Investments: Money Market Securities Flashcards
Securities Act of 1933
regulates issuance of new securities in the primary market
must be accompanied with a prospectus before purchasing
Securities Act of 1934
Regulates the secondary market and trading of securities
created the SEC to enforce compliance
Investment Company Act of 1940
Authorized the SEC to regulate investment companies
open, closed, and UITs
Investment Advisers Act of 1940
required investment advisers to register with the SEC or state
Securities Investors Protection Act of 1970
established SIPC to protect investors for losses resulting from brokerage firm failures
does not protect investors from bad investment decisions
Insider Trading and Securities Fraud Enforcement Act of 1988
defines an insider as anyone with info that is not available to the public
insiders cannot trade this info
T bills
Short term
maturity in 52 weeks
denominations in $100 increments
Commercial Paper
Maturities of 270 days
Short Term loans between corporations
has a denomination of $100,000 and are sold at a discount
does NOT have to register with the SEC
Bankers Acceptances
facilitates imports/exports
maturities of 9 mos or less
can be held until maturity or traded
Eurodollars
deposits in foreign banks that are denominated in US Dollars
Investment Policy Statement
- establishes clients objectives and limitations on investment manager
- used to measure investment manager’s performance
- does NOT include investment selection
- objectives: risk tolerance, return requirements
- constraints: time horizon, liquidity, taxes, laws and regs, unique circumstances
RR TTLLU
Dow Jones Industrial Average
- simple price-weighted average
- does not incorporate market capitalization
S&P 500
- value-weighted index that incorporates market cap of individual stocks into the average
Russell 2000
value-weighted index of the smallest market cap stocks in the Russell 3000
Wilshire 5000
broadest index that measures the performance of over 3,000 stocks
value-weighted index
EAFE
value-weighted index that tracks stocks in Europe, Australia, Asia, and far East
The only price weighted index
- DJIA (not value-weighted)
Traditional Finance
- investors are rational
- markets are efficient
- the mean-variance portfolio theory governs
- returns are determined by risk
Behavioral Finance
- investors are “normal”
- markets are not efficient
- the behavioral portfolio theory governs
- risk alone does not determine returns
Affect heuristic
deals with judging something, whether good or bad
do they like/dislike some company based on non-financial issues
anchoring
attaching/anchoring ones thoughts to a reference point even though there may be no logical relevance or is not pertinent to the issue in question
also known as conservatism or belief perseverance
availability heuristic
when a decision maker relies upon knowledge that is readily available in their memory
this may cause investors to overweight recent events or patterns while paying little attention to longer term trends
bounded rationality
decision makers are limited by the available info
having additional info does not lead to an improvement in decision making due to the inability to consider significant amounts of info
confirmation bias
you do not get a second chance at a first impression
people tend to filter info and focus on info supporting their opinions
cognitive dissonance
tendency to misinterpret info that is contrary to an existing opinion or only pay attention to info that supports existing opinion
disposition effect
AKA regret avoidance or faulty framing where normal investors do not mark their stocks to market prices
investors create mental accounts when they purchase stocks and continue to mark their value to purchase prices even after market prices have changed
Familiarity Bias
- investors tend to over/under estimate the risk of investments with which they are unfamiliar/familiar
gamblers fallacy
herding
hindsight bias
illusion of control bias
overconfidence bias
overreaction
prospect theory
recency
similarity heuristic
Naive diversification
the process of investing in every option available to the investor
common with 401k plans
AKA 1/n diversification
equally diversified in all funds
representitiveness
thinking that a good company is a good investment without regard to an analysis of the investment
Peleton!!
Familiarity
causes investment in companies that are familiar, such as an employer
Enron
loss aversion
suggests investors prefer avoiding losses more than experiencing gains
YOUR LOSSES ARE ALWAYS LARGER THAN YOUR GAINS
unwillingness to sell a losing investment, in the hopes that it will turn around
socialization
process of acquiring values, beliefs, and behaviors that are acceptable and expected by society
multicultural psychology
defined as an extension of general psychology that recognizes that multiple aspects of identity influence a persons worldview including race, ethnicity, language, sexual orientation, gender, age, disability, class status, education, religion, etc when psychologists are helping clients, training students, advocating for social change and justice, and conducting research
Social Consciousness
awareness of and sense of responsibility for problems or injustices that exist within society
Coefficient of Variation
useful in determining which investment has more relative risk when investments have different average returns
tells us the probability of actually experiencing a return close to the average return
the HIGHER the CV, the MORE RISKY an investment per unit of return
= Std Dev / Avg Ret
Distribution of returns
- normal distribution
- longnormal distribution
- skewness
Normal Distribution
appropriate if an investor is considering a range of investment returns
Longnormal Distribution
not a normal distribution
appropriate if an investor is considering a dollar amount or portfolio value at a point in time
with a longnormal distribution, you are looking for a trend line or ending dollar amount
Skewness
commodities are skewed
Right Skewed = positive skewness
Left Skewed = negative skewness
Kurtosis
refers to variation of returns
little variation of returns = high peak = positive kurtosis = leptokurtosis = treasuries
greater variations of returns = low peak = negative kurtosis = platykurtic
Mean Variance Optimization
process of adding risky securities to a portfolio, but keeping the expected return the same
finding the balance of combining asset classes that provide the lowest variance as measured by std dev.
Monte Carlo Simulation
- simulation that adjusts assumptions in order to reflect the probability of an event occurring
Covariance
measure of 2 securities combined and their interactive risk how price movements between 2 securities are related to each other measure of RELATIVE risk COV
= (std dev A) * (std dev B) * (correl coeff AB)
Correlation
ranges from -1 to +1 provides the investor with insight as to the strength and direction 2 assets move relative to each other +1: 2 assets are perfectly positively correlated
0: assets are completely uncorrelated
- 1: perfectly negative correlation
Diversification benefits begin anytime correlation is LESS THAN 1
Beta
measure of an individuals security’s volatility relative to that of the market used to measure the volatility of a diversified portfolio measures systematic risk meta of the market is 1
Beta is used for well-diversified portfolios
>1: stock fluctuates more than the market and has greater risk
=1: Beta of the market
<1: stock fluctuates less than the market and has less risk
= security risk premium / market risk premium
= fund return / market return
Standard deviation
- measures total risk for a nondiversified portfolio
Coefficient of Determination (R^2)
measure of how much a return is due to the market or what % of a security’s return is due to the market
R^2 = squaring the correlation coefficient
R^2 = % of the fund’s return is due to the market
provides insight as to how well-diversified the portfolio is
if B > or = 0.70, then B is an appropriate measure of total risk
if B < or = 0.70, then B is not an appropriate measure of total risk and std dev should be used to measure total risk
Systematic Risk
the lowest level of risk one could expect in a fully diversified portfolio
non-diversifiable risk
market risk
economy-based risk
beta
Unsystematic Risk
exists in a specific firm or investment that can be eliminated through diversification
diversifiable risk
unique risk
company-specific risk
standard dev
Systematic Risks
- Purchasing power risks
- reinvestment rate risk
- interest rate risk
- market risk
- exchange rate risk
systematic risk = market risk = PRIME
purchasing power risk
- type of systematic risk
Reinvestment Rate Risk
- type of systematic risk
Interest Rate Risk
- type of systematic risk
Market Risk
- type of systematic risk
Exchange Rate Risk
- type of systematic risk
Unsystematic Risks
- accounting risk
- business risk
- country risk
- default risk
- executive risk
- financial risk
- government/regulation risk
unsystematic risk = ABCDEFG = diversifiable risk
Account risk
- type of Unsystematic Risk
business risk
- type of Unsystematic Risk
country risk
- type of Unsystematic Risk
default risk
- type of Unsystematic Risk
executive risk
- type of Unsystematic Risk
financial risk
- type of Unsystematic Risk
government/regulation risk
- type of Unsystematic Risk
Modern Portfolio Theory
the acceptance by an investor of a given level of risk while maximizing expected return objectives
investors seek the highest return attainable at any level of risk
investors want the lowest level of risk at any level of return
the assumption is also made that investors are risk averse
efficient frontier
curve which illustrates the best possible returns that could be expected from all possible portfolios
Risk and return comparison finding the most optimal portfolio
portfolios beneath the efficiency curve are inefficient
portfolios above the efficient frontier are considered unattainable
indifference curves
constructed using selections made based on this highest level of return given an acceptable level of risk
efficient portfolio
occurs when an investors indifference curve is tangent to the efficient frontier
optimal portfolio
the one selected from all efficient portfolios
the point at which an investors indifference curve is tangent to the efficient frontier, represents that investors optimal portfolio
Capital Market Line (CML)
macro aspect of the CAPM
specifies the relationship between risk an dreturn in all possible portfolios
CML becomes the new efficient frontier, mixing RF assets with a diversified portfolio
a portfolios return should be on the CML
inefficient portfolios are below the CML
is not used to evaluate the performance of a single security
Rp = Rf = std dev (p) * ((Rm - Rf)/ std dev (m))
Capital Asset Pricing Model (CAPM)
calculates the relationship of risk and return of an individual security using B as its measure for risk
often referred to as the SML
Ri = Rf + (Rm - Rf)B
Ri = required or expected rate of return
Rm - Rf = market risk premium
CAPM uses standard deviation as risk
Market risk Premium
(Rm - Rf)
how much an investor should be compensated to take on a market portfolio vs a rf asset
Security Market Line (SML)
CAPM = SML
the SML intersects the y-axis at the risk free rate of return
SML = Beta as risk
if portfolio return is above SML = considered undervalued and should be purchased
if portfolio return is below SML = considered overvalued and should not be purchased
SML can be used for individual securities
Information Ratio
- a relative risk-adjusted performance measure
- measures excess return and the consistency provided by a fund manager, relative to a benchmark
- the higher the excessive return (information ratio), the better
- can be either positive or negative
IR = (Rp - Rb)/ std dev (A)
Rp = portfolios actual return
Rb = return of the benchmark
Rp - Rb = excess return
Std dev A = tracking error of active return
Treynor Index
- uses beta of a portfolio as its denominator, and the difference between the portfolio return and the rf return as the numerator
- the higher the ratio, the better
- risk-adjusted performance measure
- measure of how much return was achieved for each unit of risk
- measures the reward achieved
Tp = Rp - Rf / Bp
Rp = realized return on the portfolio
Rf = risk free rate of return
Bp = beta of portfolio
Sharpe Index
- provides a measure of portfolio performance using a risk-adjusted measure that standardizes returns for their variability.
- risk-adjusted performance measure
- measure of how much return was achieved for each unit of risk
- the higher the Sharpe ratio, the better
- Sharpe uses Standard dev, treynor uses beta
Sp = (Rp - Rf) / std dev (P)
Rp = realized return on the portfolio
Rf = risk free rate of return
std dev (P) = standard dev of the portfolio
Jensen’s Alpha
- is indicative of the level of a managers performance
- higher the alpha, the better the performance
- negative alphas = managers underperformed the market on a risk-adjusted basis
- is the actual return of the fund less the expected return on the fund
ALPHA p = Rp - {Rf + (Rm - Rf)Bp]
Rp = realized portfolio return
Rf = risk-free rate of return
ALPHA p = alpha, the intercept that measures the managers contributions to the portfolio return
Bp = beta of the portfolio
Rm = expected return on the market
if Beta > 0.70
use beta as a measure of risk
portfolio is considered diversified
use Treynor and Alpha as appropriate risk-adjusted performance measures
if Beta < 0.70
use standard deviation as a measure of risk
portfolio is considered non-diversified, use standard deviation
Sharpe ratio uses std dev as its measure of risk
Geometric Average
- a time-weighted compounded rate of return
NPV
- used to evaluate capital expenditures that will result in differing CFs over the useful life of the investment period
- if +: make investment
- if 0: make investment
- if -: do not make investment
NPV = PV of CFs - initial cost
IRR
- the discount rate that sets the NPV formula = 0
- can be thought of as a compounded rate of return
- should be calculated with uneven CFs and are asked to calculate a compounded rate of return
- if NPV +, IRR > Discount Rate
- if NPV -, IRR< Discount Rate
- if NPV 0, IRR = discount rate
Dollar Weighted Return
- calculate the IRR!
- Takes into account additional share purchases
- looking for investor return
Time Weighted Return
- Calculates the IRR using security’s CF
- Only concerned with the activity of 1 share
- assumes a buy and hold
- does NOT take into account additional share purchases
- concerned with the growth of a single purchase of a share
- MFs report on a time-weighted return basis
Arbitrage Pricing Theory (ABT)
- asserts that pricing imbalances cannot exist for any significant period of time
- multi-factor model that attempts to explain return based on factors
- when facto = 0, the factor has no impact on return
- attempts to take advantage of pricing imbalances
- inputs of factors: inflation, risk premium, and expected returns and sensitivity to those factors
- std dev and beta are not input variables
Ri = a1 + b1F1 + b2F2 + b3F3 + e
Foreign Currency Translation
- convert US dollars to the foreign currency to determine the cost
- compute the return, typically utilizing the holding period return calc
- convert the foreign currency back to US dollars
Dividend Discount Model
- constant growth dividend discount model
- values a company’s stock by discounting the future stream of cash flows
V = D1 / (r - g)
PE Ratio
- represents how much an investor is willing to pay for each dollar of earnings
- measures the relationship between a stocks price and its earnings
- useful to value a stock if the firm pays no dividends
PEG Ratio
- compares a stocks PE Ratio to the company’s 3-5 year growth rate in earnings
- used to determine if the stocks PE Ratio is keeping pace with the firms growth rate in earnings
- PEG = 1: the stock is fairly valued bc PE ratio is in line with the earnings growth rate
- PEG > 1: the stock price is fully valued bc an expanding PE ratio is contributing to the stock price appreciating more than the growth rate of earnings
Book Value
- represents the amount of stockholders equity in the firm or how much the company’s shareholders would receive if the firm was liquidated
- if the stock price is significantly higher than the firms book value, it may indicate that the firm is overvalued
- if book value per share is = or higher than the firm’s stock price, it may indicate the firm is undervalued
dividend payout ratio
- the relationship between the amount of earnings paid to shareholders in the form of a dividend, relative to EPS
- the higher the div payout ratio, the more the mature the company
- high div ratio = indicate that the possibility of the dividend being reduced
- low div payout ratio = may indicate the div may increase, increasing the stock price
common stock dividend / earnings per share
Return on Equity
- measures the overall profitability of a company
- there is a direct relationship between ROE, earnings and dividend growth
= EPS / stockholders equity per share
Dividend Yield
- states the annual dividend as a % of the stock price
= dividend / stock price
- a company will raise its dividend to match it’s EPS
Fundamental Analysis
- process of conducting ratio analysis on the balance sheet and income statement to determine future financial performance and a forecasted stock price based upon that future financial performance
- includes: liquidity, activity, profitability, and common stock measurements
- looks at economic data to determine how the economy will impact various industries
- includes: GDP, unemployment, interest rates, inflation
- believe that a stock price performance is largely driven by the financial performance of the firm
- assumes:
- investors can determine reliable estimates of a stocks future price behavior
- some securities may be mispriced and can be determined which are
Technical Analysis
- the process of charting/plotting a stocks trading volume and price movements
- these activities will predict the future direction of stock prices long before fundamental analysis will
- does not involve ratio analysis
- believe S & D drive a stock price
Resistance
- may develop when investors who bought on an earlier high may now view this as a chance to get even
- some may see as an opportunity to take a profit
Support
- may develop when a stock goes down to a lower level of trading because investors may choose to act on a purchase opportunity that they previously passed
- this is a signal that a new demand is coming into the market
Tools of technicians
- charting
- market volume
- short interest
- odd lot trading
- dow theory
- breadth of the market
- advance decline line
charting
- plotting of historical stock prices to determine a trading pattern
- plotting 50-, 100-, or 200- day moving averages along with historical stock prices
market volume
gives investors insight into sentiment
if market volume is high and market goes up: positive indicator regarding investor sentiment
if volume is high and market goes down: negative indicator of investor sentiment
if volume is low and market goes up: negative indicator
if volume is low and market goes down: positive indicator regarding investor sentiment
short interest
- # of shares sold short gives insight into future demand for a stock
- stock that was sold short eventually needs to be purchased
- high short interest = pent up demand
odd lot trading
- trades less than 100 shares
- done by small investors
dow theory
- signals an end to a bull or bear market
- does not indicate when it will happen, just confirms that it has ended
breadth of the market
- measures the # of stocks that increase in value vs the # of stocks that decline in value
advance decline line
- the difference between the # of stocks that closed up vs. the # of stocks that decreased in value
Efficient Market Hypothesis
- investors cannot consistently achieve above-average market returns
- prices reflect all information that is available and change very quickly to new info
- stock prices will follow a “random walk”
- investors who believe in the efficient market hypothesis believe a passive investment strategy is appropriate, such as a buy and hold index
Random Walk Theory
- behavior of stock prices closely resembles a random walk
- prices of stock are unpredictable but not arbitrary
- its impossible to consistently achieve above-average market returns
- at any given moment, prices that exist on securities are the best incorporation of all available info and a true reflection of the value of that security
- prices are in equilibrium
- changes in P and volume of trading are generated by changing needs of investors
3 Forms of the Efficient Market Hypothesis
- Weak Form
- Semi-strong form
- strong form
Weak Form
- Believes in fundamental analysis
- historical info will not help investors achieve above-average market returns
- rejects technical analysis and asserts that fundamental analysis will help an investor achieve above average returns
- security prices reflect all price and volume data
- in direct contradiction with technical analysis, which attempts to predict future pricing based on the study of past pricing and volume patterns
- Price reflects = historical price data
- advantage = fundamental analysis & inside info
Semi-strong Form
- asserts that both historical and public info will not help investors achieve above-average market returns
- rejects both technical and fundamental analysis, but inside info will lead to above average returns
- Price reflects = public info
- advantage = inside info
Strong Form
- No above average returns, passive investment strategy
- asserts that historical, public, and private info will not help investors achieve above-average returns
- suggests that stock prices reflect all available info and react immediately to any new info
- even with inside info, the market cannot be outperformed on a consistent basis
- Price reflects = all info
- advantage = none
Market Anomalies
- January Effect
- Small firm effect
- value line effect
- P/E effect
These do not support the EMH in any of the 3 forms
January Effect
- jan tends to be a better month due to tax loss selling in Nov and Dec followed by investors getting back into the market in Jan
Small Firm Effect
- small caps tend to outperform large caps
- easier for them to grow revenue and earnings faster than a large cap
Value Line Effect
- stocks that receive Value Line’s highest ranking outperform stocks that receive the lowest ranking
P/E Effect
- stocks with a low PE ratio tend to outperform stocks with a high PE ratio
Investing Strategies
- active
- passive
Active Investment Strategy
- investors believe that markets are efficient
- investors can achieve above-average market returns through active investing and market timing
Passive Investment Strategy
- Investors believe that markets are efficient
- difficult difficult to achieve above-average returns
- passive buy-and-hold investment strategy is best
- ex: laddered bonds, ETFs, barbell bond strategy, UITs, and index investing
Strategic Asset Allocation
- involves assessing the likely outcomes for various allocation mixes between asset classes
- done every few years
- an active allocation strategy
Tactical Asset Allocation
- an active allocation strategy where the investor determines expected returns for asset classes, then rebalances the portfolio to take advantage of the expected returns
- performed frequently
Expected Rate of Return
- provides an investor with an approximation of the rate of return that a given security, meeting certain levels of pricing and divs, may be expected to provide
PE Multiplier
- used to price or value a stock if that stock is a growth stock that pays no dividends
US Treasury Securities
- not taxable at the state and local level
Nonmarketable US Treasury Issues
- not easily bought/sold
- Series EE Bonds
- Series HH bonds
- Series I Bonds
Series EE Bonds
- sold at face value
- $25 minimum purchase
- offered at one half of face val
- nonmarketable, nontransferable
- do not pay interest periodically
- bond slowly increases in value over 20 years based on a fixed rate at time of purchase
- redeemable after 1 year with 3 months interest penalty if redeemed in less than 5 years
- interest is not subject to fed income taxes until bond is redeemed
- may qualify for tax free treatment if redeemed for education expenses
- interest is not taxed at state/local level
Series HH Bonds
- pay interest semi-ann
- have not been issued since 2004
Series I Bond
- inflation-indexed bonds issues by US gov
- sold at face val and have no guaranteed rate of return
- mitigates against purchasing power risk
- interest consists of:
- fixed rate of return
- inflation component that is adjusted every 6 months
Marketable US Treasury Issues
- Tbills
- Tnotes
- Tbonds
- all bills, notes and bonds are sold in denominations of $100+
- treasury securities are sold on an auction basis with the lowest yield winning the auction
T Bills
- less than 1 year to maturity
- sold on a discount yield basis, they do not pay interest, the bond just matures at par
T Notes
- maturity between 2 - 10 years
- interest is paid semi-annually
T Bonds
Maturity of > 10 years
interest paid semi-annually
Original Issue Discount (OID)
- issued at a discount from par value
- example is a zero coupon bond that is sold at a deep discount to par
- a $1,000 par zero-coupon bond sells for $600
- must recognize income each year even though no interest is received (phantom income)
- semi-annual
Treasury Inflation Protected Securities (TIPS)
- provide inflation and purchasing power protection
- par value adjusts for inflation and the coupon rate is applied to the new principal amount
- coupon rate does not change
Separate Trading of Registered Interest and Principal Securities (STRIPS)
- periodic coupon payments are separated from the bond and each coupon payment including par trade separately
- STRIPS create zero- coupon bonds
- are highly liquid and appropriate for investors looking for a low risk, highly liquid net investment and with a specific time horizon
Federal Agency Securities
- agency bonds are moral obligations of the US gov but are not backed by the full faith and credit of the US gov
- 1 exception: GNMAs are backed by full faith and credit of US gov
On-budget debt
- GNMA - Ginnie Mae, division of Department of Housing and Urban Development
- Farmers Home Administration (FHA)
Off-budget Debt of the Agencies
- FNMA - Fannie Mae
- FHLMC - freddie Mac
- SLMA - Sallie Mae
- Fed Farm Credit Banks - FFCB
- Fed Intermed Credit Banks - FICB
- Fed Home Loan Bank FHLB
Mortgage Backed Securities
- GNMA
- Consists of a pool of FHA/VA guaranteed mortgages
- each month GNMA distributes interest and principal payments to investors
- FNMA and Fed Home Loan Mortgage Corp
- historically not backed by the gov
- biggest risk with MBS is falling interest rates
- Mortgages could get repaid early, bond gets retired early, which leaves investors with a reinvestment problem
Corporate Bonds
- secured bonds
- collateralized mortgage obligations (CMOs)
- Unsecured Corporate Bonds
Secured Bonds
- MBS
- backed by a pool of mortgages
- payment consist of both interest and principal
- prepayment risk is biggest risk to bond holder
- collateral trust bond
- backed by an asset owned by the company issuing the bonds
- the asset is held in trust by a 3rd party
- in the event of default on the debt payment, the bond holders are entitled to the asset being held in trust
CMOs
- investors are divided into tranches which determine which investors will receive principal repayment
- investors are divided into tranches A-Z, which are short, intermediate, and long term tranches
- interest from the pool of mortgages is distributed pro-rata and the principal repayments are used to retire tranches sequentially
- investors in the ST tranches receive principal repayment before the intermediate and LT tranche
- these are meant to mitigate against prepayment risk associated with MBSs
Unsecured corporate bonds
- debentures:
- unsecured debt not backed by any asset
- backed on the belief of the credit worthiness that the issuing company will repay the debt
- Subordinate debentures:
- have a lower claim on assets than other unsecured debt
- have more risk because of the lower claim on assets if the company defaults on the bond repayments
- Income bonds:
- interest is only paid when a specific level of income is attained
Bond Rating Agencies
- Moody’s and S&P both rate bonds on the company’s default risk and investment quality
- higher the bond rating, lower the yield
- bond rating agencies analyze a firms:
- liquidity
- total amount of debt
- earnings and stability of those earnings
Moody’s Ratings
Aaa - C
Aaa - Baa: investment quality bonds
Ba and below are junk bonds
S & P Ratings
AAA - D
AAA - BBB: investment grade bonds
BB and below: junk bonds
Guaranteed Investment Contract (GIC)
- issued by insurance companies with a guaranteed rate of return
- insurance company agrees to repay the principal and guaranteed rate of return for a period of time
- yield is higher than treasury securities
Municipal Bonds
- nontaxable at the fed, state, and local level if you live in the issuing state
- bonds issued by territories of the US are not subject to taxes at the fed, state and loval levels
- 3 types of muni bonds:
- General obligation bonds
- revenue bonds
- private activity bonds
General Obligation Bonds
- backed by the full faith, credit and taxing authority of the muni that issued the bond
revenue bond
- backed by the revenue of a specific project
- are NOT backed by the full faith, credit and taxing authority of the entity issued the bond
private activity bonds
- used to finance construction of stadiums
Insured Municipal bonds
- american municipal bond assurance corp (AMBAC)
- municipal bond insurance association corp (MBIA)
- if an insured muni bond is in default, the insurance company will pay the interest and principal amounts
Fixed Income Risks
- Corporate Bond risk
- US Gov Bond Risk
Corporate bond risk
- default risk
- reinvestment rate risk
- interest rate risk
- purchasing power risk
US Gov bond risk
- reinvestment rate risk
- interest rate risk
- purchasing power risk
Tax equivalent and tax exempt yields
- the yield a taxable corporate bond would need to pay for the yield on a tax-exempt muni to be equivalent to a taxable corporate bond
- TEY is the after tax rate of return a taxable corporate bond pays
- if a bond is double or triple tax free, simply combine fed state and local income tax rates
- this is used for the marginal tax rate in the formula below
- to be double TF the bond holder must love in the state that issued the muni bond
- to be triple TF the bond holder must live in the local muni that issued a bond
Tax Equivalent Yield (TEY)
= r / (1-t)
= corporate rate * (1 - marginal tax rate)
r= tax exempt yield
t = marginal tax rate
Municipal Bonds
- exempt from BOTH fed and state taxes
Treasury Security
Exempt from ONLY state and local taxes
TEY on a treasury security
= paid amount of a treasury security / ( 1 - (state income tax)
TEY on a muni bond
= issue of a municipality / (1 - [fed tax rate + (state tax rate *(1 - fed tax rate))])
coupon Rate
the periodic interest payment received by a bond holder
the annual payment
calculated as a constant $ payment
a bond with a 10% coupon pays $50 semi-annually each time
= PMT
par value
the principal amount which is $1,000 on bonds unless stated otherwise
the amount that will be repaid to bond investors at the end of the loan period
= FV
length of time to maturity
- the time remaining until the bondholder receives par
- described as the # of periods to maturity or that the loan will be outstanding
= N
Market Interest Rates
- the yield that is currently being earned in the marketplace
- the rate used to discount a bond to determine what it is currently selling for in the market
= i
YTM
compounded rate of return if an investor buys a bond today and holds it until maturity
assumes that an investor is able to reinvest the coupon payments at the YTM rate
= i
YTM
ALWAYS ASSUME SEMI-ANNUAL COMPOUNDING UNLESS TOLD OTHERWISE
Liquidity Preference Theory
- lower yields for shorter maturities bc some investors prefer liquidity and are willing to pay for liquidity in the form of lower yields
- LT yields should be higher than ST yields bc of the added risks associated with LT maturities
Market Segmentation Theory
the yield curve depends on S and D at a given maturity and there are distinct markets for given maturities with distinct buyers and sellers at each maturity
when S > D at a given maturity, rates are low. Rates will then have to increase for D to increase
when D > S at a given maturity, rates are high. Rates will then begin to decrease to drive demand down
Expectations Theory
- since investors are uncertain or believe inflation will be higher in the future, LT yields are higher than ST yields
- when inflation is expected to be lower in the future, LT rates will be lower than ST rates
Unbiased Expectations Theory
- related to the term structure of interest rates
- today’s LT interest rates have embedded in them expectations about future ST interest rates
- LT rates are geometric averages of current and expected future ST interest rates
1rN = [(1+1R1)(1+E(2r1)…(1+E(nR1))]^(1/n) - 1
Borrowing money for n years at the x rate today should be equivalent to borrowing money for 1 year for x # of years
Bond Duration
- weighted average maturity of all CFs
- the bigger the duration, the more price sensitive/volatile the bond is to interest rate changes
- the moment in time the investor is immunized from interest rate risk and reinvestment rate risk
- a bond portfolio should have a duration = to the investors time horizon to be effectively immunized
- underestimates the P appreciation when interest rates decrease
- Overestimates the P depreciation when interest rates increase
Modified Duration
a bond’s price sensitivity to changes in interest rates
Calculating Bond Duration
- Zero Coupon bond: bond will always have a duration = to its maturity
- as the coupon rate increases, the duration decreases
- as the YTM increases, duration decreases
- As the term of a bond increases, duration increases
Bond A: 30 year zero coupon bond, duration = 30
Bond B: 30 year 5% coupon, duration = 27
Bond C: 30 year 10% coupon, duration = 25
Vary INversely with duration
INterest rates
coupon rate and YTM
Bond Strategies
- Tax Swaps
- Barbells
- Laddered Bonds
- Bullets
Tax Swap
- involves selling a bond that has a gain and a bond that has a loss which offset each other
- involves sell a bond that has a loss and just buying a new one
- similar to tax harvesting, offsetting the losses for tax purposes
Barbells
- involves owning both ST and LT bonds
- when interest rates move, only 1 set of positions needs to be sold and restructured
Laddered Bonds
- requires purchasing bonds with varying maturities
- as bonds mature, new bonds are purchased with longer maturities that what is outstanding in the portfolio
- helps reduce interest rate risk bc bonds are held until maturity
Bullet
- have very little payments during the interim period and then a lump-sum at the specified date in the future
- most of the bonds in this strategy will mature in or around the same time period
- zero coups, treasuries, and corporates are most likely candidates for this strategy since they pay little or no coupon during the period and the payoff comes at some predetermined date in the future
- used when the investor has a balloon payment due on a liability at some future date
Preferred Stock
has both equity and debt features
- debt:
- par val
- dividend rate as a % of par
- Equity:
- price of a preferred stock may move with the price of common stock
- Differences:
- divs do not fluctuate like common stock
- no maturity date like a bond
- price of preferred stock is more closely tied to interest rates than common stock
- Corporate investors benefit most from the tax advantages of preferred stocks
- they receive a 50-60% deduction of dividends based on a % of ownership of the company paying divs
Convertible Bonds
- conversion value is the value of the convertible bond in terms of the stock into which it can be converted
- even if the stock does not perform well, the investor has a floor built in
- the floor is the par value of the bond that the investor will receive if the convertible is held until maturity
CV = (Par / CP) * Ps
Ps = price of the common stock
CP = conversion price
(1,000 / CP) = conversion ratio or # of shares the convertible can be converted into
Types of investment companies
- closed end
- open end
- UITs
Closed end
- have a fixed initial market cap bc specific # of shares are initially sold to the public
- those shares are then traded on an organized exchange
- no new shares are issued by the fund
- shares may trade at a premium or discount to NAV
Open end funds
- have unlimited # of shares
- as long as open-end fund receives contributions the fund fam will continue to issue shares
- shares are bought/redeemed directly from fund fam
- shares trade at NAV = (assets - liabs) / shares outstanding
Unit Investment Trust
- can be equity or fixed income UIT
- Typically fixed income trust
- managed by a TTEE, there is no investment manager
- self liquidating
- have passive management and no trading of assets within the trust
- issues units, not shares
- can be sold back to the UIT at NAV
- there is a very thinly traded secondary market
no load funds
- do not charge a sales commission when bought/sold
load funds
- charge a sales commission when bought/sold
- include A, B and class C shares
A shares
- front-end load fund
- small 12-b 1 fee (marketing fee used to pay distribution expenses)
- no redemption fee or back-end load
- appropriate for LT investors bc of low 12-b1 fee
B shares
- contain a back-end sales load
- have high 12b-1 fee, max of 1%
- do not have front end load sales loads
- can be converted to A shares
- advantage is that an investor would not pay the front-end load but they would pay the higher 12b-1 fee until the shares are converted into A shares
- many funds no longer offer B shares
C shares
- do not chare a front load
- usually charge a small back-end load and charge the max 12-b1 fee
- usually most appropriate for ST investors
- do not convert to A shares
ETFs
- portfolio of stocks that represent an index
- traded on an exchange similar to stocks and can be traded intra-day unlike traditional MFs
- investors do not have to buy and sell blindly
- have a low cost of ownership bc they are typically passive investments
- only when stocks are added/removed from an index is there actually selling of assets within an ETF
- most ETFs are tax efficient bc of the low asset turnover and passive investment strategy
Real Estate Investment Trust (REIT)
- attractive bc of the low correlation with the stock market and the diversification benefit that the provide to portfolios
- a hedge against inflation
- must distribute 90% of investment income to shareholders to maintain tax-exempt status
- 3 types: Equity, Hybrid, mortgage
Equity REIT
- invest in real estate for cap apprec
- income is generated from rental income and apprec
Mortgage REIT
- invest mostly in mortgages and construction loans
- make the spread between the lending and borrowing rate
Hybrid
- combo of both equity and mortgage
American Depository Receipts (ADRs)
- represent foreign stock held in domestic banks foreign branch
- entitle the shareholder to divs and cap gains
- cap gains include currency fluctuation
- trade on US exchanges, are denominated in US $ and trade in US $
- divs are paid in US $
- do not eliminate exchange rate risk
- There IS currency risk
General investment
- cash
- equities
- bonds
Alternative investment
- any asset that is not cash, equities or bonds
- typically high risk w/ large min purchase reqs and high fees
- actively managed
- limited liquidity
- no secondary market
- REITs, CMOs, Limited Partnerships, hedge funds, collectibles, precious metals, crypto
Options
- derivative security
- value depends on the value of another underlying asset
- contract is an agreement btwn 2 parties, the seller (writer) or buyer
- all transactions are handled through a clearing house
- 2 types: calls and puts
Call Option
- right to buy specific # of shares @ specific price within a specific period of time or at a future date
Put Option
- the right to sell a specific # of shares at a specific price within a specific period of time or at a specific future date
3 reasons people invest in options
- hedging
- speculation
- income
“ which option will provide the investor with the max gains if stock P appreciate”
Buy a call
“ what option will maximize gains if the stock price falls”
- buy a put
Intrinsic Value of a call
stock price - strike price
stock price is the expiration stock price $
Intrinsic Value of a put
strike price - stock price
stock price is the expiration stock price $
time value
= premium - intrinsic value
“STOPS” gain/loss on option position
St: stocks gain or loss - if you own the underlying stock
O: Option gain or loss (intrinsic value)
P: premium paid (-$)
S: # of shares (usually # but then multiply by 100)
CANNOT HAVE NEGATIVE INTRINSIC VALUE
CANNOT HAVE NEGATIVE INTRINSIC VALUE
Option Trading Strategies
- Covered call
- married put
- straddles
- collar/zero cost collar
covered call
married put
“protecting profits” or “locking in gains”
- BUY A PUT
Long Straddle
Short Straddle
Collar or Zero-cost collar
Option Pricing Models
- Black/scholes
- Put/call parity
- binomial pricing model
Black/scholes pricing model
put call parity pricing model
binomial pricing model
Taxability of options
long term equity anticipation securities (LEAPS)
Warrants
Futures Contracts
- commodities futures: Copper, wheat, pork bellies, oil
- financial futures: currency, interest rate, stock indices
- obligate the holder to make to take delivery of the underlying asset
Process of hedging a position
an investors greatest loss
selling a naked call option
Options contracts
give the holder the right to do something
Players in the Futures Market
hedgers
speculators
hedgers
producers and processors
protecting their interests in underlying commodity or financial instrument
provide the actual products being sold
speculators
investors
trying to profit on expected swings in prices of futures contracts
long positions benefit if price increases, short position benefits if price decreases
Bearer Bonds
- these bonds are considered to be owned by whoever possesses them
UITs
= low fees
debenture
- unsecured corporate debt
a lower coupon rate
- represents a more volatile bond
Tax Exempt OID bond
- bond basis increases at a set rate each year
- difference between maturity value and the OID price is known as the OID
- bonds earnings are treated as exempt interest income
- bond was issued at a discount to its par value
Risk of MBSs
- actual maturity is not known with certainty
- actual CFs are not known with certainty
ideal correlation for portfolio construction
-1
optimal portfolio on the efficient frontier
the best combo of risk and return for a given combo of investments
stock that lies above the SML
- has a positive alpha
margin call
= required equity ( price per share * mm)
= actual equity (current price - current loan)
Establishes the initial margin requirement
Federal Reserve
triggers a margin call
= loan \ (1-mm)
loan = (price per share * initial margin)
Dividend Discount Valuation
= (D1)/(r-g)
Constant Growth Dividend Model
D1 / (r-g)
Correlation
- always the strongest determinant as to what should be added to the portfolio
low PE Ratio stocks
- an anomaly to the EMH
alpha in a morningstar report
- tells you the diff between a funds realized return and its risk-adjusted expected return
Duration
- the better indicator for evaluating a bonds sensitivity to interest rate risk
- the time remaining when a securitys discounted FCF remains at risk
Bond immunization
- match the average weighted duration of the bond portfolio to the investment horizon
Zero coupon
- longest duration
the duration of a bond is a function of its
- current price
- time to maturityYTM
- coup rate
duration
- used to estimate the price of a bond, given a change in interest rates
lower coupon rate but same maturity
- more volatile
same coupon rate, shorter maturity
less volatility
the bond with the lowest coupon rate
- will have the biggest duration
- the bigger the duration, the more price sensitive the bond is to interest rate changes
SELLING A NAKED CALL
- most dangerous position
Buying
Protects
DCA
= sum of purchases / total # of shares = average price
Muni Bond Insurance Association
- One group that insures muni bonds
insured muni bonds
- have lower rates of return due to lower risk
value line average
- uses the geometric average to compute daily value
DJIA
- price weighted average
NASDAQ, NYSE, and the Wilshire
- price weighted average
compounded rate of return
= IRR
factors to consider when investing in a mutual fund
- size of fund
- amount of time until a distribution is made
- amount of time the current portfolio manager has managed the fund
Close-end funds
traded on the secondary market
Mortgage REIT
- receive monthly income from investing in real estate loans
substitution swap
- designed to take advantage of anticipated and potential yield differentials between bonds that are similar with regard to coupons, rating, maturities, and industty
rate anticipation swaps
- utilize forecasts of general interest rate changes
yield pickup swap
designed to alter the cash flow of the portfolio by exchanging similar bonds having different coupon rates
tax swap
replaces bonds with offsetting cap gains and losses
Intrinsic Value Formula
- used to determine whether a stock is overvalued or undervalued
straddle
- buying a put and a call on the same security at the same price for same period of time
spread
- purchasing a put and call on the same security at different prices for the same period of time
strip
- purchase a put and call at the same price and the time are the same, but 2 puts and 1 call are purchased
strap
buys a put and a call on the same security 2 calls, 1 put at the same price for the same amount of time
if you are in a profitable long position in an orange futures contract and do nothing as the contract expires
- expect the oranges to be delivered to you
lower call options on stock
- if there is a cash dividend issued on underlying stock
Buy Put
protects the downside
Buy
protect
Sell
hedge
neglected firm affect
- a market anomalie
- if a stock produces superior earnings and rates of return but has gone unnoticed by securities analysts and is often considered underpriced
bottom up analysis
- analysts start with the company, then industry and finally the economic climate
top down analysis
- starts with the economic climate, moves to the industry and then the company
income producing strategy
- sell covered calls on the stock option
preferred stock
- market fluctuations are greater than the LT bond market fluctuations
- more risky than debt
Wilshire 5000
the best index to use capturing the overall US market
Controlling volatility
- 2 equally weighted investments with a correlation of -1
“minimum Margin”
- 50%
- set by the federal reserve
Beta Calculation
= COV (im) / std dev ^2 m
or
= (correlation coeff * std dev i) / (std dev m)
high R^2
means that the fund’s performance patterns have been in line with the index
- the higher, the less non-systematic risk is present
Zero Coupon
- investment with the greatest amount of price volatility due to interest rate changes
Revaluation of the Yen
- if there is a rise in the price of the Yen in relation to the US Dollar
GO Bond
- issued with a restrictive revenue base
Advantage of Equity REITs over mortgage REITs
equity REITs participate in the appreciation of the underlying properties
Top Down style managers
- group rotation managers
- market timers
Bottoms Up Equity Managers
- value managers
- technicians
Margin call
loan / (1-MM)
Modified Duration
Macualay Duration / (1+YTM)
Coefficient of Variation
standard dev / x
information ratio
alpha / std dev
Geometric mean
n sq rt (1 + R1)(1+R2)(1+R3) - 1 * 100
Multi stage div discount model
Holding Period Return
PE Ratio
EPS
Risks that bonds are faced with
DRIP
- default risk
- Reinvestment rate risk
- interest rate risk
- purchasing power risk
risks that GOVERNMENT bonds may be faced with
RIP
- Reinvestment rate risk
- interest rate risk
- purchasing power risk
T bill
- = Risk free rate
- is not subject to DRIP or RIP risks
How much equity should an investor contribute
= (new Price - MM) - (new Price - loan)
open end investment companies
MFs
closed-end investment companies
- traded on the exchange
Bankers acceptance
- financing exports
Investment Policy statement includes
- RRLLTU
- risk, return, liquidity, laws, taxes, unique circumstances
- does not include investment selection
Tactical Asset Allocation
- an active management portfolio strategy that rebalances the % of assets held in various categories in order to take advantage of market pricing anomalies or strong market sectors
DCA
strategy for accumulating wealth
involves purchasing during market highs and lows
Strategic Asset Allocation
- a “buy and hold” strategy
Value investing
- represents the purchasing of stock with low PE ratios to hold over a long time horizon
Tactical Asset Allocation
- repositioning assets during economic downturn
if interest rates increase, the price of a bond will
- decrease by the # of years of duration but in % form
Conversion Value
= (par / conversion price) * price of the stock
conversion price
= par / # of convertible shares
when adding new investments to a portfolio, always add the one with
- the lowest correlation coefficient
- -1 is always the best
international mutual funds
- are less efficient that US markets
- due to lower correlation with US stocks, foreign stocks can lower total portfolio risk
best performance measure to evaluate the return of 2 investment managers
- time weighted return
Market Value
= Net operating income / capitalization rate
Net Operating Income
= net income + interest + depreciation
PE Multiplier
= price per share / EPS
expected market price
projected earnings * PE multiplier
NPV
is a better method for evaluating projects that the IRR method
NPV vs IRR
- npv has more realistic reinvestment rate assumptions
- is a better indicator of profitability and shareholder wealth
- always choose the higher NPV over the IRR option
odd lot theory
- these purchase levels indicate the # of small investors in the market
- says that small investors are always wrong
Technical indicator signaling a bear market
- moving average chart indicates that actual prices have dropped through the moving 200 day average line
Forward contract
- requires a buyer and seller
Buyer of an orange grove
- should LONG the commodity and SELL a futures contract
Call
- created by individuals
- have shorter durations than warrants
- receives the stock shares from a seller of the option when exercised
warrant
- issued by corporations
- longer durations than calls
- receives the stock shares from the seller of the warrant when exercised
value of a firm
= net earnings / capitalization rate
information Ratio
= ALPHA / std dev
lowest coupon bond
= highest duration
lower the coupon rate
- higher the volatility
“Riding the Yield Curve”
refers to the purchase of debt instruments in anticipation of fluctuations in the rates of return on both long and short-term instruments.
Correlation
is always the strongest determinant as to what should be added to a portfolio
