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