Understanding Products & Their Risks Flashcards

Question

Treasury Note

Answer 1

- a U.S. government debt security with a fixed interest rate and maturity between two and 10 years. - available either via competitive bids, in which an investor specifies the yield, or non-competitive bids, in which the investor accepts whatever yield is determined. - just like a Treasury bond, except that they have different maturities—T-bond lifespans are 20 to 30 years

Answer 2

- are fixed-rate U.S. government debt securities with a maturity range between 10 and 30 years. - pay semiannual interest payments until maturity, at which point the face value of the bond is paid to the owner. - along with Treasury bills, Treasury notes, and Treasury Inflation-Protected Securities (TIPS) - one of four virtually risk-free government-issued securities - after they have been sold at auction by the U.S. government, they trade on the secondary market

Answer 3

- highly liquid due to significant trading by both institutional and retail investors in treasury bonds - actually the largest security market in the world

Answer 4

- Notes and bonds are quoted on the secondary market at the percentage of par in 1/32 point increments - each 1/32nd is referred to as a tick - each percentage point or basis point is a bip - the spread is the difference between the yields of 2 different bonds ex: if a 10-year bond is trading with a yield of 5% and the 5-year bond is trading at 4% the spread would be 1% (5%-4%=1%) - traders typically look at spreads when deciding which bonds offer the most value

Answer 5

- private corporations that are granted government charters because their activities are deemed important to public policy - backed by full faith and credit of the U.S. government, thus their agency bonds risk is virtually as low as Treasury bonds

Answer 6

- backed by the receivables a bank or servicer is owed on loans for everything from automobiles, credit cards, and mortgages to company inventory and student loans - originated by a bank or finance company, then packaged and sold to investors - have different tranches with varying levels of risk more senior tranches receive interest and principal first while the riskiest, equity-like tranches only receive the residual payment on the riskiest loans

Answer 7

- refers to a type of mortgage-backed security that contains a pool of mortgages bundled together and sold as an investment - organized by maturity and level of risk - receive cash flows as borrowers repay the mortgages that act as collateral on these securities

Answer 8

- a complex structured finance product that is backed by a pool of loans and other assets - these underlying assets serve as collateral if the loan goes into default. - though risky and not for all investors, area viable tool for shifting risk and freeing up capital

Answer 9

- turn a bank into an intermediary between the homebuyer and the investment industry - the bank handles the loans and then sells them at a discount to be packaged to investors as a type of collateralized bond - for the investor, is as safe as the mortgage loans that back it up

Answer 10

- Ginnie Mae - issues bonds backed by the full faith and credit of the U.S. government - guarantees principal and interest on MBS backed by loans insured by the Federal Housing Administration & the Department of Veteran Affairs

Answer 11

- Fannie Mae - issues a variety of debt securities with maturities across the yield curve to fulfill its ongoing needs - issues both short and long-term debt - can either be callable or noncallable

Answer 12

- can be called away by the issuer before the maturity date, making them riskier than noncallable bonds. - compensate investors for their higher risk by offering slightly higher interest rates. - face reinvestment risk, which is the risk that investors will have to reinvest at lower interest rates if the bonds are called away. - a good investment when interest rates remain unchanged - typically called when interest rates decline and the company can find less expensive financing - also called a redeemable bond

Answer 13

- a financial security that cannot be redeemed early by the issuer except with the payment of a penalty - the issuer subjects itself to interest rate risk because, at issuance, it locks in the interest rate it will pay until the security matures. If interest rates decline, the issuer must continue paying the higher rate until the security matures.

Answer 14

- pools of securities (typically mortgages) that are sold as a single security

Answer 15

- issued by corporations - taxable securities - set maturity (usually pay the full principal at maturity, some amortize like mortgages and asset-backed securities) - typically set par value of $1,000 - trade on major exchanges, but sometimes OTC - accrues interest in the same manner as Treasury bonds (except when "traded flat")

Answer 16

- formal agreement between the bond issuer and the investor KEY ITEMS: - the form of the bond - total dollar amount in the bond issuance - the property pledged behind the bond (not always is there property) - any protective covenants - redemption rights and call privileges

Answer 17

- acts that must be or cannot be performed by the issuer | e. g. working capital requirements, debt-equity ratio requirements, and restrictions on dividend payments

Answer 18

- when a buyer doesn't have to pay the accrued interest on a bond to the seller - usually occurs when the bonds are in default since there is no guarantee that the buyer will received the entire interest payment that's due

Answer 19

- grants the investor the right to "put" the bond back to the corporation that issued it and receive their principal - typically occurs in a rising interest rate because the investor can receive a higher rate for investing the same principal - typically offered at a lower yield in exchange for the optionality - some bonds have both a call and a put option

Answer 20

- allows the issuer to call the bond if such a call gives the bondholder a lump sum equal to the present value of the coupons they'd have received if they had held the bond until its scheduled maturity date - doing this allows the issuer to reduce the amount of debt on their balance sheet

Answer 21

- enable the bondholder to convert the bond into stock from the same company - sometimes have a variable interest rate (rather than a fixed rate, the coupon rate fluctuates on an index value) - variable rate bonds have more stable prices than fixed-rate bonds - fixed-income interest payments, but can be converted into a predetermined number of common stock shares - the conversion from the bond to stock happens at specific times during the bond's life and is usually at the discretion of the bondholder - offers investors a type of hybrid security that has features of a bond, such as interest payments, while also having the option to own the underlying stock.

Answer 22

- determines the number of shares an investor receives upon the conversion of each bond = BOND PAR VALUE/CONVERSION PRICE

Answer 23

- the price of a convertible bond is equal to the price of the underlying stock

Answer 24

- when investors try to take advantage of pricing discrepancies between convertible bonds and underlying stock - buying the undervalued asset and selling the overvalued asset until the price aligns, in theory, generates a profit for the investor

Answer 25

- a risk-management tool, used to measure and manage a portfolio's exposure to market risk. - is a measure of the curvature in the relationship between bond prices and bond yields. - demonstrates how the duration of a bond changes as the interest rate changes. - If a bond's duration increases as yields increase, the bond is said to have negative convexity. - If a bond's duration rises and yields fall, the bond is said to have positive convexity. - price and yield have an inverse relationship

Answer 26

- debt obligations issued by state or local government - either general obligation bonds or revenue bonds - GO bonds are backed by the full faith and credit of the municipality and are paid with general revenue and borrowings - revenue bonds are paid from the revenue tied to a specific

Answer 27

- analyzing the debt of a GO is different than a corporate bond, should consider factors such as unemployment rate, demographic info, and tax base - revenue bonds cannot pay bondholders from the general taxpayer populations, only from the project that it is funding

Answer 28

- backed by the issuing entity but not by its full taxing power - riskier than bonds backed by the full taxing authority

Answer 29

- a tax on specific goods such as gasoline, tobacco, and alcohol - usually are not backed by the taxing power of the municipality

Answer 30

- repaid from the taxes of those who benefit from that specific good - ex: a bond that finances a new road, whoever buys a home or starts a business on that road pays a special tax levy to pay for the bond that funded the road

Answer 31

- have funds set aside to pay them off at their call date | - an advance refunding occurs 90 days before their call date

Answer 32

- has its interest and principal guaranteed by a larger municipality - in this, if the revenue from the financed project isn't sufficient, then the municipality pays the remainder of the bonds

Answer 33

- where investors purchase a share of lease revenues rather than securing them with the actual revenues - dependent upon the legislative appropriations process

Answer 34

- where the price is lowered until it matches a bid | - Municipal and Treasury bonds are sold via a Dutch auction

Answer 35

- bonds are structured to meet the demands of both the investors and the issuer - an underwriter is selected - typically happens when the issuer has poor credit, the issue is large, the terms are exotic, the company does not have a strong earnings history, or the market is volatile

Answer 36

- a debt instrument that represents borrowed funds that are payable on demand and accrue interest based on a prevailing money market rate, such as the prime rate - every time the prevailing money market rate changes the VRDN adjusts accordingly - can be adjusted daily, weekly, or monthly - payable on demand as they have an embedded put option

Answer 37

- used by corporations, sometimes municipalities, to fund operations on a short term basis - typically range from overnight (called the Repo market) to 270 days - advantage is that it doesn't require the cost of SEC registration in it matures within 270 days of issue - is typically found in a money market fund - doesn't pay a coupon, simpy issued at a discount that reflects current interest rates - has restrictions (like covenants) can be used for funding inventories, but not fixed assets

Answer 38

- bought in bulk by the brokerage firm and resold to its customers - these typically pay a premium (typically 1%) as compared to CDs issued by traditional banks - tradeable instruments whereas regular CDs are not (which can result in a loss to an investor0 - do not require an investor to ay a commission upon purchase

Answer 39

- a negotiable piece of paper that functions like a post-dated check, although the bank rather than the account holder guarantees the payment - used by companies as a relatively safe form of payment for large transactions - can be found in money market funds - guaranteed by a commercial bank - trade at a discount on the secondary market, often used in international secondary markets

Answer 40

- not insured by the FDIC - no guarantee that the funds will maintain a net asset value of a dollar - must be mainly invested only in short-term securities with the average maturity not exceeding 90 days, and none exceeding 13 months - customers are prohibited from selling securities before the shares are paid in full

Answer 41

- financial derivatives that give buyers the right, but not the obligation, to buy or sell an underlying asset at an agreed-upon price and date. - can be categorized into two forms: American and European - American: exercised or closed at any point prior to the date of expiration - European: stipulate a shorter duration of time in which the option can be exercised, this window of opportunity is usually just prior to or on the expiration date

Answer 42

- an option sold on a registered exchange - include securities such as market indexes, common stocks, and exchange-traded options - have predetermined exercise prices and expiration dates - however, contract can be adjusted in special circumstances, such as the underlying company experiences some type of reorganization

Answer 43

- give holders of the option the right, but not the obligation, to sell a specified amount of an underlying security at a specified price within a specified time frame - are available on a wide range of assets, including stocks, indexes, commodities, and currencies - increase in value as the underlying asset falls in price, as volatility of the underlying asset price increases, and as interest rates decline - lose value as the underlying asset increases in price, as volatility of the underlying asset price decreases, as interest rates rise, and as the time to expiration nears.

Answer 44

- gives the owner the right, but not the obligation, to buy a specified amount of an underlying security at a specified price within a specified time - the specified price is known as the strike price and the specified time during which a sale is made is its expiration or time to maturity - you pay a fee to purchase the option, called the premium; this per-share charge is the maximum you can lose on this option - may be purchased for speculation or sold for income purposes or for tax management - may also be combined for use in spread or combination strategies

Answer 45

- all options tied to a particular stock or index

Answer 46

- a subset of an option class that has the same strike price and expiration date

Answer 47

- class: call or put option - style: American or European - type: equity index or exchange-traded security - expiration date - symbol: varies according to the company - strike price: the price at which the option can be exercised by the investor - multiplier: usually starts at 100, used to determine the amount of the underlying asset attached to some options contracts - contract size: initially 100, meaning when 1 contract option is exercised, 100 shares will be bought and sold

Answer 48

- the price that an investor is willing to pay for the opportunity to buy an asset at a specified price within a specific time period - some investors consider the equity of a company a call option, since the stockholder reserves the right to call the residual income away from a company

Answer 49

The value of an option were it to be exercised immediately

Answer 50

Meaning the intrinsic value is zero Because of time value, this doesn’t mean it’s worth nothing - it still has the possibility to exceed the exercise price prior to the expiration date

Answer 51

The delta between the price and its exercise price Option premium = time value + intrinsic value Call option formula —> value = stock price - exercise price Put option formula —> value = exercise price - stock price

Answer 52

States that the call value less the put value should be equal to the difference between the forward value of the asset less the strike price of the contract discounted at the risk-free rate When this isn’t in balance investors can buy or sell to take advantage of mispricing

Answer 53

The maximum number of contracts an investor can hold on the underlying security Can be based upon the number of liquidity in a stock and the number of shares outstanding Prevent excess leverage in the market and promotes stability

Answer 54

The maximum a person can exercise on one particular options class within a set time frame This prevents one investor from artificially influencing the price of options

Answer 55

When a party enters into an option contract and owns the underlying asset Less risky than “naked” options since the risk is not unlimited

Answer 56

Valued using the difference between the exercise price and the value of the yield on the underlying debt instrument A call position will increase when interest rates rise (which actually decreases the value of the underlying security)

Answer 57

When an investor buys a call option on a stock or index

Answer 58

When the investor sells the right to the buyer to call the stock from the investor

Answer 59

The opposite position of an opening position When this position closes, they will have chosen to exercise the contract and thus profited either by calling or putting

Answer 60

Profit when the option is not exercised, meaning they got paid by the closing position and it wasn’t exercised, thus they keep the premium paid and the contract expired

Answer 61

Stocks and ETFs trade 3 market days after the trade date Options settle 1 market day after the trade date

Answer 62

The date the buyer exercised the right to buy (or sell) the underlying shares

Answer 63

The broker’s notification of the intention to exercise the contract Forwarded to the seller, which is completed through the OCC (options clearing corporation)

Answer 64

In contracts the buyers and sellers aren’t matched at time of agreement, but rather time of settle. So the OCC will randomly select an outstanding contract to fulfill.

Answer 65

When an investor buys the same number of call and put options with varying maturities and strike prices

Answer 66

When all of the spread options on the single security expire in the same month, but have varying strike prices

Answer 67

When all of the options in a single security have different expirations, but the same strike price

Answer 68

When all of the options on the single security all have varying expiration dates and strike prices

Answer 69

The risk is limited and calculated by the sum of the premiums paid to purchase them

Answer 70

More advanced than vertical, horizontal, & vertical. In a basic one: an investor buys a call option at a certain strike price, writes 2 calls at a higher strike price, and then buys a second call at an even higher strike price. This allows the investor to fund two long positions with the premiums earned by writing the 2 calls. There is risk if the stock has significant price increase and the investor doesn’t own the underlying shares, then they will have to go into the open market to purchase those shares to cover the second position written. In a modified version, it’s more complex as there are both calls and puts written. In this case, there is only one breakeven vs the basic wherein there are multiple.

Answer 71

Options with expiration dates significantly further out than a typical option Traditional options have maturities on a monthly basis going out 12 months, while this can go 2 years or more Always expire on the 3rd Friday in January Must be purchased at a higher premium than normal as there is such time for the stock to exceed the strike price Margin is required - 75% of current value when more than 9 months Gains are taxes at long term capital rate of 20%

Answer 72

- open-end funds - closed-end funds - exchange-traded funds

Answer 73

- launched through an initial public offering (IPO) in order to raise money for investment - trades in the open market just like a stock or an ETF - only a set number of shares are issued. But since the shares continue to trade, their market price is affected by supply and demand. That means the shares may trade at a price above or below their net asset value (NAV), the price at which it was issued - the purpose of these funds is to pay distributions to their investors, which may include earnings, capital gains, and return of principal - Nearly 70% of them use leverage as a way to produce bigger gains. Using borrowed money to invest can create big losses as well as big gains - can be small cap or large cap - can be growth or value oriented - can focus on a certain sector or managed to beat an index like the S&P 500 or NYSE - do not pay taxes, responsibility of the investor and shareholder, to maintain tax free status they must pass on 90% of their income from dividends and interest payments to investors (and at least 98% of capitalized gains) `

Answer 74

- traditionally considered a mutual fund | - usually have an NAV directly tied to their assets that is calculated on a daily basis

Answer 75

- basket of securities that is traded in exchanges - usually passively managed, like an index fund - can be made up of all the stocks in an index, bonds, commodities, or currencies - typically trade at NAV - usually offered through broker dealers - liquid investments - can focus on a certain sector or be managed to beat an index like the S&P 500

Answer 76

- do not pay taxes themselves - to maintain tax-free status, they must pass on 90% of their income from dividends and interest payments - they must also pass on 98% of capitalized gains

Answer 77

- a U.S. financial company that buys or holds a group of securities, such as stocks or bonds, and makes them available to investors as redeemable units - similar to both open-ended and closed-end mutual funds in that they all consist of collective investments in which many investors combine their funds to be managed by a portfolio manager. - like open-ended mutual funds, these are bought and sold directly from the company that issues them, although sometimes they can be bought on the secondary market - like closed-end funds, issued via an initial public offering (IPO). - unlike mutual funds, these have a stated expiration date based on what investments are held in their portfolio; when the portfolio terminates, investors get their cut of the net assets. - also unlike mutual funds, these aren't actively traded, meaning securities aren't bought or sold unless there's a change in the underlying investment, such as a corporate merger or bankruptcy. - fixed portfolios that are established for a specific duration of time - redeemable securities that the issuer will buy back at NAV - can be made up of bonds or stocks or both - investors can make a decision based on the strategy - taxable on dividends, interest, and capital gains - can be found in IRAs and given the same tax consideration (deferred until pulled)

Answer 78

- permanent life insurance with the added characteristic of reflecting the performance of a subinvestment - greater opportunity, but greater risk - has a fixed death benefit and premium - have additional benefits that can be added, i.e. riders

Answer 79

- contract most often issued by life insurance companies - continue to provide an income for as long as the owner is alive - can be a fixed payment or variable depending upon the type

Answer 80

- open-end funds report a net asset value (NAV) -

Answer 81

= TOTAL VALUE OF ASSETS OWNED BY THE COMPANY - TOTAL VALUE OF LIABILITIES THE COMPANY HAS _____________________________________________