WEEK 4: Trading Securities, Risk, and Return

Question 1

Trading long vs short

Answer 1

Long: own the security positive outlook
Short: sell security without owning it, negative outlook

Question 2

covered vs uncovered sales

Answer 2

Covered sale: sell a security you already own, write a call option
Uncovered sale (naked): sell the security without owning it first - very risky

Question 3

types of trading

Answer 3

Day trading: intraday trading (few minutes, hours, or day), profit from short-term price fluctuations
Intermediate training (swing trading): days to months, actively trading
Long-term trading (position trading): several months or years, stay here for a while, infrequent

Question 4

Bid-Ask

Answer 4

Bid - highest current price someone is willing to buy the security
Ask - lowest current price someone is willing to sell the security
Last - most recent transaction
Spread = difference between bid and ask price
Change = last price quote compared to previous day close
As you get more liquid securities thousands of people want to buy/sell, spread gets closer
Smaller the spread, the more liquid the security, can quickly buy/sell

Question 5

quote levels

Answer 5

Level 1 - shows best bid best offer
Level 2 - shows depth of best bids/offers, usually 5-10 orders
Level 3 - shows up to 20 bids and offers

Question 6

Order types

Answer 6

market order (immediate fill), limit order (fills if execution meets price condition), stop order (price triggers the trade order)

Question 7

market order

Answer 7

fill order immediately at the next available price, go buy it at the market, used during market hours in liquid markets

Question 8

limit orders

Answer 8

no guarantee of a fill, order fills only if security can be bought or sold at the specified price or better, small stocks

Question 9

stop orders

Answer 9

allow investor to place a buy or sell order ahead of time, with price being the order’s trigger
Stop orders: order to buy or sell a stock once the market price reaches that level, when triggered the stop order becomes a market order
Going on vacation and cannot watch your shares
Stop limit orders: once market price triggers the stop, the order becomes a limit order (filling at the limit price or better)

Question 10

trade time limitations and conditions

Answer 10

Day order: active until end of trading day
Good-till-canceled: active until completely filled or canceled by the trader
All or none: trade executive 100% (no partial buys or sell); the order is in effect until canceled
Fill or kill: entire trade 100% filled, otherwise canceled immediately
Immediate or cancel: any portion of trade filled, the canceled immediately

Question 11

trade settlements

Answer 11

Stocks, bonds and mutual funds: Required to settle two business days after the trade
On settlement day, certificate and money exchange hands
Government securities and options: Settlement is one business day after trade

Question 12

physical certificate vs book entry

Answer 12

Physical certificate: issuer records investor as owner, hard-copy
book entry: street name registration, broker-dealer registered as owner on issuer’s book, investor is the beneficial owner

Question 13

types of accounts

Answer 13

cash account: 100% settlement made in cash
margin: allows investor to use leverage in purchasing security
option: options must be traded in an options account

Question 14

margin accounts

Answer 14

margin offers investors trading leverage. cash + margin = security settlement. investor pays interest on margin loan

Question 15

margin rules

Answer 15

minimum account balance, $2000 or 100% of purchase price, Federal reserve Board sets initial margin %, broker-dealer establishes maintenance margin. if account falls below maintenance margin, investor will get a margin call and must add cash or sell

Question 16

order authority

Answer 16

discretionary/solicited: broker-dealer or advisor has the authority to decide what to buy and how to purchase
non-discretionary/unsolicited: investor makes the buy/sell decisions

Question 17

expected risk vs expected return

Answer 17

cash equivalents, short-term, intermediate, long term-bonds, large-cap, mid-cap, small-cap equities, alternative investments

Question 18

unsystematic risk

Answer 18

factors that are unique to the individual firm (micro)

Question 19

systematic risk

Answer 19

factors that influence the entire market (macro)

Question 20

types of unsystematic risk

Answer 20

business, financial, credit (default), liquidity, marketability, industry, prepayment, call risk

Question 21

types of systematic risk

Answer 21

business cycle, interest rate, inflation, reinvestment, country, political, regulatory, currency risk

Question 22

risk reduction by diversification

Answer 22

holding 15-30 diversified assets effectively eliminates unsystematic risk

market/systematic risk cannot be diversified away

Question 23

equity risk premium

Answer 23

long-term equity returns are greater than bonds because you are rewarded for holding systematic risk. you are not rewarded for unsystematic risk because you can diversify it away

Question 24

concentrated positions

Answer 24

review allocation and holistic asset holdings and rebalance as appropriate, tax-efficient selling, apply option strategies to spread income tax allocation over several tax periods.

Question 25

simple vs compound interest

Answer 25

simple: interest applied to only the beginning contribution
compounding: interest and dividends applied to beginning contribution plus annual additions

Question 26

time-weighted return

Answer 26

not affected by the timing of the portfolio cash flows. simply measures portfolio return during period
- total return
- annualized return over holding period
- arithmetic/geometric average return

Question 27

dollar-weighted return

Answer 27

accounts for the timing and amount of the portfolio cash flows
- internal rate of return (IRR)

Question 28

total return (HPR)

Answer 28

includes all returns on investments including capital gains and distributions (interest/dividends)
(endPrice + cash distribution - beginPrice)/(beginPrice)

Question 29

annualized HPR

Answer 29

Given quarterly returns: (1 + HPR1 ) x (1 + HPR2 ) x (1 + HRP 3 ) x (1 + HPR n )] -1
Given 3-year HPR: (1 + HPR1 )(1/N) -1

Question 30

arithmetic returns

Answer 30

sum of the series of returns and divide by number of returns
- best used when forecasting a future return because offers estimate of return in that next period
- used for portfolio optimization data inputs

Question 31

geometric returns

Answer 31

average compounded growth rate of the investment portfolio, calculated by taking the nth root of the product of the returns
- useful in explaining how much a portfolio would have grown over a period

Question 32

internal rate of return (IRR)

Answer 32

measures investment performance considering all beginning, intermediate, and ending cash flows, the return is the rate that makes NPV = 0, often used as part of a portfolio manager performance assessment

Question 33

after-tax return

Answer 33

as an investor, you are concerned about the return you get to keep after taxes
= investment return * (1 - marginal tax rate)

Question 34

tax-equivalent yield

Answer 34

tax-free yield: taxable yield * (1 - marginal tax rate)
tax-equivalent yield: tax-free yield/(1-marginal tax rate)

Question 35

nominal yield

Answer 35

coupon rate

Question 36

current yield

Answer 36

total annual cash flows/current price

Question 37

yield to maturity (YTM)

Answer 37

internal rate of return on all cash flows
- assumes bond is held to maturity
- discount rate % that equates the PV of all interest and return of principal payment to price of bond

Question 38

yield to call (for callable bonds)

Answer 38

IRR on all cash flows up to the first date the bond could be called

Question 39

real rate of return

Answer 39

quantified the actual return of an investment after adjusting for impact of inflation

real rate = [(1+nominal rate)/(1+inflation rate)]-1