Investments Flashcards
What is the maturity of a Treasury Bill
One year or less
What is the duration and minimum denomination of commercial paper?
$100,000 and 270 days or less
What is a banker’s acceptance?
An instrument used to finance imports and exports.
They are bearer securities.
Maturity is nine months or less.
What is a Yankee Bond?
A dollar denominated bond issued in the U.S. by foreign banks and corporations. They are registered with the SEC.
Who pays the accrued interest when a bond is sold?
The buyer of the bond. The accrued interest is added to the price of the bond. Buyer then receives the next full interest payment.
Is there a difference between an Original Issue Discount Bond and a Zero Coupon Bond?
With an OID tax exempt obligation, the bond’s interest can be either accreted or paid. An OID coupon bond is not a pure zero.
What is the maturity of a Treasury Note?
1 - 10 years
What is the maturity of a Treasury Bond?
10 - 30 years
What is a STRIP?
Zero coupon Treasury bond
What is the tax treatment of a STRIP?
The discount is treated as taxable income, earned annually.
What are CATS and TIGRS?
Securities created by large broker/dealers that buy a block of Treasury bonds, removing all coupons and then offering investors either the interest to be received in a specific year or the principal at the bond’s maturity.
What is a TIP?
A Treasury inflation-protected security. The face value of a TIP is adjusted semi-annually to keep up with inflation. They are sold in $1,000 denominations. (Face value is adjusted. Interest rate stays the same, but interest payment goes up as face value goes up.)
What is the tax treatment of a TIP?
TIPS, like conventional Treasuries, are exempt from state and local taxes. The increase in face value is phantom income that is not collected until bond is sold or matures, but is recognized and increases basis. If there is a decrease in face value, the decrease will reduce the interest income and then will be an ordinary deduction. (Interest payment does not affect basis.)
What is the minimum denomination of a TIP?
$1,000
What are the general principles applicable to EE/I/HH savings bonds?
1) Minimum denomination is $50.
2) They must be held a minimum of one year.
3) There is a three month penalty applied to bonds held less than five years from the issue date.
4) Treasury agrees that that a bond’s value will double after 20 years and will continue to earn a fixed rate set at the time of issue unless a new rate structure is announced.
5) They are nonmarketable, nontransferrable and nonnegotiable.
6) Issued at face value
7) Have a fixed rate of interst.
Tax treatment of EE bonds?
1) Taxed as ordinary income at redemption, but the owner has the option of having interest taxed each year.
2) Interest earned not subject to ordinary income tax if used for education and parents’ AGI is less than phase-out.
Difference between EE and HH bonds?
1) Not available after August 2004 (EEs used to be exchanged to HHs.)
2) They pay interest semi-annually by check.
Difference between EE and I bonds?
They are inflation-indexed (but like EEs, they are issued at face value). Unlike EEs, they have no guaranteed interest rate. The interest rate is composed of two parts: a fixed base rate and an inflation adjustment.
Tax treatment of I bonds?
If certain requirements are met, interest on I bonds redeemed for education expense is tax-exempt. The owner can choose to defer tax. Must be held by a person 24 years old to qualify for interest exclusion.
What is GNMA?
Government National Mortgage Association. That pools insured mortgages and sells interests in the pool. They are a direct guarantee of the U.S. government, but because they are not issued by the Treasury, they are taxed at federal state and local levels. Minimum certificate is $25k.
What is a CMO?
A Collateralized Mortgage Obligation. Based on expected cash flow (mortgage payments received) separate classes called “tranches” are created.
What is a debenture?
A general corporate debt obligation backed only by the integrity of the borrower.
What is an indenture?
A formal agreement, also called a deed of trust, between an issuer of bonds and the trustee.
What risks are bonds subject to?
Corporate and Municipal are DRIP
Federal are RIP (except zeros)
By definition, what is a high yield corporate bond?
A bond that has a rating of BB or lower.
What is the intrinsic value of a security (including a bond)?
The present value of its expected cash flows. To calculate, use the FV ($1,000 if a bond), the calculated payments that will be received, the term and the interest rate given for comparable debt. This will allow you to calculate the PV, which is the intrinsic value. Intrinsic value can also be referred to as investment value.
What is the Floor Value?
The amount that a convertible security will not sell for less than. It is the larger of 1) its value as a bond or 2) its conversion value. IF a bond’s conversion value is less than its intrinsic value, you would not convert.
When is an issuer likely to call a bond?
When interest rates have dropped in the market since the bond was issued. The cost to the issuer for early redemption is the call premium.
What is a Samurai?
Yen denominated bonds sold in Japan by non-Japanese issuers.
What are Bulldogs?
British-pound denominated foreign bonds sold in the United Kingdom.
Who is the typical purchaser of preferred shares and why?
Corporate treasurer - 50% of dividends received are typically excluded from taxation (where as interest from a bond is taxable).
For preferred stock that pays annual dividends, the stock holder must own the stock for how long for those dividends to be “qualified?”
90 days in a 181 day period that begins 90 days before the ex-dividend date.
What are ADRs?
American Depository Receipts - for shares of foreign-based corporations held in vault of U.S. bank. Prices are quoted in U.S. dollars, and dividends are paid in dollars, but declared in the foreign currency.
What are GICs?
Guaranteed Investment Contracts (GICs) - Similar to CDs, but instead of being issued by commercial banks, they are issued by insurance companies.
How do you calculate the intrinsic value of a real estate property?
Intrinsic Value =
Net Operating Income / Capitalization Rate
What is NOI (Net Operating Income)?
It represents the property’s cash flow (not the investor’s cash flow). Do not include depreciation, amortization or debt service.
What are the REIT rules?
75% of the REIT’s income must come from real estate investments.
15% can come from securities like GNMAs.
If it distributes 90% or more of net investment income, it only pays tax on the undistributed portion.
If it fails to distribute 90%, then all the net investment income is taxable to the REIT.
Shareholders can deduct 20% of pass-through income from REITS.
REITS cannot invest in limited partnerships.
What are the differences between REITs and Real Estate Limited Partnerships?
REITS are portfolio investments, subject to taxation like a stock (ordinary income/capital gains).
Limited partnerships are subject to passive loss rules.
What is a REMIC?
Real Estate Mortgage Investment Conduit - a limited-life, self-liquidating entity that invests exclusively in real estate mortgages or in securities backed by real mortgages. They represent a range of risk levels (unlike CMOs, which are typically AAA bond ratings). They are pass through entities.
What is intrinsic value with respect to an option?
It is the minimum price an option will command. It is the difference between the market price of the underlying asset and the exercise price of the option.
INTRINSIC VALUE CANNOT BE NEGATIVE!
What happens to the market price of an option (the premium) as it approaches its expiration date?
It approaches its intrinsic value.
What is the time premium of an option?
It is the amount the market price of an option exceeds its intrinsic value.
How does time to expiration affect options?
If there is a long time to expiration, a premium is probably due to time value; if it has a short time to expiration; a premium is probably due to volatility.
What is the taxation of call options?
The writer:
due to lapse - premium received is short-term gain;
due to exercise - premium received is added to the sale price (which can be LTCG or STCG).
To the holder:
If the option is not exercised, then it is considered sold (it expires) and produces a short-term loss.
What is the taxation of put options?
The writer:
due to lapse - premium received is short-term gain.
What is the “spot price” of a future?
the current market price of a commodity in the cash market.
What are the three main types of futures contracts?
commodity futures
financial futures
foreign currency futures
Futures “long position”
Wants to buy the commodity/financial (bullish)
Futures “short position”
Wants to sell the commodity/financial (bearish)
What is a warrant?
Similar to a call option. An option to purchase, within a specified time period, a stated number of shares of the issuer’s common stock at a specified price. Differences between the two:
1) warrants issued by corporations - calls by individuals on exchanges
2) warrants typically have maturities of at least several years whereas listed calls generally expire within 9 months.
3) warrant terms are not standardized whereas call options are standardized
4) warrants are issued with no intrinsic value
How are precious metals taxed?
They are treated as collectibles for tax purposes. Regardless of holding period, the capital gains rate will be 28%.
Who/what regulates futures contracts?
The Commodity Futures Trading Commission, not the SEC. They are not securities.
What is systematic risk?
Risk that cannot be diversified away. The risk of the overall market (PRIME). It cannot be minimized by owning more securities.
What is unsystematic risk?
The risk of a portfolio that is not diversified. Un or nonsystematic risk is diversifiable risk. (Business risk and financial risk)
What is total risk?
Total risk is portfolio risk. It is the combination of systematic and unsystematic risk that an investment or portfolio presents.
How is total risk measured?
Standard Deviation
How is systematic risk measured?
Beta
Difference between liquidity and marketability?
Liquidity means a security can be sold or purchased without delay and without a substantial change in price absent new information. Marketability refers only to the speed of a transaction.
Covariance vs. Correlation Coefficient
1) Both express the extent to which the movements of stocks/securities in the same portfolio are similar or not.
2) Covariance has an infinite possibility of outcomes.
3) Correlation Coefficient is a standardized version of the covariance that ranges from -1 to +1.
4) To determine the Correlation Coefficient you need the Standard Deviation of each security and the Covariance between the returns on the securities.
What is the Coefficient of Variation?
A measure of relative variability used to compare investments with widely varying rates of return and standard deviations. CV indicates risk per unit of expected return. (higher CV = riskier)
How do you calculate Coefficient of Variation (CV)?
Standard Deviation / Average or Mean Return
In a bell-shaped distribution, what percentage of results will fall within one standard deviation?
68%
In a bell-shaped distribution, what percentage of results will fall within two standard deviations?
95%
If there are two stocks in a portfolio and they are equally weighted, what is the average risk of the portfolio?
The average risk of the two stocks.
True or False?
Unless the securities are all perfectly positively correlated (+1), the Standard Deviation (risk) of the portfolio must be less than the weighted average standard deviation of the individual securities.
True
What is Beta?
The measure of the volatility of a particular security’s (or portfolio’s) rate of return or price relative to the volatility of the market as a whole. (Calculated based on the historical record of the security.) The greater the Beta, the greater the systematic risk (nondiversifable risk) associated with the individual stock.
How do you calculate geometric mean/time-weighted return?
- Add 1 to the returne (1 + .50)(1-.50)
- Multiply the returns 1.5 x .5 = .75
- .75 becomes the future value (FV)
- 1 was the present value
- Time was two years. 1 = (CHS)PV, .75 FV, 2N = 13.40i
The result is in percent.
Is dollar-weighted return the same as IRR/NPV?
Yes
Explain Internal Rate of Return
The discount rate at which the present value of future cash flows equals the cost of the investment. When the NPV of the cash flow is zero, the discount rate being used is the IRR. When the IRR is greater than the required return, the investment is acceptable.
What is the “effective yield of a bond?”
Its Yield to Maturity
How do you calculate the current yield of a bond?
annual interest in dollars / bond’s current price
What is TEY?
Tax Equivalent Yield - the interest rate on taxable bonds necessary to provide the same after-tax return as a municipal security.
How do you calculate TEY?
(tax-exempt yield) / (1 - marginal tax rate)
How do you calculate the after-tax yield of a corporate bond?
(interest rate of bond) x (1 - marginal tax rate)
Is the interest from a zero coupon bond taxable every year?
Yes. It is not deferred.
When do aggressive investors prefer bonds with high durations?
Only when they anticipate that interest rates will decline.
What is the duration of a zero coupon bond?
It is equal to its maturity.
How much does a bond gain or lose in value if interest rates of similar bonds rise or drop by 1%?
The change in value will generally equal its duration.
What is convexity?
It expresses the degree to which duration changes as a bond’s yield to maturity changes.
What is capitalized earnings?
A way to value a stock based on estimates of an issuer’s underlying earning power times a derived capitalization rate.
What is the calculation for valuing a stock based on dividends that do not grow (same for preferred stock because dividends are fixed).
No Growth Model:
Price = Dividend/Required Rate of Return
What is the calculation for valuing a stock based on dividends that are presumed to grow at a constant growth?
Constant Growth Model:
Price = Dividend(1 + growth rate of dividend) / (required rate of return - growth rate of dividends)
What is the calculation for valuing a stock based on dividends that are accelerating or decelerating?
Dividend Discount Model:
Shortcut - when the dividend growth rate is split, begin with the second growth rate to calculate the DDM value.
Shortcut #1 - If the first growth rate is lower than the second growth rate, choose the next lowest number in the answer.
Shortcut #3 - If the first growth rate is higher than the second growth rate, choose the next highest number in the answer.
What ratios can be used to value a stock?
- Price/Earnings:
Current market price = Earnings x P/E ratio - Price/Free Cash Flow:
Similar to DDM. Dividend replace by free cash flow.
What is the Book Value of a company?
The sum of common stock outstanding, capital in excess of par and retained earnings.
What is Return on Equity used for?
To determine if a company’s profitability is increasing or decreasing and why.
What is the Dividend Payout Ratio?
The percentage of earnings paid to the common shareholders as cash dividends.
What are the four steps of Modern Portfolio Theory (MPT)?
- Security Valuation
- Asset Allocation Decision
- Portfolio Optimization
- Performance Measurement
What does the Capital Market Line represent?
It expresses the macro aspect of MPT. It specifies the relationship between risk and return on a portfolio rather than on one investment. It shows the expected return on a fully diversified portfolio. (Rf is the risk free return - 100% T-bills).
Is the indifference curve of risk averse investor steep or flat?
Steep - large amount of additional return is necessary to take on more risk.
What does the Security Market Line represent?
The relationship between risk and return for an individual asset.
The Security Market Line has the same formula as what else?
The Required Rate of Return
What is the Current Ratio?
Current Assets / Current Liabilities
What is a stock split?
A distribution of more than 25% of the outstanding shares. Par value per share is reduced and the number of shares is increased proportionally.
How do you calculate a stock split? (3:2)
Multiply by the fist; then divide by the second. (x3 /2)
What is the Wash Sale Rule?
No loss deduction is allowed for the disposition of stock of within a period beginning 30 days before and ending 30 days after the sale, the taxpayer acquires substantially identical stock or securities (which can include warrants or options that can be exercised into the underlying stock). Basis is increased by the amount of the disallowed loss.
When must an investor purchase stock to be the holder of record in order to receive the dividend?
BEFORE the ex-dividend date.
Purchase, Ex-Dividend, Date of Record
What does the Sharpe ratio measure?
The ratio of excess return of the portfolio to its Standard Deviation.
What does the Treynor ratio measure?
The ratio of the excess return of the portfolio to its Beta.
What does the Jensen ratio measure?
The contribution of the portfolio manager. Also known as Alpha.
What does the Information Ratio measure?
Portfolio returns above the returns of a benchmark (usually an index) to the volatility of those returns. The higher the IR, the more consistent a manager is and consistency is an ideal treat.
What is a bullet bond strategy?
An investor purchases intermediate duration bonds and does not acquire any long duration or short duration bonds.
What is a barbell bond strategy?
One that is generally half in short-term and half in long-term bonds.
What investments are marginable?
Only actively-traded securities. Not mutual funds or options.
What are four possible factors that may affect Arbitrage Pricing Theory (APT)?
- Unexpected Inflation
- Unexpected changes in the level of industrial production
- Unanticipated shifts in risk premium
- Unanticipated changes in the structure of yields
What are the five variables used in the Black-Scholes option valuation model?
- Price of the underlying stock
- Exercise price of the option
- Time remaining to the expiration of the option
- Interest rate
- Volatility of the underlying stock
(All the variables have a direct (up) relationship for calls except for the exercise price. Think “call up”)
What is Binomial option pricing?
An alternative to the Black-Scholes option-pricing model.
True or False?
Correlation affects both variability (standard deviation) and volatility (beta).
True
How would an investor value rental property?
Net Operating Income / Capitalization Rate (given)
What is Standard Deviation?
An absolute measure of the variability of returns around the average or mean of those returns. In a normal distribution, 68% of all returns fall within 1 SD, 95% fall within 2 SDs.
What does Standard Deviation measure?
The variability of returns used in a nondiversified portfolio and is a measure of total risk.
What does Beta meausure?
The volatility of returns used in a diversified portfolio. It is a measure of systematic risk. It measures the volatility of a security’s return relative to a market index.
How do you compare mutual funds using risk-adjusted returns?
Divide a fund’s realized return by its Beta
What is the short cut to solving for Geometric Mean?
- Add 1 to each year’s return (20% would be 1.20.
- 40% would be .60) - Multiply each outcome by the preceding one
- Use the result as the FV
- Use 1 as PV
- N is the number of years
- Solve for I
What is Holding Period Return?
Total return (income plus price appreciation and dividends or interest received less margin interest paid) divided by the price of the investment.
When calculating the yield to maturity on a bond, what do you do with the coupon rate?
Use it to calculate the payment received. You must solve for I to find the Yield to Maturity.
What is the shortcut to calculate duration?
If it is a coupon paying bond, look at the maturity. Duration must be less than the maturity. Pick the number close but less than maturity, but not too close to maturity.
True or False?
Duration is inversely related to the current yield on comparative bonds.
True
What is the optimal risky portfolio?
The point where the (straight) Capital Market Line meets the Markowitz efficient frontier.
What does the capital asset pricing model tell us?
The return required by investors before they will commit to an investment given its risk. Unless an expected return exceeds the required return, an investment is unacceptable.
What is an anomaly and list them
An exception to the Efficient Market Hypothesis: P/E Effect Neglected Firm Effect Small Firm Effect Value Line January Effect
What is R2?
The Coefficient of Determination. It is the square of the Correlation Coefficient (R). It describes the percentage of a fund’s movements that correspond to movements in the S&P 500.
If R2 is high, what formula would you use?
Jensen/Alpha. When Alpha is not an option, default to Treynor.
If R2 is low, what formula would you use?
Sharpe
