Phase 1 Flashcards

1
Q

What is a Warrant?

A
  • A derivative security that gives the holder the right to purchase securities (usually equity) from the issuer at a specific price within a certain time frame.
  • Often issued during IPO’s as a sweetener as the price may be expected to fall below the IPO price.
  • Capital gains taxable upon excercize.
  • Warrants are issued by the company (unlike a call option which is an exchange traded derivative)
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2
Q

What is a convertible security?

A
  • Convertibles link two assets.
  • They allow the holder to transfer a bond or preferred stock into a fixed number of shares of common stock regardless of market price.
  • Conversion ratio is usually at a deep discount not profitable unless there is a significant increase in stock price/decrease in bond price.
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3
Q

What is Modified Duration?

A

Macaulay’s duration - Weighted average of the times until each payment is received, with the weights proportional to the present value of the payment.
- Modified duration uses Macaulay’s duration to calculate the % change in a bonds price to a % change in its yield.

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4
Q

What is convexity?

A
  • Modified duration is a linear approximation of price-yield
  • The relationship is in fact curved. Convexity captures this and measures the curvature of the price-yield curve.
  • This increases accuracy of approximation.
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5
Q

What is Standard Deviation?

A

Standard Deviation is variation about the mean of a value a portfolio is subject to 68% of the time.

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6
Q

What is Value at Risk? VaR

A

VaR is expressed as maximum percentage loss in the value of a portfolio that occurs on 95% of loss occasions. ie. “1 year VaR in the UK is 25% so there is a 95% chance you will lose less than this and a 5% probability of loss worse”

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7
Q

What is Conditional Value-At-Risk? CVaR

A

-The average return in the portfolio in the worst 5% of cases
“If I end up in the tail of say, 5% of worst outcomes, what is the average loss I will incur”.

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8
Q

What is the Variance of Portfolio Formula?

A
VoP = Va(%a)^2+ Vb(%)^2+2(%a)(%b)Cov
cc= correlation coeffecient
Covab= SDa x SDb x cc
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9
Q

Mean, Median, Mode, Kurtosis and Skewdness?

A

If the mean is to the left of the Median you have negative skewdness avv.
Platykurtic means distribution of returns is less centered on the mean.
Mesokurtic means normal
Leptokurtic means distribution of returns in more centered on the mean than predicted by normal distribution.

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10
Q

What is a Futures Contract?

A
  • Standardized contracts in terms of size and delivery date specifying quantity and quality of underlying.
  • Profits and losses are realized immediately as they are marked to market.
  • Margins are maintained to reflect price movements.
  • When traded on exchange they are regulated.
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11
Q

What is a Forward contract?

A
  • Customized tailored contacts in terms of size and delivery dates with the price agreed at the start.
  • Private OTC contracts between two parties.
  • Allows for more precise hedging for companies.
  • Not regulated and Margins set once on the initial transaction.
  • Profit or loss realized on delivery date.
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12
Q

What is the multiple Gordons Growth Model and Dividend Pay Out Ratio Formula possibilities?

A

DPR = DPS/EPS

GGM - Ex Div Share Price = DPS/(r-g)

Forecast return =risk free rate + equity risk premium

*Forward P/E = DPR/ (r-g)

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13
Q

How is a zero coupon bonds risk free rate more suitable than a coupon paying bond?

A
  • Remember to explain the product
  • Zero coupon bonds only have one cash flow, the bond is purchased at a discount with the price rising to par and therefore no re-investment risk.
  • Hi yield coupon bonds even those from default risk free issuers will have reinvestment risk at unknown future rates.
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14
Q

List the data needed to calculate Equity Risk Premium.

A

-Risk Free Rate
-Return on the Market
The excess return that an individual stock or the overall stock market provides over a risk-free rate. This excess return compensates investors for taking on the relatively higher risk of the equity market.

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15
Q

List the Data needed to calculate required rate of return on equity.

A

CAPM -
Risk free rate
Return on the market
Beta

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16
Q

What factors could affect bid-ask spread?

A
  • liquidity
  • trading volume supply and demand
  • recent price volatility = wider spread
  • sector news eg profit warnings
  • extremely large trades = wider spreads.
  • number of market makers - more competitions = narrower spreads
17
Q

3 Reasons a convertible may trade at a premium?

A

Convertibles exploit upside growth and protect against downside risk. Essentially an attached call option.

  • Higher premium may be due to long time to run potential more growth to share price.
  • Underlying stock expected to perform strongly
  • Intrinsic value due to low probability of default.
18
Q

Why are equities high risk class?

A
  • Idiosycratic risk.
  • Dividends only paid after bond holders and pref share holders
  • Dividends are not guaranteed.
  • Low priority over companys assets in a bankruptcy
19
Q

What is immunization?

A

Matching durations with the liabilities you are trying to meet.

  • Price risk and reinvestment risk cancel each other out.
  • If portfolio duration equals the horizon date then accumlated value at the horizon date will be unaffected by interest rate fluctuations.
20
Q

Calculation for real return vs nominal return

A

Real Return = (1+n)/(1+i)

n = nominal return i = inflation

21
Q

How does the commodities return generation differ to other assets?

A

No natural return generating process

  • Valuation based on supply and demand.
  • No income generating or natural profit generating process.
  • Speculation is a key driver.
22
Q

Current Share Price of zero coupon bond with 20 years to maturity formula?

A

Price = Par/(1+rate)^(20

23
Q

After tax accumulation compounding.

A

price invested at start x (1 + rate x tax rate eg. 0.75)^n

24
Q

Preferred stock value

A

current annual dividend / required rate of return.

eg £1 / 0.07 as a %

25
Q

Factors when considering hedging

A

Appreciation likelihood

cost of hedging
correlation structure
expense and ability to roll over currency.

26
Q

What is default spread? 4 points

A

Difference between the avg yield on corporate bonds given the credit rating and yield against avg yield on gilts of same maturity.

  • ALSO measure liquidity risk. More liquid issues limit default risk
  • In confident markets default spreads tend to narrow.
  • can signal where the economy is in its cycle.
27
Q

What is earnings yield spread?

A

Total return from bonds - total return from equities
Usually expected to be between +4% an -2%
Can explain where in economic cycle you are.
- If zero or positive Bond represent the dominant class.
- Outside the ranges can signal a major pending market correction.
- Figures should be cyclically adjusted over 10 years to smooth out peaks or troughs.
- The numerator and denominator of the equity earnings yield is often adjusted for inflation to counter the argument that equities are inflatin protect ahead of fixed income.

28
Q

What is the Correlation Coefficient Formula?

A

Cov/SDa x SDb

covariance divided by the standard deviations multiplied.

29
Q

Types of Risk for Bonds (5 types

A

Credit risk (dafault), Reinvestment risk, liquidity, Duration (interest rate Risk same thing), Event risk ( Natural disaster or regulatory change could downgrade the issue)

30
Q

Reasons why human capital may be equity like?

A
  • Workers have more shares and options in company. Waitrose staff are shareholders
  • Bonus culture common
  • Directors are performance remunerated so need to optimize business to the economic cycle such as equities.
  • very young is low equity as human capital is high and financial capital is low. then lifestyling takes over (hump shape)
    Start with low equity weights then move to lifestyling as young people have less understanding and risk appetite. Only maybe if you inherited your money you could start with a high equity allocation. page 196
31
Q

What is the Expected Return formula

A

Expected return = risk free rate + equity risk premium

32
Q

What makes up the Three Factor Model? Eugene Fama and Kenneth French academics believe in.

A

Beta
Price to Book Ratio
Size of the company
They believe Beta understates the true risk of small companies

33
Q

Factors affecting riskiness of UK quoted companies

A

Beta
Economic moat (factors affecting a company’s competitive advantage)
Financial risk (liquidity, gearing,
Cash (dividend cover and ability to cover operations)
Company size ( small companies have more risk and offer greater returns)
*composition of dilutive instruments. any convertibles or warrants outstanding?