Investment Planning Review
Weighted Average
**Weighted Average Share Price** -takes into account the number of shares each security owns **Weighted Average Portfolio Return** -takes into account 1) the current FMV of the securities held, 2) Total portfolio value, and 3) the return of each security throughout the period in question+ **Weighted Average Portfolio Beta** -similar to portfolio return **see examples on pg 52-53**
Closed End Investment Company
- have a fixed market capitalization because specific number of shares are initially sold to the public -those shares are then traded on an organized exchange -NO new shares are issued by the fund -shares may trade at a premium or a discount to net asset value
Open End Investment Company
- have an unlimited market capitalization -as long as an open-end fund receives contributions, the fund family will continue to issue new shares -shares are bought and received DIRECTLY from the fund family -shares trade at Net Asset Value (NAV) NAV = (Assets - Liabilities) / (Shares Outstanding)
10K and 10Q
-10K is an annual report of financial statements filed with the SEC; is audited -10Q is a quarterly report that is filed with the SEC; NOT audited
Dow Jones Industrial Average
-A simple price weighted average -Does NOT incorporate market capitalization ex: 3 stocks at $44, $60, and $100 Price Average = (44 + 60 + 100) / 3 = $68
Geometric Average
-A time weighted compounded rate of return **memorize formula on pg 50**
Behavioral Finance (Regret Avoidance)
-AKA The Disposition Effect -causes investors to take action in hopes of minimizing any regret leads to: 1. Selling winners too soon 2. Holding onto losers for too long
Arithmetic Average
-AKA: simple average, or mean -Sum of all numbers divided by the number of observations
Investment Company Act of 1940
-Authorized the SEC to regulate investment companies -3 types of investment companies: 1. Open 2. Closed 3. Unit Investment Trusts
Beta (equation)
-Beta is the slope of the line that represents a security's return when plotted relative to market returns Beta = (Correlation Coeff) (S.D. of the security) / (market S.D)
Capital Market Line (equation)
-CML intersects Y-axis at the RISK FREE RATE; because an investor with 100% of assets in the risk-free asset will yield a return but experience no variability (standard deviation) -CML runs tangent with the efficient frontier at the optimal portfolio -At the optimal portfolio, the investor is FULLY invested in that portfolio --He does not lend anything at the risk-free rate -To the right of the optimal portfolio, the investor is said to have borrowed at the risk-free rate to fully invest all borrowed funds in that portfolio **see graph pg 36**
Capital Asset Pricing Model (CAPM)
-Calculates the relationship of risk and return of an INDIVIDUAL SECURITY using the Beta as its measure of risk -Market Risk Premium = Return of Market - Risk-Free Rate -This is how much an investor should be compensated to take on a market portfolio versus a risk-free asset -Results of CAPM are used to construct the Security Market Line (SML)
Indifference Curve
-Constructed using selections made based on this highest level of return given an acceptable level of risk
Correlation / Correlation Coefficient (General)
-Correlation and covariance measure movement of one security in comparison to another -BOTH are RELATIVE measures -Ranges from +1 to -1 -Provides the investor with insight as to the strength and direction two assets move relative to each other +1 = perfectly positively correlated 0 = completely uncorrelated -1 = perfectly negatively correlated Diversification benefits begin anytime correlation is less than 1
Corporate Bond Risks
-Default Risk -Re-investment Rate Risk -Interest Rate Risk -Purchasing Power Risk
Insider Trading and Securities Fraud Enforcement Act of 1988
-Defined an insider as anyone with information that is not available to the public -Insiders cannot trade on that information
Eurodollars
-Deposits in foreign banks that are denominated in US dollars
Holding Period Return (items that make it more difficult)
-Dividends received - add to cashflows -Margin interest paid - subtract from cash flows -Taxes paid (only if question asks for after-tax gain/loss) - subtract from cash flows -Purchased security on margin - subtract interest paid from numerator, include total cost of the security as a subtraction from the sales proceeds, and in the denominator only include equity in the trade
Securities Investors Protection Act of 1970
-Established the SIPC to protect investors for losses resulting from brokerage firm failures -Does not protect investors from incompetence or bad investment decisions
Investment Policy Statement (Summary)
-Establishes: 1. Clients objectives 2. Limitations on investment manager -Used to measure investment managers performance -The investment policy statement does NOT include investment selection ***RRTTLLU**
Bankers Acceptance
-Facilitates imports/exports -Maturities of 9 months or less -Can be held until maturity or traded
Foreign Currency Translation
-Foreign securities are denominated in a foreign currency; so their return is affected by the growth of the security and the relative growth of the foreign currency and the U.S. Dollar -To solve these problems: 1. Convert U.S. dollars to foreign currency to determine cost 2. Compute the return, typically using HPR 3. Convert the foreign currency back to U.S. dollars
Stock Splits
-Increases shares outstanding and reduces the stock price -2 for 1 split for an investor with 100 shares at $50/share = 200 shares after split at $25/share -3 for 2 split for a investor with 100 shares at $60/share = 150 shares after split at $40/share
Non Marketable US Treasury Issues Series I Bonds
-Inflation-indexed bonds issued by the U.S. government -sold at face value and have no guaranteed rate of return -interest consists of: fixed rate of return, and inflation component that is adjusted every 6 months
Types of Mutual Funds Global Funds
-Invests in international AND U.S. securities
Types of Mutual Funds International Funds
-Invests only in international securities and EXCLUDES U.S. securities
Money Market Securities Treasury Bills
-Maturities of 4, 13, 26, and 52 weeks -Denominations of $1,000
Bond Rating Agencies
-Moody's and Standard and Poor's both rate on the company's default risk and investment quality -The higher the bond rating, the lower the yield -Analyze a firm's: liquidity, total amount of debt, earnings and stability of those earnings -Moody's Ratings: Aaa-C -Aaa - Baa are investment quality bonds -Ba and below are junk bonds -Standard and Poor's Ratings: AAA - D -AAA-BBB are investment quality bonds -BB and below are junk bonds
Municipal Bonds
-NON-taxable at the federal, state, and local level if you live in the issuing state -Three types: 1. General Obligation Bonds 2. Revenue Bonds 3. Private Activity Bonds
Holding Period Return (general)
-NOT a compounded rate of return -NO consideration for the time an investment was held HPR = (selling price - purchase price +/- cashflows) / purchase price or equity invested **memorize formula**
Distribution of Returns Lognormal Distribution
-NOT a normal distribution -appropriate if an investor is considering a DOLLAR AMOUNT or PORTFOLIO VALUE at a point in time -ex: if an investor invest $1 into the market 60 years ago, it would be worth $60 today. With lognormal distribution you are looking for a trend line or ENDING DOLLAR amount
Stock Dividend
-Not taxable to the shareholder until the stock is SOLD
Efficient Portfolio
-Occurs when an investors indifference curve is tangent to the efficient frontier
Prospectus
-Outlines the risks, management team, business operations, fees, and expenses -must be issue by an investment company prior to selling shares to an investor
Cash Dividend
-Qualified dividends receive capitals gains treatment -Cash dividend is taxes upon receipt
US Government Bond Risk
-Re-investment Rate Risk -Interest Rate Risk -Purchasing Power Risk
Securities Act of 1933
-Regulates the issuance of new securities (primary market) -Requires new issues are accompanied with a prospectus before being purchased
Securities Act of 1934
-Regulates the secondary market and trading of securities -Created the SEC to enforce compliance with security regulations and laws
Margin Position
-Represents the current equity position of the investor -Margin Position = Equity / FMV **see example pg 4**
Investment Advisors Act of 1940
-Required investment avisors to register with the SEC or state
Unsystematic Risk (General)
-Risk that exists in a specific firm or investment, that can be eliminated through diversification -An investor can eliminate this risk through ownership of several different securities -Diversifiable Risk -Unique Risk -Company-specific Risk
Short Selling
-Selling first at a higher price, in the hopes of purchasing the stock back at a lower price -Goal is to sell high and buy low -Investor makes a profit when the assets price decreases in value -Investor must have a margin account to protect against any price appreciation of the stock -Dividends paid by a corporation must be covered by the short seller
Money Market Securities Commercial Paper
-Short term loans between corporations -Maturities of 270 days or less and does NOT have to register with SEC -Denominations of $100,000 and are sold at discount
Treasury Inflation Protected Securities (TIPS)
-TIPS provide inflation and purchasing power protection -The principal/par value adjusts for inflation, and, then, the coupon rate is applied to the new principal amount -The coupon rate does NOT change
Modern Portfolio Theory
-The acceptance by an investor of a given level of risk while maximizing the expected return objectives -Investors seek the highest return attainable at any level of risk -Investors want the lowest level of risk at any level of risk -The assumption is also made that investors are risk averse
Efficient Frontier
-The curve that illustrates the best possible returns that could be expected from all possible portfolios -Compare portfolios based on their risk-return relationship -Neither portfolio ON the efficient frontier is better than the next ; depends on investors risk tolerance when determining optimal portfolio -represents the most efficient portfolios in terms of risk-reward -portfolios lying beneath the efficient frontier are INEFFICIENT because there is a portfolio that provides more return for that level of risk -portfolios above the efficient frontier are considered unattainable
Date of Record
-The date on which you must be a registered shareholder in order to receive the dividend -To receive the dividend, the investor must purchase the stock before the ex-date or 3 business days prior to date of record **2 business days after the Ex-Dividend date**
Ex - Dividend Date
-The date the stock trades without the dividend -If you sell on the ex-dividend date, then you WILL receive the dividend -If you buy the stock on or after the ex-dividend date, you will NOT receive the dividend **2 days before the date of record**
Stop Limit or Stop-Loss Limit Order
-The investor sets two prices: 1. The stop-loss price; once the price is reached the order turns into a market order 2. The limit price; an investor will not sell below the second price -The risk is that if the market moves too quickly, the order may not fill and the investor will be left with the stock at a much lower price -Appropriate for investors with a significant gain built into the stock, but may not want to sell the stock during a period of significant volatility
Systematic Risk (General)
-The lowest level of risk one could expect in a diversified portfolio -It is inherent in the "system" as a result of the unknown elements existing in securities -NON-Diversifiable Risk -Market Risk -Economy-based Risk
Maintenance Margin
-The minimum amount of equity required before a margin call
Optimal Portfolio
-The one portfolio selected from all efficient portfolios -The indifference curve represents how much return an investor needs to take on risk -If Risk Averse - the indifference curve will be very steep - means investor requires more return to take on a little more risk -If Risk Seeking - indifference curve will be more flat - means investor will not require significant amount of return to take more risk -The point at which an investors indifference curve is tangent to the efficient frontier represents THAT INVESTORS optimal portfolio
Limit Order
-The price at which the trade is executed is more important than the timing -Most appropriate for stocks that are extremely volatile and are not frequently traded
Stop Order
-The price hits a certain level and turns into a market order -A stop order to sell means that once the stop order price is reached, the stock is sold at that price or possibly less because it has become a market order -The primary risk is that the investor may receive significantly less than anticipated if the market moves too quickly
Security Market Line (SML)
-The relationship between risk and return as defined by CAPM -Results of CAPM are plotted in the SML -Both measures assume the investor should earn a rate of return at least equal to the risk-free rate -SML intersects Y-axis at risk-free rate -SML uses Beta as measure of risk -If portfolio provides a return ABOVE the SML = undervalued and should be purchased -If a postfolio provides a return BELOW the SML = overvalued and should NOT be purchased
Market Order
-Timing and speed of execution are more important than price -Most appropriate for stocks that are not thinly traded
Performance Application (which is appropriate and when)
-Treynor and Alpha both use Beta; Appropriate when considering a DIVERSIFIED portfolio -A portfolio is considered Diversified when r-squared is greater than or equal to 0.70; then Beta is reliable measure of total risk -A portfolio is considered NOT well Diversified when r-squared is less than or equal to 0.70; then STANDARD DEVIATION is reliable measurement, so SHARPE RATIO is appropriate
Wilshire 5000
-Value weighted index -Broadest index that measures the performance of over 6,500 stocks
EAFE
-Value weighted index -Tracks stocks in Europe, Australia, Asia, and Far East
Russell 2000
-Value weighted index -Measures smallest market capitalization stocks
Types of Mutual Funds Asset Allocation Funds (Lifecycle Funds)
-WELL Diversified portfolios -include stocks, fixed income, international and money market securities -as market conditions change or as the investor gets closer to their retirement goal, the asset allocation changes
How Much Equity Must a Investor Contribute?
-When a stock price falls below the stock price at which an investor will receive a margin call, the investor will receive a margin call and must contribute equity to restore the position -The investor must restore their equity position to the maintenance margin *see example pg 5**
Behavioral Finance (Cognitive Dissonance)
-a form of overconfidence because an investors memory of past performance is better than the actual results leads to: 1. Minimizing or forgetting past losses 2. Exaggerating past gains
Behavioral Finance (Hindsight Bias)
-a form of overconfidence related to an investors belief that they had predicted an event that, in fact, they did not predict leads to: 1. Complicated clients wanting to know why their advisors did not anticipate events that the client "knew" would happen
Bond Strategies Laddered Bonds
-a laddered bond portfolio requires purchasing bonds with varying maturities -as bonds mature, new bonds are purchased with longer maturities than what is outstanding in the portfolio -helps reduce interest rate risk because bonds are held until maturity
Beta
-a measure of an INDIVIDUAL security's volatility relative to that of the market -best used to measure the volatility of a diversified portfolio -measures systematic risk dependent on the volatility of the security relative to that of the market. -beta of the market = 1 -a stock with a beta of 1 will be expected to mirror the market in terms of direction, return, and fluctuation -a stock with a beta higher than 1 means the stock fluctuates more than the market and has greater risk -a stock with a beta less than one indicates that the security fluctuates less relative to market movements **measures systematic risk or market risk**
Standard Deviation (Definition)
-a measure of risk and variability of returns -the higher the S.D., the higher the riskiness of the investment -more simply, it measures how much something flip flops around an average -can be used to determine TOTAL risk of an UNDIVERSIFIED portfolio **measures TOTAL risk**
Exchange Traded Funds (ETF's)
-a portfolio of stocks that represent an index -have low cost of ownership because they are passive investments -traded on an exchange similar to stocks -there is NO active trading within an ETF because the ETF is tracking a stock index; only when stocks are added or removed is there actually selling of assets -tax efficient investments because of the low asset turnover and passive investment strategy Examples: QQQQ (NASDAQ 100), or SPY (S&P 500)
Information Ratio
-a relative risk-adjusted performance measure -measures the excess return provided by a fund manager, relative to a benchmark -the higher the excess return, the better -excess return can be positive or negative depending on the funds performance relative to its benchmark
Option Trading Strategies Collar or Zero-Cost Collar
-a strategy when the investor owns the underlying stock, but wants to protect the downside risk without paying the entire cost of the put option -investor sells a call option at a strike price slightly higher than the current stock price; this creates the premium received -the investor then buys a put option that is below the current stock price; the premium dollars received by selling the call are used to buy the put option
Calculating Bond Duration (summary)
-a zero coupon bond will always have a duration equal to its maturity -as the coupon rate increases, the duration DECREASES -as the coupon rate decreases, the duration INCREASES -as yield to maturity increases, duration DECREASES -as yield to maturity decreases, duration INCREASES **remember, coupon rate and yield to maturity are INterest rates and there is an INverse relationship**
U.S. Treasury Securities
-all are nontaxable at the state and local level -can be either Nonmarketable or Marketable
Dollar Cost Averaging
-allows an investor to invest the same dollar amount on a periodic basis, typically monthly -by investing the same dollar amount each month, an investor buys FEWER shares when the price INCREASES and MORE shares when the price DECREASES
Option Trading Strategies Long Straddle
-an investor buys a put and a call option on the same stock -investor expects volatility but is unsure of the direction
Option Trading Strategies Short Straddle
-an investor sells a put and a call option -the investor does NOT expect volatility and is hoping to keep the premiums with little to no volatility in the stock price
Options (Intrinsic Value)
-an option premium consists of intrinsic value and a time premium -Intrinsic Value: 1. Call Option = Stock Price - Strike Price -IN the money: Stock Price > Strike Price -OUT of money: Stock Price < Strike Price 2. Put Option = Strike Price - Stock Price -IN the money: Stock Price < Strike Price -OUT of money: Stock Price > Strike Price -Time Value = Premium - Intrinsic Value **intrinsic value cannot be less than 0**
Distribution of Returns Normal Distribution
-appropriate if an investor is considering a range of investment returns
Arbitrage Pricing Theory (APT)
-asserts that pricing imbalances cannot exist for any significant period of time; otherwise investors will exploit the price imbalance until the market prices are back to equilibrium -a multi-factor model that attempts to explain return based on factors - anytime a factor has a value of zero, then that factor has NO impact on return -attempts to take advantage of pricing imbalances -inputs are factors such as: inflation, risk premium, and expected returns *standard deviation and beta are NOT inputs variables to APT*
Option Pricing Models Put / Call Parity
-attempts to vale a PUT option based on the value of a corresponding call option
Option Pricing Models Binomial Pricing Model
-attempts to value an option based on the assumption that a stock can only move in one of two directions EX: $10 - Today $12 (up) or $8 - Period 1 $14 (up), $10 (down), or $6 (down twice) - Period 2 etc..
Municipal Bonds General Obligation Bonds
-backed by the full faith, credit, and taxing authority of the municipality that issued the bond
Municipal Bonds Revenue Bonds
-backed by the revenue of a specific project -NOT backed by the full faith, credit, and taxing authority of the entity issuing the bond
Time Weighted Return
-calculates IRR using the security's cash flow -assumes buy and hold **Mutual funds report on a time-weighted return basis** *can be done on calculator*
Dollar Weighted Return
-calculates the IRR using the investors cash flows *can be done on calculator*
Unit Investment Trust
-can be equity or fixed income (typically fixed income) -self liquidating** -passive management** -NO trading of assets within the trust -issues "units" not shares
Fund Expenses Load Funds
-charge a sales commission when purchased or redeemed -examples: A shares, B shares, or C shares
Preferred Stock
-comprised of both debt AND equity features: 1. Debt Features -stated par value -stated dividend rate as a percentage of par 2. Equity Features -price of preferred stock may move with the price of common stock -Differences: -dividend does not fluctuate like a common stock dividend -NO maturity date like a bond -price of preferred stock is more closely tied to interest rates than common stocks -Tax Advantage: -corporation receive a 70, 80, or 100% deduction of preferred stock dividends based on percentage of ownership of the company paying the dividends
Calculating Gain/Loss of an Option
-consider both: 1. Intrinsic Value of the Option 2. The Premium Paid or Received -Use "STOPS" to calculate total gain/loss St: stock gain or loss O : options gain or loss P : premium paid or received S : shares controlled or owned *see ex pg 119-120*
Annual Report
-contains a message from the chairman of the board on the progress in the past year and outlook for upcoming year -sent directly to shareholders
Behavioral Finance (overview)
-conventional financial theory that assumes investors are rational, seek low risk for each unit of return, and trade/invest based on logical analysis -looks at the psychological and emotional aspects of investors behavior in connection with how and why they trade -Regardless of how sophisticated an investor is, they are still susceptible to biases that plague less sophisticated investors.
Property Valuation
-determines how much an investor is willing to pay for a piece of property -similar to dividend yield formula; you are determining how much an investor is willing to pay for real estate
Treynor Index
-difference between portfolio return and risk free rate divided by a portfolios beta -a risk-adjusted performance measure -relative performance indicator - needs to be compared to another Treynor ratio to provide meaning -measures how much return was achieved for EACH UNIT of risk -the higher the better because that means more return was provided for each unit of risk -measures the reward relative to the level of systematic risk (beta) **does NOT indicate whether a portfolio manager has outperformed or underperformed the market** *see example pg 40**
Fund Expenses No Load Funds
-do NOT charge a sales commission when purchased or redeemed
Fund Expenses C Shares
-do NOT charge front-end load -usually charge a small back-end load -usually charge the maximum 12b-1 fee of 1% -usually most appropriate for short-term investors -CANNOT be converted to A shares
Duration Assumptions
-duration assumes that there is a linear relationship between a change in interest rates and a bonds price change -convexity measures the difference in price between what duration estimates and the actual price change of a bond -duration does a good job of estimating the price change of a bond for SMALL changes in interest rates -duration does NOT do a good job of estimating price change of a bond for LARGE changes in interest rates -understates the price appreciation when interest rates DECREASE -overstates the price depreciation when interest rates INCREASE **see graph pg 103**
Estimating Bond Price
-duration can also be used to estimate the price change of a bond, based upon a change in interest rates -see pg 100 **formula IS on exam sheet**
Market Anomalies
-exceptions to the rule that markets are truly efficient; these exceptions do not support the EMH in any of the 3 forms 1. January Effect -tends to bee a better month because of tax loss selling in November and December followed by investors getting back into the market in January 2. Small Firm Effect -small caps tend to outperform large caps; its easier for them to grow revenues and earnings faster than large caps 3. Value Line Effect -stocks that receive Value Line's highest ranking (1) outperform stocks that receive the lowest ranking (5) 4. P/E Effect -stocks with a low P/E ratio ten to outperform stocks with a high P/E ratio
Marketability
-exists when there is a ready-made market for something -ex: real estate is marketable but not very liquid
Fund Expenses B Shares
-have back-end sales load (redemption fee) -HIGH 12b-1 fee; typically the maximum of 1% -NO front-end sales load -can be converted to A shares -only advantage is that an investor would not pay the front-end load, but they would pay the higher 12b-1 fee until shares are converted to A shares
Fund Expenses A Shares
-have front-end load (up front sales commission) -small 12b-1 fee ; the marketing fee used to pay commissions -NO redemption fee -appropriate for long-term investors because of the low 12b-1 fees
Types of Mutual Funds Money Market Funds
-highly liquid -appropriate for an emergency fund -invests in securities with maturities less than 90 days
Liquidity
-how quickly something can be turned into cash, with little to no price concession
Stock Valuation and Ratio Analysis Exam Tips
-if required rate of return decreases, the stock price increases -If required rate of return increases, stock price will decrease -If dividend is expected to decrease, stock price will decrease -if dividend is expected to increase, stock price will increase
Investing Strategies Passive Investment Strategy
-investors believe the markets are EFFICIENT, and it is difficult to achieve above average returns -a passive buy and hold strategy works best -passive buy and hold strategies are: laddered bonds, ETF's, barbell bond strategy, UIT's, and Index investing
Investing Strategies Active Investment Strategy
-investors believe the markets are INEFFICIENT -investors can achieve above-average market returns through active investing and market timing
Efficient Market Hypothesis (EMH)
-investors cannot consistently achieve above-average market returns -prices reflect all information that is available, and change very quickly to new information -Stock prices will follow a "random walk" -investors believe a passive investment strategy is appropriate, such as buy and hold
Corporate Bonds Collateralized Mortgage Obligations (CMO's)
-investors in CMO's are divided into "tranches" which determines which investor will receive principal repayment -Tranches range form A-Z, representing short, intermediate, and long-term tranches -the short term tranch receives principal repayment before the intermediate and long-term tranches -CMO's are meant to mitigate against prepayment risk associated with mortgage backed securities
Types of Mutual Funds Growth and Income
-invests in equities and income-producing assets -primary objective: PROVIDE CAPITAL APPRECIATION AND INCOME
Types of Mutual Funds Growth
-invests in equities that: 1. have high P/E ratio 2. little to no dividends 3. rapidly growing earnings and revenue
Types of Mutual Funds Balanced Fund
-invests in more BONDS than a typical equity fund -seeks a well balanced return in the form of both INCOME and CAPITAL APPRECIATION
Types of Mutual Funds Sector Funds
-invests in sectors of the U.S. economy (healthcare, financial services, etc) -NOT well diversified -have LOW R-squared (.50 - .60)
Types of Mutual Funds Aggressive Growth
-invests in small caps -offers the greatest potential for capital appreciation
Types of Mutual Funds Value Fund
-invests in undervalued funds that have: 1. low P/E ratio 2. High dividend yields 3. Positive future outlook
Option Trading Strategies Married Put
-involves buying a put option on a stock or index that is currently owned by the investor -considered "portfolio insurance" **if asked about "protecting profits" or "locking in gains", the right answer is always BUYING A PUT**
Bond Strategies Barbells
-involves owning both short term and long term bonds -when interest rates move, only one set of positions needs to be sold and restructured
Bond Strategies Tax Swap
-involves selling a bond that has a gain and selling a bond that has a loss which will offset each other -involves selling a bond that has a loss position and just buying a new bond
Option Trading Strategies Covered Call
-involves selling call options on stock that is currently owned by the investor -appropriate for a stock that has been in a trading range, and the investor wants to generate some income but continue to own the stock -also appropriate if the investor is considering selling a stock, but wants to generate some additional premium dollars and possibly get called out of the stock
Tactical Asset Allocation
-is an ACTIVE allocation strategy -an investor determines expected returns for asset classes, then rebalances the portfolio to take advantage of the expected returns -performed frequently
Guaranteed Investment Contract (GIC)
-issue by insurance companies with a guarantee rate of return -the insurance company agrees to repay the principal and guaranteed rate of return for a period of time -the yield is higher than treasury securities
Original Issue Discount (OID)
-issued at a discount from par value -an example is a zero coupon bond that is sold at a deep discount to par value. The bond will then increase in value over the term of the bond until it matures at par value -for zero coupon bonds, the bond holder must recognize income each year, even though no interest is received. This is known as "phantom income" because the bond holder doesn't receive interest but still must pay taxes on the increase in value of the bond
Warrants
-long term call options issued by the CORPORATION -the expiration period is much LONGER than options; usually 5-10 years -warrant terms are NOT standardized (versus call options which are standardized in terms of expiration month, and number of shares controlled)
Long Term Equity Anticipation Securities (LEAPS)
-long term options that have longer expiration periods than traditional options -have expirations periods that last for 2 years or more (traditional options have expirations up to 9 months) -premiums are higher due to extended time period (more expensive)
Marketable US Treasury Issues US Treasury Notes
-maturities between 2 and 10 years -Interest is paid semi-annually -all bills, notes, and bonds are sold in denominations of $1,000 or more -sold on an "auction" basis with the lowest yield winning the auction
Marketable US Treasury Issues US Treasury Bonds
-maturities greater than 10 years -Interest is paid semi-annually -all bills, notes, and bonds are sold in denominations of $1,000 or more -sold on an "auction" basis with the lowest yield winning the auction
Marketable US Treasury Issues US Treasury Bills
-maturities of LESS than 1 year -sold on a discounted yield basis; simply means they do not pay interest, the bonds just mature at par value -all bills, notes, and bonds are sold in denominations of $1,000 or more -sold on an "auction" basis with the lowest yield winning the auction
Portfolio Risk
-measured through determination of the interactivity of the standard deviation and covariance of securities in the portfolio -utilizes the weight of both securities involved, the deviations of the securities, and the correlation coefficient of both securities. **understand formula**
Coefficient of Determination (R-Squared)
-measures how much return is due to the market -what percentage of a security's return is due to the market -Calculated by squaring the correlation coefficient -Shows an investor how well diversified a portfolio is, because the higher R-Squared, the higher percent return from the market and less from unsystematic risk -If greater than .70, Beta is appropriate measure of total risk -If less than .70, Standard Deviation is appropriate measure of total risk
Return on Equity (ROE)
-measures overall profitability of a company -direct relationship between ROE, earnings, and dividend growth ROE = (EPS) / (Stockholders Equity Per Share) **memorize formula**
Sharpe Index
-measures portfolio performance using risk-adjusted measures that standardize returns for variability -Same as Treynor Index except divides by STANDARD DEVIATION instead of Beta -relative index; needs to be compared to other Sharpe ratios -measures how much return was achieved for each unit of risk; higher =better -measures risk premiums relative to total amount of risk in portfolio -typically has similar results to Trynor in a well diversified portfolio -in a poorly diversified portfolio, results can differ greatly
Federal Agency Securities
-moral obligations of the U.S. government and NOT backed by the full faith and credit of the U.S. government. (only exception are GNMA's) 1. On Budget Debt -Government National Mortgage Association (GNMA) -Farmers Home Administrations (FHA) 2.Off Budget Debt of the Agencies -Federal National Mortgage Association (Fannie Mae - FNMA) -Federal Home Loan Mortgage Corp (Freddie Mac - FHLMC) -Student Loan Marketing Association (Sallie Mae - SLMA) -Federal Farm Credit Banks (FFCB) -Federal Intermediate Credit Banks (FICB) -Federal Home Loan Bank (FHLB)
Non Marketable US Treasury Issues Series EE / Series E Bonds
-not easily bought and sold 1. Series EE / Series E Bonds -pure discount bond (sold at 50% of face value) -nonmarketable, nontransferable -do not pay interest periodically; bond just slowly increases in value as it approaches face value -interest is not subject to federal income tax until bond is redeemed -interest is NOT taxed at state or local level
Non Marketable US Treasury Issues Series HH / Series H Bonds
-pay interest semiannually
Behavioral Finance (Belief Perseverance)
-people are unlikely to change their views given new information -similar to anchoring -"people are reluctant to search for evidence that contradicts their beliefs" leads to: 1. avoiding changes to their belief in an investment, even though new information contradicts their original premise 2. sticking to a flawed approach
Red Herring
-preliminary prospectus issued before the SEC approval -used to determine an investors interest in the security
PEG Ratio
-price/earnings to growth ratio -compares a stock's P/E ratio to the company's 3 to 5 year growth rate in earnings -The 3 to 5 year growth rate in earnings is the historical earnings growth rate -used to determine if the stocks P/E ratio i in line with the earnings growth rate -If PEG = 1 ; stock is fairly valued -if PEG > 1 ; stock price is fully valued or overvalued PEG Ratio = (Stocks P/E Ratio) / (3-5 year growth rate) *memorize formula**
Convertible Bonds
-primary benefit is that even if the stock does not perform well, the investor has a floor build in; the floor is the par value of the bond that the investor will receive if the convertible bond is held until maturity -conversion value - the value of the convertible bond in terms of the stock into which it can be converted. CV = (PAR) / (Conversion Price) * (price of common stock) **formula IS on exam sheet**
Types of Mutual Funds Bond Fund
-provides investors with a liquid bond investment -cost effective -fairly conservative
Research Reports Morningstar
-ranks mutual funds using 1 to 5 stars; 1 being the lowest, 5 being the highest
Research Reports Value Line
-ranks stocks on a scale of 1 to 5 for timeliness and safety -ranking of 1 = highest rating for timeliness and safety; signal to buy -ranking of 5 = lowest ranking; signal to sell
Real Estate Investment Trusts (REITs) (summary)
-real estate is a hedge against inflation -REIT's are attractive because of the low correlation with the stock market and the diversification benefit they provide to portfolios -REIT's must distribute 90% of investment income to shareholders to maintain tax-exempt status
Distribution of Returns Skewness
-refers to a normal distribution curve shifted to the left or right of the mean curve. -see page 21 for graph -ex. commodity returns
Distribution of Returns Kurtosis
-refers to a variation of returns -If little variation of returns, the distribution will have a high peak; also means they have POSITIVE kurtosis -ex: Treasuries -if returns are widely dispersed, the peak will be low and have NEGATIVE kurtosis **Leptokurtic = high peak / fat tails** **Platykurtic = low peak / thin tails**
Initial Margin
-reflects the amount of equity an investor must contribute to enter a margin transaction -Regulation T set the initial margin at 50% -The initial margin can be more restrictive based on the volatility of a stock
American Depository Receipts (ADRs)
-represent foreign stock held in domestic banks' foreign branch -trade on US exchanges -denominated in US dollars and trade in US dollars -dividends paid in US dollars -entitle shareholders to dividends and capital gains; capital gains in ADR's include currency fluctuation **do NOT eliminate exchange rate risk**
Price-Earnings Ratio (P/E Ratio)
-represents how much an investor is willing to pay for each dollar of earnings -measures the relationship between a stocks price and its earnings (hence p/e) -useful tool to value a stock if the firm pays no dividends -the relationship of price to earnings is known as the P/E multiplier P/E = Price per Share / EPS **memorize formula**
Book Value
-represents the amount of stockholders equity in the firm or how much the company's shareholders would receive if the firm was liquidated -book value per share is useful to compare to the firms stock price -if the stock price is significantly higher than the firms book value, it may indicate that the firm is OVERVALUED -If the book value per share is equal to the firms stock price, it may indicate the firm is FAIRLY VALUED
Jensen Model (Jensen's Alpha)
-significantly different from Sharpe and Treynor -capable of distinguishing a manager's performance relative to that of the market -can determine differences between realized returns and required returns as specified by CAPM -measures ABSOLUTE performance on a risk-adjusted basis; as opposed to relative performance - Jensen will tell you something -POSITIVE Alpha = fund manager provided more return than expected -NEGATIVE Alpha = fund manager provided less return than expected -A portfolio manager's performance is judged relative to CAPM
Monte Carlo Simulation
-simulation that gives probabilistic distribution of events occurring -adjusts assumptions and returns the probability of a particular event occurring depending on the assumption -think MGP
Capital Market Line (General)
-specifies the relationship between risk and return in all possible portfolios -CML becomes the new efficient frontier - mixes in the risk-free asset with a diversified portfolio -A portfolios return should be on the CML; all portfolios below are considered inefficient -NOT used to evaluate the performance of a single security; therefore know that Standard Deviation is measure of risk used!
Dividend Yield Formula
-states the annual dividend as a percentage of the stock price Dividend Yield = (Dividend) / (Stock Price) *memorize formula**
Strategic Asset Allocation
-strategy involving assessing the likely outcomes for various allocation mixes between asset classes -done every few years -is an ACTIVE allocation strategy
Behavioral Finance (Overconfidence)
-suggests that investors overestimate their ability to successfully predict future market events through data gathering and analysis -leads to: 1. Increased Risk Taking 2. Overtrading
Tax Exempt Yield
-the after tax rate of return a taxable corporate bond pays Tax Exempt Yield = (Corporate Rate) x (1-Marginal Tax Rate)
Current Yield (CY)
-the annual payment amount in dollars divided by the current price of the bond CY = Coupon Payment / Price of Bond
Coupon Rate or Nominal Yield (formula)
-the annual payment amount in dollars, divided by the par value Coupon Rate = Coupon Payment / Par
Random Walk Theory
-the behavior of stock prices closely resembles a random walk -prices are unpredictable but NOT arbitrary -it is impossible to achieve above-average market returns -at any given moment, prices that exist on securities are the best incorporation of all available information and a true reflection of the securities value -prices are in equilibrium -changes in price and volume of trading are generated by changing needs of investors
Yield to Maturity
-the compounded rate of return if an investor buys a bond today and holds it until maturity -assumes that an investor is able to reinvest the coupon payments at the yield to maturity rate -useful in comparing the return on different bonds **always assume semiannual compounding on exam**
Yield to Call
-the compounded rate of return if an investor buys a bond today and the bond is called by the issuer -use NUMBER OF PERIODS until bond is called NOT time until maturity -use CALL PRICE, NOT par value as the future value
Dividend Discount Model
-the constant growth dividend discount model values a company's stock by discounting the future stream of cash flows -Also known as the intrinsic value model r = Required rate of return g = Dividend growth rate D1 = Next period's dividend -D1 is the next expected dividend - it is calculated using the current dividend and dividend growth rate: D1 = D0(1+g) **Dividend Discount Formula is given on sheet**
Internal Rate of Return (IRR)
-the discount rate that sets the NPV formula equal to zero -can also be though of as a compounded rate of return -should be calculated when you have UNEVEN cash flows and you are asked to calculate a COMPOUNDED rate of return
Behavioral Finance (Anchoring)
-the investors inability to objectively review and analyze new information -they are "anchored" to the first information they reviewed leads to: 1. Returns or results that are different than expected 2. Buying securities that have fallen in value because it "must" get back up to that recent high
Covariance
-the measure of two securities combined and their interactive risk -how price movements between two securities are related to each other -measures RELATIVE risk **COV of AB = (S.D. of A) (S.D. of B) (Corr Coeff AB)
Dividend Discount Model Disadvantages
-the model requires a constant, perpetual growth rate of dividends -many stocks do not pay dividends so the security value may not be estimated using this model -the growth rate of dividends cannot be greater than the expected return -the security price becomes very sensitive to the expected return when nearing the growth rate
Separately Tradeable Registered Interest and Principal Securities (STRIPS)
-the periodic coupon payments are separated from the bond and each coupon payment, including the par value, trades separately -essentially, they create zero coupon bonds -highly liquid and appropriate for investors looking for a low risk, highly liquid investment with a specific time horizon
Coupon Rate
-the periodic interest payment received by a bond holder -the actual dollar amount of the coupon payment is entered as a payment on a financial calculator -for ex: a bond with a 10% coupon pays $50 semiannually. That is, 10% of the $1,000 par value paid semiannually
Par Value
-the principal amount which is generally $1,000 on most issues -the amount that will be repaid to bond investors at the end of the loan period
Mean Variance Optimization
-the process of adding risky securities to a portfolio, but keeping the expected return the same -finding a balance between asset classes that provide the lowest variance, as measured by standard deviation
Behavioral Finance (Herd Mentality)
-the process of buying what and when others are buying and selling leads to: 1. Buying High 2. Selling Low
Technical Analysis
-the process of charting and plotting a stocks trading volume and price movements, which will predict the future direction of stock prices long before fundamental analysis will -does NOT involve ratio analysis or financial statement analysis -technical analysts believe SUPPLY and DEMAND drive a stock price -Resistance - develops when investors who bough on an earlier high may now view this as a chance to get even or sometimes take a profit -Support - develops when a stock goes down to a lower level of trading because investors may choose to act on a purchase opportunity that they previously passed; Signals that new demand is coming into the market *see graph page 72**
Fundamental Analysis
-the process of conducting ratio analysis on the balance sheet and income statement to determine future financial performance and a forecasted stock price based upon that future financial performance. -Ratio Analysis - calculating liquidity, activity, profitability, and common stock measurements -Includes a look at economic data to determine how the economy will impact various industries -Economic data includes: inflation, interest rates, GDP, and unemployment -Fundamental analysts believe that a stock price performance is driven by the financial performance of the firm -Assumes: 1. investors can determine reliable estimates of a stocks future price behavior 2. some securities may be mispriced, and fundamental analysis can determine which securities are mispriced
Behavioral Finance (Naive Diversification)
-the process of investing in every option available to the investor -common with 401(k) or other employer sponsored plans -plan participant thinks they are adequately diversified if they invest an equal amount in all the funds -Also known as 1/n diversification
Dividend Payout Ratio
-the relationship between the amount of earnings paid to shareholders in the form of a dividend, relative to EPS -typically, the higher the dividend payout ratio, the more mature the company -a high dividend payout ratio may also indicate the possibility of the dividend being reduced -a low dividend payout ratio may indicate that the dividend may increase, thus increasing the stock price Dividend Payout Ratio = (Common Stock Dividend) / (EPS) **memorize formula**
Length of Time to Maturity
-the time remaining until the bond holder receives the par value -the "number of periods" to maturity, or that the loan will be outstanding
Options (summary)
-the value of an option depends on the value of another underlying asset (from which it is derived from) -agreement between the seller (writer) and the buyer -all transactions are handled through an option clearing house -1 option contract controls 100 shares of underlying security -call option - the right to BUY a specified number of shares at a specified price within a specified period of time -put option - the right to SELL a specified number of shares at a specified price within a specified period of time -Long Term Equity Anticipation Securities (LEAPS): options with a maturity greater than 1 year
Bond Duration
-the weighted average maturity of all cash flows -the bigger the duration, the more price sensitive (or volatile) the bond is to interest rate changes -duration is the moment in time the investor is immunized from interest rate risk and reinvestment rate risk -Modified Duration is a bonds price sensitivity to changes in interest rates -A bond portfolio should have a duration equal to the investor's time horizon to be effectively immunized
Tax Equivalent Yield (T.E.Y.)
-the yield a taxable corporate bond would need to pay for the yield on a tax-exempt muni to be equivalent to a taxable corporate bond T.E.Y. = (Tax Exempt Yield) / (1 - Marginal Tax Rate)
Yield Curve Theories Market Segmentation Theory
-the yield curve depends on supply and demand at a given maturity and there are distinct markets for given maturities with distinct buyers and sellers at each maturity -when SUPPLY is greater than demand at a given maturity, rates are LOW; rates will have to increase for demand to increase -when DEMAND is greater than supply at a given maturity, rates are HIGH; rates will then begin to decrease to drive demand down.
Yield Curve Theories Expectations Theory
-the yield curve reflects investors inflation expectations -since investors are uncertain of future inflation, long-term yields are higher than short-term yields -whenever inflation is expected to be lower in the future, long term rates will be lower than short-term rates, resulting in an inverted yield curve **see graph pg 98**
Market Interest Rates
-the yield that is currently being earned in the marketplace on a comparable security -the rate used to discount a bond to determine what it is currently selling for in the market -interest rates that change in the market DO NOT affect the coupon rate payments
Bond Strategies Bullets
-these strategies have very little payments during the interim period and then a lump-sum at some specified date in the future -most of the bonds will mature in or around the same time period -zero coupon bonds, treasuries, and corporate bonds are the best candidates for Bullet strategies since they pay little to no coupon during the period and then a payoff at some point in the future -typically used when the investor has a balloon payment due on a liability at some future date
Types of Mutual Funds Index Funds
-tracks the performance of various market indices -passive investment strategy that are tax efficient -low turnover rates; minimizes capital gains distributions
Option Pricing Models Black / Scholes
-used to determine the value of a CALL option -considers the following variables: 1. current price of the underlying asset 2. time until expiration 3. risk-free rate of return 4. volatility of the underlying asset -all variables have a DIRECT relationship on the price of an option, EXCEPT the strike price -as the strike price INCREASES, the option DECREASES in value
Net Present Value (NPV)
-used to evaluate capital expenditures that will result in differing cash flows over the useful life or investment period -if NPV = POSITIVE; the investor would make the investment -if NPV = NEGATIVE; the investor wouldnt make investment NPV = PV of Cash Flows - Initial Cost
Municipal Bonds Private Activity Bonds
-used to finance construction of stadiums
Coefficient of Variation
-useful in determining which investment is riskier when investments have different average returns -tells the likelihood of actually experiencing a return close to the average return -the higher the CV, the more risky and investment per unit of return CV = Standard Deviation / Average Return
Accrued Interest
-when purchasing a bond, the buyer pays the seller interest that has accrued since the last interest payment -the new buyer then receives the full amount of interest due at the next interest payment -the buyer receives a 1099-INT that reflects the full periods interest received; however the buyer is entitled to a deduction equal to the amount of accrued interest paid to the seller
Yield Curve Theories Liquidity Preference Theory
-yield curve results in lower yields for shorter maturities because some investors prefer liquidity and are willing to pay for it in the form of lower yields -states that long-term yields should be higher than short-term yields because of the added risks associated with long-term maturities -the added yield is meant to compensate investors for the additional risk associated with long-term maturities
Probability of Returns Normal Distribution
1 S.D. = 68% 2 S.D. = 95% 3 S.D. = 99%
Unsystematic Risks (Types)
1. Accounting Risks 2. Business Risk -inherent risk a company faces by operating in a particular industry 3. Country Risk -risk a company faces by doing business in a particular country 4. Default Risk -risk of a company defaulting on their debt payments 5. Executive Risk 6. Financial Risk -the amount of financial leverage deployed by the firm 7. Government/Regulation Risk -risk that tariffs or restrictions may impact a firm ** Remember ABCDEFG**
Technical Analysis Tools (1-3)
1. Charting -the plotting of historical stock prices to determine a trading pattern -also involved plotting a 50-, 100-, or 200- day moving average along with the historical stock prices 2. Market Volume -gives technicians insight into investor sentiment -HIGH market volume, market UP = POSITIVE indicator -HIGH market volume, market DOWN = NEGATIVE indicator -LOW market volume, market UP = NEGATIVE indicator -LOW market volume, market DOWN = POSITIVE indicator 3. Short Interest -the number of shares sold short gives insight into future demand for a stock. -stock that was sold short eventually needs to be purchased -High short interest = "pent up" demand
Types of Investment Companies
1. Closed End 2. Open End 3. Unit Investment Trust (UIT)
Corporate Bonds Unsecured Corporate Bonds
1. Debentures -unsecured debt that is not backed by any asset -backed on the behalf of the creditworthiness that the issuing company will repay the debt 2. Subordinated Debentures -have a lower claim on asset than other unsecured debt -have more risk because of the lower claim on assets 3. Income Bonds -stipulate that interest is only paid when a specific level of income is attained
3 Reasons people Invest in Options
1. Hedging 2. Speculation 3. Income
Corporate Bonds Secured Corporate Bonds
1. Mortgage Bonds -backed by a pool of mortgages -payments consist of both interest and principal -biggest risk to bond holder is PREPAYMENT risk 2. Collateral Trust Bonds -backed by an asset owned by the company issuing the bond -the asset is held in trust by a third party -in the event of a default on the debt payment, the bond holders are entitled to the asset in the trust
Systematic Risks (Types)
1. Purchasing Power Risk -a dollar today cannot purchase the same tomorrow 2. Reinvestment Rate Risk -mostly impacts bonds 3. Interest Rate Risk -interest rates will impact price of equities and bonds 4. Market Risk -impacts all securities in short term 5. Exchange Rate Risk -exchange rates will impact prices for international securities **Remember PRIME**
Investment Policy Statement (objectives)
1. Return Requirements -can be specific to a goal, such as retiring by 55 2. Risk Tolerance -narrows the universe of investment alternatives **RR**
Calculating Bond Duration (2 methods)
1. Using the formula from CFP exam sheet **see pg 99** 2. Using PV of Cash Flows **see pg 100**
Forms of Efficient Market Hypothesis Weak Form
1. Weak Form -historical information will NOT help investors achieve above average returns -rejects technical analysis and asserts that fundamental analysis will help an investor achieve above-average returns
Investment Policy Statement (constraints)
1.Time Horizon -determines which investment alternatives are appropriate and when investor will need the asset 2.Taxes -Whether being held in a taxable, tax-deferred, or tax-free account 3.Liquidity 4. Laws and Regulations 5. Unique Circumstances **TTLLU**
Forms of Efficient Market Hypothesis Semi Strong Form
2. Semi-Strong Form -asserts that both historical and public information will not help investors achieve above avg returns -rejects BOTH technical and fundamental analysis -BUT inside information will lead to above avg returns
Forms of Efficient Market Hypothesis Strong Form
3. Strong Form -asserts that historical, public and private information will not help investors achieve above-avg returns -suggests that stock prices reflect ALL available information and react immediately to any new information
Technical Analysis (Tools 4-7)
4. Odd Lot Trading -trades less than 100 shares; mostly done by small investors -asserts small investors are most likely wrong regarding their trades, so do the opposite of the individual investors 5. The Dow Theory -signals an end to a bull or bear market -does NOT indicate when it will happen, only confirms that it has ended 6. Breadth of the Market -measures the number of stocks that increase in value versus the number of stocks that decline in value 7. Advance Decline Line -the difference between the number of stocks that closed up versus the number of stocks that decreased in value
Options (transactions from both sides)
Call Options: -Buyer: believe the price will RISE -Seller: believe the price will FALL or STAY the same Put Options: -Buyer: believe the price will FALL -Seller: believe the price will RISE or STAY the same **if asked which will maximize gains if stock appreciates, the answer is: BUYING A CALL** **if asked which will maximize gains if stock price falls, the answer is: BUYING A PUT**
Taxability of Options
Call options create two potential tax consequences: 1. if contract expires -premium paid is a short-term loss / premium received is a short-term gain 2. if contract is exercised -premium is added to stock price to increase basis in stock -if underlying stock is held longer than 12 months: long-term capital gain/loss -if underlying stock is held less than 12 months: short-term gain/loss Put option 1. if contract expires -premium paid is a short-term loss / premium received is a short-term gain
Correlation Coefficient (Equation)
Corr Coeff of AB = (COV of AB) / (S.D. of A) (S.D. of B)
At What Price Does an Investor Receive a Margin Call Price?
Margin Call = Loan / (1-Maintenance Margin) **see example pg 4**
Standard and Poors 500
S&P 500 -Value weighted index -Incorporates market capitalization of individual stocks into the average
Property Valuation (Step 1 Calculation)
Step 1: Calculate NOI Gross Rental Receipts +Non-Rental Income =Potential Gross Income (PGI) - Vacancy & Collection Losses =Effective Gross Income (EGI) - Cash Operating Expenses =Net Operating Income (NOI) -cash operating expenses do NOT include depreciation or amortization (not cash expenses)
Property Valuation (Step 2 Calculation)
Step 2: Calculate Capitalized Rate Capitalized Rate = NOI / Cost
Property Valuation (Step 3 Calculation)
Step 3: Plug in to Capitalized Value Formula Capitalized Value = NOI / Capitalization Rate ( = step 1 / step 2 )
Insured Municipal Bonds
The following companies insure municipal bonds: -American Municipal Bond Assurance Corp (AMBAC) -Municipal Bond Insurance Association Corp (MBIA) -if an insured municipal bond is in default, the insurance company will pay the interest and principal amounts
Real Estate Investment Trusts (REITs) (types)
Three Types: 1. Equity -invest in real estate for capital appreciation -income is generated from rental income and appreciation 2. Mortgage -invest mostly in mortgages and construction loans -make the spread between the lending and borrowing rate 3. Hybrid -combo of both equity and mortgage
Futures Contracts
Two Types: 1. Commodity Futures -underlying asset is copper, wheat, pork bellies, oil 2. Financial Futures -underlying asset is currency, interest rate, and stock indices Differences between futures and options: -future contracts OBLIGATE the holder to make or take delivery of the underlying asset -future contracts do NOT state the per unit price of the underlying asset; is determined by supply and demand -2 primary players in futures market: Hedgers and Speculators -Futures contracts are "market to market" ; the gain or loss is credited/debited to your account daily
Expected Rate of Return
r = expected rate of return P= price D1 = Next periods dividend g = Dividend growth rate **Formula is given on sheet**