Investments Flashcards
What is Unsystematic Risk?
Risk that can be eliminated through diversification (Diversifiable, Company-Specific, Specific, Unique, (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?
Risk is inescapable even if investor diversifies (Non-Diversifiable, Market Risk)
* Investor rewarded for level of Systematic Risk
What are Types of Systematic Risk?
THINK - PRIME
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)
250K PER Ownership Category PER beneficiary (NOT PER BANK)
* Individual (250K)
* Joint (250K per owner)
* Trust (250K per beneficiary)
* IRA/Keogh (250K)
The Yield Ladder
Example 1: Premium: A 10 year, $1000 par, 4% bond, bought for $1100
Example 2: Discount: A 10 year, $1000 par, 4% bond, bought for $800
Q1) Structure Nominal Yield (N), Current Yield (CY), Yield to Maturity (YTM), and Yield to Call (YTC)
Q2) Nominal Yield
Q3) Current Yield
Q4) Yield to Maturity
Example 3: AT PAR: $1000 par (CP), 10% bond (C), $105 call price (CP), 5 year callable at par (t)
Example 4: AT Different Price: 6% annual coupon; 15 years to maturity; Callable in 2 years at 103. Rates on comparable bonds are 7%.
Q1) Nominal Yield
Q2) Current Yield
Q3) Yield to Maturity
Q4) Yield to Call
Bond Yields Influenced by Interest Rate (Coupon), Purchase Price, Time until Maturity
Interest Rate /= Yield (Except for Nominal Yield)
Interest rate: Annual interest paid by the issuer to the bondholder
Yield: Overall rate of return of the bond (Interest Rate factors into yield, but yield is different if bond is bought at discount or premium)
* Nominal Yield = Annual Income/Par
* Current Yield = Annual Income/Market Price
* Yield to Maturity
1. Discount: A 10 year, $1000 par, 4% bond, bought for $800
FV= 1000, PV = -800, N=20 (10x2), PMT= 20 (1000x4%/2), I=3.39 (semi-annual)x2 = 6.78%
2. Premium: A 10 year, $1000 par, 4% bond, bought for $1100
FV= 1000, PV = -1100, N=20 (10x2), PMT= 20 (1000x4%/2), I=1.42 (semi-annual)x2 = 2.84%
* Yield to Call
AT PAR: $1000 par (P), 10% bond (C), $105 call price (CP), 5 year callable at par (t)
FV= 1050, PV = -1000, N=5, PMT= 100 (1000x10%), I (Yield to Call) =10.8%
AT Different Price: 6% annual coupon; 15 years to maturity; Callable in 2 years at 103. Rates on comparable bonds are 7%.
Current Bond Price: n=15, I/YR=7% (Market Rate), PMT=60 (Annual), FV=1000, PV=908.93
PV = -909, FV= 1030, N=15, PMT= 60 (1000*6%), I (Yield to Call) =12.85%
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 with monthly interest accumulation (compounds semi-annually)
- Fixed Interest Rate based on 10yr Treasury Yields → Double every 20YR guarantee
- 10K Yearly Max (min $25)
- 1 yr withdraw wait and 3 month penalty if withdrawn <5 years
- Subject to Federal Taxes ONLY when redeemed (Unless used as education bonds) → Report Earnings Annually or at Redemption
What are the Provisions of I (US Treasury) Bonds?
- Non-marketable, non-transferable, can’t be used for collateral
- Sold at Face Value with monthly interest accumulation for 30 years (compounds semi-annually)
- Interest Rate Has Two Parts:
- Fixed Base Rate (Same for Bond Life)
- Inflation Adjustment (Adjusted every 6 months)
- 10K Yearly Max (min $25)
- 1 yr withdraw wait and 3 month penalty if withdrawn <5 years
- Subject to Federal Taxes ONLY when redeemed (Unless used as education bonds) → Report Earnings Annually or at Redemption
What are the Types of Municipal Securities?
Pay interest semi-annually and EXEMPT from Federal Tax and sometimes even state and local taxes (Lower yields than Federal Bonds)
* General Obligation (GO) Bonds: Backed by full faith, credit, and taxing power of issuer. Considered safest types of municipal credit.
* Revenue Bonds: Backed by revenue from a specific project/source (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.
State GO less risky than Local GO less risky than Revenue Bonds (pay lower yield accordingly)
What do Indenture Agreements Cover?
Agreement of Benefits and Obligations of two or more Parties (Bonds & Bankruptcy)
* Form of Bond
* Amount of Issue
* Property Pledged (Collateral for Bond)
* Protective Covenant, including any provision for a sinking fund. (If bond is retired)
* 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 Capitalization (CAP) thresholds (size)?
Market Cap: The total value of a company’s outstanding shares of stock
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 declared in foreign currency and paid in US dollars
* Most (but not all) are “qualified foreign corporation” and taxed at LTCG
* Attain diversification and risk reduction due to lower correlation with US securities
* Receive foreign tax credits for income tax paid to foreign country
* Sponsored/Unsponsored ADRS (Level 1-No SEC/Accounting Guidelines, Level 2 & 3 - Listed on US exchanges, SEC, Accounting Guidelines, and Reports)
What is NOI Calculation for Improved Land/Real Estate?
NOI = Intrinsic Value of Real Estate Property
NOI = Potential Gross Income (PGI) - Vacancy & Collection Losses - Operating Expenses (excludes interest + depreciation)
Improved Land: Usually income producing
Improved Properties: Rental, commercial, and industrial
What are General Definitions for Options?
-American/European
-Intrinsic Value (Call/Put)
-Exercise Price
-Premium
American → Buy/Sell Anytime, European → On Expiration
Intrinsic Value (IV): 0 if OOTM
* Call IV = Current stock price - Call strike price
* Put IV = Put strike price - Current stock price
Exercise (Strike) Price: Price stock can be purchased or sold on exercise of option
Premium: Amount market prices of an option exceed its intrinsic value. (IV+TV+VV = Premium)
More Risk Writing options than buying call/put
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 Same Strike Price and Expiration for PUT and CALL (Buyer doesn’t own the stock)
→ GOAL: Profit from Big Move Either Direction
Collar: Selling call (out-of-the money) at one Strike price and buying Put at lower strike price; (Investor owns stock!)
→ GOAL: Protect against big losses (limits upside gain)
Protective Put: Buying a PUT for STOCK YOU OWN
→ GOAL: Create Max Loss (Put Price + Premium)
Compare: Warrants vs. Call Options:
Warrants allow companies to raise money to secure future capital (Entice Big Investors)
* 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
Future’s Contract = RISK MANAGEMENT (Not Profit Based) → (Commodity, Stocks, Currency, Metal, Treasury)
* Long Hedge: Buying a futures contract to hedge against rising prices of an asset (e.g., an airline purchasing oil futures to lock in fuel costs).
* Short Hedge: Selling a futures contract to hedge against falling prices of an asset (e.g., a wheat farmer selling wheat futures to secure a price before harvest)
Compare: Reg D Accredited vs. Non-Accredited Investors
This is about RAISING Investments for early stage private companies
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 (r^2)
r^2 = Square of correlation coefficient (r) measuring proportion of variance explained by movement of another variable.
- Regression line from data has r and r^2 (Think GPA vs. Study Time) → y =b0+b1x
- r close 0 → Not Correlated, r close 1 → Positive Correlated, r close -1 → Negative Correlated
- r^2 close 0 → weak relationship, r^2 close 1 → strong relationship
- 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)
* Higher SD means more volatility and risk
* +/- 1 SD → 68% of data
* +/- 2 SD → 95% of data
* +/- 3 SD → 99.7% of data
Beta: PRICE volatility compared to theoretical market portfolio of all investable assets (Used in a diversified portfolio → measure of systematic risk)
* Beta = 1 matches index/benchmark
* Beta > 1 More volatility/risk index
* Beta < 1 Less volatility/risk index
* Beta < 0 Inverse Relationship (Gold as Example)
Types of Portfolio Returns
-Arithmetic Return: (r1+r2+…+n) / n
-Geometric Return: [(1+r1) x (1+r2) x … (1+rn)]^1/n - 1
Example 1: Y1(2%), Y2(3.5%), Y3(-0.5%), Y4(1.2%), Y5(0.3%), Y6(-2.6%), Y7(0.3%), Y8(12%)
-Internal Rate of Return (IRR/Money-Weighted): Cash Flows
Example 1: $120 stock, yearly cashflow; year 1($7), year 2($8), year 3($9) and sell for $140.
Example 2: Need $21K (Year 0-4), $33K (Year 5-10). Required RoR 6.5%. Find NPV.
Arithmetic Return: Simple average of returns over a time period (Not considering volatility/standard deviation/time sequence) → Could be used for future prediction
Geometric (time-weighted) Return: Evaluates performance of portfolio
* Ignores Cash Flows (Objective Measure)
* (1+HPR1)x(1+HPR2) = (1+TWR)^2 → ((HPR1+HP2)^½) - 1 = TWR
* Example 1: (1.1666)^1/8 -1 = 1.94%
IRR (money/dollar-weighted): Compares absolute dollar amounts
* Factors in Cash Flows: Contributions, reinvested distributions, charges/withdrawal
* Example 1: -120 [CFj]; 7 [CFj]; 8 [CFj]; 149 [CFj]; IRR = 11.5658 (ADD cost of Capital/initial investment)
Holding Period Return (HPR)
Example 1: $50 stock, sold at $100, 50% margin, 5% margin interest
Example 2: $50 stock, sold at $100, 50% margin, 5% margin interest, $5 dividend paid, held for 6 months
Total Return over Entire Period (Income + Price Appreciation + Dividends - Marginal Interest) / Out of Pocket Cost of Investment
* HPR = (P1+D1-I1-P0)/P0
Example 1: $100 - $25 (basis) - $25 (loan repayment) - $1.25 (margin interest) / $25 cost = 195%
Example 2: $100 - $25 (basis) - $25 (loan repayment) - $0.63 (margin interest) + $5 (dividend) / $25 cost = 217.5%
Taxable Equivalent Yield (TEY)
Compare municipal bonds to taxable bonds
TEY = Tax Exempt Yield / (1 - Marginal Tax Rate)
What is Bond Duration?
ΔP / P = -D[Δy/(1+y)]
-What does Duration 3 mean?
-Time to Maturity influence on duration?
-Coupon Rate influence on duration?
Measure sensitivity of bond price to changes in interest rates
* Bond Duration 3: 1% Interest Rate increase leads to 3% bond price decrease
* Time to Maturity: Longer TTM means higher duration
* Coupon Rate: Lower Coupon means higher duration
SHORTCUT: Interest Rates go up/down 1%, Bond Prices go up/down (inverse) 1% times years of duration
* ΔP / P: Change in Bond Price
* D: Duration
* Δy: Change in bond price in decimal form (CAN BE NEGATIVE)
* y: Origional yield in decimal form
Zero Coupon Bonds
Interest EXAMPLE: 10-year zero coupon bond. Par value → $1,000; Purchased for $445. Taxable in Year 2?
-Calculate Yield?
-Bond Price End Year 1?
-Bond Price End Year 2?
-Income at End Year 2?
- Sold at Deep Discounts to PAR
- No Reinvestment Rate Risk
- Duration equal to maturity
- Fluctuates more than coupon bonds with same maturities (Investors stuck if Rates go up!)
- No Coupon Interest, yet produces “phantom” income (Pay INCOME TAX each year on IMPUTED INTEREST and no Capital Gains at end unless you sell early)
Interest EXAMPLE: 10-year zero coupon bond. Par value → $1,000; Purchased for $445. Taxable in Year 2?
* Calculate Yield: PV=-445, N=10, PMT=0, FV=1000, I=? (I=8.4336)
* Find Bond Price End Year 1: N=9 (10-1), FV=1000, I=8.4336, PMT= 0, PV=? (PV=482.53)
* Find Bond Price End Year 2: N=8 (10-2), FV=1000, I=8.4336, PMT= 0, PV=? (PV=523.23)
* Income at End of Year 2: 523.23 - 482.53 = $40.69
Rules for Using Duration to Manage Bond Portfolios (With changing interest rates)
- 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
GREATER price Fluctuations with:
* Less money (smaller coupon)
* Longer term to maturity (longer time)
* Lower market interest rate (lower interest rates)
Convexity
Measures curvature of relationship between bond prices and interest rates (More Convexity is Better)
* When interest rates increase, bond prices decrease at slower rates
* When interest rates decrease, bond prices increase at faster rates
* Convexity GREATEST for low coupon and long-maturity bonds (allows investor to improve duration approximations for bond price changes)
What is Return on Equity (ROE)
ROE = Company Profit (Net Income) / Shareholder Equity (Not affected by stock price) → Tell us how the business is growing
* Net Income = Profit After Expenses BEFORE dividends
* Equity = Assets - Liabilities
* Compare ROE to peers, evaluate if company is truly growing, and watch debt to equity
* Example 1: Higher ROE → Profit growth without new assets/liabilities→ GREAT (more efficient)
* Example 2: Higher ROE → No Profit growth with new liabilities→ BAD (only more debt)
How to Calculate Dividend Payout Ratio
Dividend Payout Ratio: Common Dividends Paid / Earning Available (ROE)
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/cap weighted
Russell 2000 (small caps): Smallest 2000 stocks of Russell 3000 index, value/cap weighted
NASDAQ: Broadest mature of OTC trading, value/cap weighted.
Europe, Australia, and Far East (EAFE): Equity performance of major foreign markets, value/cap weighted.
Wilshire 5000: Broadest measure of activity and movement of overall stock market, value/cap weighted
Barclays Aggregate Bond: More than 5000 US government, corporate, and mortgage-backed and asset-backed bonds, value/cap weighted
Dow Jones: Tracks 30 large, publicly owned blue-chip companies, price weighted
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)
Sharp = Rp-Rf /σp
Example: Portfolio Beta (βp=1.4), Portfolio Return (Rp=10%), Portfolio SD (σp=27%), S&P 500 Expected Return (Rm=8%), S&P 500 SD (σm=18%), Risk Free Rate (Rf=3.5%)
SHARP: Risk-adjusted return of a financial portfolio (Over 1–> Good)
* Ex: sharp = 0.24% (0.24% of excess return for 1% exposure total risk)
M^2: Portfolio performance to the market on risk-adjusted basis
SHARP: Excess Returns (M^2) per unit of total Portfolio Risk
* 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)
-Jensen’s Alpha = Rp- [Rf + βp(Rm-Rf)]
-Treynor = (Rp-Rf)/βp
Example: Portfolio Beta (βp=1.4), Portfolio Return (Rp=10%), Portfolio SD (σp=27%), S&P 500 Expected Return (Rm=8%), S&P 500 SD (σm=18%), Risk Free Rate (Rf=3.5%)
Jensen’s Alpha: Return of a portfolio/investment based on its risk level (beta) and the market’s performance (POSITIVE–> Good, NEGATIVE –>BAD)
* Ex: alpha = 0.2 (0.2% better than expected based on systematic risk)
Treynor: Portfolio’s excess return per unit of systematic risk (beta)
* Ex: Treynor = 4.64% (4.64% excess return for 1% of systematic risk)
Jensen/Treynor SHORTCUT: Excess Returns (M^2) per unit of Systematic Risk
* Step 1: Look for high R^2 (60+) or diversified portfolio
* Step 2: Look for the highest positive alpha. If no alpha, highest Treynor.
What is Margin (Maintenance) call?
Example: Buy 100 shares of stock at $100/share. Initial margin is 50%, maintenance margin is 30%.
Q1) Per Share Basis
Q2) Margin Account Basis
Q3) Margin Amount Due at $60/share
Margin Requirement is CASH NEEDED (Rest is LOAN)
Formula:
Margin Call = Debt Balance/(1-Maintenance Margin %)
Q1: ($50/share / 0.7) =$71.43 (Price at/below)
Q2: ($5000 / 0.7) = $7,143 (Portfolio at/below)
Q3:
* Required Equity: $18/share ($60/share x 30%)
* Current Equity: $10/share ($60/share - $50/share)
* Deficit: $8/share
* Deposit Required: $800
Maximum Stock Margin: 50% of Stocks
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
- Fundamental Analysis
Arbitrage Price Theory (APT) Keys
Financial model that predicts an asset’s expected return by considering its exposure to multiple risk factors (ALTERNATIVE TO CAPM)
- Unexpected Inflation
- Unexpected Changes in Industrial Production
- Unanticipated shifts in risk premium
- Unanticipated changes in structure of yields
Calculation:
APT = rf + β1 * RP1 + β2 * RP2 + … + βkn * RPn
FOR EACH COMPARABLE FACTOR
Bond Sale Lingo → PDQ 4s M’39 @96 (What is Current Yield?)
- PDQ → Company name
- 4s → 4% Interest Rate ($40/annually)
- M’39 → Matures in 2039
- @96 → 96% of $1000 (PAR) → $960
- Current Yield = $40/$960 = 4.2%
Dividend Discount Model (Gordon Growth Model)
Example 1: Intrinsic Value given 7% dividend, par value $35, priced at $33, required rate of return is 9%?
Example 2: Intrinsic Value given ROE of 12.5%, retention ratio of 50%, dividend of $3.50, required rate of return is 12%?
Example 1: Intrinsic Value given 7% dividend, par value $35, priced at $33, required rate of return is 9%?
* Dividend is percentage of par value (with no growth rate) → 0.07 *35 = $2.45
* V = D1/(r-g) → V =2.45 / 0.09 = $27.22
Example 2: Intrinsic Value given ROE of 12.5%, retention ratio of 50%, dividend of $3.50, required rate of return is 12%?
* Dividend Growth Rate = ROE * Retention Ratio → 0.125 * 0.5 = 6.25%
* First Year Dividend: $3.50; Second Year Dividend: $3.50 * 0.0625 + $3.50 = $3.72
* V = D1/(r-g) → V = $3.72 / (0.12 - 0.0625) = $64.70
Dividend Discount Model (General Formula)
Predicts the price of a company’s stock based on the sum of present value of its expected dividends
Po = D1 / (1+r)^1 + D2 / (1+r)^2 + … + P4 + D4 / (1+r)^4
Mortgage Loan Payments Using HP10Bii+
($175K House, 20% down, 30 yr, 4.75%)
- PV = -140K (175K x 0.80), N=360, I/RR=0.4 (4.75/12), FV = 0, PMT= 730.27
- Total Amortization (Principal/Interest/Balance) 1 INPUT, 5, ORANGE, AMORT (Periods 1-5)
