Module 5: Alternative Investments and Derivatives Flashcards
Undeveloped Land
Passive investment, and it produces a negative cash flow (in the form of ongoing expenses) while generating no income. Therefore, this asset is held by an investor strictly for the possibility of significant capital appreciation.
Undeveloped Land Taxation
The appreciation is taxed as a capital gain at the sale of the property unless the owner is treated as a dealer in real estate by the IRS, in which case ordinary income treatment will result. In addition, the real estate taxes are normally tax deductible by the owner of the undeveloped land during the entire period of ownership.
Undeveloped Land Risks
- The land may be adversely rezoned
- The investor may not be able to obtain permits to build on the land
- Access to the investor’s land may be restricted by adjacent landowners
- The population growth anticipated by the investor may not occur
**Considered Extremely risky by CFP
Commercial or Residential Rental Property
Single Family Homes, condo’s, hotels, apartments, motels (residential)
Commercial - any type of building that is rented to a business
Ways to value Residential or Commercial Property
Net Operating Income (NOI)
Gross Rental receipts from the property +
Nonrental or other income (e.g Laundry Receipts)
+ Potential gross income (PGI)
- Vacancy and collection losses
= Effective Gross Income (EGI)
- Operating Expenses (excluding interest and depreciation)
= NOI
NOI Computation Test Tip
The focus of NOI computation is the property’s cash flow, not the investors cash flow.
Intrinsic Value of a rental property
Divid it’s NOI by an estimated capitalization rate for the market and location of the property. In general, the cap rate for a particular property can be approximted by examining the implied cap rtes of recent sales of comparable properties.
Rental Property Taxation
Current income from rental real estate is received in the form of rents, which are taxable as ordinary income to the owner, and net profit (that is, after deductible expenses) is reported by the owner. Because an annual depreciation deduction is afforded the owner who invests in rental real estate, recovery of some of the investment dollars expended through the claiming of such a deduction may occur. Note, however that the depreciation allowance is only a tax benefit, and it does not affect the cash flow generated from the rental real estate to its owner.
Real Estate Limited Partnerships (RELPs)
Nonpublicly traded, syndicated limited partnership, consisting of two owners: one is the syndicator or promotor of the partnership, who usually serves as the general partner, and the second is the investor or limited partner. The syndicator will typically acquire a tract or tracts of real property and then attempt to sell it to the limited partner investors.
Real Estate Investment Trusts
Servest as a source of long-term financing for real estate projects by investing in real estate short-term construction loans, and mortgages. Achieves diversification and marketability that is generally lacking with the RELP form.
REIT Taxation
A REIT entity is not subject to federal income taxation as long as it distributes at least 90% of its net annual earnings to shareholders each year. Along with the requirement that is that at least 75% of an entity’s gross income must be derived from real estate. Dividends from a REIT are taxed at OI but may be classified as qualified dividends.
Types of REITs
Equity REITs, Mortgage REITS and Hybrid REITs
Equity REIT
Acquire real estate for the purpose of renting the space to other companies.
Mortgage REITS
In the business of financing real estate ventures. Make loans to develop property or finance construction
Hybrid REITs
A hybrid of mortgage and equity REITs, by 2010, there were no hybrids in the overall publicly traded REIT market
Positive Reasons to Invest in REITs
- Inflation Hedge (equity REITs)
- Diversification
- Global Reach
- Investment Management Philosophy
3 Differences Between REIT’s and RELPs
- Liquidity - REITS are generally more liquid because they are actively traded on national and regional stock exchanges. RELP’s a not readily marketable and illiquid.
- Organizational Structure - A REIT is managed by a board of directors, whereas a RELP is managed by a general partner.
- Risk - REIT - loss of potential purchasing power, RELP - liquidity and marketability risk
Real Estate Mortgage Investment Conduits (REMICs)
- A self-liquidating, flow-through entity (similar to a partnership) that invests exclusively in real estate mortgages or mortgage-backed securities and terminates when the mortgages that constitute the investment of the REMIC are repaid. Typically issued as Debt Securities to the public.
REMIC Taxability
REMIC is a pass through entity that is wholly exempt from federal income tax. Thus, it acts as a conduit, and holders of REMIC bonds must report any taxable income from the underlying mortgages.
Option Contract Expiration Dates
No longer than 9 months, with the exception of Long-Term Equity Anticipation Securities or LEAPs, which can have expiration dates extending beyond two years.
Clearing house for options contracts
The Options Clearing Corporation
How many shares of underlying stock does each option represent?
100 shares of underlying stock
Intrinsic Value of an Option
The minimum price at which the option will trade on an exchange.
The Trading Value of an Option
The intrinsic value of the option and the time value of the option. These two parts make up the option premium.
Intrinsic Value of CALL Option Calculation
Is the greater of zero, and it’s the market price less the exercise price of the underlying stock.
Intrinsic Value of a PUT Option Calculation
Is the greater of zero Exercise price less the market price of the underlying stock.
Time Value
the amount by which the trading value of the option exceeds its intrinsic value.
“In the money”
When the intrinsic value is positive
“Out of the money”
When the intrinsic value is zero and the exercise price does not equal the market price of the underlying security
“At the money”
when the exercise price of the option equals the market price of the underlying stock
Long Call
the investors loss is limited to the cost of the option, and there is theoretically no limit to the amount of potential gain.
Short Call
The investors gain is limited to the amount of option premium received, and there is theoretically no limit to the amount of potential loss.
Long Put
the investors loss is limited to the amount of option premium paid.
Short Put
The investors profit is limited to the amount of option premium received, and the theoretical limit to the amount of potential loss is that of the underlying stock going to zero.
Options Tax Characteristics
An option contract that is purchased as an invesetment is a capital expenditure and is eligible for capital gains tax treatment. But it depends on:
- Type of Option
- Whether you’re the buyer or the writer
- Whether the option expires, is exercised or is sold
Taxation of a Call Option for Holder
Exercised - Add premium on call to basis in stock purchased
Expires - Premium is a capital loss on date of expiration
Sold - Difference between Call Premium paid and amount received for same is a capital gain or loss
Taxation of a Call Option for Writer
Exercised - Increase amount realized on sale of stock by call premium
Expires - Premium is ST capital gain on same date
Sold by holder - does not affect the writer
Taxation of Put Option for Holder
Exercised - reduce amount realized on sale of stock by put premium
expires - premium is a capital loss on date of expiration
sold by holder - difference between put premium paid and amount received for same is capital gain or loss
Taxation of Put Option for Writer
Exercised - reduce basis in stock purchased b premium received for put
expires - premium is a ST capital gain on same date
Sold by holder - does not affect the writer
Binomial Option Pricing Model
attempts to estimate the price of a call option. Assumes the price of the option will change in discrete increments based on the movements in price of the underlying stock. And that the stock can go up or down. Works like a binomial tree, extrapolating different scenario’s of up or down, once the number of time periods increases, it reaches the Black-Scholes option valution model.
Black-Scholes Option Valuation Model
is designed to determine the estimated price of a European call option. Assumes the price will change constantly because the market price of the underlying security also changes constantly.
Black-Scholes holds that the value of the option is dependent on these 5 factors:
- The current underlying stock price on which the option is written
- The options exercise price
- The time to expiration of the option
- The risk-free rate of return
- The volatility of the securities returns
Exercise price is the only factor that moves in the opposite direction of the price
Put-Call Parity
is based on the premise that the premium of a call option implies a certain fair price for the corresponding put option having the same exercise price and expiration date. They must be in parity to prevent arbitrage opportunities.
Why should you sell American Options in the secondary market?
If you exercise the option before it comes do you are not getting the time value that is associated with the option, where you will realize the time value if you sell it to another investor rather than exercise it.
The three most widely used options strategies
- Buying options for speculation
- Writing covered calls for income
- Hedging a portfolio or position by buying protective puts
Buying options for speculation
Speculators obtain additional leverage in an investment portfolio by buying call or put options. It also provides speculators with a way to limit their risk to just their premium paid.
Writing Covered Calls for Income
The call option writer can earn this additional income in exchange for a willingness to forgo additional capital appreciation, should the security for which the writer has written an option continues to increase in value. If the options writer already has a large capital gain in a stock, giving up future capital gains may be an acceptable trade-off, so long as the investor believes that the stock may now b trading at or above it’s intrinsic value.
The Premium Amount Paid is based on:
- the proximity of the current market value of the stock to the fixed price at which the option writer has agreed to sell the stock to the buyer
- The amount of time until the option expires
- The volatility of the underlying stock
Hedging by buying protective puts
Buying a put option for a security that you already own.
Straddle
Options strategy combining the use of a capp option and a put option with the same exercise price and expiration date. Long Straddle = Volatility, Short Straddle = low volatility
Zero-Cost Dollar
A strategy used to protect a gain in a long position of a stock.
- a long position in the underlying stock,
- a long put option, and a short call option
The idea is to purchase the put option to protect against a decline in the value of the underlying stock and sell a call option to generate premium income to cover the cost of the premium for the put option.
What is a futures contract?
An agreement between two parties to make or take delivery of a specified amount of a commodity or financial asset at a future time, place, and unit price.
Where are futures contracts traded?
They are traded on exchanges such as the New York Mercantile Exchange (NYMEX) or the Chicago Mercantile Exchange (CME)
Long vs. Short Futures Positions
Buying a contract for future delivery is a long-position, and selling a contract for a future delivery is a short-position.
Good Faith Deposit
This is the initial margin requirement for a futures contract, also known as a performance bond
Maintenance Margin Requirements
If equity falls below this amount, then the investor must deposit enough funds into the account immediately to bring the account back to at least the initial margin requirement amount
Spot Price
This is the current price of the asset in the cash market if you were buying the commodity right now “on the spot.”
Future Price
This is the price of the contract for future delivery
Daily Price Limit
This is the maximum price a futures contract may go up or down relative to the settlement price of the previous day
Open Interest
This is the number of futures contracts in existence on any given day.
Marked to Market
This is a settlement process whereby any increase or decrease in account equity is adjusted for daily changes in the price of the underlying asset.
Margin’s for Futures Investors
Futures investors must deposit a margin amount for each futures contract they purchase. That amount is generally about 5-10% of the total amount of the contract. Each commodity has different margin requirements. The investor must either deposit more margin money immediately or close out the contract and settle up for the difference if they have a margin call. The funds must be wired into the account before the market opens the next day.
Futures Contracts with Stock Indices
For every point the stock index moves, it is a gain or loss of $250.
Futures Contracts with Bonds
You need to remember that you are in effect buying or selling a bond, which has an inverse relationship with interest rates. So, if you believe interest rates are going to increase, you would then sell a bond futures contract.
Short Futures Position
When a person does not currently own a commodity, but will need to purchase it at some future date. So you want to lock in the price that you want to buy the supplies at in case the price goes higher.
Tax Characteristics of Futures Contracts
Since all futures contracts are market to market, at the end of the calendar year, net gains or losses on the contract are treated as 60% Long term capital gain and 40% short term, regardless of the actual breakdown of gain and loss.
Tangible Assets
Take the form of either collectible, or precious metals.
Taxation of Tangible Assets
Most tangible investments produce only capital gains and losses. The long-term capital gains rate for collectibles if 28%. The nature of a tangible asset investment makes it a form of a tax shelter. Until the asset is sold, no capital gains tax is owed on its appreciation. If the asset is held until the owner’s death, the asset’s basis is stepped up to its fair market value on the date of death.
Gold
Historically, gold has been perceived as a safe haven in times of political and economic turmoil. Especially during times of inflation
Two ways to Invest in Gold
Direct Investment in Gold
Investing in Gold Mining Stocks
Direct Investment in Gold
Buying a gold bullion, or buying bullion coins such as the American Eagle, Gold Buffalo, Canadian Maple Leaf, Chinese Panda or South African Krugerran.
Investing In Gold Mining Stocks
Allows the investor to spread their risks across a wide variety of gold mining companies. Gold mining companies are about twice as volatile as the average large-cap stock. Stick with large, reputable companies that have a long operating history. Or use mutual funds if you do not have the inclination to conduct in-depth research on golf-specific mining companies
How much may an advisor recommend for gold, or gold funds?
5-10%
Natural Resources
Includes investments in oil and gas properties or timberlands.
How may investors participate in Natural Resource Markets?
- Investing in properties or lands via limited partnerships
- investing in the stock of companies that develop the natural resources
- Investing in mutual funds that specialize in natural resources
Advantages of Natural Resource Investing
The pass-through of certain tax benefits, such as deductions for depletion or intangible drilling costs. The returns often happen when supply cannot keep pace with demand. Historically, been a good diversifier for portfolios because natural resource prices can rise when the price of financial assets fall.
Foreign Investing Risks
Exchange rate risk and country risk
Foreign Market Characteristics
- Foreign Securities and Foreign markets often have higher standard deviations than similar securities in the United States
- The correlation of returns of foreign securities compared with US Securities is generally low, and between foreign countries is low
- The correlations of foreign bonds with U.S bonds and stocks are low
- Accounting standards in foreign countries differ greatly from GAAP, these differences make analysis of foreign companies difficult, financial ratios may not be comparable
- When foreign securities are purchased, the investor owns not only an interest in a foreign country but also a foreign currency
- Foreign income taxes are withheld on the income earned from an investment in a foreign security, and can be deducted on the investors US income tax return.
Emerging Market Characteristics
- low levels of income, as measured by GDP
- low levels of equity capitalization
- questionable market liquidity
- potential restrictions on currency conversio
- high volatility
- prospects for ecnomic growth and development
- stabilizing poitical and social institutions
- high taxes and commission costs for foreign investors
- restrictions on foreign ownership and on foreign currency conversion
- lower regulatory standards and lack of trasnparency
Developed Market Characteristics
- large levels of equity capitalization
- few, if any, currency conversion restrictions
- highly liquid markets with many brokerage insitutions and market makers
- many liquid markets with many brokerage insitutions and market makers
- many large capitalization securities
- Well defined regulatory schemes leading to transparency
Who are the developed countries (for mutual funds)?
UK, Canada, Germany, Australia, and Japan
Who are the emerging market countries (for mutual funds)?
Brazil, Russia, South Korea, China, Poland, and India.
Frontier Markets
Bulgaria, Croatia, Romania, Ukraine, Serbia, Kenya, Nigeria, Lebanon, and Vietnam
Single Country Sector Funds
Mutual Funds that invest in a singly country’s stocks or bonds.
Single Country Sector Fund Characterstics
- Professional Management
- Currency Risk
- Low correlations among countries with major indices
- High Standard Deviation
- Capital appreciation as key objective
American Depository Receipts (ADR’s)
A trust receipt issued by a US Bank for shares of a foreign company purchased and held by a foreign branch of the bank.
Benefits of ADR’s
- Denominated and pa dividends in US dollars, not foreign currencies, saving the investor on transaction costs although exchange rate risk is not completely eliminated
- INformation about foreign company is often more easily attainable with ADRs because the bank holding the security has ready access to that informatio
- Relatively liquid and marketable
ADR Taxation
Dividends paid are taxed to the investor as ordinary income in the year earned. But if the corporation trades on an established US securities market, they may qualify for the long term capital gains rates.
What does it mean for the dollar to strengthen?
It means that you can buy more of the foreign currency. But that also means that you investments in foreign currency are worth less US dollars. A US investor in a foreign security wants the US dollar to fall relative to the currency of the foreign country.
What types of Gains/Income to Equity REITS and Mortgage REITS generate?
They can both produce gains and income, but the equity reit is more likely to produce gains because the mortgage reit is just based off of the interest from the mortgages themselves.
What risks are associated with tangible assets?
- Price Fluctuations
- Higher front-end costs
- Loss from Fraud and Theft
- Lack of liquidity and marketability
What is the minimum price that an option will trade on an exchange
The intrinsic value of the option
