Investments Flashcards
1
Q
What is the formula for Margin Call?
A
Margin Call = Loan / (1 - Maintenance Margin)
2
Q
What does Value Line rank?
A
Value Line ranks stocks, using a scale of 1 to 5
3
Q
What are the Value Line rankings and are they a buy/sell signal?
A
Ranking 1 - highest ranking - signal to BUY!
Ranking 5 - lowest ranking - signal to SELL!
4
Q
What does Morningstar rank?
A
Morningstar ranks mutual funds, stocks, ETFs, and Bonds using 1-5 stars
5
Q
What are the Morningstar rankings and are they a buy/sell signal?
A
1 star - lowest ranking - low performing
5 stars - highest ranking - high performing
6
Q
What is the relationship (in number of days) between the “ex-dividend date” and the “date of record”?
A
- An investor must purchase the stock before the ex-dividend date or 2 business days prior to the date of record.
- The ex-dividend date is one business day prior to the date of record.
- Remember: An investor must buy the stock prior to the ex-dividend date to receive the dividend.
7
Q
Characteristics of the Securities Act of 1933
A
- Regulates the issuance of new securities (Primary Market)
* Requires new issues are accompanies with a prospectus before being offered.
8
Q
Characteristics of the Securities Act of 1934
A
- Regulates the secondary market and trading of securities.
* Created the SEC to enforce compliance with security regulations and laws.
9
Q
Characteristics of the Investment Company Act of 1940
A
- Authorized the SEC to regulate investment companies.
* Three types of investment companies: Open, Closed, and Unit Investment Trusts.
10
Q
Characteristics of the Investment Advisers Act of 1940
A
- This act required investment advisors to register with the SEC or state.
- To register with the SEC, an advisor must file Form ADV.
- Less than $100 million in assets, register with the state.
- Greater than $110 million, register with the SEC.
- Between $100 million and $110 million in AUM, have the choice to register with the state or SEC.
11
Q
Characteristics of the Securities Investors Protection Act of 1970
A
- Established the SIPC to protect investors for losses resulting from brokerage firm failures, but not from investment losses.
- This act does not protect investors from incompetence or bad investment decisions.
12
Q
Characteristics of the Insider Trading and Securities Fraud Enforcement Act of 1988
A
- Defines an insider as anyone with information that is not available to the public.
- Insiders cannot trade on that information.
13
Q
Treasury Bills: Maturities and Denominations
A
- Maturities of varying lengths, 52 weeks or less
- Denominations of $100
- Sold at a discount to par value
14
Q
Characteristics of Commercial Paper
A
- Short term loans between corporations.
- Maturities of 270 days or less.
- Not registered with the SEC.
- Commercial paper has denominations of $100,000 and are sold at a discount.
15
Q
Characteristics of Bankers Acceptance
A
- Facilitates imports/exports.
- Maturities of 9 months or less.
- Can be held until maturity or traded.
16
Q
Eurodollars
A
Deposits in foreign banks that are denominated in US dollars.
17
Q
What are the 2 objectives and 5 constraints covered in an Investment Policy Statement?
A
Objectives: Risk and Return
Constraints: Taxes, Timeline, Liquidity, Legal, and Unique circumstances
18
Q
Price-Weighted Average
A
Only takes stock price into consideration when considering the average
e.g. Dow Jones Industrial Average (DJIA)
19
Q
Value-Weighted Index
A
Takes market capitalization (shares outstanding * price) into account.
e.g. S&P 500 Index, Russell 2000, and EAFE
20
Q
Characteristics of Monte Carlo Simulation
A
- A spreadsheet simulation that gives a probabilistic distribution of events occurring.
- Then adjusts assumptions and returns the probability of an event occurring depending upon the assumption.
- Allows for “what if” scenarios and sensitivity analysis if variables such as inflation or savings rate change.
21
Q
Systematic Risks
A
Non-diversifiable risks as measured by Beta
PRIME P = Purchasing Power Risk R = Reinvestment Rate Risk I = Interest Rate Risk M = Market Risk E = Exchange Rate Risk
22
Q
Unsystematic Risks
A
Diversifiable risks
A = Accounting Risk* B = Business Risk C = Country Risk D = Default Risk E = Executive Risk F = Financial Risk G = Government/Regulation Risk
*not on exam but useful for mnemonic
23
Q
What measure of risk does the CML use?
A
Standard deviation
24
Q
What is the CAPM formula?
A
r = r_f + B*(r_m - r_f)
where:
r = The required or expected rate of return.
r_f = The risk-free rate of return
B = Beta, which is a measure of the systematic risk associated with a particular portfolio.
r_m = The return of the market
r_m - r_f = The market risk premium
25
What is the Holding Period Return formula (HPR)?
(Selling Price - Purchase Price +/- Cash flows - Margin Interest Paid) / (Purchase Price or equity)
This formula is easier to use than the one provided on the exam formula sheet.
Taxes are subtracted within the numerator. For margin purchases, only the initial equity is in the denominator.
26
Describe time-weighted returns
Based upon the _security's_ cash flow. Mutual funds report on a time-weighted basis. Ignores any purchases of extra shares.
27
Describe dollar-weighted returns
Take an investor's cash flows into consideration. Investors report returns on a dollar-weighted basis.
28
Arbitrage Pricing Theory (APT)
* a multi-factor model that attempts to explain return based on factors. Any time a factor has a value of zero, then that factor has no impact on the return.
* APT attempts to take advantage of pricing imbalances.
* Inputs are factors (f) such as inflation, risk premium, and expected returns and their sensitivity (b) to those factors.
* KEYWORDS - multi factor model, sensitivity to those factors, and standard deviation & Beta are not inputs
r_i = a_1 + b_1*F_1 + b_2*F_2 + b_3*F_3 + e
29
What is the Constant Growth Dividend formula?
Be sure to use next year's dividend when determining the value of stock using the constant growth dividend formula.
V = D_1 / (r - g)
where:
r = The required rate of return
g = the dividend growth rate
D_1 = next period's dividend
If D_1 is not provided, you can use D_0, which is this year's dividend multiplied by the growth rate provided: D x (1 + g).
30
What is the Dividend Payout Ratio?
Common Stock Dividend / Earnings Per Share
Determines the percentage of earnings paid out in dividends to shareholders.
31
What is the Return on Equity formula?
ROE = Earnings Per Share / Stockholders Equity per share
32
What do technicians consider in their analysis?
* Charting (use movements, not prices)
* Market Volume (Volume Indicator - the number of shares traded)
* Short Interest
* Odd Lot Trading
* The Dow Theory
* Breadth of the Market (Advance Decline Line) - Price Indicator
e.g. a 39 week moving average of a company's stock prices
33
What does Fundamental Analysis consider?
* Financial statement analysis through ratio analysis
* Economic data such as GDP, inflation and interest rates.
* Provides a method for determining a securities price based upon future cash flows.
* Considers (i) debt as a percent of total capital, (iii) interest rate trends, and (iv) the growth rate of the industry of which a company is a part.
34
What are the three forms of the Efficient Market Hypothesis?
1. Weak Form
2. Semi-Strong Form
3. Strong Form
35
Weak Form
* Asserts that historical will not help an investor achieve above average market returns.
* Rejects technical analysis
* States that prices reflect historical information.
36
Semi-Strong Form
* Asserts that both historical and public information will not help investors achieve above average market returns.
* Rejects both technical and fundamental analysis
* "Stock prices adjust rapidly to the release of all new public information."
37
Strong Form
* Asserts historical, public and private information will not help investors achieve above average market returns.
* Suggests stock prices reflect all available information and react immediately to any new information.
38
Series EE Bonds
* NOT marketable securities.
* Interest is paid when the bond is redeemed.
* Sold at face value.
* Tax-exempt interest on federal return if proceeds are used for college education (with some requirements, including AGI)
39
Agency Bonds
* not backed by the full faith and credit of the US government
* they are a moral obligation of the US government
* Exception: GNMA bonds are backed by the full faith and credit of the US government (but not guaranteed against investment losses)
40
Three Types of Municipal Bonds
1. General Obligation Bonds
2. Revenue Bonds
3. Private Activity Bonds
41
General Obligation Bonds
Municipal bonds that are backed by the taxing authority that issued the bond
42
Revenue Bonds
Municipal bonds that are backed by the revenues to be generated by the project for which the bond was issues, e.g. toll roads
43
Private Activity Bonds
Municipal bonds used to fund private activities such as stadiums.
44
What companies insure municipal bonds?
* American Municipal Bond Assurance Corp. (AMBAC)
| * Municipal Bond Insurance Association Corp. (MBIA)
45
Formulas for Tax-Equivalent & Tax-Exempt Yields
Tax-Equivalent Yield = (Tax-Exempt Yield) / (1 - Marginal Tax Rate)
Tax-Exempt Yield = (Corporate Rate) x (1 - Marginal Tax Rate)
46
Characteristics of Bond Duration
* Measures a bond's price sensitivity to changes in interest rates
* The bigger the duration, the more price sensitive or volatile the bond is to interest rate changes.
* Duration is the moment in time the investor is immunized from interest rate risk and reinvestment rate risk.
* It's the weighted average time until an investor receives all of the coupon payments and principal.
* A bond portfolio should have a duration equal to the investor's time horizon to be effectively immunized.
47
Relationship between Duration, Term, Coupon, and YTM
Direct relationship: as term increases/decreases, duration will increase/decrease
Inverse relationship:
* As the coupon rate increases/decreases, duration decreases/increases.
* As yield to maturity increases/decreases, duration decreases/increases.
Remember: coupon rate and yield to maturity are INterest rates and there is an INverse relationship with duration.
48
When does an investor buy a call?
Anytime the exam asks which option will provide the investor with the maximum gains if the stock price appreciates the right answer is "Buying a Call".
49
When does an investor buy a put?
If the exam asks about maximizing gains if the stock falls or you want to "protect profits" or "lock in gains", the right answer is "Buying a Put".
50
Intrinsic value formula
Cannot be less than 0. If you get a negative number, select 0 as the answer on the exam.
Call Option: Stock Price - Strike Price
Put Option: Strike Price - Stock Price
51
Option Pricing Models
1. Black Scholes
2. Put/Call parity
3. Binomial Pricing
52
Black Scholes Model
considers the following variables:
(1) Current price of the underlying asset
(2) Time until expiration
(3) The risk-free rate of return
(4) Volatility of the underlying asset
53
Put/Call Parity
Attempts to value a PUT option based upon a call option
54
Binomial Pricing Model
Explains prices based upon the underlying asset price moving in two directions.
55
What are the distribution percentages of a normal distribution?
1 std dev = 68%
2 std devs = 95%
3 std devs = 99%
56
Characteristics of Correlation Coefficient
* Correlation ranges from +1 to -1 and provides the investor with insight as to the strength and direction two assets move relative to each other.
* A correlation of +1 denotes that two assets are perfectly positively correlated.
* A correlation of 0 denotes that two assets are completely uncorrelated.
* A correlation of -1 denotes a perfectly negative correlation.
* Diversification benefits (risk is reduced) begin anytime correlation is less than 1.
57
Net Operating Income (NOI) formula and Value of Real Estate formula using NOI
NOI = Net Income + Depreciation + Mortgage Interest Payments
Value = NOI / Capitalization Rate
58
Covariance Formula
This first formula is not provided on the exam formula sheet.
COV_AB = stdev_A x stdev_B x Corr_AB
where sigma is standard deviation
and a p looking symbol is the correlation coefficient (which is between +1 to -1)
This is used in the formula for the standard deviation of a two asset portfolio:
stdev_p = sqroot[ (w_A^2 x stdev_A^2) + (w_B^2 x stdev_B^2) + 2 x w_A x w_B x COV_AB ]
59
Describe the SML and what measure of risk is used.
* The SML represents the tradeoff between systematic risk and return for a security.
* The intersection of the SML on the y-axis represents a risk-free rate of return.
* The SML also graphically represents the CAPM.
* Beta is the risk measure used.
60
What risk measures do the following risk adjusted performance measures use:
Alpha
Treynor
Shapre
Alpha and Treynor use Beta.
| Sharpe uses standard deviation.
61
Characteristics of the Treynor ratio
* A relative risk adjusted measure, so you must compare one Treynor to another.
* The higher the Treynor the better.
* Treynor is appropriate to use when r-squared is equal to or greater than .70.
T_p = (r_p - r_f) / B_p
where
r_p = The realized return on the portfolio
r_f = The risk-free rate of return
B_p = The beta of the portfolio
62
Characteristics of the Sharpe ratio
* A relative risk adjusted measure, so you must compare one Sharpe to another.
* The higher the Sharpe the better.
* Because Sharpe does NOT use beta, it is okay to use Sharpe even when the r-squared is less than 0.70.
S_p = (r_p - r_f) / stdev_p
where
r_p = realized return on the portfolio
r_f = risk-free rate of return
stdev_p = standard deviation of the portfolio
63
Characteristics of Jensen's Alpha
* Alpha is an absolute measure of risk, therefore you can look at it and it tells you something.
* A positive Alpha is good. A negative Alpha is bad.
* Alpha tells how much excess return was actually earned, based upon the amount of return expected for the risk under taken.
* To know how a portfolio manager performed relative to how they were expected to perform on a risk-adjusted basis.
a_p = r_p - [r_f + B_p x (r_m - r_f) ]
```
where:
r_p = realized portfolio return
r_f = risk-free rate of return
a_p = alpha, an intercept that measures the manager's contribution to portfolio return
B_p = beta of the portfolio
r_m = expected return on the market
```
64
What is the Geometric Average formula?
[(1 + r_1) x (1 + r_2) ... (1 + r_n)] ^ (1/n) - 1 x 100
where:
n = return for a given period of time
n = number of periods
Provided on the exam formula sheet.
Note that this will usually be slightly lower than the arithmetic average.
65
What is the P/E ratio?
P/E = Price per Share / EPS
or
Price per share = P/E x EPS
The P/E ratio measures how much investors are willing to pay for each dollar in earnings.
66
What is the PEG ratio?
PEG = (Stock's P/E Ratio) / (3 to 5 Year Growth Rate in Earnings)
* The PEG ratio provides insight to determine if the P/E ratio is expanding faster/slower than the firm's growth rate in earnings.
* If the PEG ratio > 1, then the investor is paying more for the stock than is perhaps justified by earning growth; the stock may be overvalued.
* If the PEG ratio < 1, then investors are paying less for the stock than is perhaps justified by earning growth; the stock may be undervalued.
67
What is the Dividend Yield formula?
Dividend Yield = Dividend / Stock Price
68
Characteristics of the Liquidity Preference Theory
* Investors are willing to accept a lower yield on short term bonds because of their preference for liquidity.
* Results in an upward sloping yield curve (up and to the right).
69
Characteristics of the Market Segmentation Theory
* The yield curve depends on supply and demand for bonds and various maturities.
* When supply is greater than demand, rates are higher to incentivize investors.
* When demand is greater than supply, rates are lower since issues don't have to pay as much to attract investment.
70
Characteristics of the Expectations Theory
* The yield curve reflects investors' inflation expectations.
* When inflation is expected to be higher in the future, long term rates will be higher than short term bonds.
71
What is Overconfidence? What does it lead to?
Overconfidence suggests that investors overestimate their ability to successfully predict future market events through both the data gathering and analysis processes. Overconfidence leads to: increased risk taking and overtrading.
Hindsight bias and cognitive dissonance are both types of overconfidence.
72
What is Hindsight Bias? What does it lead to?
Hindsight bias is a form of overconfidence related to an investor's belief that they had predicted an event that, in fact, they did not predict. It leads to: complicated clients wanting to know why their advisors did not anticipate events that the client "knew" would happen.
73
What is Cognitive Dissonance? What does it lead to?
Cognitive dissonance is also a form of overconfidence because an investor's memory of past performance is better than the actual results. It leads to: minimizing or forgetting past losses, exaggerating past gains.
74
What is Anchoring? What does it lead to?
Anchoring represents the investor's inability to objectively review and analyze new information. The investor is "anchored" to the first information they reviewed. It leads to: (a) returns or results that are different than the investor expected and (b) buying securities that have fallen in value because it "must" get back up to that recent high.
75
What is Belief Perseverance? What does it lead to?
* Belief perseverance is similar to anchoring in that people are unlikely to change their views given new information.
* Barberis and Thaler (2002) said, "At least two effects appear to be at work. First, people are reluctant to search for evidence that contradicts their beliefs. Second, even if they find such evidence, they treat it with excessive skepticism."
* It leads to: (a) Sticking to a flawed approach and (b) Avoiding changes to their belief in an investment, even though new information contradicts their original premise for investing.
76
What is Regret Avoidance? What does it lead to?
Regret avoidance, also known as the disposition effect, causes investors to take action (or inaction) in hopes of minimizing any regret. It leads to: (a) Selling winners too soon and (b) Holding onto losers for too long.
77
What is Herd Mentality? What does it lead to?
Herd mentality is the process of buying what and when others are buying selling. It leads to buying high and selling low.
78
What is Naive Diversification?
* Naive diversification is the process of investing in every option available to the investor.
* This is common with 401(k) or other employer sponsored retirement plans.
* A plan participant thinks they are adequately diversified if they invest an equal amount in all the funds.
* Also known as 1/n diversification.
79
What is Representativeness?
Representativeness is thinking that a company is a good investment without regard to an analysis of the investment.
80
What is Familiarity?
Familiarity causes investment in companies that are familiar, such as an employer. Clearly this can cause devastating effects on a portfolio, e.g. Enron.
81
Greatest reinvestment rate risk
Highest coupon when there is a lack of similar rates currently. No reinvestment rate risk with zero coupon bonds.
82
When to sell a call option?
* Not worried about downside risk
* Don't believe stock will go up forever and willing to sell at $X
* Want to gain the premium from selling the call
83
When do put option sellers do best?
If the market price of the stock rises or remains at the same price - they keep the premium and don't need to worry about it being exercised.
Their maximum loss is the exercise price.
84
When do put option buyers do best?
When the security's price falls
85
Selling a naked call option
* aka writing a naked call
* the most dangerous position
* The sky is the limit as to how high the price could go and then the option writer would have to sell anyway.
86
Classification of Money market securities
Short-term instruments categorized by time considerations, not product.
87
Classification of Equity and debt securities
The order of claims in the event of liquidation (debt vs. equity and which is more senior)
88
Classification of Bond markets
(including mortgage bonds): divided into short, intermediate and long-term markets
89
Classification by participants
Each market has participants that prefer different segments of the yield curve. A participant in this case is an insurance company, bank, manufacturing company, etc. Different participants will prefer mortgage bonds over shorter term maturities.
90
Physical assets
are suitable as an investment in the portfolio of an investor looking for long-term capital gains
91
Can you use options on debt instruments?
Yes, to protect against interest rate risk.
92
Long hedge position (futures contract)
The investor is short the underlying commodity and long the futures contract. (They own the futures contract to insure a certain price of a commodity that they do not yet own.
93
Hedge
taking an opposite position than their inherent underlying position
94
If the Federal Reserve is tightening the money supply, what should the treasurer and CFO of a company do to protect your company's long-term bond inventory?
Take a short position to hedge against decreases in bond prices.
(You own a long position on the bonds. A tightening of money will cause a rise in the interest rates, thus exposing your bonds to a loss in value when bond prices decrease as a result. So you should undertake a short position in interest rate futures to protect your position.)
95
Stock dividend
* signals to investors that the firm is retaining capital growth related activities
* used for acquisition, increased R&D or occasionally to fend off takeovers
96
During the peak of the economic cycle, what should one do?
(i) Sell debt instruments and (ii) Begin allocations to cash positions.
An excellent time to sell fixed (and generally lower return) investments, begin appropriations to cash in preparation for opportunities that may arise, and a good time to acquire metals.
97
Limited general obligation bonds
A municipal bond issued with a restricted revenue base.
(A bond issued by an entity that has some ability to levy taxes to support itself (for example, a school district). However, this ability is limited when compared to that of the general taxing power of the state.)
98
Fourth market
The market where exchange and broker dealer services are eliminated entirely, where corporation and institutional investors deal directly with one another.
99
What effect will The Federal Reserve Board selling large quantities of Treasury securities in the near future have on stock prices?
Stock prices will decrease because the required rate of return for investors will increase.
(The sale of Treasury securities results in a reduction of cash in the market place, thus a decrease in supply causing an increase in demand. This will lead to an increase in the cost of money and a lessening of funds for investment, thus a reduction in stock prices.)
100
Holding period yield formula
(Selling Price - Purchase Price) / Purchase Price
* ignores cash flows
101
Why might a company call bonds that were previously issued?
If interest rates have decreased since the bonds were issued = prices would have increased = bonds are selling at a premium
The company would be motivated to retire the higher yield bonds and issue new bonds at lower market interest rates.
102
Arbitration clauses in investment advisory agreements
Both the SEC and FINRA require arbitration if voluntary negotiation fails.
103
Value Line Average
uses the geometric average to compute its daily value
104
Developing cash flow projections and valuations for real estate can be difficult due to...
The unpredictability of changes in economics and demographics, which directly impact values
105
Loss aversion
People more strongly prefer to avoid losses than to seek gains
106
What are factors to consider when investing in a mutual fund?
(i) The size of the fund, (ii) The amount of time until a distribution is made, and (iii) The amount of time the current portfolio manager has managed the fund
107
12b-1 fees
Used for marketing and distribution costs. All other costs, such as legal, accounting, and analysis are paid through management fees. Commissions are paid using either a front load or a back load.
108
Bottom-up equity managers
Value managers and technicians
109
Top-down style equity managers
Group rotation managers and market timers
110
A rise in the price of the Japanese Yen in relation to the US Dollar results in...
A revaluation of the Yen
| And the opposite would be a devaluation
111
Riding the yield curve (a bond investment strategy)
Investing either short-term or long-term to take advantage of anticipated interest rate changes
112
Neglected firm effect
A market anomaly. A stock that has produced superior earnings and rates of return but has gone mostly unnoticed by securities analysts and is often considered underpriced. (This anomaly is said to exist because the security in question is allowed greater potential for movement as a result of the lack of scrutiny by analysts.)
