CFP: Investment Planning

Collateral Trust Bonds

Collateral trust bonds are backed by other securities that are usually held by the trustee. A common situation of this sort arises when the securities of a subsidiary firm are pledged as collateral by the parent firm.

Debentures

Debentures are general obligations of the issuing corporation and thus represent unsecured credit. To protect the holders of such bonds, the indenture will usually limit the future issuance of secured debt as well as any additional unsecured debt.

12b-1

Fee to cover marketing expenses

Time Diversification

It is important to realize that implicit in a standard deviation statistic, is a holding period of one year. The concept of time diversification can be easily understood by long holding periods

Alpha

The description of alpha that follows should not be confused with Jensen's alpha, which is something different. Alpha is the intercept term for the characteristic line. Alpha is the value on the vertical (y) axis where the characteristic line intersects. Alpha can also be interpreted to be an estimate of the assets rate of return when the market is stationary. Beta represents the market effect on an assets return while alpha represents the portion of the assets return that is affected by the assets inherent values, or its residual risks. In a portfolio, the alpha represents the free return from the performance above the market or the value added by the portfolio manager. The alpha of an asset is calculated as the expected return of the asset of the period minus the beta times the expected return of the market of the period. As an intercept point, when beta = 0: If alpha > 0, the positive value represents the extra return that an investor is rewarded for taking on risk beyond the market. If alpha < 0, the negative value represents the return that was less than what the market itself performed.

Investing in Closed-End Fund Shares

The fact that the share price of a closed-end investment company differs from its net asset value, with the magnitude of the difference varying over time, introduces an added source of risk and return. By purchasing shares at a discount, an investor may be able to earn more than just the change in the companys net asset value. For instance: If the companys discount remains constant, the effective dividend yield will be greater than that of an otherwise similar no-load, open-end investment company, because the purchase price will be less. If the discount is substantial when the shares are purchased, it may subsequently narrow and the return will be even greater. If the discount increases, the investors overall return may be less than that of an otherwise comparable open-end investment company. Holding a portfolio of shares in several closed-end investment companies can reduce some of the risk associated with varying discounts.

Federal Agency Securities

The federal governments activities are financed directly through taxes and debt issued by the Treasury. In addition, a substantial amount is also financed in other ways: Various government departments provide explicit or implicit backing for the securities of quasi-governmental agencies. The federal government guarantees both the principal and coupon payments on bonds issued by certain private organizations. Many of the bonds are considered second in safety only to the debt obligations of the U.S. government itself.

Mortgage-Backed Securities

Mortgage-Backed Securities (MBS) are securities that are backed by pools of mortgage loans. Because the underlying mortgages can be prepaid, prepayment risk is a major concern for MBS investors. MBS include: Mortgage pass-through securities Collateralized Mortgage Obligations (CMOs) Stripped mortgage-backed securities

Relationship to Bond Price

One implication of the fifth theorem is that bonds having the same maturity date but different coupon sizes may react differently to a given change in interest rates. In other words, the prices of these bonds may adjust by notably different amounts when there is a given change in interest rates. However, bonds with the same duration will react quite similarly. So, the duration can be thought of as a measure of the price risk of a bond. Specifically, the percentage change in a bonds price is related to its duration in the following fashion: Percentage change in price is approximately equal to duration times the percentage change in a bonds yield. For example, if the yield of a $1,000 bond, with a duration of 10 years, changes from 8% to 9%, then the change in the price of the bond will be approximately: 10(1%) = 10% or $100, leaving the new price of the bond equal to $900. (Remember that bond prices and interest rates have an inverse relationship. When interest rates go up, the market prices for bonds tend to go down and vice versa.) CASE-IN-POINT Modified duration is an equation frequently used to approximate the effect that changes in interest rates have on a bond prices. Dm = D/(1 + y) Consider a bond that is currently selling for $1,000 with a yield-to-maturity of 8%. Given that the bond has a duration of ten years, how much will the bonds price change if its yield increases to 9%? Therefore, Dm = 10/1.08 = 9.26 The one-percentage-point rise in the yield will cause approximately a 9.26% drop in the bonds price to $907.40 = $1,000 (.0926 X $1,000). These equations reflect the price risk of a bond only when the yield curve is horizontal and any upward or downward shifts in the curve are parallel. Hence, in the example above, the current yield curve is assumed to initially be flat at 8% and then to shift either up to 9% or down to 7% so that the yield curve remains horizontal afterward. Yield curves are seldom horizontal and infrequently shift in a parallel manner, so these equations are best viewed as approximations. Comprehensive Example of Bond Price Estimating Consider the previous example of calculating duration using the formula. We had a 20-year, annual payment coupon of 8%, with market rates (YTM) of 7%. We calculated the duration to be 11.05 years. From this we could calculate the modified duration to be 10.33 years (11.05 / 1.07). As stated above in Case-in-point, it is common to use modified duration as an estimate of the bond's price sensitivity to changes in interest rates. If rates were to suddenly shift upward (downward) by ½ of 1% (50 basis points), then we would estimate that the approximate change in price of the bond would be a 5.165% (10.33 X .0050) decrease (increase). It is worth re-emphasizing, that the true price of the bond will always be higher than the modified duration estimate. This is true due to the convex shape of the price/yield function. Fortunately, we have a simple method to actually calculate the real price of the bond, which will take the convex shape of the price/yield function into account. This simple method is called the full valuation approach. First determine the price of the bond prior to the interest rate change. Your calculator keystrokes are FV 1000, PMT 80, N 20, 7 I, we solve for PV = $1,105.94. As a check and balance, with the market rates (YTM) below the coupon rate, we were expecting the price to be a premium. Now let's revalue the bond, with the interest rate change. Your calculator keystrokes are FV 1000, PMT 80, N 20, 7.5 I, we solve for PV = $1,050.97. This is the actual price, directly on the convex price yield function. Taking convexity into account, the price dropped $54.97. Since the graph of duration is linear, we would expect duration to provide an estimated price that is worse than the actual price. Let's confirm this. At the beginning of this example, we stated that modified duration would provide an estimate of a 5.165% price decline. Starting with our initial price of $1,105.94, a 5.165% drop in price ($57.12) would provide an estimated new price of $1,048.82. This demonstrates than regardless of the directional change in interest rates, the duration estimate will always under estimate the actual price.

After-Tax Yield

When considering a taxable bond versus a municipal bond, a comparison can be drawn between the after-tax yield of the taxable bond and the tax-free yield of the municipal bond. The same comparison can be made between a taxable bond fund and a municipal bond fund. The Tax Equivalent Yield (TEY) is often used to make these comparisons. The equation for the TEY is: TEY = Tax Free Yield/(1 + Tax Bracket) This yield gives the person a basis to take a tax-free yield and make it a taxable yield equivalent.

Front Load

Commission collected when purchasing a fund

Alta Cohen is considering buying a machine to produce baseballs. The machine costs $10,000. With the machine, Alta expects to produce and sell 1,000 baseballs per year for $3 per baseball, net of all costs. The machine's life is five years, with no salvage value. On the basis of these assumptions and an 8% discount rate, what is the net present value of Alta's investment?

$1978.13 Explanation: The first step is to establish a cash flow line: Time / Cash Flows 0 / (10,000) 1 / 3,000 2 / 3,000 3 / 3,000 4 / 3,000 5 / 3,000 Keystrokes: 10000 CHS g CFo 3000 g CFj 5 g Nj 8 i f NPV The Calculator Returns: 1,978.13 The Project should be accepted since the NPV is positive.

Types of Corporate Bonds

An exhaustive list of the names used to describe bonds would be long and cumbersome. For that reason, different names are often used for the same type of bond, and occasionally the same name will be used for two distinctly different bonds. A few major types do predominate, however, with relatively standard nomenclature. The names are typically tied to some feature. If a feature lowers the risk of the bond, for example a collateralized bond, the yield would be lower. If the feature increases the risk of the bond, for example a debenture or unsecured bond, then the yield would be higher. The various types of bonds are different because of the resources used (or not used) as collateral or to fund the interest payments. On the surface, it would seem that a bond backed by an asset would be less risky. But you must also consider who issued the bond. For example, Anheuser-Bush is less likely to need to back an issue of bonds with its equipment or assets as collateral than a smaller brewer. The following list details the types of corporate bonds. Mortgage Bonds Collateral Trust Bonds Equipment Obligations Debentures Subordinated Debentures Asset-Backed Securities Convertible Bonds Other Types of Bonds

Book Value

Book value is calculated by dividing the net worth of a company by the number of shares outstanding. As a corporation generates income over time, much of it is paid out to creditors as interest and shareholders as dividend. Any remainder is added to the amount shown as cumulative retained earnings on the corporations books. The sum of the cumulative retained earnings and other entries such as common stock and capital contributed in excess of par value, under stockholders equity is the book value of the equity. The book value per share is obtained by dividing the book value of the equity by the number of shares outstanding. Cumulative Retained Earnings + Capital Contributed in Excess of Par + Common Stock = Book Value

Skewness

In the real world most probability distributions are either positively or negatively skewed. Skewness refers to the extent to which a distribution is not symmetrical. We only use the normal distribution, with its symmetrical bell-shape for simplicity reasons. A positively skewed distribution is characterized by many outliers in the upper, or right tail. A positively skewed distribution is said to be skewed right because of its relatively long upper tail. Stock market returns for instance, exhibit a positively skewed distribution. This should be evident by the fact that there are many more positive return years than negative ones. A negatively skewed distribution has many outliers that fall within its lower, or left tail. This type of distribution is said to be skewed left.

TIME INFLUENCE ON VALUATION

TIME INFLUENCE ON VALUATION

T-Bonds

Treasury Bonds have maturities from more than ten to thirty years. Those issued before 1983 may be in either bearer or registered form while subsequent issues are all in registered form. Denominations range from $1,000 and upward. Unlike Treasury Notes, some Treasury Bond issues have call provisions that allow them to be called during a specified period that usually begins five to ten years before maturity and ends at the maturity date. The Treasury has the right to force the investor to sell the callable U.S. Treasury Bonds back to the government at par value. In 2001, the U.S. Treasury discontinued issuing new T-Bonds but started re-issuing 30-year Treasury bonds again in 2006.

Diversifiable Risk (Unsystematic)

Unsystematic or diversifiable risk is risk or variability that can be eliminated through diversification. It results from factors unique to a particular stock. Statisticians call the diversifiable risk, VAR(e), the residual variance, or the standard error squared. Diversifiable risk is made up of idiosyncratic fluctuations that are unique to the investment. Some sources of unsystematic risk include business risk, financial risk, default or credit risk, regulation risk and sovereignty risk. The percentage of total risk that is diversifiable can be measured by subtracting the coefficient of determination or R-squared from one.

Time-weighted sample problem

1. Fred had $20,000 in his portfolio at the beginning of the year. He added $5,000 to the portfolio in the middle of the year. The account value before he added the $5,000 was $19,178 and at the year-end, it was $25,998. What was the annual time-weighted return for Fred's portfolio? A. 20.89% B. 3.992% C. 3.108% D. 20% Answer and Explanation Correct Answer: C. 3.108% Explanation: The return for first half year = ($19,178 - $20,000)/$20,000 = -.0411. The return for second half year = ($25,998 - $19,178 - $5,000) /($19,178 + $5,000) = .075275. The time-weighted return = [(1-.0411)(1+.075275)-1] = .03108 or 3.108%.

Warrants and Rights

A warrant is also called a stock purchase warrant and may be distributed to stockholders in lieu of a stock or cash dividend or sold directly as a new security issue. It is a call option (contract for the option to buy shares at a fixed price) issued by a company with its stock as the underlying security. A right is similar to a warrant in that it is like a call option issued by the firm whose stock serves as the underlying security. Rights are issued to give existing stockholders their preemptive right to subscribe to a new issue of common stock before the general public is given an opportunity.

Asset's Total Risk

An investments total risk, measured by its variance of returns, can be partitioned into two components: Unsystematic or Diversifiable risk Systematic or Nondiversifiable risk By rearranging the characteristic line, you can attribute the returns that are diversifiable vs. nondiversifiable.

Certificate of Deposit (CD)

Certificates of deposit (CDs) represent time deposits at commercial banks or savings and loan associations. Large-denomination (or jumbo) CDs are issued in amounts of $100,000 or more, have a specified maturity, and are generally negotiable, meaning that they can be sold by one investor to another. Such certificates are insured by the Federal Deposit Insurance Corporation (FDIC) or the National Credit Union Administration (NCUA). It is important not to confuse these negotiable CDs with the non-negotiable ones sold in smaller denominations to consumers.

Redemption Fee

Charge for leaving fund before certain holding period, proceeds go back to the pool

Dollar-Weighted Return

Difficulties are encountered when deposits or withdrawals occur sometime between the beginning and end of the period. One method that has been used for calculating a portfolios return in this situation is the dollar-weighted return (or internal rate of return). Dollar-weighted return is what an investor should use to determine how well their investment performed. Example: Consider a portfolio that at the beginning of the year has a market value of $100 million. In the middle of the year, the client deposits $5 million with the investment manager, and subsequently at the end of the year, the market value of the portfolio is $103 million. $100 million = -$5 million/ (1+r) + $103 million/(1+r)2 r = -.98% The dollar-weighted average (r) is a semi-annual rate of return. It can be converted into an annual rate of return by adding 1 to it, squaring this value, and then subtracting 1 from the square, resulting in an annual return of -1.95%. [1+(-.0098)]2 - 1 = -1.95%

Hedge Funds

Hedge funds are privately organized, pooled investment vehicles that primarily invest in publicly traded securities and their derivatives. Hedge funds tend to have diversification benefits due to their low-correlation with long-only funds. The classic definition of a hedge fund allows for holding gross long positions in excess of total capital, but offsetting these excesses by short positions such that the net long position is between zero and 100% of capital. The current definition allows hedge funds to develop more speculative positions. This is accomplished by holding the gross long position in excess of 100% of capital, or even by taking a net short position. Hedge funds employ several strategies in an attempt to achieve superior returns and to reduce risk. These include shorting, leverage, concentration, and derivatives. Short positions offset systematic risk, making security selection a much larger component of overall risk. Short positions broaden a managers ability to profit from security selection. By taking short positions in securities that are expected to under perform the market, a second source of potential profit on security selection emerges. Leverage can be used to develop market neutral strategies (equal proportions of long and short positions), or to adopt a leveraged directional position (e.g., long positions amounting to 120% of capital and short positions amounting to 55% of capital, netting to a long position equal to 65% of capital). Concentration occurs when managers develop less diversified portfolios with larger positions in fewer securities. The purpose is to attempt to augment returns, but this strategy also increases the overall risk. Derivates are used as an alternative source of leverage and as an alternative way to establish a long position or a short position in the underlying security. Furthermore, derivatives are an effective method to reduce the portfolio risk (e.g., portfolio insurance long (buying) puts on the aforementioned concentrated positions).

Using Money Market Instruments for Emergency Funding.

PRACTITIONER ADVICE: The CFP Board recommends that investors hold 3 to 6 months' worth of living expenses as emergency funding. The money should be held in cash or funds comprised of money market securities.

Maintenance Margin Example

Reconsider investors B and S, who had, respectively, bought and sold a July wheat futures contract at $4 per bushel. Each investor had made a deposit of $1,000 in order to meet the initial margin requirement. The next day the price of the wheat futures contract rose to $4.10 per bushel, or $20,500. Thus the equity of B increased to $1,500 while the equity of S decreased to $500. If the maintenance margin requirement is 65% of initial margin, both B and S are required to have equity of at least $650 (0.65 X $1,000) in their accounts every day. Because the actual level of equity for B clearly exceeds that amount, B does not need to do anything. Indeed, B may withdraw an amount of cash equal to the amount by which the equity exceeds the initial margin. In this example, B can withdraw cash of $500. However, S is under margined and will be asked to make a cash deposit of at least $500, because this will increase the equity from $500 to $1,000, the level of the initial margin. In the event that S refuses to make this deposit, the broker will enter a reversing trade for S by purchasing a July wheat futures contract. The result is that S will simply receive an amount of money approximately equal to the accounts equity, $500, and the account will be closed. Because S initially deposited $1,000, S will have sustained a loss of $500. On the third day the price of the July wheat futures contract is assumed to settle at $3.95 per bushel, representing a $750 loss for B and a $750 gain for S. As a consequence, B is now under margined and will be asked to deposit $750 so that the equity in Bs account will be $1,000. (This example assumes that B had withdrawn the $500 in excess margin that had accumulated from the previous days price change.) Conversely, S can withdraw $750, because the equity in Ss account is over the $1,000 initial margin requirement by that amount. (Remember that S had added $500 to bring the accounts equity up to $1,000 at the end of the previous day.)

Investing in Land

Returns on investment in land are modest but certainly not poor. The risks associated with land depend directly on the kind of land you buy. For example: The price of farmland reflects the prices of crops that can be grown on it. Since commodity prices are volatile, you can expect farmland prices to be volatile as well. Natural resource land, such as coal land also shows a volatile pattern. Land held for residential or commercial development represents a different set of risks. Such land is unproductive until development is finished. The future value of such land is determined greatly by future population and business trends that are not easily predicted. Most land investments are characterized by: Poor cash flows during their holding periods, Poor tax-sheltering opportunities, since land is not depreciable, and A high future payoff when the land is finally developed or sold. This adds up to considerable risk. As a result, land investment is usually appropriate only for the very wealthy.

Stock Value

Some investors take the price quoted for a stock to be its true worth, while others are determined to uncover a hidden value. Those who believe there is a hidden value will use various stock valuation methods to determine the intrinsic value of the stock and compare it to the actual price. If the value they come up with is higher than the market price, then the stock is undervalued. They will buy and hold the stock until it reaches or exceeds what they have determined should be the stocks true value. If their valuation comes up with a price that is below the market price, then the stock is overvalued. In this case, they may sell shares at the stocks current price. Investors and brokers use many different methods to determine whether a stock is undervalued or overvalued. Because many factors affect the price of stocks, valuation methods are not always successful in predicting the future movement of stock prices. Some terms used to express different values of a stock are: Par value, Book value, and Market value. These terms are used in various valuation methods.

Nondiversifiable Risk (Systematic)

Systematic or nondiversifiable risk is that portion of a stock's risk or variability that cannot be eliminated through diversification. It results from factors that affect all stocks. In fact, the term "systematic" comes from the fact that this type of risk systematically affects all stocks, i.e. it is of the system. Some sources of risk that maybe considered as systematic include market risk, interest rate risk, inflation risk, reinvestment risk, and exchange risk. The percentage of total risk that is nondiversifiable can be measured by the coefficient of determination or R-squared.

Price vs. Value Weight

CASE-IN-POINT This example will illustrate the difference between price-weight and value-weight. Lets suppose that there are only two stocks in the market: Stock A and Stock B. Stock A has 50 million shares outstanding and Stock B has 1 million shares outstanding. The price of Stock A was $10/share at the beginning of the day and $14/share at the end of the day. The price of Stock B was $50/share at the beginning of the day and $40/share at the end of the day. HERE IS THE BREAK DOWN OF THE FACTS: Stock Shares Outstanding Beginning Price Ending Price Beginning Market Cap Ending Market Cap A 50 million $10 $14 500 million 700 million B 1 million $50 $40 50 million 40 million Price-weighted method: Begin: $10 + $ 50 = $60/2 = $30 End: $14 + $40 = $54/2 = $27 Percentage change: ($27 - $30) = -$3/$30 = 10% decrease Value-weighted method: Begin: 500 million + 50 million = 550 million/2 = 275 million End: 700 million + 40 million = 740 million/2 = 370 million Percentage change: 370 million 275 million = 95 million divided by 275 = 35% increase There is a big discrepancy between the actual movements of the hypothetical market. The price-weighted calculation allowed the higher-priced Stock Bs drop in price influence the whole market, even though Stock B only represented approximately 5.7% of the total market at the end of the day. The value-weighted calculation reflected a rise in the market with Stock A because the size of the company was used as the weight rather than share price. Keep in mind that this was an example of a market with only two stocks to over-simplify the difference between the two methods. In real life, the discrepancy between the DJIA and the S&P 500 is not that great. In fact, the two indexes are fairly correlated.

Determining Return

Calculate Total Return, determine After Tax Return, then determine the real return (adjusts for inflation).

Spring Valley Bedding stock currently sells for $53 per share. The stock's dividend is expected to grow at 6% per year indefinitely. Spring Valley just paid a dividend of $3 per share. What would be the stock's internal rate of return?

12% Explanation: Assuming that a stock is fairly valued if its dividend is growing at a constant rate, the internal rate of return can be found by solving the intrinsic value equation for k* = (D2/V)+g = [($3X 1.06)/ $53] + 0.06 = .12 or 12%.

Annual return sample problem

3. The quarterly returns for Fred's portfolio are 2.5%, 1.7%, -3.6% and 2%. What was the annualized return of his portfolio using the compounding method? A. 2.5% B. 4.026% C. .10% D. -3.2% Answer and Explanation Correct Answer: A. 2.5% Explanation: Return = [(1+.025)(1+.017)(1-.036)(1+.02)]-1 = 2.5%.

Bond Return Measurements are IRR calculations

A bond yields returns in the form of interest payments for a specific number of years. At maturity, a bond is redeemed by paying back the investor the par value of the bond. The bonds periodic cash flows (coupon payments plus final repayment of the bond's par value) are used for measuring a bonds return. It is important to note, that both the YTM and YTC calculations are internal rate of return calculations. As such, the calculations assume the investor has an opportunity to reinvest at that rate (either YTM or YTC). For this reason, it should be understood that the yield to maturity and yield to call figures should only be used as relative measure when comparing bonds and not used as any type of expected return. Furthermore, the described weakness of the reinvestment assumption for YTM and YTC is the exact strength of the Realized Compound Yield (RCY) calculation, which will also be discussed in this section. The rate of return on bonds most often quoted for investors is the yield to maturity (YTM), which is defined as the promised compounded rate of return an investor will receive from a bond purchased at the current market price and held to maturity. Most corporate bonds, as well as some government bonds, are callable by the issuers, typically after some deferred call period. If a bond is likely to be called, then the yield to maturity calculation is unrealistic. In the case of callable bonds, a calculation of the promised yield to call (YTC) should be used instead.

Reinvestment Rate Risk

A bonds YTM is an expected return (promised YTM), which assumes that all interest income will be reinvested at the same YTM that existed on the day the bond was initially purchased. This assumption is dubious because the bonds income from coupon-interest payments might be reinvested to earn less than the YTM, or the coupon income might be consumed. The bonds YTM is reduced because the investor will not be able to earn interest on the interest. In contrast, the same bond has a realized total yield if the coupons are reinvested. These different realized returns show the importance of reinvestment opportunities and highlight an often-ignored source of bond risk. Reinvestment rate risk can cause a bonds realized yield to deviate significantly from its promised YTM. Most corporate bonds, as well as some government bonds, are callable by the issuers, typically after some deferred call period. Since bonds would only be called when interest rates are lower, all of the remaining cash flows are exposed to reinvestment risk. For bonds likely to be called, the yield-to-maturity calculation is unrealistic. A better calculation is the yield to call.

Stock Splits

A company's management may decide to alter the value of the stock by either a stock split or a reverse stock split. Splits and reverse splits only affect the price per share. A stock split adds shares based on a ratio; therefore the price per share declines. A reverse split would combine shares and therefore raise the price per share. CASE-IN-POINT: For example, if a $100 par value stock is split two-for-one, the holder of 200 old shares will receive 400 new $50 par value shares, and none of the dollar figures in stockholders' equity will change. If the shareholder's total market value for the shares was $50,000, the total market value will remain the same. The only change is that the number of shares he or she owns has doubled. Stock splits do not change anything for the company in terms of revenue or expenses. However, it can sometimes generate excitement around the stock. A stock split can signal that the firm's management believes the stock to be undervalued in the market. It can also bring the share price to a more desirable trading range. Either way, these reasons can cause a short-term abnormal increase of activities around the stock. PRACTITIONER'S ADVICE: Many investors are mistakenly led to believe that they are somehow better off following a stock split. This misconception may stem from the fact that companies tend to split their stock if they are confident of future growth. It is not uncommon to see a run up in a stock price following a split, which may be somewhat of a self-fulfilling prophecy.

Derivatives

A derivative security is so named because its value is derived from the value of another asset, referred to as the underlying asset. As that assets value changes, so does the value of the derivative. Although there is a speculative lure to investors because of their potential to produce large gains in short periods of time, derivative securities have gained a great deal of unfavorable press in recent years. Misuse of derivatives has led to some notoriously large losses such as in the case of Orange County, California. There is a speculative lure to investors because of their potential for large gains in short periods of time. However, most portfolio managers use derivatives as way to hedge their bets. A big appeal with derivatives is that the change in their value is usually far greater, percentage-wise, than the value change in their underlying assets. In this sense, they are said to have built-in leverage. There are various types of derivatives, but you are most likely to encounter option contracts and futures contracts.

Stock Funds

A diversified common stock (equity) fund invests most of its assets in common stocks, although some short-term money market instruments may also be held to accommodate irregular cash flows or to engage in market timing. In 1997, CDA/Wiesenberger classified the majority of diversified common stock funds as seeking one of the following three objectives: Capital gain, Growth, or Growth and income. These classifications are arranged in decreasing order of the emphasis they place on capital appreciation, and in increasing order of the emphasis they place on current income and relative price stability. Because high-dividend portfolios are generally less risky than portfolios with low dividends, relatively few major conflicts arise, even though two rather different criteria are involved. There are many choices in stock funds and different types of funds vary in degrees of risk and investment philosophy and style. Stock funds are ideal for investors who are seeking long-term growth and are able to handle larger price fluctuations than those typically associated with balanced or bond funds. There are many types of stock funds ranging from conservative funds that invest in large well-established companies, to funds that invest in small and unknown companies.

Specialized Funds

A few specialized stock funds concentrate on the securities of firms in a particular industry or sector. These are known as sector funds. For example, there are: Chemical funds Aerospace funds Technology funds Gold funds Other specialized stock funds deal in securities of a particular type. Examples include funds that: Hold restricted stock, Invest in over-the-counter stocks, or Invest in the stocks of small companies. Still others provide a convenient means for holding the securities of firms in a particular country, such as India and Indonesia funds. These funds allow investors to diversify beyond domestic companies and gain access to countries in which investing would otherwise be difficult. However, specialized funds limit the portfolio managers ability to diversify away all of the nonsystematic risks of the assets within their portfolios. For example, a fund that invests in only Internet-related stocks is subjected to risks specific to the Internet industry. Investors who believe that certain sectors or countries will outperform the broad market may want to invest in these funds. PRACTITIONER ADVICE Do not be drawn into abnormal returns. People are always drawn into hot sectors (such as the Internet). Sectors can pay off a great return, but they also present higher risk. By the time the sector becomes the buzz, it has probably gained its return already.

Fixed Annuities

A fixed annuity is an annuity in which the principal is guaranteed. The value of a fixed annuity can only increase. The interest rate on fixed annuities is guaranteed for a short period of time, such as a year. After this initial period, the interest rate can be changed at the discretion of the insurance company, so long as it doesn't fall below some guaranteed minimal interest rate, such as 3 percent. The distinction has to do with the preservation of principal during the accumulation period.

Holding Period Return

A measure that can be used for any investment is its holding-period return. Holding period is defined as the length of time over which an investor is assumed to invest a given sum of money. The holding period return has a major weakness because it does not consider the time or how long it took to earn the return. When this procedure is applied, the performance of a security can be measured by comparing the value obtained in this manner at the end of the holding period with the value at the beginning. Please note that in the formula below, any coupon (from a bond), interest, dividend, or any other cash flow received from the investment does not assume reinvestment. Any reinvestment (like capital gains distributions and dividends from a mutual fund) would be imbedded in the ending value (P1) and the separate addition of theses payments would overstate the return. HPR = (P1 + D - P0)/P0 Where P0 = price in the beginning of the period, P1 = price at the end of the period, and D = any dividend, interest, or cash flow paid. TEST TIP This is one of the equations that does not appear on the CFP® Certification Examination equation sheet. In order to be ready for the exam, please realize: The price at the end (P1) less the price at the beginning (P0), divided by the price at the beginning (P0), represents a capital appreciation (depreciation) figure. While the dividend, interest paid, or any cash flow received (D), divided by the price at the beginning (P0), and represents an income yield component. There actually was a prior CFP® Board test question that required such a calculation. In this case, it is easier to separate the HPR calculation into two separate equations: (P1 - P0)/P0 and D/P0 . This formula (HPR) can be used when there is no dividend, interest, or interim cash flow received, (i.e. options). For instance, if an investor bought a call option for $400 two weeks ago, and sold the option today for $540, what would the HPR be? $540 - $400 / $400 = .35 = 35% The HPR can easily be asked for a bond. An investor pays $875 for a bond with an annual coupon of 6%. There is exactly 7 years to go before the bond matures. Assuming that the investor does hold the bond until maturity, what is the HPR of the bond? $1,000 - $875 + 420 / 875 = 62.3% In reference to point (1), this could have been asked as a capital appreciation and income yield component: $1,000 - $875 / $875 = 14.3% (Capital gain component) and $420 (7 coupon payments x $60) divided by $875 = 48%. The two together would sum to the total of 62.3%. For example, Dan purchased a round lot of 100 shares of Dannon stock for $2,000 or $20/share. Two years later, he sold his shares for $32/share. Dan also received dividends of $4/share. What would be the holding period return? ($3,200 + $400 - $2,000)/$2,000 = .80 or 80% An annual average return figure can be determined through: Arithmetic Mean Return, or Geometric Mean Return.

Mortgage Pass-Through Securities

A mortgage pass-through security represents a claim against a pool of mortgages. Any number of mortgages may be used to form a pool, and any mortgage in the pool is often referred to as a securitized mortgage. These pass-through securities may be traded in the secondary market, and therefore have the economic effect of converting illiquid mortgages into liquid mortgages - a process known as securitization. The investment characteristic of these instruments is a function of their cash flow features and the strength of their governmental guarantee. The monthly cash flow the investor receives is made up of the scheduled pass-through of principal and interest payments from the amortized loans in the pool, minus a small service charge. In addition, any refinancing activity of the underlying mortgages will create an unexpected pass-through of principal. The three major types of pass-through securities are: Ginnie Mae. Issued by the Government National Mortgage Association (GNMA), an agency of the U.S. Government under the Department of Housing and Urban Development. The payments from a GNMA fund are guaranteed and backed by the full faith and credit of the U.S. Government. Fannie Mae. Issued by the Federal National Mortgage Association (FNMA), a corporation originally created by the federal government. Freddie Mac. Issued by the Federal Home Loan Mortgage Corporation (FHLMC), a corporation originally created by the federal government. It is important to note that Fannie Mae and Freddie Mac are not truly governmental agencies, and therefore are not backed by the full faith and credit of the U.S. Government as a direct obligation. They are, however, a moral obligation of the U.S. Government. This moral obligation came to fruition in the financial crisis of 2008 and 2009 where the U.S. Government stepped in to prevent the agencies from going bankrupt.

Zeroes and Strips

A non-callable Treasury Note or Bond is, in effect, a portfolio of pure-discount bonds or equivalently, a portfolio of zero-coupon bonds. That is, each coupon payment, as well as the principal, can be viewed as a bond unto itself. The investor who owns the bond can therefore be viewed as holding a number of individual pure-discount bonds. In 1982, several brokerage firms began separating these components, using a process known as coupon stripping. Noting the favorable market reaction to the offering of these stripped securities, in 1985 the Treasury introduced a program for investors called Separate Trading of Registered Interest and Principal Securities (STRIPS). This program allows purchasers of certain coupon-bearing Treasury securities to keep whatever cash payments they want and to sell the rest. Duration is the weighted-average term-to-maturity of the cash flows (coupon and par payments) of a bond. It is often used in place of time-to-maturity as a more accurate measure of a bond's volatility. The longer the duration, the more sensitive a bond's price is to changes in prevailing rates. Because there is only one payment at the maturity of the bond, a zero coupon bond's duration is equal to its maturity. Coupon-paying bonds always have a duration shorter than their maturity. So zero coupon bonds are more aggressive than coupon-paying equivalents. Investors purchase zero coupon bonds because they are deeply discounted. So if a zero coupon bond cost $200, you can ultimately purchase 5 for the price of one coupon-paying bond. And since they are more volatile, if interest rates decrease, then you would have capital appreciation for five bonds rather than one.

Put Options

A second type of option contract for stocks is the put option. It gives the buyer the right to sell or to put away a specific number of shares of a specific company to the option writer at a specific selling price at any time up to and including a specific date. The following is a list of put option contract elements: The company whose shares can be sold, The number of shares that can be sold, The selling price for those shares, known as the exercise price or striking price, and The date when the right to sell expires, known as the expiration date. A writer of a put is expecting that the price of the stock will increase or remain above the exercise (strike) price. If the price does not drop below the exercise (strike) price, the option will probably be left unexercised at maturity and the writer will make money on the premium of the put contract. A buyer of a put is hoping that the price of the stock will decline below the exercise (strike) price providing an opportunity to buy the shares at a lower price. The buyer would then exercise the contract by selling the shares at a higher price to the writer. The buyer could also sell the put contract to someone else on the secondary market.

Annualized Return

Adding or multiplying all the quarterly returns can give the annual measure of return. For example, if the returns in the first, second, third, and fourth quarters of a given year are denoted r1, r2, r3, and r4, respectively, then the annual return can be calculated by adding the four figures: Annual return = r1 + r2 + r3 + r4 Alternatively, the annual return could be calculated by adding 1 to each quarterly return, then multiplying the four figures, and finally subtracting 1 from the resulting product: Annual return = [(1 + r1)(1 + r2)(1 + r3) (1 + r4)] - 1 This return is more accurate because it reflects the value that one dollar would have at the end of the year if it were invested at the beginning of the year and grew with compounding at the rate of r1 for the first quarter, r2 for the second quarter, r3 for the third quarter, and r4 for the fourth quarter. That is, it assumes reinvestment of both the dollar and any earnings at the end of each quarter.

Time-Weighted Return

Alternatively, the time-weighted return on a portfolio only concerns itself with the portfolio appreciation or depreciation in value from one period to the next. That is, all cash flows into and out of the fund are totally disregarded from the return data. Time-weighted return is the only acceptable method to display the results of a portfolio manager's performance. From the previous example, assume that in the middle of the year the portfolio has a market value of $96 million, so that right after the $5 million deposit the market value was $96 million + $5 million = $101 million. Return for first half year = ($96 million - $100 million)/$100 million = -4% Return for second half year = ($103 million - $101 million)/$101 million = 1.98% Next, these two semi-annual returns can be converted into an annual return by adding 1 to each return, multiplying the sums, and then subtracting 1 from the product. Annual return of [(1 - .04) x (1 + .0198)] - 1 = -2.1%

Trading Corporate Bonds

Although most of the trading in corporate bonds takes place through dealers in the over-the-counter market, many corporate bonds, as well as Treasuries, agencies, and municipals, are listed on the New York Stock Exchanges Fixed-Income Market. Bonds that are listed on the NYSE are traded through a computer system known as the Automated Bond System (ABS). With this system, subscribers enter their bid or ask prices, along with the quantities, into computer terminals. Other subscribers can see these orders by looking at display terminals and can respond by entering an order at a terminal. Thus, ABS not only provides subscribers with quotes, it also provides them with execution capability. A second bond market, run by the Nasdaq Stock Market, is known as the Fixed-Income Pricing System (FIPS). This market is devoted to trading high-yield bonds. Quotes are entered on FIPS by dealers and must be at least one-sided. Subsequent trades are made by contacting a dealer, typically by telephone, and depending on the bond, may have to be reported within five minutes of execution. Nasdaq and other market data vendors disseminate trade report summaries on an hourly basis for the fifty most liquid issues and on a daily basis for all the others.

Municipal Bond Funds

Although municipal bond unit investment trusts have been available for many years, open-end municipal bond funds were first offered in 1976. Some municipal bond funds hold long-term issues from many states to create tax-free bond funds. Others, known as single-state funds, specialize in the long-term issues of governmental units in one state, which allows the funds to provide an investment vehicle for residents of that state who wish to avoid paying state and federal income taxes. Still other funds hold only short-term municipal securities to create tax-free money market funds, with some specializing in the short-term issues of governmental units in one state. Municipal bond funds pay a lower nominal yield than regular bond funds, due to the tax-free treatment of the funds dividends. This benefits investors who are in higher tax bracket. Investing in a single state municipal bond fund can also offer investors tax-exempt income at the federal and state levels. However, focusing on only one state increases the investors exposure to state-specific risk. CASE-IN-POINT: Municipal bond funds can offer potentially higher returns by diversifying into lower credit ratings that would be too risky as an individual holding. This diversification can boost the funds overall yield.

Likelihood of Default

An important distinction among fixed-income securities is the likelihood of the issuer to default on payment of interest and principal of the loan. This risk is called default or credit risk. Any security backed by the full faith and power of the U.S. government is considered the highest quality (considered to have absolutely no default risk). For all other fixed-income securities, there are rating systems. There are several companies that actively rate bonds. Standard and Poor's and Moody's rating systems are the most commonly referred to in the bond industry. Bonds that have the highest ratings are referred to as investment-grade bonds or high-quality. They fall into a rating of AAA through BBB for S&P, Aaa through Baa for Moody's. Any bond rated below BBB (S&P) or Baa (Moody's) ratings are considered speculative-grade. Click here to see S&P's rating definitions. Speculative-grade bonds are better known as junk bonds. Since the issuer must compensate investors for taking on the additional default risk, speculative-grade bonds are also called high-yield bonds. These bonds are much more volatile in the secondary market. Their market prices will fluctuate more than investment grade bonds. Therefore, it is very important to consider and communicate their exposure to risk when purchasing or recommending high-yield bonds. PRACTITIONER ADVICE High-yield bonds are not to be feared, but investors need to understand the risk associated with the bond. The only reason high-yield bonds pay a higher coupon rate is because they have higher default (credit) risk. There is no exception to the risk reward relationship. High-yield bonds can be utilized as part of a well diversified bond portfolio to increase the portflio's yield, but the risk of default needs to be understood and compensated.

Maintenance Margin

Another key margin account topic is the maintenance margin. According to the maintenance margin requirement, the investor must keep the accounts equity equal to or greater than a certain percentage of the amount deposited as initial margin. Typically, an investor must have equity equal to or greater than 65% of the initial margin. If this requirement is not met, the investor will receive a margin call from his or her broker. This call is a request for an additional deposit of cash known as variation margin to bring the equity up to the initial margin level. If the investor does not or cannot respond, then the broker will close out the investors position by entering a reversing trade in the investors account.

Income-Producing Property

An income-producing property provides periodic rentals. As the owner, you receive these rents, usually every month. It is your responsibility to provide tenants all the services specified in the rental agreement. These services can range from virtually nothing, where all you provide is the land, to practically everything, such as heat and air conditioning, painting and repairs, water and sewage, and possibly other services. From gross rentals you must deduct costs of providing tenants' services, and the difference is your net operating income (NOI), which is one source of return. Another gain is if you happen to sell the property for more than you have invested in it, and a third source is any tax savings you might enjoy because of deductions allowed by the IRS. CASE-IN-POINT: Things to consider when investigating income-producing property include: Future Value - What is the neighborhood's property value? What does the future look like for this neighborhood? Is the local government planning on doing anything to raise its value? Sweat Equity - Is this a fix-up project that you will end up needing to put in a lot of manual labor and capital to improve? Do you have the expertise to renovate the property? Professional Management - Are you stringent with collecting rents and paying of bills? Properties need management to be profitable. If you don't pay your bills, and there is not enough gas to heat the units, the tenants may have legal grounds not to pay rent and the problems can snowball from there.

Index Funds

An index fund attempts to provide results similar to those computed for a specified market index. The fund manager does this by investing the portfolio in the same companies and in similar proportions as the market index the fund is trying to mimic. The portfolio is then passively managed to remain consistent with that market index. For example, the Vanguard Index 500 Trust, a no-load open-end investment company, provides a vehicle for small investors who wish to obtain results matching those of the Standard & Poors 500 stock index, less operating expenses. Similarly, a number of banks have established commingled index funds, and some corporations and organizations have set up index funds for their own employee retirement trust funds. Since index funds do not have much active trading or active management, both operating and management expenses are lower than actively managed funds. Index funds are ideal for those who are willing to accept the return and risk similar to the market. PRACTITIONER ADVICE: Why invest in index funds? It depends on your view of the efficient market hypothesis. The strong form of this hypothesis believes that all information is available to investors about investments. There is no additional advantage to researching to uncover hidden values and to exploit inefficient knowledge. Very few funds actually beat the S&P 500, the benchmark that many large cap funds are measured against. Investors buy Index Funds because they believe there is little value gained investing in large cap funds which on a load-adjusted basis may not exceed the index returns.

Insurance of Munis

An investor concerned about possible default of a municipal bond can purchase an insurance policy to cover any losses that would be incurred if coupons or principal were not paid in full and on time. An investor can contract with a company to have a specific portfolio of bonds insured. Alternatively, the issuer of the bonds can purchase such insurance from one of the firms that specializes in issuing this type of insurance. The cost of this insurance is generally more than offset by the lower interest rate that the issuer has to pay as a result of insuring its bonds. Regardless of whether the investor or the issuer purchases the insurance, the cost of the insurance will depend on the bonds included and their ratings. Municipal Bond Insurers AMBAC (American Municipal Bond Assurance Corporation) FGIC (Financial Guarantee Insurance Company)

Options

An option is a contract between two people wherein one person grants the other person the right to buy a specific asset at a specific price within a specific time period. Alternatively, the contract may grant the other person the right to sell a specific asset at a specific price within a specific time period. Options have zero sum gains which means whatever the buyer gains the writer loses, and vice versa. Option Buyer: The person who purchases the option for a premium price receives the right to exercise the contract. The option will either be the right to buy at the exercise (strike) price or the right to sell. Option Writer: The person who receives a premium for creating the option contract has sold the right, and thus must respond to the buyers decision. If the buyer exercises the right to buy shares, then the writer of that option must deliver the shares. If the buyer exercises the right to sell, then the writer must come up with the money to purchase the shares. It is important to note that the difference between option contracts and another type of derivatives called futures contracts centers around the buyers' obligation to deliver. Option contracts give buyers the right to exercise, not an obligation to deliver. Futures contracts require the buyers to deliver according to the contract terms. The variety of contracts containing an option feature is enormous. Many types can be found within the domain of publicly traded securities.

Put Option Example

Andrew expects the price of Acme Construction Co.'s stock to decrease over the next few months. However, Maria believes that the stock price will remain steady and may even increase. Maria decides to write a put contract that will allow the buyer to sell 100 shares of Acme Construction to her for $30 per share at any time during the next six months. Currently Acme Construction Co. is trading at $35 per share on an organized exchange. Andrew paid $6 per share as premium for the put contract. If the price of the stock decreases to $20/share, then Andrew could buy 100 shares for $2,000, then exercise the option and sell the shares to Maria for $3,000. In this case, Andrew would make $3,000 - $2,000 - $600 = $400. Maria would pay $3,000 for 100 shares that she can sell for $2,000. Netting the premium of $600, Maria's loss would be $400. Andrew can choose to sell the contract for $400 instead.

Inflation Risk

Another source of systematic (nondiversifiable) risk is inflation. Inflation risk reflects the likelihood that rising prices will eat away the purchasing power of your money. This risk is especially present in long-term bonds, wherein the par value paid say twenty years down the road will only provide a fraction of the purchasing power available today for an equivalent amount of money. For example, even at an average rate of 3% inflation over a twenty-year period, $1,000 received 20 years from now would only be worth $553 in today's dollars. Unexpected increases in inflation may cause a financial plan that appears to be solid to fall short in achieving its goals. Fortunately for stock investors, over long periods of time, common stocks have produced a return well above the rate of inflation, thereby preserving the purchasing power of your money. CASE IN POINT: Imagine that you have $10,000 in a one-year CD that pays 5% interest. You hold it for a year in anticipation of paying for your childs tuition. Meanwhile, the college tuition increased 6% in the same year. In this example, inflation outpaced the investment return.

Options Margin

Any buyer of an option would like some assurance that the writer can deliver as required if the option is exercised. Specifically, a buyer of a call option would like some assurance that the option writer is capable of delivering the requisite shares, and the buyer of a put option would like some assurance that the writer is capable of delivering the necessary cash. All option contracts are with the OCC, so it is the concern of the OCC to see that the writer is able to fulfill the terms of the contract. To relieve the OCC of this concern, the exchanges where the options are traded have set margin requirements. Brokerage firms are allowed to impose even stricter requirements if they so desire, because they are ultimately liable to the OCC for the actions of their investors: In the case of a call, shares are to be delivered by the writer in return for the exercise price. In the case of a put, cash is to be delivered in return for shares. In either case the net cost to the option writer will be the absolute difference between the exercise price and the stocks market value at the time of exercise. The OCC is at risk if the writer is unable to bear this cost. The Options Clearing Corporation (OCC) is the first clearing organization in the world to have implemented a risk-based margin methodology for the U.S. listed securities options markets. OCC's Theoretical Intermarket Margining System (TIMS) methodology is a sophisticated system for measuring the monetary risk inherent in portfolios containing options, futures, and options on futures positions. TIMS allows clearing institutions to measure, monitor, and manage the level of risk exposure of their members' portfolios.

Preferred Stocks

Aside from common stocks, a company can also issue preferred stocks. Preferred stock is a form of equity investment that receives only a stipulated dividend. Owners of preferred stocks have a right to a companys earnings before common stock shareholders. Payments on preferred stocks are called dividends and do not qualify as a tax-deductible expense for the issuing corporation. Preferred dividends are stated as a percent and are required to be paid to shareholders before common stock shareholders receive any dividends. There are various provisions protecting the preferred stockholders against potentially harmful actions. Many issues of preferred stock are callable at a stated redemption price. Some firms issue more than one class of preferred stock. In the event of dissolution of the firm, preferred stockholders receive preferential treatment as it relates to assets. Many preferred stocks are traded on major exchanges in a manner similar to common stocks. Trading prices are reported in the financial press in the same format used for common stocks.

Other Pooled and Managed Investments

Aside from mutual funds and unit investment trusts, there are a few more pooled and managed investments to explore. There are private investment clubs that manage the pool of investments from their members. Other pooled and managed investments also include Hedge Funds, Separately Managed Accounts (SMA), Real Estate Investment Trusts (REIT), Real Estate Mortgage Investment Conduits (REMIC) and limited partnerships.

Asset-Backed Securities

Asset-backed securities are much like participation securities. However, instead of mortgages being pooled and pieces of ownership in the pool being sold, debt obligations such as credit card revolving loans, automobile loans, student loans, and equipment loans are pooled to serve as collateral to back the securities. The basic concept is known as securitization. Originators of these loans pool them and sell securities that represent part ownership of the pool. A servicing company collects the payments made by the debtors over a period of time, such as a month, and then pays each owner the appropriate percentage of the aggregate amount received. Similar to investors in participation certificates associated with mortgages, two concerns for investors in asset-backed securities are default risk and prepayment risk.

Reversing Trades

Assume the price per bushel of wheat was $3.95, and the next day B finds that people are paying $4.15 per bushel for July wheat. This change in price represents daily profit to B of $.20 per bushel. If B believes that the price of wheat will not go any higher, then B might sell a July wheat futures contract for $4.15 to someone else. Conversely, S might buy a July wheat futures contract because Ss equity has been reduced to zero. In this situation B has made a reversing trade, because B now has offsetting positions with respect to July wheat. Equivalently, B is said to have unwound, closed out or offset his or her position in July wheat.

Balanced, Flexible Income, and Asset Allocation Funds

Balanced funds are open-end companies that hold both equity (stocks) and fixed-income securities (bonds). These funds seek to minimize investment risks without unduly sacrificing possibilities for long-term growth and current income. Balanced funds typically hold relatively constant mixes of bonds, preferred stock, convertible bonds and common stocks. They can be appropriate for people who are ready for more growth than bond funds, but not entirely comfortable with the risks associated with stock funds. Flexible income funds seek to provide liberal current income. Often, these funds will periodically alter their proportions in an attempt to time the market and gain current income. Asset allocation funds also attempt to time the market but in doing so, focus on total return instead of current income. The most significant new type of an asset allocation fund is the so-called target funds. These funds are targeted to a specific time horizon. "Mutual Fund 2017, 2020, etc.". These funds are of particular interest for retirement and college funding goals.

U.S. Stock Exchanges

Besides electronic markets like the Nasdaq, stocks also trade in organized exchanges with physical locations. The most famous and largest stock exchange is the New York Stock Exchange (NYSE). The NYSE lists about 3,000 common and preferred stocks issued from American companies. It is an auction market for large corporation stocks such as General Electric, IBM and Coca-Cola. Smaller corporations are listed on other local exchanges such as the Boston Stock Exchange, the Philadelphia Stock Exchange, or the Chicago Stock Exchange.

Bond Funds

Bond funds invest in fixed-income securities. Bond funds vary greatly in risk from very conservative, such as funds comprised of short-term U.S. Treasury Notes, to very aggressive, such as funds invested in long-term high yield bonds. The amount of income a bond fund pays can also vary depending on the maturity and quality of the bonds within the portfolio. Some bond funds are listed below: Corporate bond funds U.S. government bond funds GNMA (or Ginnie Mae) funds High-yield bond funds Bond funds can offer a supplement to income for people who want to receive the dividends. Bond funds can also provide moderate capital appreciation for investors who reinvest the dividends. Very aggressive bond funds, such as those that invests in the high-yield debt of emerging countries, can actually carry more potential risk and return than some stock funds.

Yield to Call (YTC)

Bond prices are calculated on the basis of the lowest yield measure. Therefore, for premium bonds selling above a certain level, yield to call replaces yield to maturity, because it produces the lowest measure of yield. Callable bonds have an embedded option that the bond issuer may or may not find profitable to exercise. The uncertainty about whether or not the bond will be called forces the investor to evaluate each of the possible future scenarios: First scenario: If market interest rates rise, then it is safe to assume the bond issuer will not find it profitable to exercise the call option. When the bond is not called, it is customary to assume the bond remains outstanding until its maturity date. In the event of this first outcome, the traditional YTM is the appropriate yield measure. Second scenario: If market interest rates decline, then it would be profitable for the bond's issuer to call the bond before it matures. To evaluate this second scenario, the bond's Yield to Call (YTC) must be calculated. The investor never knows in advance which of the two scenarios will occur. The conservative approach is to compute both of these two different yields and then select the lower yield for investment decision-making purposes, because that return represents the minimum yield that the investor can expect to earn. YTC is calculated the same way as YTM, except the terminal number (T) is the time to call rather than time to maturity.

Federal Agency Bonds

Bonds issued by federal agencies provide funds to support activities such as: housing through either direct loans or the purchase of existing mortgages; export and import activities via loans; credit guarantees; insurance; the postal service; and the activities of the Tennessee Valley Authority. Many issues are backed by the full faith of the U.S. government, but some are not (Tennessee Valley Authority issues are not.) Being backed by the full faith of the government is not the same as being backed by the full faith and power of the government. It is an implied backing, and therefore carries slightly more risk than treasuries.

Internal Rate of Return (IRR)

Calculating the internal rate of return (IRR) associated with the investment is similar to the NPV method and offers an alternate method for making investment decisions. The IRR for a given investment is the discount rate that makes the NPV of the investment equal to zero. To compute the IRR, the NPV is set equal to zero, and the discount rate, which is unknown, is then calculated. The decision rule for IRR involves comparing the investments IRR (denoted by k*) with the required rate of return for an investment of similar risk (denoted by k). Specifically, the investment is viewed favorably if k* greater than k, and unfavorably if k* less than k. As with NPV, the same decision rule applies if either a real asset or a financial asset is being considered for possible investment. Again, since k* will be compounded over t periods, time has a significant influence over the internal rate of return. PRACTITIONER ADVICE: In comparing the NPV and IRR methods, the NPV method is superior in that the underlying assumption in the calculation is the opportunity to reinvest future cash flows at the investors required return. IRR however, makes the unrealistic assumption that the investor has an opportunity to reinvest at the IRR! This difference is significant, and the ramifications are such that given a choice on these methods, the NPV should always be used.

Call (Prepayment) Risk

Call risk is the risk to bondholders that a bond may be called away before maturity. Calling a bond refers to redeeming the bond early. Many bonds are callable. When a bond is called, the bondholder generally receives the face value of the bond plus one year of interest payments. This risk applies only to investments in callable bonds. The reason a company may call their outstanding bond issues is that the current interest rates are lower than what the outstanding issue pays in coupon rates. Therefore, the company would lower its interest payable by calling its bonds and issuing new ones at lower coupon rates. The risk for the investor is that once they receive the bonds par value, they must now invest it in an environment of lower interest rates for the remainder of their investment time horizon. Prepayment risk is similar to call risk in that it refers to mortgage payers paying off their mortgage early. A common practice for this is when interest rates are low and homeowners refinance their homes at lower rates. This causes debt instruments made of mortgages such as GNMAs to accelerate the amount of principal returned to the investor. Again, the investor receives his or her original investment earlier than anticipated and at a time when the interest rates are lower. Call risk and prepayment risk overlap with reinvestment risk. Instead of the investor selling early or purchasing instruments that mature before their investment time horizon, this is a case of the investor being forced out of their position prematurely during their holding period.

Par, Premium, and Discount

Cash flows characterizing a typical bond involve the payment of a lump sum on a stated date. This payment is known as the bonds principal or par value. Most corporate bonds will have a par value of $1,000. If the market price of a bond is greater than its par value, the bond is said to be selling at a premium. Conversely, if the market price of a bond is less than its par value, the bond is said to be selling at a discount. THE FOLLOWING TABLE ILLUSTRATES THE RELATIONSHIP BETWEEN A BONDS PRICE RELATIVE TO ITS PAR VALUE, AS WELL AS THE RELATIONSHIP BETWEEN A BONDS YTM AND ITS COUPON RATE AT DIFFERENT BOND VALUES: Bond Value Price YTM Par Value Market price = Par value Yield-to-maturity = Coupon rate Discount Value = Market price < Par value = Yield-to-maturity > Coupon rate Premium Value = Market price > Par value = Yield-to-maturity < Coupon rate

Money Market Instruments

Certain types of short-term, highly marketable loans play a major role in the investment and borrowing activities of both financial and non-financial corporations. Money market instruments are short-term loans that typically mature in less than twelve months. Because of their short maturity, high liquidity, and high-quality issuers, they are considered to be very conservative or low-risk securities. Individual investors with substantial funds may invest in such money market instruments directly, but most do so indirectly via money market accounts at financial institutions. Some money market instruments are negotiable and are traded in active secondary dealer markets; others are not. Some may be purchased by anyone with adequate funds, others only by particular types of institutions. Many are sold on a discount basis. To ensure that you have a solid understanding of money market instruments, the following topics will be covered in this lesson: Money Market Mutual Funds Certificate of Deposit (CD) Commercial Paper Bankers' Acceptance (BA) Euro Dollar Repurchase Agreement (Repo) Money Rates Listing

Co-Movement (Co-Variance)

Co-variance measures the tendency for two random variables to move together (to co-vary). Instead of referring to the probability distribution for a single random variable, co-variance considers the joint probability distribution of two random variables. That is, in a given state, the two random variables assume particular values. The joint probability distribution describes those pairs of values for each possible state and the probabilities of those outcomes occurring. Co-variance can be used to look at the relationship of two or more assets and how closely they move together. You can use it to solve for the correlation coefficient. The correlation coefficient (p) is an index number where p is less than or equal to one, and greater or equal to negative one. Positive values mean that the two assets' prices tend to move in the same direction; the closer to one, the more the assets behave similarly. Negative values would indicate the assets behave inversely.

Collateralized Mortgage Obligation (CMO)

Collateralized mortgage obligations (CMOs) are a means to allocate a mortgage pools principal and interest payments among investors in accordance with their preferences for prepayment risk. A CMO originator (or sponsor) transforms a traditional mortgage pool into a set of securities, called CMO tranches. Each tranche represents a different investment. They differ in the amount of principal that is distributed. The tranches will retire at different times. The tranch that receives more principal in the beginning will retire before the others. The primary purpose of dividing a mortgage pass-through pools principal and income flows into various tranches is to create a set of securities with varying levels of interest rate and prepayment risks. Investors can match their risk preferences and predictions with the appropriate securities. Sponsors of CMOs may be government agencies, such as GNMA or FNMA, or they may be private entities, such as brokerage firms.

Commercial Paper

Commercial paper is an unsecured (not backed by any assets) short-term promissory note. Both financial and non-financial companies issue instruments of this type. The dollar amount of commercial paper outstanding exceeds the amount of any other type of money market instrument except for Treasury bills, with the majority being issued by financial companies. Such notes are often issued by large firms that have unused lines of credit at banks, making it highly likely that the loan will be paid off when it comes due. The interest rates on commercial paper reflect this small risk by being relatively low in comparison with the interest rates on other corporate fixed-income securities. Commercial Paper Features: Denominations of $100,000 or more Maturities of up to 270 days Large institutional investors Terms are non-negotiable Issuer may prepay the note

CDSC

Commission collected when selling fund before certain holding period, proceeds go to distributor

Options Quotes

Common stock options are currently traded on the Chicago Board Options Exchange (CBOE), the American, and Philadelphia stock exchanges. The figure shows a portion of the daily listing of the trading activity on the CBOE: The first column lists the name of the company and, indented below it, the closing price on its common stock. The next column lists the exercise price for the option contracts on the company, followed by a column giving the expiration date. The next two columns give the trading volume and last trade premium for call options having the exercise price and expiration date shown on the left. The last two columns give the trading volume and last trade premium for the matching put option. For example, AT&T common stock closed at $45.50 on October 7, 1997. By the end of that day, 234 AT&T call option contracts having an exercise price of $40 per share that expire on the third Friday of January of 1998 had been traded. The closing trade that day took place at $6.50 per share or $650 per contract. Similarly, 74 AT&T put option contracts with the same exercise price ($40) and expiration date (January 1998) had been traded. The closing trade was at $ 11/16 per share or $68.75 per contract (per 100 shares).

Convertible Bonds

Convertible bonds, a popular financial instrument, are securities that can be converted into a different security of the same firm under certain conditions. The typical case involves a bond convertible into shares of the firms common stock, with a stated number of shares received for each bond. Usually no cash is involved; the old security is simply traded in, and the appropriate number of new securities is issued in return. Convertible preferred stocks are issued from time to time, but tax effects make them, like other preferred stock, attractive primarily to corporate investors. For other investors, issues of convertible bonds are more attractive. For example, if a convertible bond has a conversion ratio of 20 shares of stock per bond, then the conversion price would be equal to: $1000 / 20 shares = $50/share. So it would only be beneficial for the bondholder to convert if the stock price rises above $50. TEST TIP Scenario-based questions may appear asking when it would be beneficial for a bondholder to convert bonds into stock.

Duration

Duration is a measure of the "average maturity" of the stream of payments associated with a bond. More specifically, it is a weighted average of the lengths of time until the remaining payments are made. This "weighted average" is based on discounting future cash flows by the market rate of interest (also known as the yield-to-maturity). A more pragmatic way of thinking about duration is that it represents the point in time in which the investor is least likely to lose money. TEST TIP 1 The most important point to know for the exam is that you match the duration of a bond to the client's time horizon, and not the maturity. PRACTITIONER ADVICE If you are using bonds to target a specific client goal, you will not be able to use a bond mutual fund. Practically all bond mutual funds are managed to obtain a rather constant duration. For example, you may have a client with a cash need in seven years. If you buy a bond fund with a duration as 7, you may be initially immunizing the portfolio to interest rate changes. However, five years down the road (when your client's goal is in 2 years) you will need the bond fund to have duration of 2 at that point. Most likely, your bond fund will still have duration of 7, and you will have exposed your client to un-necessary risk. My advice is to create your own bond fund with individual bonds, and self-manage the duration. Calculating duration of the portfolio is as simple as a weighted average of individual durations based on market values. If you were to place a driver (golf club) sideways on your finger, the spot where the club balances would be similar to the point of duration. The balance point is where the future value of coupon payments (the clubs handle and shaft) equals the present value of par (head of the club) and coupon payments for the remainder of time until maturity. The lower the coupon rate, the closer duration is to maturity. Duration is always less than maturity, except in a bond that does not pay coupons (zero coupon bond). TEST TIP 2 When it comes to calculating duration, focus your attention on the formula that follows. While the prior example nicely demonstrated the relationship between the time to the maturity, the market rate of interest (YTM) and the coupon rate all have on the duration of a bond, it is not a practical procedure for longer-term bonds with semi-annual compounding. The formula that follows (which is on CFP Board's formula sheet) easily accommodates short-term or long-term bonds, as well as annual or semi-annual coupon payments.

Relationship Between Duration and Convexity

Convexity and duration both measure the association of change in a bonds price with a change in the bonds yield-to-maturity. Hence, it is important to consider the relationship between the concepts of convexity and duration. The graph represents a bond that is currently selling for P and has a yield-to-maturity of y. Note the straight line that is tangent to the curve at the point associated with the current price and yield. If the bonds yield increases to y+, then the associated price of the bond will fall to P-. Conversely, if the bonds yield decreases to y-, then the associated price of the bond will rise to P+. However, if the yield decreases to y-, the estimated price will be PD+, and if the yield increases to y+, the estimated price will be PD-. The relationship between the bonds price, yield, and duration is not exact. Instead, an approximation assumes that the percentage change in the bonds price is a linear function of its duration. Hence, in the graph the new price is approximated in a linear fashion represented by the straight line, leading to an error that is a consequence of convexity. That is, because the relationship between yield changes and bond price changes is convex and non-linear, the new price associated with an estimate from duration is underestimated with either an increase or a decrease in the bond's yield. However, for small changes in yields, the error is relatively small. The graph shows that the size of the pricing error becomes smaller as the size of the yield change gets smaller. (Note that the distance between the linear approximating line and the convex curve will be smaller for smaller changes in yields from y.)

Gems

Diamonds and other gems seem to be everybodys best friends. The wholesale price of a one-carat, highest-quality diamond (called D flawless) went from $1,800 in 1970 to $53,000 in 1980 and by 1982, its price was down to $14,000. Being a gem investor requires specific skills. There are resources available to enhance your knowledge about gem investing, such as Precious Gem Investor magazine and Gemstone Investing, a free brochure published by the Federal Trade Commission.

Interest Rate Risk

Interest rate risk is defined as the risk of fluctuations in security prices due to changes in the market interest rate. Regardless of their source, interest rate changes can mean bad news for bond investors. Changes in interest rates affect the price of bonds inversely. If interest rates increase, new bonds will have better coupon rates than existing bonds. Therefore, the market price of the existing bond will decrease. The good news is that if interest rates decrease, because existing bonds will have higher coupon rates than new bonds, their market value will be worth more. As interest rates rise, investors will demand a higher return for all investments, including stocks. What you can earn from one investment will determine what you demand from another. Unfortunately, because increases in interest rates affect all securities in the same way, its impossible to eliminate interest rate risk. Therefore, interest rate risk is a type of systematic (nondiversifiable) risk.

Investopedia Definition of Duration

Duration is a measure of the sensitivity of the price -- the value of principal -- of a fixed-income investment to a change in interest rates. Duration is expressed as a number of years. Bond prices are said to have an inverse relationship with interest rates. Therefore, rising interest rates indicate bond prices are likely to fall, while declining interest rates indicate bond prices are likely to rise. BREAKING DOWN 'Duration' The duration indicator is a complex calculation involving present value, yield, coupon, final maturity and call features. Fortunately for investors, this indicator is a standard data point provided in the presentation of comprehensive bond and bond mutual fund information. The bigger the duration, the greater the interest-rate risk or reward for bond prices. It is a common misconception among non-professional investors that bonds and bond funds are risk free. They are not. Investors need to be aware of two main risks that can affect a bond's investment value: credit risk (default) and interest rate risk (rate fluctuations). The duration indicator addresses the latter issue. Effects of Duration Duration is measured in years. Therefore, if a fixed income security has a high duration, it indicates that investors would need to wait a long period to receive the coupon payments and principal invested. Moreover, the higher the duration, the more the fixed income security's price would fall if there is a rise in interest rates. The opposite is true. Normally, if interest rates change by 1%, a fixed income security's price is likely to experience an inverse change by approximately 1% for each year of duration. Duration Example For example, assume an investor wishes to select bonds which suit her portfolio's criteria. She believes interest rates to rise over the next three years and may consider selling the bonds prior to the maturity date. Therefore, she would need to consider the duration when investing and may wish to invest in bonds with shorter-duration. Assume an investor wishes to purchase a 15-year bond that yields 6% for $1,000 or a 10-year bond that yields 3% for $1,000. If the 15-year bond is held to maturity, the investor would receive $60 each year and would receive the $1,000 principal after 15 years. Conversely, if the 10-year bond is held until maturity, the investor would receive $30 per year and would receive the $1,000 principal invested. Therefore, the investor would want to consider 10-year bond because the bond would only lose 7%, or (-10% + 3%), if interest rates rise by 1%. On the other hand, the 15-year bond would lose 9%, or (-15% + 6%), if rates rose by 1%. However, if interest rates fell by 1%, the 15-year bond would receive rise more than the 10-year bond.

Clearinghouse

Each futures exchange has an associated clearinghouse that becomes the sellers buyer and the buyers seller as soon as a trade is concluded. The procedure is similar to that used for options. This is not surprising, because the first market in listed options was organized by people associated with a futures exchange. To understand how a clearinghouse operates, consider the futures market for wheat. Assume that on the first day of trading in July wheat: Buyer B agrees to purchase 5,000 bushels from seller S for $4 per bushel, or $20,000 in total. B might believe that the price of wheat is going to rise whereas S might believe that it is going to fall. After B and S reach their agreement, the clearinghouse will immediately step in and break the transaction apart; that is, B and S will no longer deal directly with each other. It is the clearinghouses obligation to deliver the wheat to B and to accept delivery from S. At this point, there is an open interest of one contract (5,000 bushels) in July wheat, because only one contract exists at this time.

Bankers' Acceptance (BA)

Earlier bankers acceptances were created to finance goods in transit but now they are used to finance foreign trade. For example, the buyer of the goods may issue a written promise to the seller to pay a given sum within 180 days or less. A bank then accepts this promise, obligating itself to pay the amount when requested, and obtains in return a claim on the goods as collateral. The written promise becomes a liability of both the bank and the buyer of the goods and is known as a bankers acceptance.

One Period Model

Equation for the One-Period Rate of Return: The following shows how the equation for determining the one-period rate of return is derived by rearranging the equation so that it is equal to the time value model: One-period rate of return, r = (Terminal value Present value)/Present value One-period rate of return, r = (Terminal value/Present value)- 1 (1 + r) = Terminal value/Present value (Present value)(1 + r) = Terminal value Equation for Present Value: The one-period rate of return and the time value models are related to the present value model. The equation shown above is rearranged below to show how to determine the present value of an investment. (Present value)(1 + r) = Terminal value Present value = (Terminal value)/(1 + r)

Equipment Obligations

Equipment trust certificates and equipment obligations are backed by specific pieces of equipment, for example, railroad cars and commercial aircraft. If necessary, the equipment can be readily sold and delivered to a new owner. The legal arrangements used to facilitate the issuance of such bonds can be very complex. The most popular procedure uses the "Philadelphia Plan," in which the trustee initially holds the equipment and issues obligations and then leases the equipment to a corporation. Money received from the lessee is subsequently used to make interest and principal payments to the holders of the obligations. Ultimately, if all payments are made on schedule, the leasing corporation takes title to the equipment.

PV for Stock with Constant Dividend Growth Rate and No Dividend Growth Rate

Example for Stock with Constant Growth Rate Jana is wondering whether or not she should pay the market price of $51.50 for a stock issued by a large NYSE-listed corporation that is currently paying an annual cash dividend of $3 per share. Jana believes this dividend will grow at a rate of g = 3% per year for as long as she can see. Assume we use k = 13.0% as the risk-adjusted discount rate to use in valuing the stock. PV = DIV (1 + g) / (k - g) = $3(1.03)/(.13 - .03) = $30.90 Based on these calculations Jana decides not to buy the stock because it is overpriced by $51.50 - $30.90 = $20.60 per share. Example for Stock with No Growth Rate (also works for Preferred Stock) Alex is considering paying the market price of $50 for a share of preferred stock that will pay an annual cash dividend rate equal to 4.5% of its $100 face value per share forever. This $4.50 annual cash dividend is fixed, g = 0. Alex plans to hold the preferred stock indefinitely. Some financial research leads Alex to conclude that k = 13.0% is an appropriate risk-adjusted discount rate to use in valuing this preferred stock. = $4.50/.13 = $34.615 The stock's perpetual stream of constant cash dividends is worth $34.615 per share. Alex maximizes his wealth by deciding not to buy the stock, because it is overpriced by $50 - $34.62 = $15.38 per share. CASE-IN-POINT: The following are sources of growth rates: historical average, industry average, and sustainable growth rate*. * Sustainable growth rate = (1 - Payout ratio)ROE

Options Trading

Exchanges begin trading a new set of options on a given stock every three months. The newly created options have roughly nine months before they expire. For example, options on Widget might be introduced in January, April, July and October, with expiration dates respectively in September, December, March and June. The exchange might decide to: Introduce long-term options on Widget, dubbed LEAPS by the exchanges, for long-term equity anticipation securities that expire into the future as far as two years. Allow the creation of customized options on Widget, dubbed FLEX options for flexible exchange options that have exercise prices and expiration dates of the investors choosing. Generally, two call options on a stock are introduced at the same time. Both are identical in all respects except for the exercise price. New options may also be introduced. These may have the same terms as the existing ones but the exercise prices may differ. Once listed, an option remains listed until its expiration date, specifically, listed options on common stocks generally expire on the third Friday of the specified month.

Federally Sponsored Agency Bonds

Federally sponsored agencies are privately owned agencies that issue securities and use the proceeds to support the granting of certain types of loans to farmers, students, homeowners, and others. A common procedure involves the creation of a series of governmental banks to buy securities issued by private organizations that grant the loans in the first instance. The government may provide some or all of the initial capital for these banks, but subsequent amounts typically come from bonds issued by the banks. Although the debts of agencies of this type are usually not guaranteed by the federal government, governmental control is designed to ensure that each debt issue is backed by extremely safe assets. It is generally assumed that if there were any danger of the agencies defaulting on a loan, the federal government would provide assistance.

Financial Risk

Financial risk is associated with the use of debt by firms. As a firm takes on more debt, it also takes on interest and principal payments that must be made regardless of the firms performance. If the firm cant make the payments, it could go bankrupt. Thus, how a firm raises money affects its level of risk. Financial risks are specific to the company and therefore are unsystematic (diversifiable). Consider what happens when someone applies for a mortgage. The lender would conduct an analysis of the applicants ability to make payments.

The Five Major Segments of Hedge Funds

Five major segments are used to define hedge funds. The following list differentiates the main features of these five segments. They are: 1. Fundamental Long/Short Funds Investment Strategy: Seek out mispriced securities based on the business prospects of firms, utilizing both long and short positions. Use of Leverage: Maintain leverage positions from slightly short to 100% long. Risk Control: Often accomplished through market-neutral strategies. The goal is to eliminate systematic risk. 2. Quantitative Long/Short Funds Investment Strategy: Seek out mispriced securities using statistical analysis, which is applied to historical data. Use of Leverage: A high degree of leverage is used to capitalize on small but statistically significant return opportunities. Risk Control: Using derivatives and net neutral positions, managers eliminate all risk except the risk that is viewed as profitable. 3. Arbitrage/Relative Value Funds Investment Strategy: Seek out basic mispriced securities. Use of Leverage: A high degree of leverage is used to capitalize on otherwise small pricing differences. Risk Control: Necessary to eliminate broad market risk in order to capitalize on relative mispricing. 4. Macro Funds Investment Strategy: Seek out mispriced securities in global stock, currency, and bond markets. Use of Leverage: Is kept to a minimum due to the lack of adequate risk control. Risk Control: Difficult to achieve because of the low correlation between currencies and indices within a market. 5. Funds of Funds Investment Strategy: Seek out diversification by investing in a variety of hedge funds. Use of Leverage: Although the underlying hedge fund investments use leverage, the use of leverage at the Funds of Funds level is not used. Risk Control: Is achieved through diversification of the underlying hedge funds.

Fixed Income Summary

Fixed-income securities are investments that range from very conservative to very aggressive. Investors can use them for a number of reasons. Institutional investors use money market securities to facilitate business transactions while individual investors use them in money market mutual funds. Investors primarily invest in bonds for income. Some invest in speculative bonds for potential capital appreciation. Fixed-income securities vary depending on maturity and the issuer's default risk. It is important to consider each investor's tolerance for risk and the need for income. The key concepts to remember are: Fixed-Income Attributes: Fixed-income securities are loans that have a finite maturity, principal amount, and stated interest (coupon) payments. They vary in default risk and maturity. Money Market Instruments are short-term debt securities that mature in less than one year. They are considered very conservative because of their short maturity. U.S. Government Securities: The U.S. Treasury and Federal Agencies issue these securities. U.S. Treasuries are considered the safest debt securities because they are backed by the full faith and power of the U.S. Government. Federal Agencies and federally sponsored agencies also offer fixed-income securities such as Mortgage Backed Securities (MBS). Municipal Bonds are issued by states and local governments. They are classified into general obligation bonds and revenue bonds. Municipal bonds are income tax-exempt on the federal level and on the state and local level if the investor purchases municipals from where they live. Investors in higher tax brackets benefit from investing in municipal fixed-income securities. Corporate Bonds are issued by companies both in the United States and Foreign Countries to finance their operations. Depending on the issuer, they may be backed by assets or by the full faith and power of the company. Corporate bonds may vary in risk from investment grade bonds issued by well-established companies to speculative bonds issued by small companies. Coupon rates increase as a bond issue's inherent exposure to risk increases. Foreign Bonds enhance the level of diversification within a fixed income portfolio. However, there are special risks to be aware of in any type of foreign investing including exchange rate risk, political risk, and tax risk. PRACTITIONER ADVICE Bonds fall in and out of favor, but they do play an important role for investment planning decisions in a balanced portfolio. When rebalancing asset allocation near retirement age, your bond holdings should increase. Bond funds can lower risk through diversification. Having bonds in the portfolio also adds diversification to an otherwise equity-only portfolio. Be careful of falling into the trap of buying bonds when they've been doing well and then selling them when they are not. The time to consider buying bonds is typically when the stock market is peaking and bonds have been doing poorly.

Futures

Futures are also known as futures contracts, which are based on the future delivery of commodities, like frozen orange concentrate, or financial instruments, like U.S. Treasury Bonds. The steps in creating a futures contract are as follows: One party agrees to accept delivery of a standardized quantity of an item at a future date. The second party agrees to make such delivery. Both parties agree on the price at which the exchange will take place. The person taking delivery is called the buyer: If the market price of the item goes above this contract price, the buyer will make a profit. If the price goes below this contract price, the buyer suffers a loss. Whereas options are rights to exercise, it is important to note that the futures contract is a legal obligation to perform (deliver or take delivery). If you buy a futures contract, then your losses are virtually unlimited, that is, they continue to mount as long as the commoditys price falls. The situation works in reverse if you are the seller of a futures contract; you lose when prices go above the contract price and gain when they go below it.

Futures Contracts

Futures contracts are standardized in terms of delivery as well as the type of asset that is permissible for delivery. For example, the Chicago Board of Trade specifies the following requirements for its July wheat contracts: The seller agrees to deliver 5,000 bushels of either no. 2 soft red wheat, no. 2 hard red winter wheat, no. 2 dark northern spring wheat, or no. 1 northern spring wheat at the agreed-upon price. Alternatively, a number of other grades can be delivered at specified premiums or discounts from the agreed-upon price. In any case, the seller is allowed to decide which grade shall be delivered. The grain will be delivered by registered warehouse receipts issued by approved warehouses in Chicago or Toledo, Ohio. Toledo deliveries are discounted $0.02 per bushel. The delivery will take place during the month of July, with the seller allowed to decide the actual date. Upon delivery of the warehouse receipt from the seller to the buyer, the latter will pay the former the agreed-upon price in cash. The exchange will authorize trading in the contract. After an organized exchange has set the terms of a futures contract, except for its price, buyers and sellers meet at a specific place on the floor of the exchange and try to agree on a trading price. If they succeed, one or more contracts will be created with all the standard terms, and prices are stated on a per unit basis. Thus, if a buyer and a seller agree to a price of $4 per bushel for a contract of 5,000 bushels of wheat, the amount of money involved is $20,000.

Interest Rate Futures

Futures involving fixed-income securities are often referred to as interest-rate futures because their prices are greatly influenced by the current and forecasted interest rates. More specifically, their pricing can be related to the term structure of interest rates, which in turn is related to the concept of forward rates. Just how the pricing of interest-rate futures is related to the concept of forward rates can be illustrated with an example. Consider the futures market for Treasury bonds, which is the most popular long-term interest rate futures contract in the United States. As indicated in the figure, on October 8, 1997, any purchaser of a futures contract calling for delivery in December 1997 of a $100,000 face value Treasury bond would have paid a settlement price of 115-29, meaning 115-29/32 of par, or $115,906.25. However, the actual amount that the purchaser would pay equals the settlement price times a conversion factor, plus accrued interest. The conversion factor varies depending on which Treasury bond is delivered to satisfy the contract, because the contract calls for delivery of a Treasury bond that either: Is not callable and, thus, has a maturity of at least 15 years from December 1 or Is callable and, thus, has a first call date of at least 15 years after December 1. Specifically, the conversion factor is the proportion of par the delivered Treasury bond would be selling for on the first day of the delivery month if it had a yield-to-maturity of 8% (the market yield on the underlying bond for which the futures contract is written). Thus, deliverable bonds with coupons of less than 8% will have conversion factors of less than 1 (because they would be selling at discount), and those with coupons of greater than 8%will have conversion factors of greater than 1 (because they would be selling at a premium).

Gold

Gold mania swept the world throughout the late 1970s and early 1980s and then again in the financial crisis of 2008. Almost overnight, every shopping center had a gold store where you could sell coins, jewelry, and anything else that had a trace of gold or silver. Gold can be an extremely risky investment, and this must be understood and appreciated before you invest. It also carries storage cost with no incoming cash flow. Gold can also be invested in through the use of specialty mutual and exchange traded funds. You can invest in gold in a number of ways. You can own gold indirectly by buying the common stock of companies that mine gold. Changes in the market prices of the stocks of these companies are closely correlated to changes in the price of gold. Buying gold indirectly by investing in such companies is called a play on gold. It has an advantage over owning gold directly in that many of these stocks pay annual dividends, thereby providing a current return. Gold Bullion comes in ingots weighing 32.15 ounces. If the price of gold is say, $400 an ounce, each ingot would be worth $12,860. This puts it out of reach for most investors. Concerns include storing it and having it certified if you sell it. Gold Coins: The most popular gold coins are the one-ounce South African Kruggerand and one-ounce Canadian Maple Leaf. Their weight and purity are standardized, making them easily transferable. Gold coins have two big disadvantages. They provide no current income and they sell at a premium over their intrinsic gold value. Gold Certificates: Buying gold certificates may be the way to own gold if you don't want current income and don't care to handle or look at the metal itself. Many commercial banks sell gold certificates. The certificate is your ownership claim. The actual gold is owned or controlled by the selling institution. There are storage costs. Commissions or markups are lower with certificates than with bullion or coins, particularly on large orders. PRACTITIONER ADVICE Mutual funds invested in gold and gold mining companies are often used by investors who are hedging against inflation and in times of international crisis.

Guaranteed Investment Contracts

Guaranteed Investment Contracts (GICs) are large denomination debt instruments offered by insurance companies. It is a contract between an insurance company and a corporate profit-sharing or pension plan that guarantees a specified rate of return on the invested capital over the life of the contract. The life of the contract runs typically one to five years. GICs are considered highly conservative and virtually risk free, since you are "guaranteed" to get the principal back. The guarantee is as good as the insurance company behind it. Although some large insurance companies are safe, there have been instances where insurance companies were unable to fulfill their obligations. Many 401(k) plans offer a GIC fund, often called a stable value fund or an insurance contract fund. These funds are made of GICs from many different insurers. They provide a conservative investment option for those who seek shorter-term objectives in their retirement plan such as a temporary holding place, or if a worker is approaching or receiving a mandatory distribution.

Real Estate (Investor Managed)

Have you ever personally owned or know someone who owns a vacation home on a lake or a beach somewhere? They rent it out most of the year and vacation there once or twice a year. The income generated from it pays for the mortgage. Someday, the property will become a retirement home. Sounds like an ideal dream? Well, there is quite a bit of work that goes into owning property. Real estate appeals to people who like to be active in managing their investments. As the landlord, you have control over the property. When you buy shares of Ford, you do not get to design their next concept car, but when you buy an apartment complex, you are the boss. Another major appeal is that most of your investment is financed with borrowed funds through a property mortgage. Therefore, the bank puts up the money, tenants pay you rent and you pay the mortgage. The difference is yours to keep. The leverage of a bank mortgage and the tax laws enhances the profit potential. As the value of the property increases, your equity increases and leverage decreases. Plus you can get tax deductions on the interest paid on the mortgage. In addition to interest, expenses for repairs and depreciation can also be deducted from taxes as well.

Foreign Currency Futures

Have you ever traveled and had to exchange your native currency for a foreign currency? The value of your domestic currency versus that of a foreign countrys will change from day to day. There is an active spot market for foreign currency, and the rate at which one currency can be exchanged for another varies over time. Currency futures contracts involve a buyer and a seller who agree to exchange a specific amount of one currency for a specific amount of another currency at some future date. For example, if you bought a contract where you agreed to exchange at a rate of US$1 to 100 yen, and the exchange rate changed so that on the delivery date it takes US$1.50 to purchase 100 yen, you would gain from the stronger yen and weaker dollar. Markets for foreign currency futures attract both hedgers and speculators. Hedgers wish to reduce or possibly eliminate the risk associated with planned future transfers of funds from one country to another. Speculators use exchange futures to make bets based on the direction they believe exchange rates are heading.

Hobbies and Collectibles

Have you inherited a U.S. stamp or U.S. coin collection? And, if so, have you priced it recently? If not, you may be in for a pleasant surprise. Hobbies and collectibles can be the riskiest of all your investments, particularly if your knowledge of the items is inadequate. Collections often include one-of-a-kind items, and establishing their value may be impossible. And even if you are successful and buy an item that appreciates, say, 50 percent in value in one year, you may find that your transaction costs and commissions will be 30 percent or more. Knowledgeable collectors insist you should always buy the very best items you can afford, even if these are small pieces such as a set of china or a fine museum print. As little as $500 can get you started if you follow this approach, but even at this level it is important to know what you are doing. Fads can be hard to pick. Today, there may be a collectible such as beanie babies that is a hot item for toy collectors. However, whether or not it is a genuine collectible, only time will tell. Finally, the federal income tax law does not allow losses from hobby activities, but you must pay taxes on any profits. This is a major disadvantage to having collectibles as an investment. REAL LIFE EXAMPLE: A planner showed up to a clients house for an appointment. When the planner asked the client for a list of his savings and assets, the client brought the planner into a room full of Santa Clause figurines. He proudly announced that this was his lifes savings. Could the client retire on his collection? Maybe, it all depends if there was a market for the figurines. Sometimes, collectibles have a greater perceived value for the owner than they do in the market.

Money Rates Listing

Interest rates on money market instruments are often reported on what is known as a bank discount basis. As an example, a note would be described in the media as having a discount of 2% per quarter, or 8% per year. However, the discount does not represent the true interest rate on the note. The discount rate is expressed as a percent of the face value, when in fact the investor is actually purchasing the discounted amount. Therefore, the true interest rate realized would always be higher than what is reported on a bank discount basis. In this case it equals $2,000/$98,000 = 2.04% per quarter, or the equivalent of 8.16% per year (with quarterly compounding, it would equal 8.41% = 1.02044 - 1).

Private Placements and Venture Capital

If only I had been one of the original investors of Microsoft or Apple or Compaq, moans one who has a knack for pointing out the obvious. How do these companies get their start? Two ways companies get started are through private placements and venture capital. Many companies and wealthy people wanted to find their future star in Internet companies in the late 90s. These investors found out how hard it is to find a diamond in the rough after millions of dollars were lost to start-up companies that ultimately disappeared along with their investments. Private placements are securities that are sold to a small amount of investors (typically institutional investors, such as a bank or corporations). These securities do not need to be registered but issuers must be assured that the investor is either sophisticated or accredited and do not intend to sell the security prior to the date specified in the investment letter. Venture capital is an important source of equity for start-up companies. It represents money provided by professionals who invest alongside management in start-up companies. Professionally managed venture capital firms generally are private partnerships or closely-held corporations funded by private and public pension funds, endowment funds, foundations, corporations, wealthy individuals, foreign investors and the venture capitalists themselves. When investing in private placements or venture capital for start-up companies it is important to carefully study the merits and business plans for the company or the proposed company. Diversification may be achieved through investing in several start-up companies. There are professional companies who specialize in bringing together investors and start-up companies through venture capital and private placements.

The internal rate of return is sometimes referred to as:

Implied return Explanation: The present value of expected dividends can be calculated for a given required rate of return. However, many investment firms use a computerized trial and error procedure to determine the discount rate that equates the present value of the stock's expected dividends with its current price. Sometimes this long-run internal rate of return is referred to as the security's implied return.

Dow Jones Industrial Average

In 1884, one of the founders of Dow Jones & Company, Charles Dow, started publishing the daily average of eleven stocks in The Wall Street Journal; it was called the Dow Jones Industrial Average (DJIA). Today, the DJIA, one of the most widely followed indices, is a price-weighted index. It involves the prices of 30 stocks of large companies. General Electric is the only one of the original 11 stocks on the index that remains today. Other large stocks in the DJIA include Coca-Cola, Exxon and Boeing. Since the DJIA is only made up of blue chip stocks, it is a better representation of large company stocks. However, tradition leads many to use it as an indicator of the U.S. stock market as a whole. The Dow Jones Industrial Averages is reported in almost every daily newspaper. Historical data on the averages, including quarterly dividends and earnings figures, are published periodically.

Inflation-Adjusted Securities (TIPS)

In January of 1997, the United States Treasury issued its first inflation-adjusted securities called Treasury Inflation-Protected Securities (TIPS). They are similar to U.S. Treasury Bonds in every way, except their principal amount increases by the change in the Consumer Price Index (CPI) and their coupon payments are then calculated based on the inflated principal. This difference gives investors protection against inflation eroding the purchase power of future payments of interest and principal. Example: Let us compare the yield available on 10-year Treasury Bond to a TIPS equivalent. If the CPI is 3%, a 10-year Treasury Bond yielding 6.5% would have an approximate real yield (nominal yield minus inflation, or 6.5%-3.0%) of 3.5%. This means a 10-year TIPS should be paying 3.5%. The logistics of TIPS: An investor buys $100,000 of TIPS bearing a 3.5% coupon. For the next 6 months, the inflation rate averages 3% per year. What will be the coupon payment made to the investor? The coupon rate (3.5% in this case) is fixed. The principal is adjusted every six months to reflect the inflation rate. In this case the principal would be increased to $101,500 ( $100,000 X .03 / 2), and therefore the payment of the first coupon would be $1,776.25 ($101,500 X .035 / 2). It is important to note that the principal amount can be increased or decreased every payment period. However, the treasury guarantees that the principal will not ever decline below par value ($100,000 in this case).

Annuities

In the early years of the family life cycle, when you have responsibilities, it is important that you provide an estate for the protection of your survivors. In later years, it is important that you protect yourself against the possibility that your estate may run out before your death. Annuities help provide such assurances. The trade off is that you give up your assets now and receive your assets back systematically later on. The goal of financial planning is to accumulate wealth for your estate. Insurance products are meant to help make up for what you could not accumulate. The drawback to annuities is that investors are taxed on their distributions at their tax bracket. Had the investor invested in the stock market and held the stocks for over a year, when they sell the shares, they would be taxed at the lower long-term gain tax instead. Annuity contracts sold by life insurance companies are a convenient means of saving for retirement and of providing security in retirement. There are two periods associated with annuities: Accumulation Period: Your principal builds through investments and returns on investments, while benefits are deferred. The annuity contract may allow the buyer to make a single investment, which is a single premium annuity, or a series of investments during the accumulation period. Liquidation Period: You can typically receive the accumulated cash value in a lump-sum payment or in the form of an annuity. In the liquidation period the owner can receive the annuity benefit in monthly or annual installments. When you elect the type of payments to be received, you are said to annuitize the contract. There are two basic types of annuities: Fixed Variable

Commodities Futures

In the movie Trading Places starring Eddie Murphy and Dan Akroyd, the subplot revolved around insider information regarding frozen orange concentrate futures contracts. Original futures contracts, such as these, are written with commodities as the underlying assets. The value of a contract is derived from the price movement of the various commodities associated with the contract. Buyers and sellers agree on a delivery date and price of the commodity. Commodity exchanges are registered with and regulated by the Commodity Futures Trading Commission, whose role in the commodity futures market is similar to that of the SECs role in the securities market. Futures contracts can be based in a variety of industries and markets. There are commodities futures contracts based on meats such as live hogs, pork bellies (bacon), or cattle. Agricultural futures contracts are based on corn, wheat, oats, soybean meals, rice, cotton and frozen concentrated orange juice. Metal futures contracts exist for copper, gold, silver and platinum. Fuel-based futures include crude oil, natural gas, heating oil and electricity.

Euro Dollar

In the world of international finance, large short-term CDs denominated in U.S. dollars and issued by banks outside the United States are known as Eurodollar CDs or Euro CDs. Also available for investment are U.S. dollar-denominated time deposits in banks outside the United States, known as Eurodollar deposits. A key distinction between Euro CDs and Eurodollar deposits is that Euro CDs are negotiable, meaning that they can be traded, whereas Eurodollar deposits are non-negotiable, meaning that they cannot be traded. The demand and supply conditions for such instruments may differ from other U.S. money market instruments, due to the restrictions imposed by the United States and other governments. However, enough commonality exists to keep interest rates from diverging too much from rates available on domestic alternatives. One difference from CDs issued by U.S. banks is that the Euro CDs do not have federal deposit insurance.

Real (Inflation Adjusted) Return

In times of changing prices, the nominal return (dollars received) on an investment may be a poor indicator of the real return (also known as the real rate) obtained by the investor. This is because part of the additional dollars received from the investment may be needed to recoup the investors lost purchasing power due to inflation. As a result, adjustments to the nominal return are needed to remove the effect of inflation in order to determine the real return. Frequently, the consumer price index (CPI) is used for this purpose. For example, assume that at the start of a given year the CPI is at a level of 150, and that at the end of the year it is at a level of 160. This means that the same amount of the CPI market basket of goods that could have been purchased for $150 at the start of the year costs $160 at the end of the year. Assuming that an investments nominal return is 9% for this year, the investor who started the year with $150 and invested it would have $150 x 1.09 = $163.50 at year-end. An increase in the CPI from 150 to 160 can be translated into an inflation rate of (160/150) 1 = .0667, or 6.67%. This inflation rate can be denoted as CCL (change in the cost of living), and the real return can be calculated using the following formula, known as the Fisher model: [(1+ NR) / (1 + CCL)] 1 = RR Note that for the example, RR = (1.09/1.0667) - 1 = .0218, or 2.18%. For a quick calculation involving the Fisher model, the real return can be estimated by simply subtracting the inflation rate (CCL) from the nominal return: (NR CCL) is approximately equal to RR In this example, the "quick method" results in an estimate of the real return of .09 .0667 = .0233, or 2.33%. Thus the error resulting from use of this method is .0233 .0218 = .0015, or .15%.

Other Types of Bonds

Income bonds are more like preferred stock than bonds. Payment of interest in full and on schedule is not absolutely required, and failure to do so need not send the corporation into bankruptcy. Interest on income bonds may not qualify as a tax-deductible expense for the issuing corporation. Guaranteed bonds are issued by one corporation but backed in some way by another. Participating bonds require stated interest payments and provide additional amounts if earnings exceed some stated level. Voting bonds, unlike regular bonds, give the holders some voice in management. Serial bonds, with different portions of the issue maturing at different dates, are sometimes used by corporations for equipment financing. Convertible bonds may, at the holders option, be exchanged for other securities, often common stock. Putable bonds give the holders an option, but this time it is to exchange their bonds for cash equal to the bonds face value. This option generally can be exercised over a brief period of time after a stated number of years have elapsed since the bonds issuance.

Investment Manager Risk

Investment manager risk is asset-specific and therefore is considered to be a diversifiable, nonsystematic risk. As with tax risk, pooled investments, by their nature, are where this risk is most acute. Anytime an investor delegates investment management responsibility for their portfolio (or fraction there of) to an investment manger, the investor will be exposed to this risk. A subtle but good example of this risk is style drift. For example, an investor allocates a certain portion of their equity holdings to large-cap value stocks. In turn, the investor purchases ABC large-cap value fund. Over the course of the year, ABCs fund manager, feeling pressure to enhance the funds returns, begins purchasing small-cap growth stocks. The investor, without even being aware of it, has now drifted outside the designed allocation parameters for the equity portion of their portfolio.

Natural Resources

Investments in natural resources, such as oil and gas, can be made through direct participation programs. There are oil and gas limited partnerships available to match limited partners (investors) who have funds with general partners who manage the operation of exploration, drilling, or development of oil and gas. As passive owners, limited partners can deduct losses from their personal taxes. Expenses incurred for operations will be deducted from income. There are four types of oil and gas projects: Exploratory Drilling or Wildcatting Programs: The most speculative of the programs, involves exploring for natural resources in areas that are not proven to have natural resources. Both risk and reward is high with this type of program. Development Programs: Drilling in areas or around areas where natural resources are proven to exist. Balanced Programs: Mix of exploratory and development programs. Income Programs: Acquire interest in a site that is currently producing natural resources. They offer steady income, but less expenses to deduct.

Sovereign Risk

Investors in a foreign country should evaluate the possibility that the foreign countrys government could collapse, its legal system could be inadequate or corrupt, its police force may not be able to maintain order, the settlement process for securities transactions breaks down occasionally, or other problems arise. CASE-IN-POINT The following list displays the factors that signify political upheaval in a country: The new government might seize investments made by foreigners. The government may repudiate its debts. The government reschedules debt payments without consulting lenders. The government denies foreign investors the right to withdraw their funds. There are disadvantageous taxes and tariffs imposed. The government forces nonresident investors to give up ownership of investments. Hostile forces within country may destroy foreign-owned assets.

Pricing of Closed-End Fund Shares

Investors of closed-end investment companies buy and sell shares at prices determined by supply and demand in the open (secondary) market. Some closed-end funds have share prices that are above their net asset values. Such shares are said to sell at a premium. Other funds have share prices that are below their net asset values. These shares are said to sell at a discount. In contrast, open-end mutual funds are bought and sold at the funds NAV. A closed-end funds market price will be at a premium to the NAV if there is demand that exceeds supply for the shares, and at a discount from the NAV when the supply is greater than demand.

Call and Put Provisions

Issuers may want the right to pay off their bonds at par before maturity. This ability provides management with flexibility because debt could be reduced or its maturity altered by refunding. Most importantly, expensive high-coupon debt that was issued during a time of high interest rates could be replaced with cheaper lower-coupon debt if rates decline. Despite the cost of obtaining this sort of flexibility, many issuers include call provisions in their bond indentures. This gives the corporation the option to call (essentially refinance their debt at better rates or terms) some or all of the bonds from their holders at stated prices during specified periods before maturity. In a sense, the firm sells a bond and simultaneously buys an option from the holders. Thus, the net price of the bond is the difference between the value of the bond and the option. Put provisions give the holders an option, but this time it is to exchange their bonds for cash equal to the bond's face value. This option generally can be exercised over a brief period of time after a stated number of years have elapsed since the bond's issuance. PRACTITIONER ADVICE: It's not always smart to go after a bond because of the amount of coupon that is being paid. Consider a callable bond that pays a 10% coupon versus a non-callable bond that pays an 8% coupon. If the 10% coupon bond is called, then the issuer will need to seek another fixed-income security that is likely to earn less than 10% annually. In the meantime, the person who bought the 8% coupon bond is still receiving 8% annually because the bond cannot be called. Therefore, it is important to make purchase decisions based on more than just the coupon rate.

One Period Model Example

James Clark purchased Coca-Cola stock for $54 per share. He sold KO (Coke's NYSE ticker symbol) one year later for $64 to realize a capital gain of $10 and a cash dividend of 80 cents per share. Jim's total income from the stock is $10.80 per share and his rate of return is 20%. (One-year rate of return, r = 20%) = [(Price change, $10) + (Cash dividend, $0.80)] /(Purchase price, $54) = $10.80 Income/$54 Invested Jim's one-period rate of return can be analyzed equivalently as follows: r = 20% = [(Terminal value, $64.80) - (Present value, $54)] /(Present value, $54) = [(Terminal value, $64.80)/(Present value, $54)] - 1 Jim analyzed the investment in KO under different assumptions about his required rate of return (opportunity cost, discount rate, cost of capital): Underpriced: If Jim's required rate of return is k = 19%, he will think the stock is under-priced at $54 and will be happy to buy it (value = $54.45>$54 = price). (Present value, $54.45) = (Terminal value, $64.80)/(1 + k) = (Terminal value, $64.80)/(1.19) Priced Correctly: If Jim's required rate of return and the stock's rate of return are identical, k = 20% = r, he will think the stock is priced correctly at $54. He would still be okay purchasing the stock, as long as the expected return equals his required return. (value = $54 = price). (Present value, $54) = (Terminal value, $64.80)/ (1 + k) = (Terminal value, $64.80)/(1.20) Overpriced: If Jim's required rate of return is greater than the anticipated return on the stock, k=. 21 > r, he will view the stock as overvalued. He will not be interested in purchasing the stock, until the price falls (to at least $53.55) and the stocks anticipated return increases to at least his required return. (Value = $53.55 < $54 = price). (Present value, $53.55) = (Terminal value, $64.80)/(1 + k) = (Terminal value, $64.80)/(1.21) Conclusion: An investor's required rate of return is an important determinant of the investor's behavior. However, time has not been added in as a factor for compounding yet

Limited Partnerships

Limited partnerships belong to a subset of pooled investments, know as direct participation programs. The difference between direct participation programs and other pooled investments is that the result of investment is passed directly to the partners. The partners not only receive profits, but they can also deduct losses from their income tax. Limited partnerships may invest in a variety of assets including real estate, oil and gas operations, and equipment. In a limited partnership, general partners manage the pooled investment and limited partners are passive and have no say in the management of the assets. Since the profits are before tax, partners receive more income from profitable partnerships—compared to shareholders of a corporation who receive dividends after the corporation pays income taxes. Like other pooled investments, limited partners' liabilities are limited to the extent of their investments. Limited partnerships were originally used to take advantage of tax laws to report losses. For example, a partnership might own drilling operations that drilled where there was no oil to create losses for the partners to report against their gains. In 1986, tax laws changed to reduce the opportunity of leveraging losses. Today, limited partnerships are legitimate operations with more risk than typical pooled investments. Limited partnership investments can be illiquid and selling partnership investment may require permission from general partners. Unlike shareholders of investment companies, in order to maintain their limited liability, limited partners must give up their right to vote on management matters. Limited Partnerships also tend to provide tax reporting statements (known as K-1s) later than most other investments requiring investors to file for extensions on their personal income tax returns.

Liquidity Risk

Liquidity risk deals with the inability to sell a security quickly and at a fair market price. The difference between liquidity and marketability is in the fair market price. Marketability refers to the ability to sell something. Liquidity not only means the ability to convert the asset to cash quickly, but also without a significant loss of the principal. For investments that are infrequently traded, such as the stocks of small companies, it can be hard to find a buyer. Sometimes its impossible to find a buyer at a fair market price, and you wind up having to sell for less than the assets worth sometimes even for a loss. Liquidity is very important for emergency funding. Therefore, assets with great liquidity risks would not be appropriate for emergency funds. For example, a house has high liquidity risks because it cannot be converted to cash quickly. Liquidity risk is unsystematic and can be diversified. You should have an asset allocation plan that allows enough liquidity as a portion of your portfolio. Imagine if you held shares of Enron stock. When the company was doing well on paper and adored by the press and the investment community, the stocks were probably very liquid. However, as the scandal of unethical business practices unfolded, it would have been very difficult to find a buyer for your shares without giving up a significant amount of principal.

Futures Listing

Listings of active futures markets are published regularly in the financial press with each item for delivery, such as corn, having a heading that indicates the number of units per contract, say, 5,000 bushels, and the terms on which prices are stated, in cents per bushel. This shows a set of daily quotations that provide the prices at which some popular futures contracts were traded and the total volume of sales for each type of contract. Delivery date: The date a commodity is exchanged for cash. Open: The price at which the first transaction for the day was made. High and low: The highest and lowest prices during the day. Settle: Shortened version of settlement price which is a representative price. For example, the average of the high and low prices during the closing period designated by the exchange in question. Change: The difference between the current price and the previous days settlement price. Lifetime high and low: The highest and lowest prices recorded during the lifetime of the contract. Open interest: The number of outstanding contracts from the previous day. For each futures contract, summary figures are given for the last delivery date. They indicate the total volume or number of contracts traded on that day and on the previous trading day, as well as the total open interest in such contracts on that day and the change in total open interest from the previous day.

Tangible Assets

Many people prefer investing in tangible assets as an alternative. These investors look toward precious metals and gems, and some have found their most profitable investments right in activities they most enjoy doing: building their hobbies and adding to their collectibles. Precious Metals and Gems have appealed to people throughout the ages. Gold and silver are extremely durable and easily fashioned into jewelry or other objects. These precious metals and gems like diamonds, emeralds and rubies are sought after throughout the world. How much would you bid for your favorite collectible on eBay? Markets for all types of collectibles have developed over the years for items such as baseball cards, comic books, beanie babies, Happy Meal toys and rock star memorabilia.

Market Risk

Market risk is associated with overall market movements. There tend to be periods of bull markets, when most stocks seem to move upward; and times of bear markets, when most stocks tend to decline in price. The same tends to be true in the bond markets. These periods may be a result of changes in the economy, changes in the mood of investors, or changes in interest rates. Market risk and interest rate risk are examples of overlap in sources of risk. Market risk is synonymous with systematic risk or nondiversifiable risk. Market risk is measured by beta and is expressed as having a beta of one.

Net Present Value

Money has time value because interest charges and payments exist. By using an appropriate interest rate to discount the value of future cash flows, you can determine the money's present value. The present value is the value in todays dollars of future sum or sums of money. It is the present value of future cash flows minus the purchase price of an investment. The discounted present value method states that the true or intrinsic value of any asset is based on the future cash flows that the investor expects to receive from owning the asset. Since these cash flows are expected in the future, they are adjusted by a discount rate to reflect not only the time value of money but also the riskiness of the cash flows. The sum of these discounted cash flows is the present value (PV). When the cost of an investment is deducted from PV, Net Present Value (NPV) is obtained. Concisely, NPV = PV of Future Cash Flows less Purchase Price. The NPV calculation is used for deciding whether a given investment activity should be undertaken. For a simple project involving actual cash outflow in the present (at t = 0) and expected cash inflows in the future, a positive NPV means that the present value of all the expected cash inflows is greater than the cost of making the investment. Conversely, a negative NPV means that the present value of all the expected cash inflows is less than the cost of making the investment.

Money Funds

Money market funds hold short-term fixed-income instruments, such as bank certificates of deposit, commercial paper, and treasury bills. A manager of this fund extracts an annual management fee, usually between .25% and 1% of the average value of total assets. The popularity of money funds exploded when regulation made it hard for banks to pay competing rates on savings or checking accounts. During this period, many investors withdrew their investment funds from banks, and invested their savings in the open-ended mutual fund industry through money market accounts instead. Later, more regulation changes were made which allowed banks to sell mutual funds. Today, many banks carry money market funds to try to draw back some of the business that was lost to mutual fund companies. Money funds usually carry no load charges, and investors may add or remove money from their accounts at any time. Dividends are usually declared daily. Additionally, arrangements with a cooperating bank often make it possible to write a check on an account, where the bank obtains the amount involved by redeeming shares in the fund when the check clears. Money funds are an ideal place for people to hold their emergency funds. Some investors use money funds as a safe haven for their investments in a tumultuous market environment. Other investors use money funds as a place to park a lump sum distribution or a large monetary settlement until they decide what to do with it.

Money Market Mutual Funds

Money market funds specialize in short-term securities and provide investors an alternative to savings accounts and other time deposits offered by banks. They invest in commercial paper, repurchase agreements, bankers acceptances, negotiable CDs, Treasury bills, and tax anticipation notes. Most of these securities will be discussed shortly. It is important to realize that investment companies (mutual funds) offer this product, and as such, these instruments are not protected under FDIC insurance. However, considering the underlying instruments that money markets invest in, they are generally considered to be safe. Money market funds are also an acceptable investment alternative for an emergency fund due to their high degree of liquidity.

Ratings of Funds

Morningstar ranks mutual funds based on a risk-adjusted performance scale. The Morningstar Risk-Adjusted Rating is determined by subtracting the funds downside risk measure from its return measure. The funds return measure is a comparison of its average return compared to the other funds of the same category. A funds downside risk is calculated by first subtracting the risk-free return of a T-Bill from the funds return. Only the negative excess returns are summed, and the absolute value is then divided by the number of months to provide a measure of the funds downside risk. In the case of Fidelity MagellanTM, its ten-year risk-adjusted performance is .96, or 1.57 - .61. The funds risk-adjusted measure is compared against all the other funds in the same category; percentile ranks are determined and a rating is then assigned. Morningstars rating system has five ranks, as follows: Stars Percentile Return Category Risk Category 5 1 - 10 Highest or High Lowest or Low 4 11 - 32.5 Above Average Below Average 3 33.5 - 67.5 Average Average 2 68.5 - 90 Below Average Above Average 1 91 - 100 Lowest or Low Highest or High REAL LIFE EXAMPLE: Buyer Beware! Often companies focus their advertisements on only their top rated funds. Or they may try to tell their clients to unload funds with poor ratings and buy funds with good ratings. This may produce a short-term rise in the portfolio. However, it is important to remember that the performance that is evaluated and rated is historical. There is no guarantee for the future. The problem with choosing funds based on ratings alone is that the buyer typically purchases at a high price and ultimately sells at or near the low. The problem is then compounded when the client repeats the performance. For example, when the economy is doing poorly, the Fed lowers interest rates and bond funds will do well. Their ratings could increase. However, interest rates are bound to go up when the Fed decides to curb inflation. So if someone purchases bond funds based on high ratings alone, they may be buying into lowering interest rates that already occurred only to face rising interest rates and a falling price.

Caveats of Using Morningstar

Morningstar's performance measures are useful in giving an investor a quick reading of how a mutual fund has performed in the past relative to other funds. However, several things should be kept in mind. Indices used for comparison may not be appropriate benchmarks for all types of funds. Morningstar's performance measures do not indicate which approach the fund is using in its quest for abnormal returns. The use of peer group comparisons to evaluate performance has several serious conceptual and practical shortcomings. In an attempt to minimize this problem, Morningstar uses more narrowly defined categories for comparison purposes, but such categorization is still far from perfect. Survivorship bias (tendency for poorly performing funds to go out of business and hence leave the peer group) skews comparisons with similar funds. PRACTITIONER ADVICE: It is most important to remember that a rating measures past performance. The management could have done well and continue to do so. However, cyclical effects could have been a factor to good ratings. The most important thing is to look beyond the ratings and focus on diversification, asset allocation and rebalancing based on objectives, risk tolerance and time horizon.

Mortgage Bonds

Mortgage bonds represent debt that is secured by the pledge of specific property. In the event of default, the bondholders are entitled to obtain the property in question and to sell it to satisfy their claims on the firm. In addition to the property itself, the holders of mortgage bonds have an unsecured claim on the corporation. Mortgage bondholders are usually protected by terms included in the bond indenture. The corporation may be constrained from pledging the property for other bonds (or such bonds, if issued, must be junior or second mortgages, with a claim on the property only after the first mortgage is satisfied). Certain property acquired by the corporation after the bonds were issued may also be pledged to support the bonds.

PV for Bonds

Most bond investors obtain three types of cash flows: 1. periodic coupon interest payments, 2. reinvestment of those coupon payments, and 3. repayment of principal when the bond matures. Example: Georgia is thinking about buying a semi-annual coupon 3-year U.S. Treasury note. How will you help her valuate this Treasury note? You can restate the Present Value equation as follows. PV = Coupon1/(1+YTM)1+ Coupon2/(1+YTM)2+ (Coupon3+ Par)/(1+YTM)3 If a bond with a par value of $1,000 repays its principal in 3 years and the coupon rate is 6% (paid semi-annually), the bond pays [($1,000)(0.06/2)]= $30 twice per year for each year of its 3-year life. Assume the required rate of return is 5.5%. PV = $30/(1+.0275)1+ $30/(1+.0275)2+ $30/(1+.0275)3+ $30/(1+.0275)4+ $30/(1+.0275)5+ $30+$1,000/(1+.0275)6 = $1,013.66 Note: Since the bond pays coupon semi-annually, its time periods are multiplied by two while the coupon rate and discount rate are divided by two. Keystrokes: 1000 FV 6 n 30 PMT 2.75 i PV The calculator returns: 1,013.66 This calculation concludes that the bonds present value is $1,013.66. If Georgia can buy this bond at a price below $1,013.66, it is a good investment, because she is buying it for less than it is worth. Here is another example of calculating the intrinsic value of a bond: What is the intrinsic value of a bond that matures in 7 years with a maturity value of $1,000, pays a 6% coupon (paid semi-annually), and market rates for comparable bonds are 7%? Keystrokes: 1000 FV 14 n 30 PMT 3.5 i PV The calculator returns: -945.40

Bond Equivalent Yield

Most bonds in the United States pay semi-annual coupons. Semi-annual coupons are half the size of annual coupons but are paid twice as often. When the YTM of a fixed-income structure is calculated by doubling the number of time periods from T years with annual coupons, to 2T 6-month periods with semi-annual coupons used in annual coupons it is called a bond equivalent yield. Additionally, money market instruments that are sold at a discount with no actual interest payments can be quoted as having a bank discount rate or a bond equivalent yield.

Business Risk

Most stocks and corporate bonds are influenced by how well or poorly the company that issued them is performing. Business risk deals with fluctuations in investment value that are caused by good or bad management decisions, or how well or poorly the firms products are doing in the marketplace. Businesses can go bankrupt, and management can make poor decisions. A CEOs decision to leave a company, or a companys decision to lay off part of their staff, may cause the share price of the companys stock to rise or fall depending on the impact of the decision on the companys performance. Business risk is specific to the stock or bond that the business issues. Business risk is a type of unsystematic, or diversifiable risk. PRACTITIONER ADVICE: Business risk is the source for potential downside risk as well as upside return. The reason why some people buy specific stocks is because they believe something specific about that business will yield a profit for them. The downside of business risk can be limited through diversification. If an investor bought a portfolio of securities rather than holding only one companys securities, the investor will limit the effects of the downside risk of one company to his or her entire investment.

Types of Municipal Bonds

Municipal Bonds can be classified into general obligation bonds and revenue bonds. General Obligation Bonds are issued by state and local agencies and are backed by the full faith and credit of the agency. In other words, the bonds are backed by their full taxing power which means they are safer than other municipal bond types. Revenue Bonds are backed by revenues from a designated project, authority, or agency or by the proceeds from a specific tax. Such bonds are only as creditworthy as the enterprise associated with the issuer. Revenue bonds may be issued for the following reasons: 1. financing publicly owned utilities, 2. financing quasi-utilities, like transportation, 3. financing by levying a tax on properties that benefit from the expenditure, for example a new sewer system, and 4. Industrial Development Bonds are used to finance the purchase or construction of industrial facilities that are to be leased to firms on a favorable basis. Although most municipal financing involves the issuance of long-term securities, a number of different types of short-term securities have been issued in order to meet short-term demands for cash. In each case, the name of the security refers to the source of repayment. Municipalities also issue notes. The following is a list of municipal notes: Tax anticipation notes (TANs) Revenue anticipation notes (RANs) Grant anticipation notes (GANs) Tax and revenue anticipation notes (TRANs)

Municipal Bond Market

Municipal bonds are usually issued as serial bonds. One pre-specified group matures a year after issue, another two years after issue, another three years after, and so on. Alternatively, term bonds (bonds that all mature on the same date) or a mixture of serial and term bonds may be issued. Unlike corporate bonds, municipal bonds do not need to be registered with the SEC before public issuance. Municipal bonds may be callable at specified dates and prices. Occasionally, the issuing authority is obligated to make designated payments into a sinking fund, which is used to buy similar bonds. As the issuing authoritys bonds mature, the money for paying them off will come from having the sinking fund sell some of its holdings. A secondary market for municipal bonds is available, but relatively small. Most investors buy new issues and hold to maturity in order to receive tax-exempt income. Investors can also purchase mutual fund portfolios made up of municipal bonds.

Performance of Funds

One way to evaluate mutual funds is to study their past performance. According to SEC regulations, advertisements that include performance figures must state that, "past performance is not indicative of future returns." This statement reminds investors that although a fund may have done well in recent months or may have had consistent performance over time, future returns of the same level are not guaranteed. Typically, performance is measured by hypothetical total return figures (income plus change in price) for a specific holding period. An assumption is made that during the specified holding period no additional investments or withdrawals have been made, and all dividends and distributed gains have been reinvested. These performance figures are only useful when compared to relevant data. Relevant data include: Historic Data: Identifies trends and averages. Performance of Index: Allows you to compare performance against a benchmark. Performance of Competitors: Allows you to compare performance against competition.

Mutual Funds

Mutual funds are investment companies that take the pooled assets of multiple investors and purchase a variety of securities in accordance with stated objectives. Some mutual funds, known as closed-end funds, make an initial offer of a set number of shares that are then traded exclusively in the secondary market. In contrast, open-end funds continuously offer new shares to the public at the funds net asset value. Mutual funds are by far the most popular type of pooled investment in the United States today. In fact, there are more mutual funds available in the mutual fund market than there are stocks in the New York Stock Exchange. Mutual funds provide investors with a variety of choices for meeting their investment goals. Investment objectives for mutual funds can vary widely, from achieving aggressive capital growth, to supplementing income, to simply preserving principal. All mutual funds take a percentage of the total assets in the fund as a fee for managing the assets. Some mutual funds have sales charges called loads, some have distribution fees, and some have neither. A funds fee structure depends on the funds share class and how the fund is sold. There are two methods used by mutual funds to sell their shares to the public: Direct marketing: The mutual fund sells shares directly to investors without using a sales organization. Use of a sales force: A sales force is paid a commission based on the number of shares sold. The sales force may include brokers, financial planners, and employees of insurance companies and banks.

Net Asset Value

Net asset value is an important concept in understanding how investment companies operate. Investment companies have assets that consist of a variety of securities. The market value of all the assets held by the investment company is determined at the end of each trading day. The value of all the liabilities for that day is then subtracted from the total assets to determine the investment companys net asset value. Then the net asset value is divided by the number of outstanding shares of the investment company to arrive at the net asset value per share or the NAV. NAV = (Assets - Liabilities) / Shares Outstanding For example, an investment company holds two common stocks (Company A and Company B). At the end of the day, Company A's stock traded at $10/share and Company B's stock traded at $20/share. The investment company holds 10 shares of each stock. So the total assets of the investment company at the end of the day was $300 = ($10 x 10 shares) + ($20 x 10 shares). If the investment's total liabilities for the day was $50, then the net asset value would be $250 = $300 - $50. The per share NAV is $12.50 ($250 / 20 shares) at the close of the day.

Repurchase Agreement (Repo)

Often, one investor will sell another investor a money market instrument and agree to repurchase it for an agreed-upon price at a later date. It is similar to individuals who sell a personal possession to a pawnshop for a sum of money, but later return to repurchase the item. For example, investor A might sell investor B a number of Treasury bills that mature in 180 days for a price of $10 million. As part of the sale, investor A has signed a repurchase agreement or "repo" with investor B. This agreement specifies that after 30 days, investor A will repurchase these Treasury bills for $10.1 million. Thus investor A will have paid investor B $100,000 in interest for 30 days use of $10 million, meaning that investor B has, in essence, purchased a money market instrument that matures in 30 days. The annualized interest rate is known as the repo rate, which in this case is equal to 12%. Note how this repurchase agreement is like a collateralized loan from B to A, with the Treasury bills serving as the collateral. Such loans involve very little risk to the lender (B), because the money market instruments typically used in repurchase agreements are of high quality.

Cash vs. Stock Dividends

One potential stock investment benefit is the right to earn income or dividends. When a company has earnings that exceed its internal needs such as expenses, repayment of debt, research and development, or capital expansion, its board may choose to pay dividends to its shareholders. Dividends can be paid in the form of cash or shares of additional stock. Cash Dividend: 1. Declaration Date board of directors declares amount of dividends per share on a quarterly basis. 2. Ex-dividend Date share price is reduced by the amount of the dividend. This date is always 2 trading days prior to record date. 3. Record Date dividends are only paid to the stockholders on record as of this date. Stock has to have been purchased at least 3 days prior to record date. 4. Payment Date payments are made in cash to stockholders. 5. The dividend amount may be of almost any size, subject to certain restrictions such as those contained in the charter or in documents given to creditors. Stock Dividend: The board of directors may decide to forego a cash dividend and pay a stock dividend instead. For example, if a 5% stock dividend is declared, the owner of 100 shares receives five additional shares. The effects of issuing a stock dividend: 1. The common stock account would increase by an amount equal to the par value times the number of new shares. 2. The remainder of the increase would go into the capital contributed in excess of par account. 3. The total book value of stockholders equity is kept the same by reducing the retained earnings account by an equivalent amount.

Exchange Traded Funds

One type of closed-end investment company that has emerged in recent years is the exchange traded fund (ETF). ETFs are traded in the secondary market in much the same way that individual stocks are traded on the exchange. Similar to a stock investment, shares of ETFs can be traded throughout the day as well as purchased on margin. An example of an ETF is the SPDR (pronounced as spider) that tracks the S&P 500. Compared to open-end funds, ETFs offer several advantages including greater trading flexibility and lower expenses. Lower expenses are the result of indexing rather than active management. These funds have mostly institutional customers. Since they are traded in the secondary market, fund management is shielded from investor activities. This makes the funds more tax efficient because the forced sale of securities for investor redemption requests results in fewer capital gains being distributed. Another significant advantage to ETFs is they can be bought and sold at inter-day prices. That is, the transaction price does not have to wait to the close of the trading day. A disadvantage of exchange traded funds is that they are not appropriate for dollar cost averaging through systematic purchases. Since these funds can only be bought through a broker, there is a fee associated with each transaction.

Basic Return Measurements SUMMARY

One way to look at how well you have done with your portfolio is to look at its return. Calculating return is a simple process of taking the amount of money you started with and comparing it to how much money you have at the end of your investment period. In the investment world, studying the return of an investment is a way to evaluate how well the investment performed historically, as well as how the investment performed in comparison to its peers. In this lesson, we have covered the following: Holding-Period Return is used as a measure for any investment. It specifies a holding period of any length of time, and the result will be a raw number that is not adjusted to take time value of money into account. Averages can be calculated for single periods within the holding period. Arithmetic Mean is an average of historical one-period rates of return. Geometric Mean is the compound average rate of return. Total Return is a stated holding period return used by investments such as mutual funds to communicate how they performed in the recent past. Total return is a standard of measurement that can be used to look at a funds historic performance, as well as to compare it to similar funds. It is not an indicator of future performance. After Tax Return is the return figure net of any tax expenses that may reduce the actual take-home profit of an investment. Real (Inflation Adjusted) Return is determined by adjusting the nominal return to remove the effect of inflation. The consumer price index (CPI) is frequently used for this purpose. PRACTITIONER ADVICE: Do not chase after returns. They are historical data. For example, when bonds or bond funds are displaying high total return figures, they are probably accompanied by a decreasing interest rate trend. If you buy into that return, chances are the interest rates may be heading up soon and your bond or bond fund prices will decrease. A diversified portfolio is the best way to avoid chasing returns.

No Load vs. Load Funds

Open-end funds are sold either directly from the company or through a sales force involving brokers, financial planners, and employees of insurance companies and banks. The method used to sell open-end funds is based on whether there is an additional sales commission charged to the investor. A sales commission, called a load, is used to pay for the sales of a fund. Open-end funds that are sold without these commissions are called no-load funds. Those that are sold with a commission are called load funds. There are no noticeable differences in performance between no-load versus load funds. The difference is in the services provided. No-load funds, which charge lower transaction costs and generally provide fewer services, are beneficial for investors who have some investment knowledge and an understanding of how mutual funds work. Load funds are beneficial for investors who are seeking advice or guidance from a broker or adviser and do not mind paying a sales charge. PRACTITIONER ADVICE The decision to buy a load or no-load fund is really a decision of whether to pay for advice. The quality of the fund cannot be determined solely by cost.

Stockholder Rights

Owners of common stock have certain rights and privileges. Right to a Stock Certificate. When investors buy common stock, they can obtain certificates as proof of their ownership. Voting Rights. Stockholders own the corporation. They are entitled to elect the firms board of directors, vote in person or by mail on major issues that affect the corporation, and delegate their vote(s) via proxy if not interested in voting. Right to Buy and Sell. Shareholders have the right to buy additional shares or to sell their shares whenever and to whomever they choose. Preemptive Right. The preemptive right grants existing stockholders the right-of-first-refusal on any new stock the corporation issues. This means that existing investors are guaranteed the right to maintain their previous fraction of total outstanding shares and prevents dilution of ownership control. Right to Information. The Securities Act of 1933 requires U.S. issuers to make full disclosure of all relevant information to any interested party. Publicly traded corporations in the U.S. are required to send their stockholders quarterly and annual financial reports. Stockholders may also demand additional information, such as minutes from the board of directors meetings, lists of stockholders and detailed financial reports. Right to Receive Cash Dividends. Boards of directors typically discuss the question of whether to pay cash dividends, and, if so, how much.

Brian is considering purchasing a 10-year, 5.5% Treasury Note with a $10,000 par value. If the Treasury yield curve indicates that 6% is the appropriate yield for such bonds, what is the fair market value of this bond, assuming annual payments?

PV = $550(PVIFA 5.5%,10) + $10,000 (PVIF 5.5%,10) or 10000 FV, 550 PMT, 10N, 6 I, PV = $9,632.00.

Political and Regulatory Risk

Political and regulatory risk results from unanticipated changes in the tax or legal environments that have been imposed by the government. A company may have to spend a large amount of money in order to comply with new regulations. On the upside, changes in federal or state tax laws may lead to more deductions for a company or for individual taxpayers. Regulatory risks may be unsystematic (diversifiable) depending on the size and scope of the regulation change. Tax law changes may affect all investors. Changes in environment laws such as hazardous waste disposal would only affect those companies that dispose hazardous waste. Consider a small town that changes the regulation on the size of home septic tanks. Although septic tank companies and installers may make a large profit from replacing septic tanks for everyones homes, the large expenditure may force some homeowners to take out a small loan.

Preferred Stockholder Rights

Preferred stock investors have many rights, but they are fewer than common stockholders. Since preferred stockholders stand to gain more from cash dividends than from capital appreciation, cash dividends are an important benefit to preferred stock investors. People who invest in preferred stocks are typically seeking a steady stream of income rather than capital appreciation. The following is a list of preferred stockholders rights. Shareholders have legal priority over common stockholders with respect to claims on earnings and assets. Most preferred stocks give shareholders the right to receive dividends that were promised but not paid before common stock shareholders receive any. Corporate investors (shareholder is a company rather than an individual) are exempt from paying taxes on preferred dividends. Recent trends are to give voting rights to preferred shareholders. Non-voting preferred shares may also be given voting rights if a dividend is missed. Similar to common stock shareholders, preferred stock shareholders have the right to certificates, the right to buy and sell whenever they want, and the right to receive and request information about the issuer.

Promissory Notes

Promissory notes are debt instruments where the investor is lending money to a corporation in return for a fixed amount of income (interest). Companies issue these notes to finance various business needs such as a specific new project. Most companies that issue promissory notes are not publicly traded. The danger is that very little is known about these companies. Legitimate promissory notes are typically only marketed to large sophisticated investors or corporations who have resources to conduct thorough research on the issuers. Unfortunately, there have been many recent cases of fraudulent promissory note scams where unsuspecting investors lost millions of dollars. In these cases, promissory notes were pushed to investors promising risk-free above market returns. Investors should beware of promissory notes that boast things such as: Risk free (risk free should come with low yield). Above market returns (should be associated with higher risk). Insured (check to see if the insurer is non-existent or off-shore insurer). Short-term (9 months, typically means that the note did not have to go through the due-diligence process of registering with the SEC or state).

Real Estate Investment Trusts (REITs)

REITs are closed-end investment companies that invest in real estate instead of financial assets and serve as a conduit for earnings on investments in real estate or loans secured by real estate. REITs pass these on to their shareholders and, as long as 95% of their income is distributed to shareholders, that income is free from taxation for the REIT. At least 75% of a REIT's assets and income must be derived from real estate equity or mortgages. Real estate investment trusts engage in a common financial intermediation process known as securitization. Returns to REIT investors come from rental income, which is passed on to shareholders, and from property value changes, which are reflected in REIT prices. Like investment companies, REITs come in many different varieties. Some invest in real estate mortgages; others make equity investments. Most REITs own specific types of properties, such as apartments, malls, or golf courses, in specific geographic areas. Some are publicly traded, whereas others have their shares exchanged on a privately arranged basis. Investors seeking income may be interested in mortgage REITs. Investors seeking growth of principal value may be interested in equity REITs. REITS can invest in construction loans, but they cannot invest in limited partnership interest. REAL LIFE EXAMPLE: Demand for REITs had increased in recent years because when the economy was doing well, there was a high demand for office space. Since demand out paced supply, rent was high and there was a lot of building going on. However, once the economy headed into a contraction, supply exceeded demand. There is a lag in REIT performance reflecting lower rent and building leases. Therefore, if you were to purchase a REIT now based on its recent performance, you would likely be displeased with it once it begins to reflect the lower demand for real estate.

Rights

Rights are also known as subscription warrants. Rights are issued to give existing stockholders their preemptive right to subscribe to a new issue of common stock before the general public is given an opportunity. Each share of stock receives one right. Rights typically have short lives of two to ten weeks. For popular issues of stock, they are sometimes traded on exchanges while others are available in the over-the-counter market. Often trading begins before actual availability, with the rights sold for delivery on a when-issued basis. A right is, in effect, a warrant, although the right exists for a short time before it expires. It also differs with regard to the exercise price, which is typically set above the stocks market price at issuance for a warrant and below it for a right. However, rights do not need to be protected against stock splits and stock dividends because of their short lives.

Risk Estimates

Risk is equated with variability of return, or the likelihood of the asset to deviate from the expected return. A U.S. Treasury bill is as close to risk-free as you can get, which is why its interest rate is often used as the risk-free rate for calculations. As stated earlier, we use a normal distribution for simplicity sake. Not only are real-world distributions either positively or negatively skewed, but they exhibit a property known as kurtosis. Kurtosis is a statistical measure that tells us when a distribution is more or less peaked than a normal distribution. A distribution that is more peaked than normal is called leptokurtic (lepto is from the Greek word for slender). A distribution that is less peaked than normal is called platykurtic (platy is from the Greek word for broad). A normal distribution is called mesokurtic (meso is from the Greek word for middle). Financial risk management uses tools such as Value at Risk (VAR) and downside risk to access the probability of returns being less than some predetermined amount. The issue with leptokurtic distributions is that they have a larger area in their tails (known as fat tails). These distributions are measured by kurtosis. By definition, normal distributions have kurtosis equal to three. However, most statistical package report excess kurtosis, which is kurtosis minus three. Therefore, a normal distribution has excess kurtosis equal to zero, a leptokurtic distribution has excess kurtosis greater than 0, and a platykurtic distribution has excess kurtosis less than 0.

Variability of Returns (Standard Deviation and Variance)

See 26-5 in reading. Interpretation of standard deviation is what is most important. As stated earlier, standard deviation is a measure of variability; that is, how much your actual return will vary from what you expect. Even though CFP® Board approved curriculum does not explore much of the detail that exists in quantitative methods concerning probability distributions, a few high-level generalizations are absolutely necessary. For instance, even though stock market returns are positively skewed (more up-years than down-years), for simplicity sake we assume we have "normal" distributions in investment planning. The so-called, bell shaped curve is always used to describe a normal distribution. Furthermore, we will use approximations to describe probability distributions around the mean (expected return). For instance, you need to know that there is an approximately 68% probability that the actual return you will obtain next year, will be plus / or minus one standard deviation from the mean (expected return). Let's say you own an asset with an expected return of 10%, and this asset has a standard deviation of 15%. You have a 68% probability of obtaining an actual return of somewhere between -5% and 25% (10% +/- 15%), even though you expect 10%. You also need to know that 95% of the time, the actual return will be plus / or minus two standard deviations from the mean; and finally, 99% of the time, the actual return will be plus / or minus three standard deviations from the mean. These ranges (68%, 95%, and 99%) are referred to as confidence intervals. In other words, you are 95% confident; that the actual return you will obtain in the future is the expected return, plus or minus two standard deviations. Using the asset with a 10% return and 15% standard deviation as an example, I would expect a return of 10%; but I have a 95% probability of actually obtaining a return anywhere from -20% to 40% (10% +/- 15%). Now if that seems extremely volatile, please realize that these are (approximately) the actual annual return and standard deviation statistics for the S&P 500 for the last 85 years!

Semi-Variance

Semi-variance focuses only on the half of the variance that refers to the asset performing below the expected return or average return. The recent use of semi-variance may be driven by the fact that over the years, many investors have become accustomed to think of risk only as downside risk. PRACTITIONER ADVICE: It is important not to lose sight of the entire variance picture. If you focus only on the downside, people may not understand the potential upside of an investment or the full range that the price of a security can swing. In order to complete the discussion on downside risk and semi-variance, it is necessary to return to the probability distribution concepts as they relate to a normal distribution. Recall that the expected return +/- 1 standard deviation occurs 68% of the time, expected return +/- 2 standard deviations 95%, and expected return +/- 3 standard deviations 99% of the time. Since a normal distribution has symmetrical deviation from the mean, 50% probability exists that my return will be less than the mean (expected return), and 50% probability more than the mean. In other words, all the area to the left of the mean (less than) in a bell shaped curve, represents 50% probability, and all the area to the right of the mean (greater than) represents 50% probability. This symmetry extends to the standard deviations around the mean. When we say that there is a 68% probability the return will be +/- one standard deviation from the mean we have a 34% chance of a result less than the mean but not farther than 1 standard deviation from the mean, and the same on the up side of the distribution. It may help to think of a bell-shaped curve with a center (the mean or expected return) and two tails; an upper tail and a lower tail. We start with a 50% probability in either tail. Now when we introduce this concept of standard deviations, + / - 1 is 68% probability centered around the mean (34% to the left and 34% to the right), our tails become 16% probability for both the lower and upper tails. Reference the the scenario diagram below for an illustration of these concepts.

Separately Managed Accounts (SMAs)

Separately Managed Accounts (SMA), also referred to as individually managed accounts, offer investors greater advantages compared to traditional mutual fund investing. For this type of account, the investor pays a professional money manager to buy individual stocks, bonds, cash equivalents, and other investments, which are bought directly into the investors account. Most money managers charge a quarterly fee based on the amount of assets under management. For this fee, the investor receives professional management with a focus on adequate diversification and the proper risk-reward tradeoff. SMA's have several distinct advantages, which differentiate them from traditional mutual fund investing: 1. Individual Security Selection: The money manager of an SMA is buying investments for an individual investor, rather than a mutual fund. This puts more control into the hands of the investor and allows the manger to select securities based on the investor's personal needs. 2. Social Responsibility Investing: The investor can specify any investment restrictions based on their social and environmental objectives or personal values. For example, an investor might choose to avoid any stock related to alcohol or tobacco. 3. Tax Management: SMA's provide the investors with greater ability to dictate their own tax destiny. For example, an investor can choose whether to employ a tax efficient strategy or provide input as to when capital gains are realized.

Silver

Silver is very similar to gold as an investment. It can be owned in the same way, and its risk is as great. When gold's price was rising, silver went from $2 an ounce to over $50 an ounce. Silver is in far greater supply than gold, but much more of it is lost in its industrial uses. Having industrial applications is both a good and bad feature because it increases silver's demand, but substitutes can be found for it. On balance, these applications increase its price volatility.

Types of Preferred Stock

Since preferred shares carry fixed dividend payments, they tend to fluctuate in price far less than common shares. This means that the opportunity for both large capital gains and large capital losses is limited. Because preferred stocks, like bonds, have fixed payments and small price fluctuations, they are sometimes referred to as a hybrid security. Cumulative Non-Cumulative Participating Convertible Adjustable Rate Money Market Preferred

Using the Capital Asset Pricing Model (CAPM) to compute k

Some analysts use the Capital Asset Pricing Model (CAPM) to compute k. In this case, k is also known as the market capitalization rate. Calculating k (the required rate of return) using the CAPM model: k = Rf + bi(Rm Rf) k = Market Capitalization Rate Rf = Risk-Free Return bi = Beta for security (how closely the security correlates with movements of the market) (Rm Rf) = Risk Premium: the difference between the market return and the risk free return. Thus, suppose that the risk-free rate is .03, Beta = 1.5, and the risk premium on the market portfolio is .08. k = .03 + 1.5(.08) = .15 or 15%

Newspaper Listing

Some corporate bonds are traded on the NYSE. The prices of those bonds are listed in the financial sections of newspapers. For example: Bond Current Yield Volume Close Net Change ATT 7-1/2 20 7.0 10 106 7/8 +1/8 According to this example, the listed AT&T bonds carry a 7.5% coupon (paid semi-annually) and mature in 2020. The coupon is expressed as a percentage of par. Most corporate bonds have a par value of $1,000. Therefore, this bond pays 7.5% X $1,000 = $75/ year or $37.50 semiannually. It was last traded (as of the date of quotations) at 106 7/8. The price is a percentage expression of the par value. Therefore, the closing price for the bond is $1,000 X 106.875% = $1,068.75. The current yield is determined by dividing the annual coupon rate by the current price or $75/$1,068.75 = 7%. There were ten bonds traded during the day and the closing price of the bond was up 1/8 or $1.25 from the previous day. Treasury Bonds are quoted in 1/32 or $0.03125. Major trades of bonds are generally negotiated elsewhere by dealers and institutional investors, either directly or through brokers. Thus, reported prices on the NYSE may be poor guides to values associated with large transactions (the same can be said for quotes that are publicly supplied by bond dealers) but appear to be reasonable for small transactions.

Other Preferred Stock Characteristics

Some important characteristics of Preferred Stock include: Par Value: Most preferred stocks have a par value. Unlike common stock, the par value of a preferred stock is significant in that the dividend rights and call prices are usually stated in terms of the par value. Call Feature: The cash dividend guarantee of preferred stock increases the issuing corporations vulnerability to adverse conditions and reduces its financial flexibility. Therefore, a company may want to exercise its call option if it is able to do so. Redemption: Nearly every issue of preferred stock is redeemable in one way or another. Most issues have either a sinking fund or a call provision that permits the issuer to purchase the shares before they mature. Conversion Provision: Some issues of preferred stock allow the issuer to encourage investors to convert their preferred stock into common stock by making it profitable for the investor. The main reason that issuers want to redeem or convert to common shares is if interest rates decline after the preferred stock is issued. Maturity: Some preferred stocks have maturity dates similar to fixed-income securities.

Unit Investment Trust

Some of the earliest pooled investments were unit investment trusts. A unit investment trust is an investment company that owns a fixed set of securities for the life of the company. That is, the investment company rarely alters the composition of its portfolio during the life of the company. Most unit investment trusts hold fixed-income securities that expire after the last security has matured. Life span for these companies can be as short as six months, for unit investment trusts of money market instruments, or as long as 20 years or more, for trusts of bond market instruments. Although UITs are less popular in the United States, they still draw European investors seeking to invest in fixed-income securities with a set maturity date. TEST TIP Unit Investment Trusts are passively managed. The professional management happens in the beginning for the asset selection. After that, no changes will be made to the portfolio except payment of interest and principal. Passive management results in lower management costs due to less turnover costs.

Classes of Shares

Sometimes, a company will divide its common shares into two classes: Class A Class B These classes weight certain stock investment benefits higher than others in order to meet different investor needs. A - Shares pay cash dividends and are sold to the public to raise capital, but investors might have zero or diminished voting power. Class A stock can be similar to preferred stock but is still considered to be common stock. B - Voting stock held by management that is entitled to zero or reduced cash dividends. The top managers of the corporation usually take Class B stock as payment for founding, merging, or reorganizing the corporation. Voting power, combined with its management authority, can give top executives of a corporation total control of the firm without investing any money. These executives are free to set their own salaries and fringe benefits.

Standard & Poor's 500

Standard & Poor's Corporation is a financial information company that developed its first stock market indicator in 1923. The prices of 233 stocks were compiled by hand and used to create 26 industry indices. By 1941, the list of 233 stocks had grown to 416 stocks, and they were used to create 72 industrial indices. In 1957, the sample of 416 stocks was expanded to 500 stocks, and they were used to create the Standard & Poor's 500 Stock Composite Index, which was retabulated by computer every minute throughout each trading day. The S&P 500 is a much broader representation of large companies. It is more representative of diversified common stock investing in the U.S. than the DJIA.

Issuers of Municipal Bonds

States generally issue debt to finance capital expenditures, primarily for highways, housing and education. The concept behind the issuance of such debt is that the revenue generated by the resulting facilities will be used to make the required debt payments. In some cases, the payment of debt comes directly from the revenue generated by the project, such as turnpike tolls. Others may be less direct, such as a gas tax that pays for highway construction. States cannot be sued without their consent. Thus bondholders may have no legal recourse in the event of default, and state-issued bonds that are dependent on particular revenues from some capital project may involve considerable risk. However, bonds backed by the full faith and credit' of a state government are generally considered quite safe despite the inability of the bondholders to sue. Unlike state governments, local governments can be sued against their will, making it possible for bondholders to force officials to collect whatever amount is needed in order to meet required debt payments. Local governments and authorities carry more credit risk because of their limited source of revenue to pay off the debt. Orange County of California defaulted and had to restructure their debt in 1996.

Systematic vs. Unsystematic Risk

Systematic risk is the market or nondiversifiable risk inherent in an asset or portfolio of assets. It is variability that cannot be eliminated through diversification. Unsystematic risk is company-specific risk that is diversifiable and can be offset by investing in other firms with opposing unsystematic risk. For example, if you own shares in a ski resort that does well only in the winter months, you may want to also own shares in a beach resort that does well in the summer months when the ski resort is not doing as well. The only risk you will get compensated for taking is systematic risk, because unsystematic risk can be eliminated through diversification. In effect, unsystematic risk does not exist for diversified investors. The market does not compensate investors for taking on risk they can eliminate for free. Investors demand a return for delaying consumption, and a return for taking on added systematic risk. Remember that there is an upside to fluctuation in asset value driven by its variability. Diversification is an attempt to limit the downside unsystematic risk while keeping the upside.

Test Tip regarding Formulas

TEST TIP There are many formulas presented in this module. Keep in mind that the most significant formulas for the CFP Certification Exam are the ones that appear on the exam formula sheet. The test questions that require calculations will tend to require entering the given data into a formula to solve for the missing variable. Since the formulas on the sheet are not labeled, it is important to be able to associate given data to the appropriate formula. The majority of the questions related to formulas will test the applicant's understanding of the consequences of a change in a variable within the formula. Therefore, it is more important to understand how each component contributes to the formula as a whole. For example, as you complete this module, think about how a change in the interest rate used for discounting would affect the dividend discount models presented.

Open-End Funds

Today, when people talk about mutual funds, they are typically referring to the open-end mutual funds. Open-end funds have become by far, the most popular pooled investment vehicle in the United States. Unlike closed-end investment companies, open-end investment companies (or open-end funds) stand ready at all times to purchase their own shares at par or their net asset value. These professionally managed pooled investments are easily accessible. You can buy them directly, or through brokers or advisers, retirement plans, or insurance vehicles.

INVESTMENT RISKS

Topic 25 in Reading

Tax Risk

Tax risk is defined as the investor being burdened with an unexpected tax liability. This risk is considered to be a diversifiable, unsystematic risk due to the fact that this risk is borne in asset-specific situations. By far, the most likely asset class containing tax risk is any type of pooled investment. In particular, mutual funds by their very nature, contain considerable tax risk. The unrealized capital appreciation of many mutual funds represents a certain tax liability. To make matters worse, the new investors of a fund with significant unrealized capital gains will necessarily subsidize the tax liability of the funds long-term investors. Capital gains distributions will be distributed pro rata, based on the number of shares held. Another example of tax risk for mutual funds is a simple dividend distribution. If you know that a fund will be trading ex-dividend in two days, you would not buy the fund today. If you did, you would be essentially buying a tax liability. Even if you held the fund for a month prior to an annual dividend distribution, you are subsidizing the shareholders tax liability that held the fund for the entire year prior to the annual distribution. The pro rata distribution is strictly based on the number of shares held, and is not sensitive to holding periods.

After Tax Return

Taxes can take away from return as well. It is important to consider how much is paid in taxes on investment gains when evaluating how much you have really earned. For example, if your investments yield a long-term capital gains of $1,000, then 15% of the long-term gains, or $150, is due to the IRS as Federal tax on the gains. Depending on the state you live in, there could be an additional amount due for state taxes as well. After Tax Return = Total Return (1 - tax bracket)

Morningstar Investment Style

The Current Investment Style section appears in the lower right part of the figure below. It lists several ratios that are used to evaluate funds and compares them against the benchmark index as well as other funds of the same category. For stock (equity funds), the following ratios are used: Price/Earnings Ratio Price/Book Ratio Four Year Earnings Growth Percentage Price/Cash Flow Debt as Percentage Total Capitalization Medium Market Capitalization in $mil Foreign Percentage For fixed income fund the following methods of evaluation are used: Effective Duration Effective Maturity Credit Quality Coupon Interest Rate Price Adjacent to the measures is a matrix that describes the investment style of the fund. For stocks, it is a scale based on the difference between the three styles: growth (managers look for stocks with consistent growth in earnings without concern for their price), value (look for undervalued stocks that are cheap compares to expected value) and blend (mix of both styles). It also identifies the size of companies that the fund invests in (large, medium, or small). For fixed income funds, the matrix compares duration (long, intermediate and short term) with quality (high, average and low).

Price Weight (DJIA)

The Dow Jones Industrial is a price-weighted index. To calculate a price weighted index: Add all the prices of the stocks that are included in the index. Then divide this sum by a constant (the divisor) in order to calculate an average price. The divisor is adjusted whenever there is a stock split in order to avoid giving misleading indications of the market's direction. The original divisor was 30. However, as stocks undergo stock splits or pay stock dividends, the divisor must decrease in order to keep the index from changing in value before and after the event. As of March of 2013, the divisor was 0.130216081. The reason for changing the divisor is because the DJIA takes into consideration only the price of the stocks rather than the market value of the company. Therefore, if the divisor was not changed and one of the stocks split, the total would be smaller by the reduction of the price of the stock that split. If the divisor was not adjusted, then although the company's total market value is unchanged from the stock split, the DJIA would be unnecessarily compromised. In a price weighted index the highest price stock influences the index. In a value weighted index the largest company influences the index.

Closed-End Funds

The Investment Company Act of 1940 provides two classifications for investment companies: unit investment trusts and managed investment companies. Both closed-end and open-end funds fall under the classification of managed investment companies. Unlike open-end investment companies, closed-end funds do not stand ready to purchase their own shares. Instead, the shares of these funds are traded in either an organized exchange or an over-the-counter market. Thus, an investor who wants to buy or sell shares of a closed-end fund must place an order with a broker. Closed-end funds are traded in the secondary market after the initial public offering. When the company is initially offered, it is sold in the primary market. From then on, the shares are traded through brokers in the open market. The fund company/issuer can only engage in the trading of its shares through the secondary market.

Roles of Exchange (OCC)

The Options Clearing Corporation (OCC) is a company that facilitates the trading of call and put options. It maintains a computer system that keeps track of all contracts by recording the position of each investor. As soon as a buyer and a writer decide to trade a particular put option contract and the buyer pays the agreed-upon premium, the OCC steps in, becoming the effective writer as far as the buyer is concerned and the effective buyer as far as the writer is concerned. All direct links between original buyer and writer are severed. If the buyer exercises the option, then the OCC will: Randomly choose a writer who has not closed his or her position, and assigns the exercise notice accordingly, and Guarantee delivery of stock or cash if the writer is unable to come up with the shares. Therefore, the OCC makes it possible for buyers and writers to close their positions at any time. If a buyer subsequently becomes a writer of the same contract, the OCC computer will note the offsetting positions in this investors account and will simply cancel both entries. Consider an investor who buys a contract on Monday and sells it on Tuesday: the computer will note that the investor's position is zero and will remove both entries. The second trade is a closing sale because it serves to close out the investors position from the earlier trade. The closing sale allows buyers to sell options rather than exercise them. A similar procedure allows a writer to pay, and to be relieved of potential obligations to deliver stock. Consider an investor who writes a contract on Wednesday and buys an identical one on Thursday. The latter is a closing purchase and, analogous to a closing sale, serves to close out the investors position from the earlier trade.

U.S. Treasury Securities

The U.S. government issues U.S. Treasury securities to finance its expenses, pay off existing debt, and control the supply of money. US Treasury securities are considered direct obligations of the U.S. government. About two thirds of the United States' public debt is marketable, meaning that it is represented by securities that can be sold at anytime by the original purchaser. These marketable securities can include Treasury Bills, Treasury Notes, and Treasury Bonds. Since U.S. Treasury securities are backed by the government's power of taxation and the government's ability to issue more debt, they are considered the safest debt instruments in their respective maturity categories. Often the rate of U.S. Treasury Bills is used as the risk-free rate of return for investment calculations. Since U.S. Treasuries are considered to be the safest fixed-income securities, they are highly sought after in the U.S. and throughout the world. Federal, state and local governments hold a significant portion of their funds in U.S. Treasuries. They also represent a significant portion of financial institutions' portfolios, and individual investor's holdings are substantial as well. Holdings by foreigners continue to increase as a means to hold a more stable currency than their own. U.S. TREASURIES Type Maturity T-Bills Less than 1 year T-Notes 1 to 10 years T-Bonds 10 to 30 years

U.S. Savings Bonds

The US government issues savings bonds as a convenient way for people to save money. Series EE bonds are accrual bonds, issued in the face amounts of $50, $75, $100, $200, $500, $1,000, $5,000 and $10,000. The purchase price is half of the face amount. Series EE bonds have no secondary market, therefore they must be redeemed and cannot be used as gifts or as collateral. An attractive feature is that these bonds are not subject to state and local taxes. Series EE Savings Bonds dated on or after May 1, 2005, will earn a fixed rate of interest for 20 years, at which time the bond should have reached its face value. If the bond has not reached its face value, the Treasury will make a one-time adjustment up to the face value. These EE bonds will increase in value every month instead of every six months. Interest is compounded semiannually. After the initial 20-year period, an additional 10-year extension and rate update will be initiated, for a total of 30 years of interest earning. Another tax advantage is that the interest on Series EE bonds purchased in 1990 and later may be tax-free if they are used for college education expenses for the bondholder, spouse or dependant. This occurs if the entire proceeds when redeemed are used to pay for tuition, books and fees for the family members. The bonds must be purchased and owned by the parents of a child attending college, and the parents' adjusted gross income (AGI) will determine if all or only part of the interest on the bonds is excluded from taxes in the redemption year. Series HH bonds are acquired through an exchange of Series E bonds, which the Treasury issued prior to July 1, 1980, or Series EE bonds held for 6 months or longer. With Series EE bonds, the interest accrued will remain tax-deferred until the HH bonds are redeemed. Like EE bonds, HH bonds are not marketable securities. Series HH bonds are purchased at face value in denominations of $500, $1,000, $5,000 and $10,000. These bonds pay interest semiannually at a fixed rate determined on date of issuance, and adjusted on the 10th anniversary. Their maturity may be extended for an additional 10 years with interest. The interest must be included in income for federal income tax purposes, but HH bonds are not subject to state or local income taxes. Series I bonds are sold in denominations ranging from $50 to $10,000. The Treasury sets the interest every May and November for the next six-month period. The interest rate is based on a fixed rate plus an additional amount, which is determined by the Consumer Price Index. This is a major distinction with HH bonds, which have no adjustment for inflation. The maturity is 20 years from the date of issue, with an option to extend interest payments for an additional ten years. Interest is exempt from state and local taxation, and may also be exempt from federal taxation as long as the interest is used to pay qualified higher education expenses.

Call Option Example

The Widget Corporation's stock is currently trading at $45 per share. Ben believes that the price of the stock will rise substantially over the next six months and wants to buy a call option. Wilma believes that the stock price will not rise above $50 over this time period. Wilma writes a 6-month naked call option for 100 shares of Widget stock with an exercise (strike) price of $50 per share. Ben buys the option for a premium of $3 per share, or $300 for the contract. If the stock price rose to $60/share and Ben exercises the call option, then Wilma will need to purchase the stock in the market for $6,000 and sell them to Ben for $5,000. Netting the premium, Wilma will have a loss of $700. If Ben sells the shares for $6,000, then his total gain will be the same as Wilma's loss, $700. Alternately, Ben can sell the option to someone else for $700 and thus pass the right to buy at $50 to the buyer.

Advantages of Mutual Funds

The advantages of investing in mutual funds are: Diversification. When you invest in a mutual fund, youre purchasing a small fraction of the mutual fund's already diversified holdings. Professional management. A mutual fund lets you gain access to professional management provided by fund managers who have access to all the best research from several brokerage houses. Minimal transaction costs. Mutual fund companies trade in large quantities, allowing them to pay far less in terms of commissions than small investors. Liquidity. Open-ended mutual funds are required to buy back shares from investors upon request. Therefore, open-end fund shares are easy to convert to cash. Flexibility. There are over 7,300 mutual funds with varying objectives and risk levels. As an individual investor, you should be able to spell out your desired objectives and risk level, and from that find a fund that fits your needs. Service. Mutual funds can provide you with a number of services including book-keeping services, checking accounts and automatic systems which help you to add or withdraw from your account, as well as buy or sell over the phone or the Internet.

Arithmetic Mean

The arithmetic average rate of return is a summary of a great deal of information and provides a good way to compare the performance of different investments. The arithmetic mean return (AMR), an average of historical one-period rates of return, is computed as follows: FORMULA where T denotes the terminal time period. The arithmetic mean of historical annual returns must be measured over a representative sample period. A representative sample might cover one complete business cycle, measured from either peak to peak, or from trough to trough. For example, Kerry held an S&P Index Fund for three years. Her returns during that time were 20%, -10%, and 5% respectively. What was her arithmetic mean return? (1/3)(.20 -.10+ .05) = .05 or 5% PRACTITIONER ADVICE: Arithmetic mean is less telling because the standard deviation of the period can vary significantly — the price of the investment could have been very volatile during that period. If so, then the return is not reflective of the movement of the investment during that time.

Realized Compound Yield

The assumption of the ability to reinvest at the YTM or YTC is crucial for determining how much of a return the bond will provide. The realized compound yield allows investors to make their own reinvestment rate assumptions, or in an ex-post (historical data) context, calculate the actual yield resulting from their reinvestment decisions. Since we usually compare this statistic with YTM calculations, we will use the formula in an ex-ante (projected or expectational data) context as follows: Take for example: $1,000 = par $80 = annual coupon 8% = YTM 3 = N $1,000 = PV If the realized compound yield = YTM, then: 1st coupon will compound at 8% for two years or 80(1 + .08)2 = $93.31 2nd coupon will compound at 8% for one year or 80(1 + .08) = $86.40 3rd coupon will be paid with par value = 80 + 1,000 = $1,080.00 Total amount from bond at T = $1,259.50 If the realized compound yield > YTM, then the total accumulation would be > $1,259.71. If the realized compound yield < YTM, then the total accumulation would be < $1,259.71.

Beta

The beta coefficient, or beta (B), measures the slope of one assets characteristic line. The beta coefficient, for example, of asset i is represented by the symbol Bi. The beta coefficient is an index of undiversifiable (market, systematic) risk. You can rank betas from different assets to compare the undiversifiable risk of the assets. Since the beta of the market (Bm) equals 1, if B i= 1, then the asset has the same volatility as the market. If Bi > 1, then the rates of return from the asset are more volatile than the returns from the market and the asset is classified as an aggressive asset. The return will be higher than the market if the market return increases. However, if the market return decreases, then the assets return will decrease more. If Bi < 1, then the asset is a defensive asset. Its rates of return are less volatile than the markets. The asset will earn a positive return when the market return increases, but not as much. Similarly, when the market does poorly, it will do less poorly than the market.

Promised YTM, Intrinsic Value and Required Rate of Return

The capitalization of income valuation method is used to identify underpriced and overpriced bonds. Using the time value of money equations, we can determine the promised yield to maturity. We can determine the net present value of the bond using the required rate of return of an ideal yield to maturity. If the net present value of the bond is positive, then it is worthwhile to invest in the bond. The valuation assessment can be completed when the investor is determining what he or she thinks should be the appropriate yield to maturity or required rate of return. In this lesson, we have covered the following: Promised Yield-to-maturity can be calculated for a bond if the current market price and promised cash flows of the bond are given. The investor can then compare it with an appropriate discount rate. Intrinsic Value is the present value of the bond discounted by the appropriate yield to maturity or required rate of return. The value is compared to the market price of the bond to determine the net present value of a bond. Required Rate of Return also called the appropriate yield to maturity, is determined through a thorough study of the characteristics of a bond issue.

Geometric Mean

The compound average rate of return (geometric return) is similar to the arithmetic mean return, except the geometric return, because it does take compounding into account, will always be less than the arithmetic return. The compound average rate of return is also called the geometric mean return (GMR), where the GMR is computed over T successive time periods. The GMR formula is restated equivalently as follows: FORMULA For example, Kerry held an S&P Index Fund for three years. Her returns during that time were 20%, -10%, and 5% respectively. What was her geometric mean return? [(1 + .2)(1 - .1)(1 + .05)]1/3 - 1 = [(1.2)(.9)(1.05)]1/3 - 1 = (1.134)1/3 - 1 = 4.28% Keystrokes 1.20 ENTER .90 x 1.05 x 3 1/x yx 1 - f 4 The calculator returns: .0428 (which is also expressed as 4.28%)

Correlation Coefficient

The correlation coefficient is represented by the lowercase Greek letter rho ( p ). The correlation is a standardized index number that varies in the interval from 1 to -1 and measures how two variables co-vary. The correlation is also a goodness-of-fit statistic that measures how well the data points fit a regression line: If the asset and the market returns are perfectly positively correlated, p = 1 and all the data points lay on a positively sloped regression line. If the two returns are perfectly inversely correlated when p = -1 and all the data points lay on a negatively sloped regression line. If p = zero, the dependent and the explanatory variables are uncorrelated. Two variables that are uncorrelated do not co-vary together. They are statistically independent of each other. The correlation between the typical NYSE stock and the NYSE index is 0.50. The characteristic line of Coca-Cola has a higher than average correlation at 0.785, which means that its stock returns follow its characteristic line more closely than the average NYSE stock.

Coefficient of Determination

The correlation coefficient squared is called the coefficient of determination, R2, or R-squared. R-squared measures the portion of the assets performance that can be attributed to the returns of the overall market. Since the correlation of coefficient's value is between -1 and 1, R-squareds values can only be between 0 and 1 (the square of anything less than zero will equal a positive number). If R-squared = 1, then the assets return is perfectly correlated with the return of the market. If R-squared = 0, then the assets return has nothing to do with the markets return. The closer to one that an assets R-squared value is, the more reliable its beta. Graphically speaking, if the actual points plotted between the assets return and the markets return hover close to the characteristic line, then R-squared would be closer to one. If the points are scattered randomly away from the line, then R-squared is closer to zero.

Coupon Rate

The coupon rate of a bond can also be called interest or income. They are called coupons because in the past, holders of these debt instruments were required to mail in coupons from their certificates in order to receive interest payments. Most investors purchase bonds in order to receive the income. Fixed-income securities are often considered a good alternative to supplement income. Most corporate bonds pay coupons semi-annually. Interest, or the coupon rate, is again the price of money or the cost of borrowing money. The coupon amount is influenced by the risks that an investor is taking to purchase the fixed-income securities. Plus, consideration must be given to the current interest rate environment set by monetary policies of the Federal Reserve. If the issue was exposed to a significant amount of risk, it would have to make the coupon attractive enough for investors to want to purchase it. Have you ever applied for a car loan or a home mortgage? The interest rate that you received was partially dependent on your credit history. The lower your credit score, the more money the lending institution would want from you in the form of interest to compensate for taking on the additional risk. REAL LIFE EXAMPLE: In the old days, bondholders would have to clip off coupons from the bottom of the bond certificate and mail them to the issuer in order to receive coupon payments. Brokers actually gave away scissors when investors purchased bonds. Today, brokers hold records of who owns the bonds and coupons are automatically paid to them.

Current Yield

The current yield of a bond measures an annual cash flow relative to the bonds current market price. Retirees who live on investment cash flows, for instance, are interested in a bonds current yield. The current yield is an accurate representation of what you are earning based on the price you paid. If the bond is selling at par, then the current yield is the same as the coupon rate. Current Yield = Dollars of coupon interest per year/Bonds current market price For example, Janet owns a 9% coupon bond that is currently selling for $988.09. Assuming the bonds par value is $1,000, what is the bonds current yield? Current Yield = $90/$988.09 = 9.108%

Disadvantages of Mutual Funds

The disadvantages to investing in mutual funds are: Lower-than-market performance. There is no guarantee that mutual funds will outperform the market. On an average, most mutual funds under-perform the market. Costs. The costs associated with investing in mutual funds can vary dramatically from fund to fund. Risks. In an attempt to beat the competition, many funds have become specialized or segmented. When mutual funds focus on small sectors of the market, such as health/biotechnology stocks or Latin America, they are not very well diversified. Systematic risk. You can't diversify systematic or market risk (risk resulting from factors that affect all stocks). So, if theres a market crash, investing in mutual funds isnt going to protect you. Taxes. When mutual funds sell securities within their portfolios for a profit, the majority of the capital gain is distributed to the shareholders. There is a lack of control of the holding period, so the distributed gains can have more short-term gains (which are taxed as income) than long-term gains (which are taxed at a lower fixed percentage ). Unrealized capital gain. When you buy a fund, you are essentially buying someone else's tax liability. The difference between the market value of the stocks currently held by the fund, and what the fund paid for the stock (the fund's basis) is known as "unrealized capital gain." This data, along with fund turnover (how often a fund trades its securities) information, will be a fairly good predictor of realized capital gains, as described under the tax disadvantage, above. The very nature of a mutual fund necessarily means that the newest shareholders will subsidize the capital gain taxes for the longer-term shareholders. Style drift. Over time, the internal fund managers who make asset allocation and security selection decisions, may deviate from the stated fund's objective. Poor for estate planning. Mutual funds do not lend themselves for basic estate planning issues such as giving your highly appreciated assets away, and selling losers for tax breaks. Transaction price. Can only buy or sell at a price at the end of the trading day. This can be a huge disadvantage in a rapidly moving market.

VALUATION OF BONDS & STOCKS

VALUATION OF BONDS & STOCKS

Market Index Futures

The figure below shows a set of quotations for futures contracts on the Standard & Poors 500-market index. This contract involves the payment of cash on the delivery date of an amount equal to a multiplier times the difference between the value of the index at the close of the last trading day of the contract and the purchase price of the futures contract. If the index is above the futures price, those with short positions pay those with long positions. If the index is below the futures price, those with long positions pay those with short positions. A clearinghouse is used, and all contracts are marked to market every day. The delivery day differs from other days in only one respect; after all open positions are marked to market for the last time, they are then closed. Cash settlement provides results similar to those associated with the delivery of all the securities in the index. It avoids the effort and transaction costs associated with: The purchase of securities by people who have taken short futures positions, The delivery of these securities to people who have taken long futures positions, and The subsequent sale of the securities by those who receive them.

Convexity

The first and fourth bond pricing theorems have led to the concept in bond valuation known as convexity. Consider what happens to the price of a bond if its yield increases or decreases. According to theorem 1, bond prices and yields are inversely related. However, according to theorem 4, this relationship is non-linear. Based on the above discussion the concept of convexity can be stated as: The size of the rise in a bonds price associated with a given decrease in its yield is greater than the drop in the bonds price for a similar-sized increase in the bonds yield. This relationship is true for standard types of bonds, but the degree of curvature (or convexity) is not the same for all bonds. The degree of convexity for bonds depends on: The size of the coupon payments, The life of the bond, and The current market interest rate.

American Deposit Receipts (ADR)

The first way foreign securities may be traded in the United States is for the shares of the firm to be traded directly, just as the shares of a typical U.S. firm are. The second way foreign securities may be traded in the United States is with American Depositary Receipts (ADRs). ADRs are financial assets issued by U.S. banks. They represent indirect ownership of a certain number of shares of a specific foreign firm that are held on deposit in a bank in the firms home country. A portfolio consisting of both domestic stocks and ADRs can lower the portfolios overall risk. Since ADRs are less correlated to the movement of the U.S. stock market, they provide some additional diversification to a portfolio. However, the investor in an ADR is still subject to foreign currency risk. The issuing bank does nothing to hedge against unfavorable relative currency movements between the domestic and foreign currencies. A strengthening dollar and a weak foreign currency would reduce the investor's return, while a weakening domestic (U.S.) currency and a strengthening foreign currency would enhance the investor's return. The following is a list of advantages of owning ADRs over direct ownership: Do not need to worry about the delivery of the stock certificates. No need to convert payments from a foreign currency into U.S. dollars. Depository bank forwards all financial reports from the firm. Investor pays the bank a relatively small fee for these services.

Futures Market

The futures contracts are traded on various organized exchanges. Although this method is similar to the way stocks and options are traded, some aspects of the method are different. As with stocks and options, customers can place market limits and stop orders with a Futures Commission Merchant (FCM), which is simply a firm that carries out orders involving futures. Once an order is transmitted to an exchange floor, a member must take it to the pit to be executed. What happens here is what distinguishes trading in futures from trading in stocks and options. First, there are no specialists on futures exchanges. Members can be floor brokers or floor traders. Floor brokers execute customers orders and keep a file of any orders that cannot be immediately executed. Floor traders execute orders for their own personal accounts in an attempt to make profits by buying low and selling high. Second, all futures orders must be announced by open outcry by any member wishing to buy or sell any futures contract. The member must also verbally announce the order and price at which they are willing to trade. In this way, the order is exposed to everyone in the pit, thereby enabling an auction to take place. This leads to the order being filled at the best possible price.

Loads and Fees

The load charge for front load funds represents the cost of advertising, education and promotion. By law, the percentage load charge cannot exceed 8.5% of the amount invested. Some funds have loads of less than 3.5% for purchases of all sizes and are hence dubbed low-load funds. Roughly 30% to 50% of this charge goes to the individual who sold the shares while the remainder goes to the selling organization. A few funds charge a redemption fee, which usually is no more than 1% of the funds net asset value and is not typically levied if the investor owned the shares for more than a specified time, such as one year. Hence, the basic purpose of a redemption fee is to discourage investors from selling their shares soon after buying them. In addition, mutual funds may charge current shareholders an annual distribution fee. This fee, which is called a 12b-1 fee, is not legally allowed to exceed 1% of the average market value of the total assets. It pays for advertising, promoting, and selling the fund to prospective purchasers as well as providing certain services to existing investors. If a load fund has a contingent deferred sales charge (CDSC), the load is paid when the shareholder sells the shares. In time, the amount of the load could decrease to zero. A CDSC usually starts around 5-7% and declines 1% for each year held until it reaches zero. Over time, most funds convert their B shares to A shares which typically have a lower 12b-1 fee. PRACTITIONER ADVICE: Which class is suitable for the investor? It all depends on the holding period. Anyone with large investment amounts should take advantage of breakpoints available for Class A (front load) shares. The longer you plan on holding the shares, the more beneficial it is to hold Class A shares. You are better off paying your entire load as a percentage of the initial investment amount than over time as a percent of your account each year. If your account grows each year, the percentage becomes a larger actual amount paid. For Class B (CDSC) shares, although the load disappears over time, there is a higher 12b-1 fee that is paid annually as a percentage of the account. Class C (level load) shares have an annual fee, again based on the size of the account.

Lognormal Distribution

The lognormal distribution is closely related to a normal distribution. Like the normal distribution, the lognormal distribution is completely described by two parameters. These again, are the mean and variance. However, in the case of the lognormal distribution, the mean and the variance are of its associated normal distribution. In other words, in the real world we not only must track the mean and variance of the data set, we must also track the mean and variance of the data sets distribution! A key distinguishing feature of this distribution is that zero in the lower tail will always bound it, and the distribution itself will always be positively skewed. PRACTITIONER ADVICE: You will not be responsible for the creation or formulation of a lognormal distribution. However, it is important to realize that the lognormal distribution has been found to be very accurate in the distribution of prices for many financial assets. In fact, the primary principal of the Black-Scholes-Merton Option Pricing Model is that the asset underlying the option is lognormally distributed.

Time's influence and coupon rate's influence on duration

The longer the time, the greater duration. The greater the coupon, the lower the duration.

Benefits and Drawbacks of RE

The major draw for investing in real estate is the income the property can generate coupled with the opportunity for capital gains. Unfortunately, the tax advantages that helped produce real estate fortunes in the past are largely gone or are on the way out. Direct investments in real estate are very active forms of investing, in which time, energy and knowledge are all important ingredients. Other drawbacks to investing in real estate include illiquidity. That is, if you do have to sell your property holdings, it may take months to find a buyer, and theres no guarantee that youll actually get what you feel is a fair price. In addition, overbuilding in some areas has actually resulted in a decline of property prices. For example, Southern California has seen dramatic drops in property values in recent years. The bottom line is that real estate investment is not well suited to the novice investor.

Nasdaq

The majority of U.S. stocks are traded in the over-the-counter (OTC) market. The National Association of Securities Dealers Automated Quotation (Nasdaq) system, is a computerized system that facilitates trading and provides up-to-the-minute price quotations on approximately 5,000 of the more actively traded over-the-counter stocks. Historically, Nasdaq was known as the home of many high-tech stocks. The better-known technology stocks currently quoted on the Nasdaq include Microsoft, Intel, Dell and Cisco. Rather than having a central physical location where buyers and sellers trade, the Nasdaq is the worlds largest electronic market. Because of its open architecture, it has the ability to facilitate trading of a companys stock by an unlimited number of users.

Closed-End Fund Quotations

The market prices of the shares of closed-end funds are published daily in the financial press, provided that the funds are listed on an exchange or traded actively in the over-the-counter market. Unlike the market price, a funds net asset values are published weekly and are based on the closing market price for the previous Friday. A closed-end funds shares are considered to be trading at discount when their market price per share is less than their NAV. The funds shares are considered to be trading at a premium when the shares market price is greater than the NAV. The figure below indicates that the India Growth Fund was selling at a 13.0% discount while the Indonesia Fund was selling for a 90.7% premium. These two investment companies are known as country funds, as they specialize in Indian and Indonesian stocks, respectively. Most closed-end funds that invest in stocks (with the exception of a few country funds) sell at a discount.

Market Value

The market value of a stock is dependent on the demand and supply of its shares. Many different factors can affect why someone would want to buy shares of a companys stock. It could be that the company is doing well, or the stock market in general is doing well. Market value of a stock is expressed as its quoted price. Actively traded stocks are priced throughout the day. You can obtain the price of most stocks on TV or the Internet. Most services provide real-time prices, usually for free. In the past, stock prices were quoted in fractions of eighths for amounts less than a dollar. Today, the prices are quoted in dollars and cents using a decimal. Buyers pay the quoted ask price (price at which the market maker is willing to sell the stock), while sellers receive the quoted bid price (price at which the market maker is willing to buy the stock).

Call Options

The most prominent type of option contract is the call option for stocks. It gives the buyer the right to buy or call away a specific number of shares of a specific companys stocks from the option writer, at a specific purchase price, at any time up to and including a specific date. Note: European options cannot be exercised until the day before expiration. The following is a list of call option contract elements: The company whose shares can be bought, The number of shares that can be bought, The purchase price for those shares, known as the exercise price or strike price, and the date when the right to buy expires, known as the expiration date. A writer of call options is expecting that the price of the stock will remain below the exercise price for the duration of the contract and therefore earn the amount that the buyer paid for the contract. A buyer of call options is hoping that the price of the stock will rise. If the price of the stock shares rise above the exercise price plus premium paid for the option contract, then the buyer will likely sell or exercise the option. If the option is exercised, then the buyer buys the shares at the exercise price and sells the shares in the market for a higher price. A call option where the writer does not own the stock is called a naked option. For the writer, a naked call can carry additional leverage. The writer does not put up any money, and if the option is never exercised, the writer gains the premium paid for the option. This is an example of how an option can be speculative. As the price increases beyond the exercise (strike) price, the writer will need to go into the market to purchase the shares in order to deliver. The higher the price of the stock before the buyer exercises the option, the greater the writers loss will be. Significantly less risky than a naked call, a covered call option is one where the writer of the call option already owns the underlying stock. In the event that the stock is called from the writer, they already own the shares to deliver to the buyer of the contract. The covered call writer only has one issue - are they willing to sell their shares for the contracted strike price? If so, this can be an excellent strategy to generate income until such time comes, when the stock is eventually called.

Foreign Bonds

The most significant advantage of investing in foreign bonds is to enhance the level of diversification within your fixed income portfolio. However, there are special risks to be aware of in any type of foreign investing. Exchange rate risk: The relative valuations in currencies will affect your return. If the domestic currency weakens relative to the foreign currency (which the foreign bond is denominated) your return will be enhanced. If the domestic currency strengthens relative to the foreign currency, the return will be adversely affected. Political risk, or sovereign risk, refers to possible changes in a foreign nations political climate, since political systems and even entire governments may change. Tax risk: Foreign bonds are subject to foreign taxation. Furthermore, these taxes are usually taken directly from the investment proceeds, reducing the overall return. Foreign investments are also subject to U.S taxation as well, even though the U.S. government allows a foreign tax credit to reduce some of the tax burden.

Par Value

The par value of a fixed-income security is also known as its face value. It is the initial price of the security. Some of the shorter-term fixed-income securities, like money market instruments, are typically issued at higher par values such as $100,000 or $1,000,000. Longer-term corporate bonds are typically set at a par value of $1,000. When a fixed-income security is traded in the secondary market, its market price is dependent on the current interest rate environment. When interest rates increase above the stated interest of the debt (the coupon rate), then new debt will be paying a higher rate than the existing debt. Therefore, in order for the existing debt to be as appealing to buyers in the secondary market, its market price must decrease below par value, otherwise known as a discount bond. When interest rates decrease below the stated interest of the debt (the coupon rate), the security will be worth more since new debt pays less interest. Therefore, the market price for the debt would be above par value, otherwise known as a premium bond.

Multi-Period Models

The present value model can value investments that span more than a single time period. Present value, or PV = CF1/(1+k)1 + CF2/(1+k)2 + CFT/(1+k)T This valuation model says that the value of a series of cash flows equals the discounted present value of all future cash flows. CF stands for cash flow (either inflows or outflows). The cash flows could be cash dividends from a common stock, coupon interest from a bond, rent from a piece of real estate, the assets selling price, or other cash flows. The subscripts and exponents are time period indicators. The terminal time period, when the cash flow occurs, is denoted T. These cash flows are expected to arrive at the end of successive time periods denoted t = 1, t = 2, t = 3,...., t = T. The term k represents the required rate of return that is appropriate for the investment. In case of U.S. Treasury bonds, the cash flows are known with certainty in advance and a risk-free discount rate is used. For risky investments, expected cash flows and a risk-adjusted discount rate is used. Since a corporation is assumed to survive indefinitely, it is sometimes appropriate to set T = infinity. Each time period denotes an opportunity for the cash flow to be reinvested at k. Each cash flow is compounding over the time period. Values for K The following are created based on a combination of risk premiums to compute a securitys Required Rate of Return (Cost of Capital): For Treasury bills, k = 4.5% For Treasury notes, k = 5.5% For Treasury bonds, k = 5.9% For corporate bonds, k = 6.3% For large-cap stocks, k = 13.0% For small-cap stocks, k = 14.5%

PV for Common Stock

The present value of any stock is simply the summation of the expected future cash flows discounted at the appropriate required return. As we will see in the next section, there are specific valuation models for the assumption of constant growth of the dividend (the so called Dividend Discount Models DDM), and a specific valuation model when you assume a constant dividend with no future growth (known as a perpetuity). Furthermore, as demonstrated here, there is a straight forward cash flow model to accommodate any assumptions one can make changing the dividend and expected terminal value information. The following formula shows this flexible version on stock valuation: PV = [CF1/(1+k)1]+[CF2/(1+k)2]+[CFT/(1+k)T] Example: Brenda is thinking of purchasing stock in a small corporation. She thinks the stock should earn a required rate of return of k = 14.5%. Brenda expects to sell the stock for $40 after collecting cash dividends of $2 per share at the end of the first year, and $3 per share at the end of the second year. The present value of this stock is $34.5455 per share. = [$2/(1.145)1] + [$3/(1.145)2] + [$40/(1.145)2] = $1.7467 + $2.2883 + $30.5105 = $34.5455 Brenda makes a wealth-maximizing decision to buy the stock if she can get it for less than $34.5455 Keystrokes: 0 g CF0 2 g CFj 43 g CFj 14.5 i f NPV The calculator returns: 34.5455

Marking to Market

The process of adjusting the equity in an investors account in order to reflect the change in the settlement price of the futures contract is known as marking to market. Each day, as part of the marking-to-market process, the clearinghouse replaces each existing futures contract. The new contract contains the settlement price reported in the financial press as the new purchase price. In order to understand marking to market, consider the initial margin example of wheat futures in which B and S were, respectively, a buyer and a seller of a 5,000-bushel wheat futures contract at $4 per bushel. Now, assume that on the second day of trading the settlement price of July wheat is $4.10 per bushel. In this situation, S has lost $500 = ($0.10 X 5,000) owing to the rise in the price of wheat from $4 to $4.10 per bushel, while B has made $500. Thus the equity in the account of S is reduced by $500, and the equity in the account of B is increased by $500. Because the initial equity was equal to the initial margin requirement of $1,000, S now has equity of $500 whereas B has equity of $1,500. In general, the equity in either a buyers or a sellers account is the initial margin deposit and the sum of all daily gains, less losses, on open positions in futures. Because the amount of the gains, less losses, changes every day, the amount of equity changes every day. In the example, if the settlement price of the July wheat futures contract had fallen to $3.95 per bushel the third day (that is, the day after rising to $4.10), then B would have lost $750 [5,000 X ($4.10 - $3.95)] whereas S would have made $750 on that day. When their accounts were marked to market at the end of the day, the equity in Bs account would have dropped from $1,500 to $750, whereas Ss equity would have risen from $500 to $1,250.

Future Positions

The process of marking to market every day means that changes in the settlement price are realized as soon as they occur. When the settlement price rises, investors with long positions realize profits equal to the change and those who are short realize losses. Conversely, when the settlement price falls, those with long positions realize losses, while those with short positions realize profits. In either event, total profits always equal total losses. Thus, either the buyer gains and the seller loses, or the seller gains and the buyer loses, because both parties are involved in a zero-sum game.

Yield to Maturity (YTM)

The rate of return on bonds that is most often quoted for investors is the yield to maturity (YTM), which is defined as the discount rate that equates the present value of all the bond's future cash flows with its current market price (purchase price). The YTM is the compounded rate of return of a bond. To determine the yield to maturity, or internal rate of return, an investor would use the bond's coupon rate, price, par value, and term to maturity. Thus, the present-value formula is appropriate for computing the compounded YTM for a bond that makes annual coupon payments and has T years until the bond matures and repays its par value (principal, face value). What is the YTM of a bond that matures in 9 years with a maturity value of $1,000, pays a 7% coupon (paid semi-annually), and the current price is $1,075.42? Keystrokes 1000 FV 18 n 35 PMT 1075.42 CHS PV i The calculator returns: 2.95 2 × The calculator returns: 5.91 Three conditions must be met in order for the bondholder to earn the bond's YTM: 1. Bond must be held to maturity. 2. Issuer does not default in timing of payments. 3. Payments are immediately reinvested at YTM.

Convexity and Duration

The relationship between bond prices and yields is referred to as Convexity. A graph of this relationship between YTM and bond prices would convex downwards. Although this is true for standard types of bonds, the degree of curvature is not the same for all bonds. Instead, it depends on, among other things, the size of the coupon payments, the life of the bond, and its current market price. Duration is a measure of the average maturity of the stream of payments generated by a financial asset. Mathematically, duration is the weighted average of the lengths of time until the remaining payments of the asset are made.

Normal Distribution

The symmetrical, bell-shaped distribution known as a normal distribution plays the center role in the mean-variance model of portfolio selection. The normal probability distribution is also used extensively in financial risk management. The normal distribution has the following characteristics: Its shape is perfectly symmetrical. Its mean and median are equal. It is completely described by two parameters its mean and variance. The probability of a return greater than the mean is 50%. The probability of a return less than its mean is 50%. There is approximately a 68% probability that the actual return will lie within + / - one standard deviation from the mean. There is approximately a 95% probability that the actual return will lie within + / - two standard deviations from the mean. There is approximately a 99% probability that the actual return will lie within + / - three standard deviations from the mean.

Time to Maturity

The time to maturity has a great affect on a fixed-income security's exposure to risk as well as the perceived value of the security. The longer the maturity of a fixed-income security, the greater the amount of time its coupon payments would be affected by interest rates and reinvestment risks. Therefore, longer-term fixed-income securities are perceived as higher risk and typically pay a higher coupon rate than shorter-term issues to compensate for that risk. However, there are occasions when the yield curve changes direction and becomes flat or inverted. In those cases, longer term bonds could pay the same, or less, yield than shorter-term securities. The value of a fixed-income security is derived from the present value of all of its future cash flows, including the return of principal or par value at maturity. The longer the duration of a fixed-income security, the more it is exposed to inflation risk, reinvestment risk, and interest rate risk. The added exposure to risks would again be compensated through higher coupon rates. As a security approaches maturity, its risk exposure is less and its sensitivity to interest movements is also less. PRACTITIONER ADVICE: Duration is a more accurate measure of the risk of a bond. Duration helps to determine how quickly your money is returned. It is expressed in number of years. All things being equal, the higher the coupon, the shorter the duration and vice versa. Also, the lower the duration, the less responsive the market price of a fixed-income security to interest rate changes.

Types of Options

The two most basic types of option contracts are known as calls and puts. These contracts carry an intrinsic value and can be traded on many exchanges around the world; many are created privately, that is, off exchange or over the counter. Privately created calls and puts typically involve financial institutions or investment banking firms and their clients. The types of option contracts can be defined as follows: Calls are option contracts where the writer gives the buyer the right to purchase a set quantity of securities at the exercise price from the writer. Puts are option contracts where the writer gives the buyer the right to sell a set quantity of securities at the exercise price to the writer. With Calls the Buyer wants the price of the underlying asset to increase beyond the strike price + premium cost while the Writer (Seller) wants the price to decrease below strike price + premium received. With Puts the Buyer wants the price of the underlying asset to decrease below strike price - premium cost while the Writer (Seller) wants the price to increase beyond strike price - premium received.

Future Value

The value of an investment at a future point in time is called future value. To derive the future value, we do not look at the present value of future cash flow through discounting. Instead, we look at the future value of investment through compounding. The future value of an investment for any number of years can be calculated using the following equation, where: FVn = PV(1+k)n FVn = the future value of the investment at the end of n years n = the number of years during which the compounding occurs k = the annual interest rate, and PV = the present value, or the current value in todays dollars. Again, time influences future value through compounding. Time also allows for compounding of inflation rate to erode away the purchasing power of the investment. The inflation adjusted compounding rate or the real rate is equal to: Real rate = [(1 + interest rate)/(1 + inflation rate)] - 1 For example, if a stock investment is expected to yield 11% on average over the next 10 years and the inflation rate is expected to average 4% during the same time, then the real rate = (1.11/1.04) - 1 = .0673 or 6.73%. The real rate can be used for the compounding rate to solve for the future value of the investment to show the return net of inflation. REAL LIFE EXAMPLE: There was a client who proclaimed that he didn't need to worry about his retirement planning because he had $500,000 in a savings account and that would be plenty for his retirement in 30 years. Unfortunately, this client failed to realize the purchasing power of the $500,000 in 30 years is nowhere near what it is today. Assuming that the inflation rate is at an average of 3% over the next 30 years, the future value of $500,000 discounted back 30 years is worth $205,993.38 today. If he left the $500,000 in a savings account paying him 2% per year, the future value of his account in 30 years would be $905,680.79. When $905,680.79 is discounted back using 3% for inflation, it would be worth $373,128.49 in todays dollars. In other words, unless this client can get a return of at least 3% per year, he will end up with less purchasing power for his savings. PRACTITIONER ADVICE An alternative method for calculating the real interest rate is to subtract the inflation rate from the nominal return (as a whole number), and then dividing that amount by 1 plus the inflation rate. Using the same example above, 11 - 4 = 7. Then 7/1.04 = 6.73. This is the real (or inflation adjusted) return, and is already expressed in the correct format for your calculator. The other method requires you to convert the decimal expression to a whole number.

Variable Annuities

The value of the annuity is dependent on market performance of a specified investment fund. The principal in a variable annuity is invested in a portfolio of securities. Therefore, the value of a variable annuity will increase or decrease with the changing value of the underlying securities. The future worth of the annuity will depend on the portfolios financial performance. If it does poorly, you could lose some or all of the principal. Variable annuities can have additional features to help manage the risk of their underlying investment, for an additional charge. One feature is a guaranteed death benefit. Another is a newer living benefit that provides guaranteed payments for owners or beneficiaries for the duration of the annuity contract. These payments could be higher than what an investor would receive from the annuity's actual investment performance. Since the annuity pays the insurance premium for the guaranteed death benefit and/or the living benefit, the annuity's expenses will be higher, causing the overall return to be lower. Variable annuities are often compared to mutual funds. A mutual fund is actually inside the annuity, and can consist of stock funds, bond funds, money market funds, real estate equity funds, and mortgage funds Investors choose variable annuities over fixed annuities when: They want more control over their investments. They are willing to bear the risk. They are seeking potentially higher retirement income. Investors choose variable annuities over mutual funds when: They want guaranteed life-long income (subject to sub-account performance). They want to purchase risk management features such as guaranteed death benefit amounts or living benefits. They want interest to accumulate tax-deferred during the accumulation phase, which could lower their Adjusted Gross Income (AGI). Investors choose mutual funds over variable annuities when: They want their investment earnings taxed at favorable capital gains rates. Investment earnings in variable annuities are taxed at ordinary income rates. They want to withdraw their earnings without penalties. Withdrawals of accumulated interest in variable annuities prior to age 59 ½ are subject to a 10% penalty. They don't want to pay extra mortality charges or surrender charges. Surrender charges are incurred if a variable annuity contract is terminated within the first 5-9 years. Variable annuities charge 1-2 ½ percent for management fees and mortality and surrender charges.

Expected Rate of Return

The weighted average of all the different rates of return in one probability distribution is called the expected return. It is denoted as E(r). Tom, a novice analyst, was trying to determine the expected return of Coca-Cola. The graph below is plotted based on Toms estimate of Coca-Colas probability distribution of returns. The vertical line (or the mean) through the center of the probability distribution of returns is Toms expected return, E(rCoke). This is equal to 20%. It is computed based on the weighted average of Toms estimation of Coca-Cola's likelihood to earn various returns for the coming year.

Other Indices

There are a number of other stock indices. The most well known of these is the Standard & Poors 500 Stock Index or S&P 500. Other indices in addition to this are the: Russell 2000, which is made up of 2000 small companies. Wilshire 5000, which is a very broad-based index made up of stocks from the NYSE, the American Stock Exchange and the NASDAQ. NYSE, the AMEX and the NASDAQ all have indices that chronicle the movement of their listed stocks. There are also indexes that represent small-cap stocks, micro-cap stocks, stocks of specific industries or sectors such as transportation or technology, stocks listed on other countries stock exchanges, etc. It is important to match the appropriate index with a particular stock or a portfolio of stocks. For example, it would be inappropriate to compare the performance of a Japanese companys stock performance to the DJIA. It would be more appropriate to look at the Nikkei index that is comprised of companies listed on the Japanese stock exchange.

Bond Pricing Theorems

There are five bond-pricing theorems that apply to a typical bond that makes periodic interest payments and a final principal repayment on a stated date. These are the five theorems : Theorem One: If a bonds market price increases, then its yield must decrease. Conversely, if a bonds market price decreases, then its yield must increase. Theorem Two: If a bonds yield does not change over its life, then the size of its discount or premium will decrease as its life gets shorter. Theorem Three: If a bonds yield does not change over its life, then the size of its discount or premium will decrease at an increasing rate as its life gets shorter. Theorem Four: A decrease in a bond's yield will raise the bond's price by an amount that is greater in size than the corresponding fall in the bond's price that would occur if there were an equal-sized increase in the bond's yield. (That is, the price-yield relationship is convex.) Theorem Five: The percentage change in a bonds price as a result of a change in its yield, will be smaller if the coupon rate of the bond is high.

Classifications of Common Stock

There are no formal classifications of common stock, but there are terms with which you should familiarize yourself. The most prevalent classifications are: Blue Chip Stocks are Common stocks that are issued by large companies with solid dividend growth records. Examples include McDonalds, Johnson and Johnson, and General Electric. Growth Stocks are Issued by companies that have sales and earnings growth well above the industry average. Earnings are retained and ploughed back into the company. Examples include Microsoft and Intel. Income Stocks are enerally associated with more mature firms that pay a relatively high dividend with little increase in earnings. Examples include utility company stocks. Value Stocks are out of favor with the investment community but there is some intrinsic value that may cause them to regain favor. Even blue chip stocks can be classified as value for a brief period of time. It all depends on the stocks current situation. Speculative Stocks are Risky, as it is difficult to forecast the companys future profits. Many of these stocks are traded on the OTC market. Cyclical Stocks are issued by companies whose earnings tend to move with the economy, and include producers of durable goods such as washing machines and cars. Defensive Stocks have earnings that are not affected by swings in the economy. In some cases they are inverse and perform better during downturns. Examples include producers of consumer goods such as beer, cigarettes and food products. Large, Mid and Small Caps. Refer to the size of the firm issuing the stock, and, more specifically, to the level of its capitalization or market value. Larger companies are perceived as more conservative. These classifications can overlap each other. For example, a stock can be categorized as a large company growth stock. The different classifications can help investors choose stocks suitable for their risk preferences.

Formula for Bond Duration

There are three variables that determine a bond's duration: Coupon rate, market interest rate, and the number of compounding periods until maturity. Note that price is not a determinant in calculating duration. Price is a function of the market rate of interest. Specifically, the formula for a bonds duration D is (see picture) where c denotes coupon, T denotes number of compounding periods to maturity, and y denotes the market rate of interest which can easily be determined by calculating the bond's yield-to-maturity. TEST TIP It is important to note, the formula will work for both annual and semi-annual compounding. In the examples that follow, the bonds pay an annual coupon. If in fact, the coupon payments are made semi-annually, the coupon rate would be halved, the market rate would be halved, and the compounding periods would need to reflect the number of 6-month periods. Finally, the result that you will arrive at (using semi-annual compounding) will be in units of 6-month periods. Since duration is always expressed in years, you will then have to divide by two (2). EXAMPLE: What is the duration of a 20-year bond with 8% annual coupon and an YTM of 7%? First, solve the first part of the equation and set the result aside (Set to four decimals, f 4 ) Keystrokes 1.07 ENTER .07 ÷ The calculator returns: 15.2857 Then, solve for numerator of the expression after the minus sign and set aside. Keystrokes .08 ENTER .07 - 20 × 1.07 + The calculator returns: 1.2700 Now, solve for the denominator. Keystrokes 1.07 ENTER 20 yx 1 - .08 × .07 + The calculator returns: .2996 Finally, divide numerator by denominator and subtract result from result set aside in step one. Keystrokes 1.2700 ENTER .2996 ÷ CHS 15.2857 + The calculator returns: 11.0467

Vacation Home

There was a time when only the very wealthy could consider owning a vacation home. Today, millions of Americans do. Most of these people do have incomes far in excess of the national average, but not all of them are extremely rich. Reasons why vacation homes are gaining popularity: It is easier and more commonplace to rent a vacation home during periods when it is not used. The federal income tax law might allow certain deductions that increase your after-tax income. Vacation homes have shown an excellent return on investment. Most people interested in vacation homes are those in their middle age who are planning for retirement. Their goal is to have a place to enjoy occasionally during their remaining work years and then to serve as a principal residence in retirement.

Dividend Growth Models

These are the different types of usable DDMs (dividend discount models): Zero-growth Model Constant-growth Model Multiple-growth Model

Reinvestment Risk

This type of risk refers to the inability of the investor to know the interest rate at which the proceeds from a maturing investment can be reinvested for the remainder of its holding period. For example, if an investor with a six-month holding period buys a 90-day T-bill, he or she is taking on the risk that interest rates available in 90 days may be less than what he or she is currently getting.

Exchange Rate Risk

This type of risk refers to the variability in earnings resulting from changes in exchange rates. For example, if you invest in a German bond, you first convert your dollars into German euros. When you liquidate that investment, you sell your bond for German euros and convert those euros into dollars. What you earn on your investment depends on how well the investment performed and what happened to the exchange rate. Imagine you went to Canada for a week's vacation. The day you leave you exchanged your US dollars for Canadian dollars at an exchange rate of US$1 = CAN$1.75. On the last day of your vacation, you wanted to exchange what you had left in Canadian currency back to US dollars. You discovered that during your vacation, the US dollar became stronger against the Canadian dollar and the exchange rate changed to US$1 = CAN$2. In this scenario, you assumed the exchange rate risk that the US dollar became stronger than the Canadian dollar. This lowered the amount of US dollars that you received back for your Canadian currency. For the international investor, exchange rate risk is simply another layer of risk.

Tax Treatment

Through a reciprocal arrangement with the federal government, coupon payments on state and local government securities are exempt from federal taxation, and coupon payments on Treasury and agency (except FNMA) securities are exempt from state and local taxation. Similar tax treatment is given to the price appreciation on short-term and long-term issues that are original issue discount securities. Tax treatment differs in cases where coupon-bearing securities were issued at par value but were subsequently bought at a discount in the marketplace. Such securities, known as market discount bonds, provide the investor with income not only from the coupons but also from the difference between the purchase price and the par value. Unlike the coupons, which are tax-exempt, this difference is treated as taxable interest income. An investor who resides in the state of the issuer is generally exempt not only from paying federal taxes on the coupon payments but also from paying state taxes on the coupon payments. Also, an investor who resides in a city that has an income tax and who purchases municipal bonds issued by the city, is usually exempt from paying city taxes on the coupon payments. For example, a resident of New York City would be exempt from paying taxes at the Federal, State, and City level for income generated from a New York City municipal security. Due to the tax-exempt status of municipal bonds, they pay lower coupon rates than U.S. Government or Corporate issues of similar term. However, the tax exemption may make the tax-free coupon rate more attractive to individuals who are in a higher income tax bracket. The Tax Equivalent Yield (TEY) helps investors determine whether or not they are better off investing in the lower yielding but tax-free municipal bond or in a higher-yielding taxable bond. TEY = Tax free rate/ (1- tax bracket)

Initial Margin

To buy and sell futures, an investor must open a futures account with a brokerage firm. This type of account must be kept separate from other accounts, such as a cash account or a margin account that the investor might have. Whenever a futures contract is signed, both buyer and seller are required to post initial margin. That is, both buyer and seller are required to make security deposits that are intended to guarantee that they will in fact be able to fulfill their obligations. Accordingly, initial margin is often referred to as performance margin. The amount of this margin is roughly 5% to 15% of the total purchase price of the futures contract. However, it is often stated as a given dollar amount regardless of the purchase price. For example, a July wheat futures contract for 5,000 bushels at $4 per bushel would have a total purchase price of $20,000 (5,000 X $4). With a 5% initial margin requirement, buyer B and seller S would each have to make a deposit of $1,000 (0.05 X $20,000). This deposit can be made in the form of cash, cash equivalents (such as Treasury bills), or a bank line of credit, and it forms the equity in the account on the first day. Whereas initial margin provides some protection to the clearinghouse, it does not provide complete protection. If the futures price of wheat rises to $5 per bushel by July, the clearinghouse faces a potential loss of $5,000, only $1,000 of which can be quickly recovered by the margin deposit. This is where the use of marking to market, coupled with a maintenance margin requirement, provides the requisite amount of additional protection.

Total Return

Total return represents the growth or depreciation of an investment. It has two key components: 1. Capital appreciation or depreciation 2. Dividends or interest Capital appreciation or depreciation is the difference between the purchase price and sale price. Dividends and interest are examples of income generated from the investment. The assumption is that the income is reinvested into the investment. If you are estimating the future total return of an investment for a bondholder who holds a bond until maturity, the total return will be the bonds yield-to-maturity. Predictions of a stocks future appreciation can be made using the current price/earnings ratio. Option holders can then add the premium cost to the total return. CASE-IN-POINT Advertised total returns for mutual funds are based on past performance. They list the beginning and ending of the holding period. Assuming no deposits or withdrawals are made in the account, and that all distributed dividends and capital gains are reinvested, the result is a hypothetical holding period total return. People are often confused by advertisements that boast high total return figures. When looking at advertised total return figures, there are several factors that you should consider: How does the return compare to its history? Check to see if the return was high because of an extraordinary year. Look at the average over the past three, five, and ten years. How does it compare to others? Check the return figure against the return figures of other funds in its peer group. (Be sure to use the same holding period.) What is the source of the return? If your objective is to generate monthly income from returns, then make sure that the total returns are generated from interest and dividends rather than capital appreciation. If your objective is growth of capital, then look for total returns made up of mostly capital appreciation. Remember the return is historic It is very important to point out that historical return figures are not indicative of future performance. If the return figures have been high for a few years, there is a good chance that the investment may be ready for an adjustment.

T-Bills

Treasury Bills are money market instruments issued on a discount basis, with maturities of up to 52 weeks and in denominations of $1,000 or more. All are issued in book-entry form. The buyer receives a receipt at the time of purchase and the bills face value at maturity. Although Treasury Bills are sold at discount, their dollar yield (the difference between the purchase price and the face value if the bill is held to maturity) is treated as interest income for tax purposes. Since T-Bills are sold at a discount, the true interest that investors are earning should be figured using the Bond Equivalent Yield. Because of the short-term maturity and backing of the U.S. government, U.S. T-Bills are considered as close to being risk free as a security can get. The interest rate of the T-Bill is often referred to as the risk-free rate. The current price of the T-Bill can be determined by applying the following equation: Current Price = Face Value X [1 - ((Days to Maturity/360) X Discount Yield)] For example, a 6-month T-Bill maturing in 30 days with a discount yield of 2.4% would have a current price of $998 $1000 X [1 - ((30/360) X .024)] = $998

T-Notes

Treasury Notes are issued with maturities from one to ten years and generally make coupon payments semiannually. Some, issued before 1983, were in bearer form, with coupons attached. The owner simply submitted each coupon on its specified date to receive payment for the stated amount and therefore they were described as clipping coupons. Beginning in 1983, the Treasury ceased the issuance of bearer notes and bonds. All issues since then are in registered form. The current owner is registered with the Treasury, which sends him or her each coupon payment when due and the principal value at maturity. When a registered note is sold, the new owners name and address are substituted for those of the old owner on the Treasurys books. Treasury Notes are issued in denominations of $1,000 or more. Coupon payments are set at an amount so that the notes will initially sell close to par value.

Stripped Mortgage-Backed Securities

Unlike the traditional pass-through securities, the principal and interest of stripped instruments is not allocated to the bondholders on a pro rata basis. This results in a price/yield relationship that is significantly different than the underlying pass-through. The two most common types of stripped MBS are principal-only (PO) and interest-only (IO) strips. Principal-only strips just receive the principal payment of each mortgage payment. The payments start out small and grow over time as the principal component of the mortgage payment grows. Even though they are sold at a large discount to par, eventually the entire amount of principal will be repaid to the PO investor. The only question is will the realized prepayment rates cause it to be paid sooner or later than expected. Interest-only strips just receive the interest payment of each mortgage payment. The payments start out large and get smaller over time. IO investors face a huge risk in that the cash flow over the life of the IO may be less than expected. It is even possible that the amount received will be less than the amount originally invested. This is due to the fact that as the mortgages are pre-paid (or even worse re-financed) the mortgage pool will be paid off sooner than expected, leaving the IO investor with no interest cash flow.

Types of Futures

Until the 1970s, futures contracts were limited to agricultural goods and natural resources. Since then, financial futures based on foreign currencies, fixed-income securities and market indices have been introduced on major exchanges. In terms of trading volume, these financial futures contracts are now far more important than both the underlying assets and traditional futures contracts. Unlike other types of futures that permit delivery any time during a given month, most financial futures have a specific delivery date. The exceptions involve some fixed-income futures.

Value Weighting (S&P 500)

Value weighting or capitalization weighting is another method used in computing a market index. In this method, the prices of the stocks in the index are multiplied by their respective number of shares outstanding and then added up in order to arrive at a figure equal to the aggregate market value for that day. This figure is then divided by the corresponding figure for the day that the index was started, with the resulting value being multiplied by an arbitrarily determined beginning index value. There are no special procedures needed to handle stock splits, because the resulting increased number of shares for a company is automatically used after a split in calculating its market value. The S&P 500 employs a market-value weighting system that assigns each security a weight that is proportional to the market value of all that issue's outstanding shares. Such market value weights correspond to the investment opportunities that exist in the U.S. stock market. This characteristic makes the S&P 500 a useful standard of comparison for evaluating the performance of other U.S. common stock investments. In a price weighted index the highest price stock influences the index. In a value weighted index the largest company influences the index.

Warrants

Warrants are also called stock purchase warrants. They give the holder the option to purchase shares at an exercise price. The exercise price is set initially to be substantially higher than the prevailing market price. The value of the warrant will fluctuate along with the underlying stock and can be sold in a secondary market. The main characteristics of warrants are: They may be exercised before expiration but some require an initial waiting period. The initial exercise price may be fixed, or it may change during the life of the warrant. At the time of issue, one warrant typically entitles the holder to purchase one share of stock for the appropriate exercise price. Most warrants are protected against stock splits and stock dividends. This means that the investor will be able to buy more or less than one share at an altered exercise price if a stock dividend or stock split is declared. Warrants may be distributed to stockholders in lieu of a stock or cash dividend or sold directly as a new security issue. Warrants may also be issued offering some other kind of security. Warrants are traded on major stock exchanges and on the over-the-counter market. A warrant agreement defines the scope of the warrant holders protection and specifies certain restrictions on corporate behavior. All terms associated with a warrant are contained within the agreement.

Par Value of Common Stock

When a corporation is first chartered, it is authorized to issue up to a stated number of shares of common stock, each of which has a specified par value. The par value is typically lower than the initial sales price of the stock. The difference may be carried separately on the corporations books under stockholders equity. This is capital contributed in excess of par value or paid-in capital. The par value of the stock is carried in a separate account, generally titled simply as common stock, with an amount that is equal to the number of shares outstanding times the par value per share. For an equity security, par is usually a very small amount that bears no relationship to its market price, except for preferred stock, in which case par is used to calculate dividend payments.

Stock Exchanges & Markets

When an individual or an institution wants to purchase or sell shares of stock, they enlist the help of brokers. The brokers then go to a stock exchange to fill the individuals or the institutions order request. Not all stocks are represented on all exchanges. Some stocks are listed on exchanges that do not have a physical location, like the Nasdaq. Others are listed on exchanges where live auctions are held, like the New York Stock Exchange. Primary Market: IPO market where initial shares are sold by a company to a dealer. Secondary Market: Exchanges such as NYSE, AMEX, etc. Third Market: Shares are listed in an exchange but are selling in another exchange. Fourth Market: Direct trading of exchange listed shares by investors. It is cheaper to trade and anonymous. For example, Instinet.

Subordinated Debentures

When more than one issue of debentures is outstanding, a hierarchy may be specified. For example, subordinated debentures are junior to unsubordinated debentures, meaning that in the event of bankruptcy, junior claims are to be considered only after senior claims have been fully satisfied.

Changes in Term Structure

When yields change, bond prices also change, but some react more than others. Bonds with the same maturity date can react quite differently to a given change in yields. However, the percentage change in a bonds price is related to its duration. The prices of two bonds that have the same duration will react similarly to a given change in yields. For two bonds having the same duration or modified duration, it does not automatically follow that their prices will react identically to any change in the yield curve, because the associated yield changes can be different for two bonds having the same duration. CASE-IN-POINT Consider a bond with a maturity of four years that also has a duration of 2.78 years. When there is a shift in interest rates, and the yields on the three-year and four-year bonds change by the same amount, then their prices will change similarly. For example, if the yield on the four-year bond goes from 10.8% to 11.81% and at the same time the yield on the three-year bond is going from 10% to 11%, then the percentage change in the present value of the four-year bond will be approximately -2.53% [= -2.78 x (1.1181 1.108)/1.108]. The three-year bonds price change will also be approximately -2.53% [= -2.78 x (1.11 1.10)/1.10]. Here the difference in the two bonds modified durations (2.53 = 2.78>1.10 for the three-year bond. 2.51 = 2.78>1.108 for the four-year bond) is exactly offset by the different changes in yield (1% for the three-year bond; 1.01% for the four-year bond.)

The Characteristic Line

When you think of investments as probability distributions of returns, you tend to remember them in terms of their expected returns, variances, and other risk statistics like the beta and the residual variance. Beta and the residual variance are risk statistics that measure an investments systematic (undiversifiable) and unsystematic (diversifiable) risks. A simple linear regression called the characteristic line is used to measure an investments beta and residual variance. It is a time-series regression line used to explain the return of a given asset within a given period (ri,t). It uses the markets rate of return for a specific period (rm,t) and three other measures, namely, beta (B - slope of the line), alpha (a y axis intercept), and epsilon (e - a random variable that measures fluctuations above and below the characteristic line). Using this characteristic line, analysts can isolate an investments diversifiable and undiversifiable risks. ri,t = a i,t + B i (rm,t) + ei,t

Dollar vs. Time-Weighted Return

Which method is preferable for calculating the return on a portfolio? In the example, the dollar-weighted return was -1.95%, whereas the time-weighted return was -2.1%, suggesting that the difference between the two methods may not be very important. Actually, nothing can be further from the truth! You need to know that the only appropriate method for measuring a portfolio manager, investment advisor, or mutual fund manager, is with a time-weighted return. The reason is that they are not responsible for when an investor decides to add or withdrawal funds from an investment. It is in fact, only time-weighted returns that are published for the mutual fund industry. Dollar-weighted returns are totally appropriate for an individual investor, to measure their particular return, based on their particular experience of adding (reducing) funds when they did. PRACTITIONER ADVICE A time-weighted return is a geometric return which often requires using the N key for the root calculation. In the example above, the two returns are semi-annual, which, when multiplied, produce the annual return. If the same example had used annual figures, a square root calculation would be necessary, as denoted in the Geometric Mean Return formula. CASE-IN-POINT An investor is trying to decide between investment advisor Jones and investment advisor Smith. The investor decides to place funds with each advisor and monitor results for a while before committing to a long-term relationship. Jones initially receives $100,000 and Smith receives $900,000. For the next year, the stock market does very well, and each advisor's fund does equally well - up 50%. At this point, with the Jones portfolio worth $150,000, and the Smith portfolio worth $1,350,000, the investor decides to give Jones an additional $900,000 and Smith an additional $100,000. As far as the investor is concerned, they have now given both Jones and Smith $1,000,000. The second year the stock market crashes and each advisor's portfolio declines 50%. The final value (after two years) of the Jones portfolio is $525,000, and the final value of the Smith portfolio is $725,000. At the end of the second year, the investor (not knowing about time-weighted versus dollar-weighted) keeps Smith and fires Jones. The investor stated: "All I know is that I gave them each a million bucks; at the end of two years Smith had $725K while Jones only had $525k. Therefore, Smith did a better job." 1) Calculate the dollar-weighted return and time-weighted return for each advisor's portfolio. 2) Comment on the validity if the investor's comment. Answers: Dollar-weighted (Jones): Keystrokes: 100 CHS g CF0 900 CHS g CFj 525 g CFj f IRR (45.0%) Dollar-weighted (Smith): Keystrokes: 900 CHS g CF0 100 CHS g CFj 725 g CFj f IRR (15.6%) Time-weighted (Both): (up 50% in year 1 and down 50% in year 2) [(1+ -.50) x (1+.50)] ½ -1 = (13.4%) The investor's comment is not valid because on a time-weighted basis, both advisors had an equal return of (13.4%), which was solely based on a positive return of 50% in year one, and a 50% loss in year two. While it is true that on a dollar-weighted basis Smith outperformed Jones, it was only true because Smith got the big chunk of the investment prior to the good year, and only a small portion prior to the bad year. The opposite was true for Jones. This demonstrates the point that investment advisors, fund managers, etc. are not responsible for when cash flows are added or withdrawn from a fund.