Investments Flashcards
3 Forms of Effecient Market Hypothesis
x = rejects, already reflected ✓ = helps, advantageous, not reflected, benefit, higher returns
fundamental analysis - P/E ratio
debenture
unsecured corporate debt
annual yield formula
annual income
purchase price
appreciation formula
end of year price
purchase price
original issue discount bond
- sold at discount to par
- bond basis increases set rate each year
- owner pays income tax on “phantom income” (unless tax exempt)
- upon maturity, owner receives face value and pays no tax b/c already paid
- OID = maturity value - OID price
- ex) zero coupon bond
correlation = 1
correlation < 1
Standard Deviation of returns of portfolio = weighted average of standard deviation of individual securities
Standard Deviation of returns of portfolio < weighted average of standard deviation of individual securities
intrinsic value
according to fundamental analysis…
dicounted value of all future dividends
what action can result in unlimited loss?
selling a naked call
if market risk premium were to rise, value of common stock would…
decrease due to lower risk-free rates
????
unit investment trust (UITs)
- passively managed
- self liquidating (easily LIQUID)
- equity or fixed income
- additional securities not added to trust
- units (not shares) are held until maturity NOT sold on exchange
YTM Problem
N= years
I= YTM = ?
PV=market price
PMT=1000(par) x coupon rate
FV=1000(par)
semiannual coupons
YTC Problem
N= years until callable
I= YTC = ?
PV=market price
PMT=1000(par) x coupon rate
FV=price at call
semiannual coupons
American Depository Receipts (ADRs)
- foreign securities all else US
- US dollars…trade, denomination, dividends
- US exchanges
- do NOT eliminate currency/exchange rate risk (PRIME)
substitution bond swap
takes advantage of perceived yield differential b/w bonds that are similar w/ respect to coupons, maturities, and industry
rate anticipation bond swap
based on forecasts of general interest rate changes
yield pickup bond swap
designed to change cash flow of portfolio by exchanging similar bonds that have different coupon rates
tax bond swap
offset bonds with capital gains and losses
index fund
tracks market indexes
passive
growth funds
equities with high P/E
seeks capital appreciation
growth and income funds
equities and income producing assets
seeks capital appreciation and income
not good for college savings for young family
balanced fund
more bonds than typical equity fund
global fund
US and international securities
international fund
only non-US securities
Bond Risk
- ALL bonds subject to inflation rate (purchasing power risk) Long > Short
- Muni bonds have low default risk high quality < low quality
selling a call
give opportunity to participate in additional participation before being called out
???
immunization
investment time horizion = average weighted duration
TEY
r
- don’t get thrown off my “does not itemize”, if itemizes, more info would have to be provided
(1-tax you save)
after tax yield
corporate rate x (1-marginal tax rate)
duration of a bond is a function of…
- Current Price - bottom half of formula, PRICE^TIME^RATESvDURATION^
- time to maturity
- yield to maturity
- coupon rate
closed investment companies
- fixed initial market cap
- trade on orgnized exchange, major secondary markets
- trade at premium or discount to NAV
open investment companies
- unlimited initial market cap
- bought/redeemed from fund family
- trade at NAV
- mutual funds
yield summary
High Reinvestment Rate Risk
Higher Coupon Rate
Why?
high now, but who knows later?
Greatest interest rate risk
Long/High Duration
Why?
reinvestment rate risk
vs
interest rate risk
risk an investor will not be able to reinvest at same rate of return, mostly impacts bonds
risk that changes in interest rates will impact price of equities and bonds (inverse relationship)
stand alone risk
single asset ownership
buy and hold & interest rate risk
eliminates because you aren’t buying and selling as price changes (and therefore interest rate changes)
energy sector fund risk
Systematic Plus Gov’t/Political
nominal rate of interest
- interest rate w/o inflation
- includes default premium, liquidity premium, and risk free rate of interest
spot markets
classified by time
equity markets
classified by type of claim
debt vs equity
mortgage/bond markets
classified by participants
short, intermediate, long term participants along yield curve
money markets
categorized by time constraits
short term or current price
Constant Dividend Growth Model
Intrinsic Value
Dividend Discount Model
may have to solve for r (required rate of return) using CAPM
r = (D1/P) + g
provided
expected rate of return based on current price
vs req rate of return
serial bonds
issued in series and mature in series
registered bonds
paid interest based on to whom bonds are registered, regardless of ownership
i.e. treasury bonds
bearer bonds
pays interest to holder/owner of bond
reset bonds
interest rates can be reset
increase inflation rates leads to increase interest rates…
increase demand for high returns (increase required rate of return)
income bonds
high risk bonds issued by financially troubled firms
high yield bonds
lower quality and cost issuer more in interest pmts
BILL wrote a NOTE to james BOND
- Treasury Bills - less than 1 year
- Treasury Notes - 2-10 years
- Treasuy Bonds - greater than 10 years
fbond
lowest investment grade bond
BBB
mortgage-backed securities
lack of definite maturity date
uncertain cash flows
market anomalies and EMH
exist but no impact
who sets margin requirements for all security transactions?
Federal Reserve
margin call price
Loan
1-MM
margin call
how much do you need to add in
Re - Ae
Required Equity - Actual Equity
options
warrant
written by investors
- *shorter** expiration (<=9m)
- *standardized**
issued by corporations
- *longer** expirations (5-10yrs)
- *NOT** standardized
buyers of options…
call - up
put - down
*seller’s are opposite
Long straddle
short straddle
buys a call AND a put on same security at same exercise price for same period of time
investor expect volatility, not sure which direction
sells a call AND a put
investor does NOT expect volatility, just wants to keep premiums
spread
purching put/call at different price
strip
price and time are same
BUT two puts and one call
strap
price and time are the same
two calls AND one put
selling a naked call
selling right to buy
expect market to drop
don’t actually have security
limitless loss potential because market has no ceiling to rise if doesn’t drop
options diagram
buy a call
- maximum gains if stock price rise
sell calls & buy puts
- “market may correct” wants to 1) increase income 2)protect against drops
sell call
- “good thing CANNOT go on forever”, not worries about downside
buy a put
- maximize gains if prices drop
- “possible market decline”, does NOT want to incur cost of selling or mistime market
- concerned of downturn in short term, prefers not to sell
- “optimistic about growth”, wants to “lock in” minimum price incase price drops
- “protect profits” , “lock in gains”
buy a call
- maximum gains if stock price rise
sell calls & buy puts
- “market may correct” wants to 1) increase income 2)protect against drops
sell call
- “good thing CANNOT go on forever”, not worries about downside
buy a put
- maximize gains if prices drop
- “possible market decline”, does NOT want to incur cost of selling or mistime market
- concerned of downturn in short term, prefers not to sell
- “optimistic about growth”, wants to “lock in” minimum price incase price drops
- “protect profits” , “lock in gains”
strategic asset allocation
allocating the wealth of a client among various asset classes, consistent with the clients’ investment objectives, time horizons and risk preferences.
buy and hold strategy (vs active)
tactical asset allocation
- shifting wealth between asset classes to take advantage of expected price level changes (timing) arising from broad movements in the business/economic cycle.
- rebalances her portfolio frequently to take advantage of perceived opportunities in other market sectors
- active
Investment Advisory Agreement: Arbitration Clause
Required by SEC and FINRA if voluntary negotiation fails
private placement of securities
- Sale of securities in a single block to a public pension fund.
- Sale of an entire issue of securities to a single investor.
- Sale of securities in a single block to a publicly-traded mutual fund.
public placement (IPO)
requires registration under disclosure rules with the Securities and Exchange Commission
red herring
- *preliminary prospectus** issued by managing house of an offering
- *red lettering** notifies prospective investors of status as prospectus w/o prices
Securities Investor Protection Corporation (SIPC)
insures investors against losses due to bankruptcy or insolvency of brokerage firms. There is NO protection against investment losses.
neglected firm effect
- market anomaly
- security in question is allowed greater potential for movement as a result of the lack of scrutiny by analysts
- stock that has produced superior earnings and rates of return but has gone mostly unnoticed by securities analysts and is often considered underpriced
P/E effect
market anomaly
low P/E stocks produce higher risk-adjusted returns than high P/E stocks.
size effect (small firm effect)
tendency for small cap stocks to outperform large cap stocks over time
which bond has greateset interest rate risk?
one with longest duration…most price sensative to interest rate changes
lowest coupon if term equaal
duration
time remaining when a security’s discounted future cash flow remains at risk
longer duration = greater sensativity, greater risk
stock dividend
favorable sign
retain capital growth related activities
increased research and dev’l
fend off takeovers
high net worth and ee savings bonds
phase outs for
when are physcial assets suitable for investors?
hedge against inflation…leading to price appreciation and potential capital gains
ladder bond strategy
staggers maturities and in doing so, reduces the exposure to interest rate risk
vs immunization…eliminates interest rate and reinvestment rate risk
roth ira and bonds
no need for a muni in a roth
bond barbell strategy
involves both very long-term bonds and very short-term bonds for a portfolio, and very few intermediate-term bonds
vs bond laddering - proportional staggering of maturity dates
bond swap strategy
trade different and varied maturities to meet the objective of the portfolio.
debt instruments and economic peak
excellent time to sell fixed (and generally lower return) instruments
gold
hedge against inflation
negatively correlated to market
protecting bonds against interest rate risk
options
put - lock in the price at which the security may be sold may be used to protect an investor from a drop in bond prices caused by rising interest rates.
limited general obligation bond
restricted revenue base as compared to general
ability to tax more limited
tax authority for school district vs state
geometric rate of return
how do you solve?
tvm
value weighted average indexes
simple price weighted average indexes
geometric average indexes
NASDAQ, Wilshire 5000
Dow Jones Industrial Average
Value Line Average
S&P 500
- less dramatic fluctuations than DJIA (only 30 stocks)
- reflections of sectors broad
- value weighted
- narrower base measure
fourth market
where corporation and institutional investors deal directly with one another
exchange and broker dealer services are eliminated entirely
primary market
investment bankers and corporations meet to arrange offerings to the public.
secondary market
where previously issued securities are sold (exchanges, etc.)
third market
exchange-listed securities being traded over-the-counter between non-exchange listed brokers and institutional investor
market risk premium increase, value of common stock…
decrease in order to compensate investor for increased risk
????
unissued shares
have never been held by investors
authorized shares
unissued or outstanding shares but haven’t been repurchased
treasury shares
shares that have been repurchased by a company/corporation
converstion ratio
conversion price
conversion value (expect to pay)
PAR
conversion price
PAR
shares
PAR x stock price
shares or CV
holding period yield
different than holding period return, no cash flows
SP-PP
PP
Dividend Discount Valuation (variable growth)
- Determine $ dividend for each year
- apply constant div formula
- Determine NPV
intrinsic value of a bond
equals it’s PV (TVM)
reason company would call a bond
bonds currently selling at premium…interest rates have decreased. Can retire/call higher yield bonds and issue new bonds at lower market interest rates
ideal correlation for portfolio construction
-1, any two investments move exactly opposite
best index
highest r (correlation) or r2 (coeffecient of determination)
correlation
1 - undiversified
<1 - diversified
-1 - most diversified
standard deviation of portfolio and correlation (r)
r=1=standard averge
r<1=less than standard average
correlation coefficient and covariance
measure two stocks movements relative to one another
MPT: optimum portfolio
point of tangency b/w indifference curve and effecient frontier
coeffecient of determination r2
% of fund’s return due to market
adding new investments to portfolio
lowest correlation (closest to -1) coeffecient is best…provides most diversification
capital market line (CML)
security market line (SML)
capital asset pricing model (CAPM)
standard deviation
beta
beta
Geometric mean is ___ to arithmetic mean
less than or equal to
what makes cash flow projections and valuations for real estate difficult?
changes in economic and demographic variables
equity REITs
mortgage REITs
receive income from rental or lease of RE properties
provide more opportunity for capital gains
invest in commercial properties
receive monthly income from investing in real estate loans
belief perseverance
similar to anchoring in that people are unlikely to change their views given new information.
anchoring
results in buying securities that have fallen in value because it “must” get back up to that recent high.
inability to objectively review and analyze new information.
Representativeness
thinking that a good company is a good investment without regard to an analysis of the investment.
Cognitive dissonance
form of overconfidence because an investor’s memory of past performance is better than the actual results
naive diversification
process of investing in every option available
overconfidence leads to…
overtrading
12b-1 fees
charged based on the average daily fund assets and used principally to meet marketing and distribution expenses
less effecient market
more risk, more return, more opportunity for profit
international markets are less effecient than US markets
dividend reinvestment plans
- taxable
- help firms raise new capital
- provide invesetors systematic way to accumulate capital
- companies build goodwill
Return of Equity (ROE)
Net Income
Equity
higher the equity…lower the ROE
Technical Analysis: Price Indicator
utilizes Advances and Declines of price (also known as Breadth of the Market)
Technical Analysis: Volume Indicator
number of shares traded
technical analysis: market indicators
directions of market and related averages
intrinsic value of share of common stock (fundamental analysis)
discounted value of all future dividends
company status
publically or privately held
top down managers
look at big picture economic factors
group rotation managers
market timers
bottom up managers
value managers
technicians
GNMA
- government backs the issue against default, NOT against investor loss
- amount received by the investor each month may vary due to prepayment by homeowners.
- realized yield somewhat variable because of the principal prepayments.
- If mortgage rates decrease, prepayments may increase.
rate of return determined by CAPM is
- rate of return used in Jensen’s Alpha
- security market line (SML) equation and an indicator of the required rate of return by an investor on any given security, not a market or portfolio’s return.
preferred stocks
- non-voting shares
- covertible - can convert to c/s
- participating - additional or extra dividends declared, the preferred shareholders have the right to share in the profits.
- cumlative - If dividends are not paid in a given cycle, they cannot be paid to anyone else until they are paid to preferred shareholders.
- has equity and debt features
- stated par value
- stated dividend rate
- price of bond moves with price of c/s
- dividend does not fluctuate like c/s dividend, pays fixed income like bond
- NO maturity date like bond
- 50% dividends recevided deduction - corporations 65%
- NOT same level as risk as debt
- subject to interest rate and purchasing power risk
devaluation of foreign currency
foreign currency falls in value in relation to Dollar
cost less dollars to buy foreign currency
revaluation/appreciation of foreign currency
foreign currency raises in value in relation to Dollar
cost more dollars to buy foreign currency
riding the yield curve
purchase of debt instruments in anticipation of fluctuations in the rates of return on both long and short-term instruments
yield curve
Shows the term structure of interest rates on government debt.
shows relationship between long-term and short-term government debt
time weighted return
best for evaluating return of two invesment managers
careful, evaluating investment managers not investors…managers don’t make decision on whether to buy another stock
firm commitment
investment bank, NOT issuing corporation, bears risk if entire issue is not marketed
best effort agreement
The investment banker agrees to sell a minimum number of shares before the offering closing date.
corporation bears risk
vs firm commitment
dividend payout ratio
- portion of earnings which a company pays its investors.
- The balance of earning retained by the company comprises its retention ratio.
- Percentage of net income paid out as dividends.
- A measure of a company’s earnings retention philosophy.
DPS/EPS
how to know if portfolio “follows” S&P500
highest r or r2
higer the r2 the less non-systematic risk
client wants to avoid certain types of securities
use of individual stock/bonds allows client to pick and choose
Exchange Traded Funds (ETFs)
- purchased anytime during day (mutual funds-end of day)
- can be purchased on margin or shorted (mutual funds-NO)
- more readily track underlying index (mutual funds-incur transaction costs, fund CFs)
- can trade at discount to NAV (mutual funds-always trade at NAV)
selling covered call
income producing strategy
sell/write call options against what you already own
best index to capture overall (small, mid, large) US Market
Wilshire 5000
best way to control volatility
r<0
negative correlation…assets move opposite each other
securities with interest rate risk
CDs, Treasury Bonds, CMOs
High or Low NPV
Higher the better if risk is acceptable
same expected return and low correlation of two assets
The expected return of the portfolio will remain the same, and the standard deviation of the portfolio will decrease.
