TC-Investment Flashcards
Dark Pools
Trading of large blocks of stock generally without moving the price of the stock. Execute at the midpoint between the bid and ask price.
Net present value & Internal rate of return
Measure present value and the portfolio’s existing return.
Inflation adjusted return
Compares the return on a security to the current rate of inflation.
What is Discounted Cash Flow (DCF)
Calculations on bonds include the discount rate, coupon payments, and the principal payment at maturity.
Time-Weighted Return
Eliminates the effect of cash flows to give an idea of performance. It is an effective way to measure the performance of portfolio managers to one another as well as to a benchmark.
Time-weighted return attempts to eliminate distortions in performance that can be caused by incoming and outgoing capital, thus giving a better idea of the performance of the investment. When calculating time-weighted return, longer reporting periods are broken down into smaller reporting periods and the mean (mid-point) of performance results would be the time-weighted return percentage.
Dollar-Weighted Return
Includes cash flows so that investors can get an idea of the returns and growth of their portfolio in relation to their financial goals. It is not an effective way to compare managers.
Internal Rate of Return
Modern Portfolio Theory
max risk max return
“With this investment approach and depending on client, we either look at the client’s desired level of risk and attempt to maximize returns, or we look at the client’s desired returns and attempt to minimize risk.”
One of your clients purchased 100 shares of XYZ common stock at $30 per share. The client sells the shares one year later at $35 per share. Throughout the year, your client received quarterly cash dividends of $0.25 for a total of $1 in dividends. The client’s total return on the stock was
Total Return equals
Capital gains + Divided/ Original cost
all cash distributions during the period that the investment is held. It is the best measure of an investment’s performance. In this situation, the cash dividend of $1 per share is added to the capital gains of $5 per share for a total return of $6 per share. To get the rate of return, the $6 is divided by the original cost of the security which was $30 per share. $6 return / $30 investment = 0.20 or 20%
Opening a Margin Account
investor opened a new margin account. If it were not a new margin account, the investor would have deposited $1,750 (50% x $3,500). However, the rule requires a minimum deposit of $2,000 for the initial purchase in the margin account.
CAPM (the capital asset pricing model)
CAPM = Expected return compared to required return to determine whether or not an investment should be made.
Is used to measure the relationship between risk and expected return. The result is an expected return that can be compared to the required return to determine whether or not an investment should be made.
The Dividend Discount Model
Value of a common stock using the dividends paid.
A benchmark index drops 5%. What would be the expected return on a portfolio of stocks whose R-value (correlation coefficient) with respect to that index is -1 ?
The portfolio would be expected to rise when the index falls and fall when the index rises by the same amount as the benchmark index.
The question states that the correlation coefficient for the portfolio, the R-value, is -1 with respect to its benchmark index. This means that the portfolio has a perfectly negative correlation with the index. So the portfolio would be expected to rise when the index falls and fall when the index rises by the same amount as the benchmark index. The benchmark index falls 5%, so the portfolio would be expected to rise 5%. A perfectly positive correlation of +1 would mean that the portfolio would rise and fall in the same direction and amount as its benchmark index.
Quick ratio, also known as the “acid test” ratio,
Current assets - Inventory / Current liabilities
Is the most stringent measure of corporate liquidity.
The efficient frontier in Modern Portfolio Theory
Highest return is on the efficient frontier.
Represents a set of or group of portfolios that will provide the highest return at each level of risk incurred, often measured by standard deviation. The question states that all five portfolios have the same standard deviation so the one that has the highest return is on the efficient frontier.
Modern Portfolio Theory
In Modern Portfolio Theory, portfolio returns that measure below the efficient frontier are considered sub-ideal, because the rate of return does not justify the risk. Profiles that measure above the frontier are ideal, and the returns are well balanced to the risk.
Modern Portfolio Theory attempts to optimize returns for a given level of risk, or optimize risk for a given level of returns.
Standard deviation measures
The variance or dispersion of a set of values of a portfolio from an expected return (e.g., +/- 3%).
Capital Asset Pricing Model (CAPM)
Expected Return =
Risk-Free Rate of Return + [Beta x (Market Return - Risk-Free Rate of Return)].
In other words, CAPM evaluates the expected return of an asset or investment by setting it equal to the risk-free rate of return plus a risk premium adjusted with beta (via the beta)–assuming investors demand higher returns for greater risks.
Sharpe Ratio
Return - Risk Free Return / Standard Deviation.
13% - 1% / 12%
Sharpe Ratio is a measure of the risk-adjusted return relative to a portfolio’s volatility.
Discounted Cash Flow Methodology (DCF)
Discounted Cash Flow Methodology involves discounting returns to assign value in today’s dollars, either via a number (Net Present Value) or a percentage (Internal Rate of Return).
DCF and IRR are concepts used in the time value of money.
Dispersion
Dispersion illustrates a statistical range of potential returns for an investment or a portfolio’s returns. It is a tool to help measure the risk of an investment. Types of dispersion include range, variance, standard deviation, and mean.
Historical price
Historical price volatility is the plotting of past prices of the security.
Wayne is looking at buying a block of stock for his portfolio. He is evaluating one stock in particular, which has a beta of 1.15. Wayne is using the S&P 500 as his benchmark, and it has a beta of 1.0. If the S&P 500 returned 5% in the previous year and the stock that Wayne is evaluating returned 7.5%, what is the alpha of the stock that Wayne is evaluating?
Alpha =
Realized Return - (Market Return x Beta)
Alpha = 0.075 - (0.05 x 1.15) Alpha = 0.075 - 0.0575 Alpha = 0.0175 or 1.75%
Alpha =
Realized Return - (Market Return x Beta)
Alpha = 0.075 - (0.05 x 1.15) Alpha = 0.075 - 0.0575 Alpha = 0.0175 or 1.75%
The cost-to-equity ratio
Total cost / Account average balance
Measures how expensive the trading in the customer account has been. To calculate the cost-to-equity ratio, divide the total annual costs by the account’s average balance.
Buying Call option
Contracts allows the buyer to buy the stock at the specific strike price. So when the stock market price goes up, the investor can buy the stock at the lower strike price. Since the investor is interested in being able to do this long-term they would buy LEAPS Call options.
If you were to invest in a $1,000 Treasury Bond with a 5.5% coupon and you buy the bond at par, holding it to maturity, what will your real rate of return be over the holding period if the CPI is 2% and the IRR is 3%?
The real rate of return (aka - the inflation adjusted rate of return) equals the coupon rate of return (5.5% in this case) minus the rate of inflation (CPI = 2%). The IRR is the Internal Rate of Return and is the rate that will discount future cash flows to the present value (market price). The IRR is irrelevant in this particular question.
If the current rate of return on a 3-month Treasury Bill is subtracted from the total return of an investment, which of the following is likely the case?
The 3-month Treasury Bill is commonly used as the “Risk-Free” Rate of Return in financial equations. This will give the analysis a risk-adjusted perspective, which attempts to remove return that would be considered free of risk, and show returns related to the risks taken by investing with additional risk.
Your company is considering making a substantial investment in a project. Projections currently show a Net Present Value (NPV) equal to zero on the project and the company has a required rate of return on the project of 5%. With these factors in mind, what can you determine about this proposed project’s Internal Rate of Return (IRR)?
If the required rate of return is 5% and the NPV has been determined to equal zero, then the assumption can be made that the Internal Rate of Return on the project will equal the required rate of return on the project.
An IAR is evaluating a client’s portfolio. The IAR is looking at each of the various aspects of the portfolio, determining the return on each aspect, and then weighting each aspect according to its proportion of the portfolio as a whole. These numbers will be used to find a projection of what the IAR and investor can expect in the year to come. What is the IAR looking for?
The expected rate of return on a portfolio is the weighted average of the expected annual returns for all of the components of the portfolio.
Which of the following is often used by money managers to determine whether a stock is overvalued or undervalued?
The price to book ratio is used by money managers to determine whether a stock is overvalued or undervalued.
The formula is:
Market Price / Book Value per Share = price-to-book
The ratio gives investors an idea of the relationship between the company value per share and the market value at which shares are currently trading.
XYZ Corporation has a beta of 1 and ABC has a beta of 1.4. XYZ has returned 12% and ABC 14.8%. Based on this information, ABC had alpha of
Alpha is the extent to which a security’s performance exceeds (or falls short of) what would be expected based on its beta. A stock with a beta of 1.4 would be expected to perform 40% better in an up market than one with a beta of 1.0. Because XYZ with a beta of 1.0 gained 12%, ABC should return 140% of that or 16.8% (12% x 1.4). With an actual return of 14.8%, ABC underperformed the expected by 2% and that is why it has a negative alpha.
Form 8-K must be filed by:
Form 8-K filings are required for domestic issuers, registered under the Act of 1933, to report newsworthy events to the SEC. Foreign Issuers, as well as broker-dealers and investment advisers, are exempt from having to file.
ABC’s callable convertible 4% preferred stock ($100 par) is called for $70 per share. It is convertible into common stock at $25 per share. The current market value of the common stock is $15.50 per share. An ABC preferred stockholder should:
If the company calls the stock, the stockholder must tender it, unless the stockholder has already converted it to common stock. If the stockholder tenders the preferred, he will get $70 per share. If the stockholder converts, he will get 4 shares ($100/25=4) of common stock which he can sell for $15.50 per share thus receiving $62 for each preferred share. The $70 call price would give the investor a $8 profit over converting to common.
A client is long 10,000 Dundee shares at $30; the stock is currently trading at $35. She is concerned about negative news lately about the company and asks her IAR how she can protect her profits on this position in a potentially fast moving market. The IAR should recommend a
A Stop Loss Order is an order entered to “unwind” a position (either buy or sell) if the price of the security moves against you when you have a profitable position. The client is not looking to sell her shares but protect her profit in the event of a sudden drop in market price of Dundee shares. This rules out market and limit orders. A sell short is contrary to what the investor is looking to do.
An investor purchased stock at $5/share in 2000. The stock’s market price has increased to date to $100/share. The investor wishes to ensure that if the market price goes down and drops to $75, that the stock will be sold around that price to ensure that some of their profits are locked in. What type of order would best suit this investor’s needs?
A stop order is a “trigger” order. Once the market price of the stock hits $75 on its way down, a market order is entered. From there, the investor should see an execution at a price somewhere around $75. A limit order to sell at $75 or better establishes a bottom threshold, which would mean that there would be an immediate execution at the current price if entered. A market order to sell would also translate to an immediate execution. Here, the order should be a GTC (Good Till Cancelled) order rather than a day order, because the stock is at $100 and wouldn’t be likely to go to $75 or lower in a day of trading.
Given the following information, what is the portfolio’s Treynor ratio?
Portfolio return: 14%
Risk-free rate: 3%
Standard deviation: 18%
Portfolio Beta: 2.5%
The Treynor ratio is similar to the Sharpe ratio in that it measures the risk adjusted return of a fund or investment but uses Beta as the denominator (the risk measure) rather than Standard Deviation.
Return of the portfolio – Risk Free Return
Beta
= 14% - 3%
2.5 = 4.4
Which of the following performance measurements attempts to remove distortions caused by inflows and outflows of capital to an investment over time?
Time-weighted return attempts to eliminate distortions in performance that can be caused by incoming and outgoing capital, thus giving a better idea of the performance of the investment. When calculating time-weighted return, longer reporting periods are broken down into smaller reporting periods and the mean (mid-point) of performance results would be the time-weighted return percentage.
Which of the following statements is true regarding usage of the Capital Asset Pricing Model (CAPM)?
CAPM (the capital asset pricing model), is used to measure the relationship between risk and expected return. The result is an expected return that can be compared to the required return to determine whether or not an investment should be made.
Joey recently came into some money via an inheritance. After all taxes, he received $2.5 million dollars from his grandparents. Joey has decided to spend part of the inheritance on a house that he will buy in cash, but he wants to invest a set amount to ensure that he receives $5,000 per month for his bills indefinitely. An adviser has recommended a fund which has an anticipated or expected annual rate of return of 4.8%. With these factors in mind, how much does Joey have to invest and how much remains for Joey to buy a house in cash?
In this scenario, Joey is looking for a payment in perpetuity (indefinitely, forever, etc). So with the expected rate of return that is listed, we can calculate the amount necessary to arrive at that indefinite monthly payout. Our payment is given on a monthly basis while our expected rate of return is an annual figure. So we either need to calculate the annual payout or figure out our monthly rate of return to arrive at our answer.
Monthly, Joey wants $5,000. So we can divide the 4.8% by 12 to arrive at a monthly expected return of 0.004 (0.048 / 12). We then divide $5,000 by 0.004 to arrive at the same figure of $1,250,000.
So Joey must invest $1,250,000 to receive his monthly $5,000 and he will have $1,250,000 to spend on the house.
Annually, Joey wants $60,000 ($5,000/mo). So we can divide $60,000 by 4.8% (60,000 / 0.048) to arrive at the amount that must be invested $1,250,000.
A company has a limited amount of capital that they’d like to invest. The company is presented with three projects and one potential investment. Each would fully use the capital available. If this company is looking to determine which project or investment will be most profitable viewing future inflows and outflows, which of the following would the company MOST likely use to determine the project or investment to undertake?
Net Present Value allows a company to arrive at a present value today for the future inflows and outflows of capital in the future. It is a projection of the anticipated performance of a project or investment, and can be used by companies to evaluate which project/investment would be most beneficial or profitable for the company.
What is the mean of the following series of numbers?
110, 30, 100, 110, 220
The mean is simply the average of a series of data points or numbers. There are five numbers in this series:
110+30+100+110+220 = 114
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