Series 65 - Unit 7

Barometers of economic activity

3 broad categories of economic indicators of business cycle phases: 1. leading 2. coincident 3. lagging Published on a monthly basis by The Conference Board (non-govt not-for-profit) *Leading indicators* -economic activities that tend to turn down before a recession or turn up before the beginning of an expansion - used by economists to predict direction of economic activity 4-6 months hence - not all leading indicators move in tandem, but positive changes in a majority point to increased spending, production & employment - Include: 1. money supply 2. building permits 3. average weekly initial claims for unemployment insurance 4. average weekly hours in manufacturing 5. manufacturers' new orders for consumer goods 6. manufacturers' new orders for non defense capital goods 7. Index of supplier delivers- vendor performance 8. Interest rate spread btwn the 10-year Treasury bond and the federal funds rate 9. Stock prices 10. Index of consumer expectations *Coincident (current) indicators* - economic measurements that change directly and simultaneously with the business cycle - Include: 1. nonagricultural employment 2. personal income (minus SS, vet benefits, & welfare) 3. Industrial production 4. Manufacturing and trade sales in constant dollars *Lagging indicatore* - measurements that change 4-6 months AFTER the economy has begun a new trend -confirm trend; help analysts differentiate long-term trends from short-term reversals - Include: 1. average duration of unemployment 2. ratio of consumer installment credit to personal income 3. ratio of manufacturing and trade inventories to sales 4. average prime rate 5. change in the CPI for services 6. total amount of commercial and industrial loans outstanding 7. change in the index of labor cost per unit of output (manufacturing)

Capital Structure

4 elements builds a corporations capital structure: 1. Long-term debt 2. Capital stock (common & preferred) 3. Capital in excess of par 4. Retained earnings (surplus) If company changes its capitalization by issuing stocks or bonds, the effects will show up on the balance sheet *issuing securities* - When issue shares, the net worth on balance sheet increases by the additional capital raised ("liability/net worth" side) - Cash on the "asset" side increases *convertible securities* - when investor converts bond into shares of common stock, the liabilities decreases and owner's equity increases. - Note: changes are on the same side of the balance sheet, no change to assets *bond redemption* - liabilities reduced - decrease in cash on the asset side of the balance sheet - Note: bc the current asset (cash) was used to redeem a long-term liability (bond), working capital is reduced. But, bc no longer have semi-annual interest payments on the bond, the future effect is to increase company's cash flow *dividends* A. Cash - Declared: retained earnings are lowered and current liabilities increase - Paid: cash lowered and current liabilities increase B. Stock - no change (# of shares each shareholder owns increases, but each single share represents a smaller slice of ownership in the company, so its a wash) *stock splits* - does not affect shareholder's equity - on balance sheet, only par value per share and # of shares outstanding change *financial leverage* -A company's ability to use long-term debt to increase its return on equity - stockholders benefit from leverage if the return on borrowed money exceeds the debt service costs. But risky bc increases risk of default & company affected more by changes in interest rates - A company with a high ratio of long-term debt to equity is "highly leveraged": A. industrial companies = debt-to-equity ratio of 50%+ considered highly leveraged B. utility companies = bc of relatively stable earnings & cash flow, can be highly leveraged without undue risk - DEBT-TO-EQUITY ratio = Long-term debt/ capitalization *book value per share* - fundamental analyst focuses on the company's books - book value per share similar to NAV per share of an investment company. - for corp, it is the liquidation value of the enterprise - Do not include intangible assets (i.e., goodwill) -Formula: (tangible assets-liabilities- par value of preferred) ÷ (shares of common stock outstanding) = book value per share

Investment Return Measurements - nominal yield

nominal/coupon yield is the fixed % of par value that is printed on face of the bond

Corporate SEC Filings - 3 Filings

reports required to be filed with the SEC for publicly traded companies 1. Form 8-K -newsworthy events, make available to public -change in mgmt, change in company's name, mergers, acquisitions, new product introductions, bankruptcy, etc -filed within 4 days of occurrence -foreign issuers are exempt SO ADR's are exempt 2. Form 10-K -overview of company's business and financial condition -includes audited financial statements -more detailed than annual report 3. Form 10-Q -filed quarterly (w/in 40-45 days after end of quarter) -unaudited financial statements

Technical Analysis Chart Patterns Support and Resistance

represents the price action at the end of a long rising trend A. Resistance Level -level which the stock shows a resistance to move to a further price -more sellers than buyers B. Support Level -level which the price does not want to go below -more buyers than sellers

Valuation Ratios

used to compare companies within one or multiple industries 1. Earnings Per Share (EPS) -measures the value of a company's earnings for each common share (RE/outstanding shares) 2. Dividends Per Share -dollar amount of cash dividends paid on each common share (annual div/outstanding shares) 3. Current Yield (Dividend Yield) -expresses the annual dividend payout as a percentage of the current price (annual dividend/market value per share) 4. Dividend Payout Ratio -measures the proportion of earnings paid as dividends (annual div/EPS) 5. Price to Earnings Ratio (PE) -provides a relationship between the prices of different common stocks compared to the earnings that accrue to one share of stock (current market price/EPS) -growth companies > cyclical

Fundamental analysis - industries

*1. defensive industries*= least affected by normal business cycle - generally produce nondurable consumer goods: food, pharmaceuticals, tobacco & energy - during recessions & bear markets, stock in defensive industries decline less & advance less during bull markets (less risk, lower return) *2. Cyclical industries* = highly sensitive to business cycles and inflation trends - durable goods: heavy machinery, cars, raw materials (steel - COUNTERCYCLICAL INDUSTRIES will turn down as economy turns up and vice versa. E.g., gold mining. *3. Growth industries* = each industry passes thru 4 phases during existence: introduction, growth, maturity & decline - in the growth phase if industry is growing faster than the economy as a whole bc of technological changes, new products, or changing consumer tastes - companies usually retain all earnings to finance their business expansion, so growth stocks usually pay little or no dividends *4. Special situation stocks* = stocks of companies with usual profit potential resulting from nonrecurring circumstances, such as new management, the discovery of a natural resource on corporate property, or the introduction of a new product.

Economic Indicators - Balance of payments

- measures all of the nation's import and export transactions with those of other countries for the year - balance of payment account contains all payments and liability to foreigners (debits) and all payments and obligations (credits) received from foreigners Note: as US $ weakens (buys less foreign currency), then makes US exports more competitive in foreign markets (and vice versa). Note: Investors protect against weakening $ by investing in foreign securities (through ADRs)

Investment Analysis - terminology

*Alpha* = extent to which asset's or portfolio's actual return exceeds or falls short of its expected returns (want a positive alpha) *Arbitrage* = strategy that generates a guaranteed profit from a transaction (e.g. - simultaneous purchase and sale of a security in different markets at different prices to lock in a profit) *Beta* = a measure of a stock or portfolio's volatility in relation to the overall market - Beta of 1 = moves in line with market - Beta >1 = more volatile than overall market - Beta < 1 = less volatile *Capital asset pricing model (CAPM)* = securities market investment theory that attempts to service the expected return ion an asset on the basis of the asset's systematic risk *Completely diversified portfolio* = specific risk in each asset has been diversified away *Earnings multiplier* = another term for "price-to-earning (PE) ratio." Price of the stock divided by its earnings per share *Efficient market theory* = belies that prices of securities rapidly reflect simultaneous access to all information *monte carlo simulation* = statistical method to determine the return profile of a security/portfolio that recreates potential outcomes by generating random values on the basis of the risk and return characteristics of the securities themselves *optimal portfolio* = provides highest expected returns for a given level of risk *risk-free rate* = interest rate of 90 day T-bill *R-squared* = statistical measure in the beta family. Used to reference what percentage of a portfolio's performance can be tied to a standard benchmark - Range from 0-100 - If 100, then the security (or portfolio) moves right in line with the index - when drops below 50%, the performance of the security (or portfolio) does not have much in common with the index - higher R-squared value will indicate a more useful beta figure: if R-squared close to 100 but has beta below 1, most likely offering higher risk-adjusted returns. A low R-squared means you should ignore the beta *Sharpe ratio* = measure of security or portfolio's risk in comparison to its expected return. -Calculated as the portfolio's average return that is in excess of the risk-free rate dividend by the standard deviation of the portfolio - higher the sharpe ratio, more attractive the investment *systematic risk*= (a.k.a. "market risk"). Risk in the return of an investment that is associated with the macroeconomic factors that affect all risky assets. *unsystematic risk* = specified with an investment (combined w/systematic risk, equal the total risk of an investment)

Economic indicators - GDP & GNP

*Gross Domestic Product (GDP)* = expresses the total value of all final goods and services produced within the US in a year. GDP Includes: -personal consumption -govt spending -gross private investment -foreign investment -total value of exports *Gross National Product (GNP)* = in addition to GDP, includes the income in a country's citizens earned abroad & EXCLUDES income of foreigners earned domestically Note: - *GDP* measure country's output produced within its borders regardless of who generated it - *GNP* measures the output generated by the county's citizens regardless of where they did it

Interest rates & bond prices

*Inverse relationship* - A company borrow $ by issuing bonds with a fixed interest rate. As the interest rates fluctuate, the prices of the bonds in the secondary market also fluctuate *Interest rates increase, bond prices decrease *Interest rates decrease, bond prices increase

Top Down analysis & Bottom Up analysis

*Top Down analysis* (upside down triangle) - starts with the broadest measure of the overall economy and then successfully narrows it down to finally select the company or companies that best fit the objectives *Bottom Up analysis* (triangle) - start with the narrowest indicator (a specific company) and work way up thru the industry, and then the economy

Nominal and Real Interest Rates

*nominal rate of interest* = actual amt borrower pays for loanable funds. If inflation is expected, the nominal rate of interest will exceed the real rate of interest on a loan to compensate the lender for the decline in purchasing power *real rate of interest* = the nominal rate minus the expected rate of inflation E.g. - Corp pays 8% for a 1-yr loan & rate of inflation for the year is 2%, the real rate of interest is 6%

Economic indicators - Trade deficit

- Def: An excess of one country's imports over its exports - reported as part of the balance of payments figures - overtimes excessive trade deficit will lead to devaluation of county's currency bc the country will be selling its currency to obtain foreign currency to pay for its increasing imports (?)

After-Tax Return/Yield

- Determined by reducing the investment return by the client's tax rate E.g. - investment yields 10% and client in 25% tax bracket. Multiply the return by .75; the investor retains 75% of the 10% yield for a 7.5% after-tax return

Fundamental v. Technical Analysis

- Fundamental analysis looks at the company and technical analysis looks at the market -Fundamental = measures business or financial risk inherent in investing in a particular security -Technical = measures the market risk assumed when investing in a particular security

Risk measurements - Monte Carlo Simulations (MCS)

- MCS is risk analysis technique in which probable future events are simulated on a computer, generating estimated rates of return - E.g. - MCS used to randomly generate the behavior of various asset classes to obtain the range of possible outcomes for a portfolio - MCS is good for: A. situations where no real-world data exists; B. problems with unknown variables; C. problems for which no analytic solution exists - MCS commonly used in personal financial planning for wealth forecasting with estimated cash flow

Classical & supply side economics

- belief that lower taxes and less govt regulation benefits consumers thru a greater supply of goods and services at lower costs - supply creates demand by providing jobs and wages - deficient demand never a problem bc the production of goods will always generate (thru employment) sufficient demand to purchase the goods produced - Markets will adjust quickly to direct the economy to full employment. If unemployment temporarily high, wages will fall, which will reduce costs and prices. In turn, this increases product demand and demand for labor until excess supply of labor is eliminated

Yield to maturity (YTM)

- gain or loss investor will have when bond redeemed - when investor buys bond at discount, will make a profit in addition to annual interest - when investor buys bond at premium, will suffer a loss if hold to maturity - Might be given a quoted YTM and ask for price relative to par. If yield is higher than coupon rate, then bond selling at discount (and vice versa) - YTM on discount bond > CY - YTM on premium bond < CY YTM calculation premium: annual interest - (premium ÷ yrs to maturity) / average price of the bond* - average price = price midway btwn purchase & par. (purchase at 1050, average = 1025) -YTM of bond bought at premium is always lower than nominal yield and current yield YTM calculation discount: annual interest + (discount ÷ yrs to maturity) / average price of bond -YTM of bond bought at discount is always higher than both the coupon rate and current yield

Risk measurements - Convexity

- measurement of the curve that results when plotting a bond's prices movement in response to changes in interest rates - more accurate representation than duration of what will happen to a bond's price as interest rates change Need to know for exam: - duration is a linear measurement, while convexity follows a curve - comparing 2 bonds, the one w/the higher convexity will show greater price increase when yields fall and a smaller decrease when yields rise (that is a good thing) - If we find 2 bonds with the same duration, the one with the higher convexity offers greater interest rate risk protection

Internal Rate of Return (IRR)

- method of computing long-term returns that takes into account the time value of money - the "r" in the FV and PV calculations (the discount rate) - can only be determined by trial and error process called "iteration" - YTM of bond = the IRR bc it is the interest rate that equates the value of the bond's future cash flow with its current price - IRR not practical for common stock due to uneven cash flow and no maturity date IRR can be used to determine whether investment meets the investor's required rate of return

Capital Market Line (CML)

- offshoot of CAPM - CML provides expected return based on level of risk - Provides expected return of portfolio based on risk-free rate, return on market, and SD of portfolio in relation to SD of market - (does not use alpha/beta)

Yield to Call (YTC)

- rate of return the bond provides from purchase date to call date + price - issuer only calls when bond selling at a premium; YTC lower return than YTM (and current yield)

Annualized Return

- return if investor holds investment for 1 year - determined by multiplying the actual return by an annualization factor - Annualization factor = # of days in a year ÷ # of days investment held

Systematic Risk

- risk that changes in the overall market will have an adverse affect on individual securities regardless of the company's circumstances (war, natural disaster, etc.) - cannot be diversified away - primary types: market risk, interest rate risk, purchasing power risk (inflation) Market risk - measured by a security's beta - longer investor's time horizon, the better one is able to absorb market risk - cannot be diversified, but strategies to reduce it include: 1. buy put options on a broad index (put options become more valuable when the underlying asset falls in price) 2. sell short an ETF based on a broad index (selling short generates a profit when the security falls in price) Interest rate risk - If market conditions or the Fed Reserve push interest rates higher, the market price of all bonds will be affected - when interests rates rise, market price of bonds fall - rising interest can be bearish for some common stock prices, particular for highly leverage companies such as public utilities -**The greater the duration, the higher the interest rate risk Purchasing Power (Inflation) risk - fixed income securities most vulnerable to this risk

Unsystematic Risk

- risks that can be reduced thru diversification - unique to specific industry or business enterprise, such as labor union strikes, lawsuits, product failure - primary types: business, financial, liquidity, political, regulatory Business risk - An operating risk; generally caused by poor management decisions - higher for investors whose portfolios contain stock in only 1 issuer or in lower rated bonds Financial risk - relates primarily to companies using debt financing (leverage). This is the inability to meet those debt obligations, which could lead to bankruptcy Regulatory risk - Individual companies and industries are affected by changes in rules - investments that could be affected include "green industries" (and those that tend to pollute), oil and gas exploration, airlines, & pharmaceutical manufacturers - the most common regulatory risk comes from govt agency attempts to control product prices or the competitive structure of a particular industry thru the passage and enforcement of regulations Political risk - different from regulatory & legislative risk - political instability Sovereign risk - risk of a country defaulting on its commercial debt obligations Country risk - evaluates total investment risk of a country, such as risk of default on a bond, risk of losing direct investment, risk to global business dealings, by both qualitative and quantitative factors - qualitative: political risk, economic performance, structural assessment - quantitative: debt indicators, credit ratings, access to bank finance Liquidity risk - risk that when an investor wishes to dispose of an investment, no one wants to buy it or not possible at the current price

Balance Sheet - quick ratio ("asset test ratio")

- stricter test of company's ability to pay short-term debts - uses only quick assets - quick assets = current assets - inventory **quick ratio = quick assets/current liabilities

Net Present Value (NPV)

- the difference btwn an investment's present value and its cost - NPV of $10 means that an investment that cost $100 must have a discounted present value of $110 - Expressed as a $ amt and not as a rate of return - more important than IRR Analytical concept used by corps to determine whether to invest in a capital project: - anticipated invoice is discounted to present value by using company's required rate of return as discount rate - if discount PV of projected > cost of project, then positive NPV Investment advisor use NPV to evaluate client's investment in any investment vehicle with projected income stream. - project cash flows from investment - discount projected cash flows to PV at the investor's required rate of return -If positiv NPV, good investment

Income in Perpetuity

- when a client wants to have income provided forever - Divide the desired income by the average expected rate of return to determine the lump sum required to yield that income perpetually

Income Statement

-*Sometimes called a "profit & loss statement." -This summarizes a company's revenues and expenses for a fiscal period - Fundamental analysts use the income statement to judge the efficiency and profitability of a company's operation

Modern Portfolio Theory

-Attempts to quantify & control portfolio risk. -Differs in that it looks determines relationship of risk/reward in PORTFOLIO rather then specific security - Theory holds that specific risk can can be diversified away buy building portfolios of assets whose returns are not correlated. - Aim to reduce risk while increasing returns Derived from the CAPITAL ASSET PRICING MODEL (CAPM) -pricing of stock must take into account systematic and unsystematic risk - CAPM used to provide an expected return on a security or portfolio based on level of risk *Goal of MPT = Create the most EFFICIENT PORTFOLIO* A. most return for given amt of risk; or B. least risk for given amt of return Efficient Set/Frontier: - the "feasible set" = all portfolios that can be constructed in a given set of equities - "efficient frontier"= collection of efficient portfolios (selected from the feasible set) - efficient frontier is plotted as a curve and the portfolio must lie on the curve. - Anything below the curve is taking too much risk for too little return

Eurobond

-Bond denominated in currency other than the currency of the country in which it is used -*Eurodollar bond* is issued by overseas companies outside the US, as well as the issuer's home country Advantages of eurodollar bonds: - *Do not have to register with SEC, resulting in lower insurance costs -No currency risk to US investors - rated by US ratings agencies so risk is clear - may offer higher yields than domestic bonds from same issuer Disadvantages of eurodollar bonds: - since not registered with SEC, lack of transparency - political and social risks (taken into acct by rating agencies) - less liquidity than domestic issues

Expected Return

-Estimates of the probably returns an investment may yield - to determine estimated return, the advisor assigns a probability to each return the investment is likely to earn and then multiplies that return by the probability of it occurring Expected return = (probability of return #1 x possible return #1) + (probability of return #2 x possible return #2) Expected return is also a mean or average return

Balance Sheet - current ratio

-Expresses the working capital as a ratio - The higher the ratio, the more liquid the company is **current ration = current assets/current liabilities

Risk measurements - Sharpe Ratio

-Formula: 1. Overall return - Risk-free Rate (90 day T-bill rate) = Risk Premium 2. Risk Premium / SD = Sharpe Ratio -Ratio measures the amount of return per unit of risk taken - higher the ratio, the better return per unit of risk - in order to have a positive sharpe ratio, the actual return must exceed risk-free rate *Measures risk-adjusted return*

Total Return

-Includes income from dividends or interest plus any capital appreciation (or less capital depreciation) over a given time period, usually one year - considered best measure of how security performed total return = (dividend + capital appreciation) ÷ purchase price

Economic indicators - Consumer Price Index (CPI)

-Measure of the general retail price level - compares the current cost of buying a basket of goods with the price of that basket 1 year ago - attempts to measure the rate of increase or decrease in a broad range of prices (food, transportation, housing, medical care, clothing, electricity, entertainment, services) - Published monthly by Bureau of Labor Statistics (BLS) - Most commonly used measure of rate of inflation -core CPI: all items excluding food and energy due to their high short term volatility (term used by media not govt)

Monetarist theory

-Quantity of money determines price levels and economic activity. -Believe that well-controlled money supply leads to price stability & price stability allows business managers (who are more efficient allocators of resources than the govt) to plan and invest, which in turn keeps the economy from experiencing extremes in the business cycle Basics: - money > # of goods = inflation - money < # of goods = deflation *Principal roles of Fed Reserve is monitoring $ supply and making adjustments when necessary

Balance sheet - Shareholder equity

-a.k.a. "net worth" or "owner's equity" -Stockholder's claims on company's assets after all creditors have been paid - Equals the total assets less the total liabilities 3 types of shareholder equity identified on the balance sheet: 1. *Capital stock at par* - preferred and common stock listed at par. - Par is the total $ value assigned to stock certificates when corp's owners first contributed capital. Arbitrary value w/no relation to market price. 2. *Capital in Excess of Par* - a.k.a. "additional paid in" or "paid-in surplus* - amt of $ over par value company received for selling stock 3. *Retained earnings* - a.k.a "earned surplus" - profits that have not been paid out in dividends since the company's formation - operating losses in any year reduce the retained earnings for prior years *capital stock + capital in excess of par + retained earnings = shareholder's equity

Technical Analysis

-chartists -used to measure the market risk assumed when investing in a particular security -method of attempting to predict stock price trends over the near term. Prediction based on relationship of current stock price trends to past trends -tries to reduce TIMING RISK by using charts of price movements and trading volumes of a stock in attempt to validate a trend -overbought: extended period of buying & no more buyers to provide demand (prices down or horizontal) -oversold: extended period of selling & sellers run out of securities (prices stabilize or increase) - consolidation: during period of rapidly rising stocks, market must pause to consolidate gains in order to avoid becoming overbought -trendlines: chart previous prices of stock and attempts to determine the trend by drawing a trend line

Security Market Line (SML)

-derived from CML - evaluates individual securities in a diversified portfolio - Provides expected return of security on the basis of its beta & the expectations about the market and risk-free rate - want to determine how much over risk-free rate we should earn for taking investment risk - helps identify how characteristics of portfolio impacted when a security is added E.g. - beta of ABC Co. is 1.2, expected market return 13%, risk-free return 3% and expected return ABC 15% - begin with risk-free rate and multiply the expected return in excess of that rate by the stocks beta - 3% x 1.2(10%) = 3% x 12% = 15% - On the basis of systematic risk of ABC Co., it should earn 15%

Keynesian Economics

-importance of govt intervention - 1936 book laid out how and why recessions happen and strategy for recovery was for govt to run deficits to stimulate demand and employment (higher tax and more govt spending)

Dividend Model

1. *Dividend discount model* - value of stock should be equal to PV of all future dividends 2. *Dividend growth model* - assumes the amt of annual dividend will grow at a constant rate - forecasts a higher stock price

Efficient Market Hypothesis (EMH)

-maintains that security prices adjust rapidly to to new information, so markets are efficiently priced as a result - "random walk theory" = can throw darts at stock listing to select an investment - no way to redact stock prices and passive strategy most suitable for investment success. *Actual price of security is a good estimate of its intrinsic value* 3 versions of EMH based on level of information: 1. *Weak- Form Market Efficiency* -current security prices fully reflect all currently available SECURITY MARKET data. - past price & volume don't predict future direction. Price changes independent from one period to next -technical analysis useless but still possible to use fundamental analysis to seek out mis-priced investments 2. *Semi-strong Form* - security prices fully reflect all currently available PUBLIC information - Prices include past security market & non-market info such as company statements, economic factors -fundamental analysis is useless 3. *Strong-form* -Security prices fully reflect all PUBLIC & PRIVATE INFO - means that no group of investors has sole access to info relevant to prices and non should be able to consistently achieve abnormal returns - Fund & Tech analysis useless - "private" = insider; but insider-trading prohibited so markets are not actually Strong-form efficient, but ppl engaging in insider trading are.

Risk measurements - Standard Deviation

-measure of the volatility of an investment's projected returns, computed by using historical performance date - statistical term that measures the amount of variability or dispersion around an average. - Higher SD = larger the security's returns are expected to deviate from average return; greater the risk -Generally accepted that a security will vary within one SD about 2/3 of the time and within 2 SD about 95% of the time E.g. - a SD of 7.5 means that the return of a stock for a given period may vary by 7.5% above or below its predicted return of 2/3 of the time, and within 15% about 95% of the time E.g. - security has an expected return of 12% and a SD of 5%. Investor can expect returns to range within 7-17% about 67% of the time and within 2-22% about 95% of the time *SD v Beta* - Beta is a volatility measure of a security compared with overall market and only measure systematic risk - SD is a volatility measure of a security compared with its expected performance & *includes both systematic and unsystematic risk*

Technical Analysis Chart Patterns Moving Averages

-modifies fluctuations of stock prices into a smoothed trend -takes the Friday close price for last 13 weeks and plots the average price. Each week a new Friday price is used and average is re-calculated and plotted -if the price moves below the moving average, it is a signal of a change from a rising to declining market (and vice versa)

Annual report

-must be provided to shareholders -company can provide 10-K instead of sending this report

Risk Measurements - Discounted Cash Flow

-one way of assessing value of fixed-income security is by looking at the future expected free cash flow and discounting it to arrive at a present slue - basically, take the interest payments you will receive over a given future period and adjust that for the time value of money In order to compute future cash flow for bond, need to know: -principal amt - coupon rate; and - number of interest payments Higher the discounted cash flow, the more valuable the investment

Currency or Exchange Rate risk

-purchasers of foreign securities (i.e., ADRs) face uncertainty of whether the foreign or domestic currency will fluctuate

Risk measurements - Risk Premium

-the "extra" return over the risk-free return - a premium demanded for internal & external risk factor - Internal risk factors: diversifiable; include business, credit, liquidity, currency and country risk - External risk factors: macro & nondiversifiable; include market and interest rate risk - required rate of return on any investment is a combination of risk-free rate plus a risk premium -for equity investments, risk premium can be determined by reference to a risk premium curve or by using the CAPM

Opportunity cost

-the foregone return on an alternative investment -one can invest in short-term T-bills with no risk; any return that deviates from the risk-free return represents opportunity gained or lost -E.g.: 90-day T-bill is yielding 6% and investor chooses a stock w/expected return of 11%. If the stock actually returns 2%, then the opportunity cost is 4%, bc that is the rate the investor gave up, risk free, to assume the risk of investing in the alternative choice

Risk measurements - Duration

-used to measure the potential volatility of a debt security when faced with changes in interest rate - longer the duration, greater the volatility - basically measures the time it takes for the cash flow (interest payments) to repay the principal Characteristics to remember: - lower the coupon rate, the longer a bond's duration - higher the coupon rate, the shorter the duration - the longer a bond's maturity, the longer the bond's duration -for coupon bonds, duration is always less than the bond's maturity - duration for a zero-coupon bond is always equal to its maturity - the longer a bond's duration, the more its value will change for a 1% change in interest rates; the shorter the duration, the less it will change

Reinvestment risk

-variation of interest rate risk - there is reinvestment risk as to both interest and principal

Exhausting the principal

-when client has a fixed sum and wants to know how long he can take $ out before it is exhausted E.g. - investor has $100,000 to invest and wants to withdraw 12,000 per yr, expected return is 5% per yr. - divide principal by annual withdrawal rate (100 ÷ 12 = 8.33). Then choose the next highest number on the exam choices to account for earnings on the remaining assets.

Technical Analysis Chart Patterns Breakout

-when the price moves past the support and resistance levels -confirmed when movement is at least 3% penetration - another factor confirming breakout is that volume during a breakout is higher than during a normal charted period - technicians believe in "buy low, sell high" = buy as tend begins moving up from support to resistance (and vice versa)

Technical Market Theories

1. *short interest theory* - refers to # of shares sold short - Bc short positions must be repurchased, some analysts believe short inters reflects mandatory demand that creates a support level for stock prices - High short interest = bullish indicator - Low short interest = bearish indicator 2. *odd-lot theory* - "odd-lot trading"= transactions in fewer than 100 shares (small investors) - theory holds that small investors invariably buy/sell at wrong times, so odd-lot analyst will do the opposite (odd-lot trader buys, analyst will be bearish, & vice versa) 3. *Advance/decline theory* - market breath reflected in # of issues closing up or down on a day. -Plot daily advances & declines on graph to create advance/decline line that gives indication of market breath trends - Decline > advances = market bearish (even if closed higher) - Advances > declines = market bullish

Bond strategies to reduce interest rate risk

1. Barbells - investor purchases bonds maturing in 1-2 years and then an equal amount matures in 10 or more years, w/no bonds in btwn - the long-term end of barbell contains bonds offering the higher long-term interest rates, and short-term end provides investor with soon to be realized cash that may be reinvested at higher rates - will be actively buying new bonds and the old ones get closer to maturity 2. Bullets - strategy used for specific goal (i.e., college) - bonds are purchased at different times, but will all mature at the same time (target date) - allows investor to capture current interest rates as they change 3. Ladders - bonds are all purchased at the same time, but mature at difference times (like steps on a ladder) - as the shorter maturities come due, they are reinvested and now become the long-term ones - common strategy for those purchasing CDs at local bank

Market Averages (1)

1. Dow Jones Industrial Average -This is considered a market index but bc it is PRICE WEIGHTED, is truly an average -30 industrial stocks of the 30 best known corporations in the world - published in WSJ -4 Averages: A. 30 industrial stocks B. 15 utilities C. 20 transportation D. Composite of all 65

2 broad categories of investment analysis

1. Fundamental 2. Technical Fundamental = takes into consideration the financial statements and historical performance of the investments, and economic conditions Technical = focuses on pricing patterns as revealed in the market

Know for exam

1. Identify fundamental economic principles and 4 stages business cycle 2. compare and contrast balance sheet and income statement items and various ratios that are computed to measure corporate performance 3. differentiate between fundamental and technical analysis 4. Describe how investment advisers apply the following quantitative measurements: - time value of money concepts - investment return measurements - risk measurements

Relationships of different bond yields (summary)

1. If bond has YTC lower than its CY, it is trading at premium 2. If bond has YTM & CY that are equal, it is trading at par 3. If bond has YTM less than YTC, the bond is trading at a discount 4. If bond has YTM greater than its coupon, it is trading at a discount

Portfolio benchmarks

1. Large cap - S&P 500 2. Mid cap - S&P 400 3. Small cap - Russell 2000 4. International stocks - EAFE

Statement of Cash Flow - 3 components

1. Operating Activities -includes cash receipts from selling goods or services -includes income from interest and dividends -includes cash payments (going out) for cost of inventory, payroll taxes, interest, utilities, and rent 2. Investing Activities -purchase and sale of securities, land, buildings, equipment, and other assets -making and collecting of loans 3. Financing Activities -cash proceeds from issuing stock or bonds -payments to repurchase stock or retire bonds, payment of dividends, etc

Income Statement - components

1. Revenue -total sales during the period 2. Cost of Goods Sold (COGS) -costs of labor, material and production used to create finished goods - 2 methods of accounting for material costs: A. First in, first out (FIFO) B. Last in, first out (LIFO) - COGS will reflect higher costs of more recently purchased inventory; reduces reports income 3. Pretax earnings - Pretax margin determined by subtracting COGS and other operating costs (i.e., depreciation) from sales to arrive at the gross operating profit - Gross operating profit + income from non operating activities = pretax earnings or earnings before interest and taxes (EBIT)

Market Indices (5)

1. S&P 500 -CAP weighted; base period of 1941-43 equal to 10 - Most listed on NYSE, some top stocks listed on Nasdaq -includes 4 main groups: A. 400 industrials B. 20 transportation C. 40 public utilities D. 40 financial institutions 2. NYSE Index -CAP weighted; base period of 1965 equal to 50 -includes ALL common stocks listed on NYSE 3. Nasdaq Composite Index -CAP weighted; base period 1971 equal to 100 -covers the OTC market -3,000+ companies - quoted in WSJ 4. EAFE -CAP weighted -index of foreign stocks from 21 developed countries outside US & Canada 5. Wilshire 5000 -CAP weighted -covers virtually every US based company on stock exchange (including Nasdaq but not OTC bulletin) -6,000+ companies -BROADEST COVERAGE of US stock markets

Raking bond yields from lowest to highest

1. Selling at discount -nominal -CY -YTM -YTC 2. Selling at premium -YTC -YTM - CY -nominal

Asset clases & diversification

1. cash & cash equivalents - (passbook savings & checking accounts, money-market accounts & funds, certificates of deposit, T-bills) 2. fixed income investments - hedge against deflation (corporate bonds, municipal bonds, treasury bonds, bond funds, mortgage-backed securities) 3. equities - hedge against inflation (preferred and common stocks of all kinds, stock mutual funds) 4. hard assets - (real estate, collectibles, precious metals & stones) Each asset class responses differently to different types of risk, so allocating investment resources among the classes is a way to reduce risk overall and improve performance of portfolio

Accounting for Depreciation

A company's tax bills are reduced each year the company depreciates fix assets used in the business Depreciation affects company 2 ways: 1. Accumulated depreciation reduces the value of fixed assets on the balance sheet 2. Annual depreciation reduces the taxable income in the income statement Companies may elect to use straight line or accelerated depreciation: 1. Straight Line - depreciates the fixed asset by an equal amt every year over its useful life 2. Accelerated - depreciates fixed assets more during earlier years of its useful life and less in the later years

Technical Analysis Chart Patterns Head and Shoulders

A. Head and Shoulders Top -indicates that the market has topped and future price trend will be downward (trendline at low point) B. Head and Shoulders Bottom (inverted -indicates the market has bottomed and future trend is up (trendline at high points) - If price penetrates a trendline, warning of reversal in the trend - *most important factor is how many times the trendline has been touched* - Also impt is length of trendline; the longer a trend exists, the more significant is a penetration of the line.

Balance Sheet - working capital

Amt of cash or capital a company has (measures company's liquidity) Factors that affect working capital: A. Increases in working capital, such as profits, sale of securities (long-term debt or equity) and sale of noncurrent assets; and B. Decreases in working capital, such as dividend declared, paying off long-term debt and net loss **working capital = current assets - current liabilities

Balance sheet - Assets

Appear in order of liquidity (ease turned into cash). Three types: 1. *Current assets* - cash & items expected to be converted to cash in next 12 months - cash equivalents (short-term safe investments such as money market instruments and other marketable securities) - accounts receivable (amt due from customers for goods delivered and services rendered) - inventory (the cost of raw material, works in progress, & goods ready for sale) - prepaid expenses (already paid for but not yet benefited from such as advertising, taxes, rents) 2. *Fixed assets* - property, plant and equipment - cost of assets depreciated over time or deducted from taxable income in annual installments to compensate to loss in value (wear and tear) 3. *other assets* - nonphysical properties, such as formulas, brands, trademarks, contract rights - Goodwill represents corp's reputation and relationship with its clients - In general, they have great value to this company, but little value to other entities

Inflation-Adjusted Return (Real Return)

Because inflation reduces the buying pwr of a $, inflation adjustments provide a measure of the buying pwr earned from a given investment Debt security = reduce the nominal return by the inflation rate Equity security = reduce goal return by the inflation rate Note: final returns are reduced by both taxes and inflation. So, for a fixed-income investment, first figure out the after-tax return and then subtract the inflation rate

Stages of the Business Cycle

Business cycles reflect fluctuations in economic activity as measured by macroeconomic variables such as unemployment and the GDP *1. Expansion*- increasing business activity throughout - increased demand for consumer goods - increased industrial production - falling investors - rising stock prices - rising property values; and - increasing GDP *2. Peak* - when GDP increased rapidly & businesses reach their productive capacity, the nation's economy cannot expand further *3. Contraction* - when business activity declines from its peak - rising inventories (bc less consumer demand) - rising # of bankruptcies & bond defaults (consumer debt) - falling stock markets - decreasing GDP - Short term/mild: recession (decline GDP 2+ consecutive quarters) - Long term/severe: depression (decrease in GDP for 6 consecutive quarters) *4. Trough* - when business activity stops declining and levels off

Risk measurements - Correlation Coefficient

Correlation = means that securities move in the same direction Correlation coefficient = a number that ranges from -1 to +1. +1 = perfectly correlated 0= unrelated -1 = move in perfectly opposite directions Note: index funds attempt to achieve perfect correlation with the index they are mirroring Note: diversify portfolio by including investments with negative correlation

current yield (CY)

Coupon yield ÷ market price = current yield - trading at discount, CY increases - trading at premium, CY decreases - a bond selling at par, coupon yield and current yield are equal - CY of common stock = current dividend÷current stock price

Factors influencing interest rate

Definition = cost of borrowing $ Factors that influence rate borrower pays for funds: 1. supply & demand for loanable funds 2. credit quality of the borrower 3. length of time for which $ is borrowed 4. current & expected inflations 5. overall supply & demand for funds in the economy *Note - although interest rates in general reflect investor expectations about inflation, short-term rates reflect the policy decisions of the Federal Reserve Board (FRB) as it implements the nation's monetary policy

Sector rotation

Different sectors of the economy are stronger at different points in the economic cycle. Portfolio managers attempt to buy into the next sector that is about to experience a move up & when the sector reaches the peak of its move then its time to start to sell the sector Recommended to hold multiple sectors at a time; usually a minimum of 3: one sector on the rise, one at the tope, and one that is starting to decline.

Balancing the balance sheet

Every financial change in a business requires 2 offsetting changes on the company books ("double-entry bookkeeping") - bc the BALANCE SHEET MUST BALANCE

Tools of the Federal Reserve Board

FED determines how much $ is available for businesses and consumers to spend. 3 primary tools employed to affect the $ supply: *1. Changes in reserve requirements* - by raising amt of funds commercial banks must leave on deposit with the FED, the amt of $ available for banks to lend is decreased - leads to higher interest rates (and reverse when requirements are eased) *2. Changes in the discount rate* - rate the FED charges member banks when lending them $ - higher rates discourage borrowing, reducing the $ supply (and vice versa) *3. Open market operations* - FED buys and sells US Treasury securities in the open market under the direction of the Federal Open Market Committee (FOMC). - When Treasuries are purchased, adds to the $ supply because the FOMC is purchasing the securities from commercial banks, causing the banks to have greater reserves - When FOMC sells Treasuries, $ supply is reduced bc pulled out of the banks' reserves *FED does not set the prime rate - that is done by major commercial banks. But, the FED's actions impact interest rates*

Holding Period Return

HPR = income + capital appreciation ÷ holding period

Tools of Fundamental Analysis - Financial Statements

Financial statements provide the fundamental analyst with information needed on: - corp's profitability -financial strength -operating efficiency Examine how #s from one statement relate to prior statements, and how the resulting ratios relate to company's competitors companies issue quarterly and annual financial reports to the SEC including a balance sheet and income statement Financial statements: 1. *Balance sheet* - snapshot of a company's financial position at a specific point in time - reports what assets a company owns and how it has funded them. How a firm has funded assets is revealed by the capital structure -Identifies value of company's assets and its liabilities*to determine company's equity/net worth. - Formula: *Assets-liabilities = owner's equity* - Does not indicate whether company is improving or deteriorating 2. *Income statement* - summarizes a company's revenues and expenses - used to judge the profitability of a company - 3 components: a. revenue b. cost of goods sold c. pretax income 3. *Cash flow statement* - reports business sources and uses of cash - 3 components: a. operating activities b. investing activities c. financing activities

Inflation

General increase in prices as measured by the consumer price index (CPI) *CPI* - reflects the average cost of goods and services (a *market basket*) purchased by consumers compared with those same goods and services during a base period CPI statistics published monthly Mild inflation = can encourage economic growth bc gradually increasing prices tend to stimulate business investments High inflation = reduces the dollars buying power (or value of any monetary unit, bc inflation global issue) & will reduce demand - *Increased inflation causes interest rates to rise, drives bond prices lower & bond yields up* (decreases in inflation has opposite effect) "inflation inertia" = concept that rate of inflation does not immediately react to unexpected changes in economic conditions Increase in real income = means the percentage increase in income is greater than the rate of inflation. Buying pwr has increased. Causes of inflation: 1. *Excessive demand* occurs when aggregate demand exceeds aggregate supply & prices rise 2. *monetary expansion* is a rapid increase in nation's money stock in excess of nation's growth rate

Prime Rate

Interest rate that large US money center commercial banks charge their most creditworthy corporate borrowers for unsecured loans - each bank sets its own prime rate (large banks set example) - banks lower their prime when Fed eases the money supply & raises rates when Fed contracts the money supply

Use of indexes and averages

Many technicians plot market indexes and averages instead (or in addition to) individual stocks. Then can make profits by trading securities whose performance tends to mirror the index Beta = measures the variability btwn a particular stock (or portfolio's_ movement and that of the market in general - Beta = 1; market risk similar to whole market -Beta = 1.5; more volatile (aggressive clients) - Beta = .70; less volatile (conservative clients) - Most assets have a positive Beta - Negative Beta can be impt for diversifying a portfolio bc a proper mix could create a portfolio with a 0 Beta (i.e., w/out systematic risk) E.g., Beta of -1.2 then a 10% move up in market's return would cause the stock return to decline by 12%

Measures of central tendency

Method for determining how one might approach figuring the logical outcome of a securities investment. 1. Mean - most commonly used to measure central tendency -take the sum of the variables and divdd by # of occurrences 2. Median - midpoint of a distribution - list the returns in order and find the # in the middle (or average the middle 2) - more appropriate than the mean in skewed distributions or when variable that fall far outside range 3. Mode - measures the most common value in a distribution 4. Geometric Mean - used imputed compounding -rarely used & probably wrong answer on exam 5. Range - difference btwn the highest and lowest returns in the sample -mid-range value is the # in the middle of range (so if range is 7 (9-2) mid-range value is 5.5

Yield Curve Analysis

On a graph, the difference btwn short-term and long-term interest rates *Upward sloping* = normal/positive yield curve (means that *long-term interest rates higher* than short-term) Long-term interest rates usually higher to compensate lenders for: - time value of $; - reduced buying pwr of $ resulting from inflation; - increased risk of default over long periods; and - loss of liquidity associated with long-term investments Note: yield curve also reflects *investor expectations* about inflation; if expect high inflations then will require higher rates of interest to compensate for reduction in purchasing pwr over time YIELD CURVE & ECONOMIC CYCLE *Normal/ascending yield curve* -occurs during periods of economic expansion. -Predicts that interest rates will rise in the future *Flat yield curve occurs* -when the economy is peaking -no change in interest rates is expected (short-term & long term rates the same) * Inverted/downward yield curve* - unusual -occurs when FRB has tightened credit. -Predicts rates will fall in future. -result of high current demand for $ relative to supply. -Short-term rates more sensitive to Fed policy than long-term. If sharp increase in short-term rates creates an inverted yield curve *Yield curves for issuers with different risk levels can be compared to make economic predictions* - if the yield curve spread btwn corp bonds and govt bonds is widening, then a recession is expected (investors choosing safety of govt bonds). - If yield curve btwn corp and govt bonds is narrowing, then economic expansion expected (investors willing to take risks & sell govt bonds to buy higher yield corporates) Most common method to construct yield curve: use bonds of a single issuer over varying maturities

Alpha

Positive alpha means investment performance better than anticipated, given the risk in terms of volatility Need to know how to compute alpha for a stock or portfolio: - Beta of S&P 500 assumed to be 1 - If beta of stock 1.2, then assume returns 20% greater than S&P 500. So should return 12% - If return of stock is 15% then did better by 3% - Extra 3% is called the alpha

Quantitative Evaluation Measurements

Quantitative Eval = statistical concepts used to analyze investments 1. *Time value of Money* - difference btwn present value (PV) of money and future value (FV) - on exam will know the PV and the expected annual return - E.g. - $38.55 and 10% expected return. To figure out worth in 10 years, multiply $38.55 x 110% for a total of 10 times = 100 (same as TIPS bond) 2. *Future Value* - FV depends on rate of return (r) and number of years invested (n) *FV = PV x (1+r)n* - FV reflects a compound rate of return or original investment, assuming the annual interest reinvested at identical rate for the number of years 2. *Present value* - *PV = FV÷ (1+r)n* - discount factor = interest rate over a time period 3. *Rule of 72* - determines the # of years it takes for an investment to double in value assuming compounded earning - *72 ÷ r* = # of yrs to double

Federal Funds Rate

Rate banks that are member of the Fed Reserve System charge each other for overnight loans of $1M or more -Rate considered a barometer of the direction of short-term interest rates - listed daily in newspaper - most volatile; fluctuates drastically

Discount Rate

Rate the NY Fed Reserve Bank charges for short-term loans to member banks - Established by the FRB - unlike the federal funds rate, is a managed rate: it is one of the tools of monetary policy - in contrast, fed funds rate is a market rate determined by the demand for bank reserves on the part of deposit-based financial institutions

Balance Sheet - Liabilities

Represent all financial claims by creditors against the corp's assets 1. *current liabilities* - debts due within 12 months: A. accounts payable (owed to suppliers of materials & other business costs) B. accrued wages payable C. current long-term debt (any portion of the debt due within 12 months) D. notes payable (balance due on equipment purchased on credit or cash borrowed) E. unpaid taxes 2. *long-term debts* - financial obligations for payout after 12 months A. mortgages on real property B. long-term promissory notes C. outstanding corporate bonds

Risk Measurements

Risk = uncertainty that investment will earn its expected rate of return Risk measurements measure either the historical risk or future risk of individual securities or portfolios *Beta measure only systematic risk*; the risk that can be associated with the market in general Unsystematic risk is specific to the stock and independent of the general market (i.e., competition, mismanagement, product deficiencies)

Economics Basics

Social sciences concerned with the description and analysis of production, distribution and consumption of goods and serves About how ppl choose - in every choice we make, we try to find the combination of cost and benefit that maximizes our utility (satisfaction) Micro = focuses on economic behavior of narrowly defined units, such as households and businesses Macro = analyzes aggregate, such as growth in national economic output measured by GDP, rate of inflation, unemployment (exam focus on macro) Fiscal Policy = president and congress (budgeting/taxation) Monetary policy = board of governors and federal reserve 3 major schools: (1) Keynesian; (2) classical/supply side; (3) monetarist

Fundamental analysis

Study of the business prospects of an individual company within the context of its industry and overall economy Looks for companies in industries that offer better-than-average opportunities within the current business cycle Useful to distinguish 4 types of industries

Deflation

The general decline in prices. Occurs during severe recessions when unemployment on the rise Causes of deflation: - the opposite of causes of inflation. Basically when demand for goods and services substantially below the supply, then prices must spiral down to increase demand. - also caused by shrinkage in $ supply During recessionary period when experiencing deflation, investors lean towards US govt securities because unlike stocks, real estate & commodities, Treasuries will hold onto their value and might even show some capital appreciation

Time-weight v. Dollar-wieghted returns

Time-wieghted = method determining IRR by evaluating performance of portfolio managers w/out deposits/withdrawals Dollar-weighted = method of determining IRR on basis of cash flow into and out of portfolio

Economic indicators - Employment

Unemployment level key indicator of country's economic health & bears a relationship to inflation Most common employment indicators: 1. Average weekly claims for unemployment 2. Average workweek in manufacturing Widely believed unemployment level of 4% reelects full employment, the point at which wage presses do not create undue inflation

Broker Call Loan Rate

a.k.a. "call loan rate" or "call money rate" Interest rate banks charge broker/dealers on money they borrow to lend margin account customers (usually higher than other short-term interest rates) Note: broker call loans are callable on 24-hr notice

Balance Sheet - Capitalization

capitalization = is the combined sum of its long-term debt and equity accounts capital structure = relative amounts of debt and equity that compose a company's capitalization