: Standard Deviation vs. Beta
Standard Deviation: Variability of returns used in non-diversified portfolio (measure of total risk)
Beta: Index of volatility used in a diversified portfolio (measure of systematic risk)
Geometric Return vs. Internal Rate of Return (IRR)
Geometric (time-weighted) Return: Evaluates performance of portfolio
IRR (dollar-weighted): Compares absolute dollar amounts
Holding Period Return (HRP)
Total Return over Entire Period (Income + Price Appreciation + Dividends - Marginal Interest) / Out of Pocket Cost of Investment
Taxable Equivalent Yield (TEY)
Compare municipal bonds to taxable bonds
TEY = Tax Exempt Yield / (1 - Marginal Tax Rate)
Bond Duration (Principles to Remember)
REMEMBER: Coupon and Yield are Interest Rates - Inversely Related.
* Years to Maturity: Duration and maturity are POSITIVELY related
* Annual Coupon: Duration INVERSELY related to coupon rate.
* YTM: Current yield on comparative bonds (duration is inversely related)
Zero Coupon Bonds
- Duration equal to maturity
- No Coupon Interest, yet produces “phantom” income
- No Reinvestment Rate Risk
- Sold at Deep Discounts to PAR
- Fluctuates more than coupon bond with same maturities
Rules for Using Duration to Manage Bond Portfolios
- If interest rates expected to RISE, shorten duration (UPS → “up” + “S” shorten)
- If interest rates expected to FALL, lengthen duration (FALLEN → “Fal” + “LEN” lengthen)
Conclusions to Fluctuations in Bond Prices
- Smaller the coupon, GREATER relative price fluctuations
- Longer the term to maturity, GREATER price fluctuations
- Lower the market interest rate, GREATER relative price fluctuations
Convexity
Degree to which duration changes as yield to maturity (YTM) changes
* LARGEST for low coupon bonds, long-maturity bonds, and low YTM bonds (allows investor to improve duration approximations for bond price changes)
What is Return on Equity (ROE)
ROE = Earning Available for Common (EPS) → Common Equity: Net Worth/Book Value
How to Calculate Dividend Payout Ratio
Dividend Payout Ratio: Common Dividends Paid / Earning Available for Common (EPS)
Three Types of Efficient Market Hypothesis (EMH)?
Strong-Form: Stock prices fully reflect all information, public & private. Inside info, fundamental or technical analysis DOES NOT produce superior investment results over time on a risk-adjusted basis.
Semi-Strong: Stock prices reflect all publicly held information. Fundamental or Technical analysis DOES NOT produce superior investment results. Investors with inside information may consistently achieve superior results.
Weak Form: Historical price data reflected in stock prices and no value in predicting future prices. Technical analysis WILL NOT produce superior results; Fundamental Analysis MAY.
Types of Indexes/Benchmarks
S&P 500 (large caps): Broader measure of NYSE activity, value weighted
Russell 2000 (small caps): Smallest 2000 stocks of Russell 3000 index, value weighted
Wilshire 5000: Broadest measure of activity and movement of overall stock market, cap weighted
NASDAQ: Broadest mature of OTC trading, value weighted.
Europe, Australia, and Far East (EAFE): Equity performance of major foreign markets, value weighted.
Barclays Aggregate Bond: More than 5000 US government, corporate, and mortgage-backed and asset-backed bonds.
Tax Basis of a Mutual Fund
First-in, First Out (FIFO): Method treated shares acquired first as sold first.
Specific ID: Requires seller to identify shares of fund that are sold. Allows investor to create gain, neutralize gain, or create loss.
Average Cost: Allows investor to divide total cost of all shares held by number of shares sold.
Steps to Risk-Adjusted Measures of Performance (SHARP)
Step 1: Look for low R^2 (less than 60) or non-diversified portfolio
Step 2: Look for highest sharp number
Steps to Risk-Adjusted Measures of Performance (Jensen(Alpha)/Treynor)
Step 1: Look for high R^2 (60+) or diversified portfolio
Step 2: Look for highest positive alpha. If no alpha, highest Trynor.
What is Margin (Maintenance) call?
(1 - Initial Margin % / 1 - Maintenance Margin %) x Purchase Price of Stock
SHORTCUT: ⅔ of purchase price if min maintenance is 25%. If 30% do ⅔ and choose next high number.
Examples of Passive Investment Strategies
- Buy & Hold (EMH)
- Dollar Cost Averaging
- Index Investing
- Strategic Asset Allocation (revised every few years)
Examples of Active Investment Strategies
- Market Timing
- Tactical Asset Allocation
- Technical Analysis
Arbitrage Price Theory (APT) Keys
- Unexpected Inflation
- Unexpected Changes in Industrial Production
- Unanticipated shifts in risk premium
- Unanticipated changes in structure of yields
