Investment Planning: Formula Investing & Investment Strategies (Module 10)

What are the three contrarian methods for technical analysts?

- Odd Lot Activity - Short Sale Interest - Investment Advisors Bullish/Bearish Index

Technical analysis uses the following methodologies to determine profitable stock selection and market timing opportunities?

- Charting strategies - sentiment indicators - flow of funds indicators - market structure indicators

What problems could get in the way of bond immunization?

- default or call risk - Multiple Nonparallel Shifts in a Non-horizontal Yield Curve

Active investment strategies include which of the following? 1. Dollar cost averaging 2. Mutual fund switching 3. Market timing 4. Buying an Index fund

2, 3 Dollar cost averaging and buying an Index fund are passive investment strategies.

Your client read an article about Dow Theory and asks you to explain its basic elements. Which of the following will you tell your client about the Dow Theory? 1. Dow Theory reflects a passive strategy that is supported by Modern Portfolio Theory. 2. Dow Theory indicates an active strategy that is not supported by Modern Portfolio Theory. 3. Dow theory factors price action, support and resistance levels, stock values, confirmations, and divergences. 4. Dow Theory focuses on the Dow Jones Industrials Index. 5. Dow Theory focuses on the Dow Jones Transportation Index.

2, 3, 4, 5 Dow Theory contradicts Modern Portfolio Theory and the Efficient Market Hypothesis. Technical analysis is an active strategy. Dow Theory is concerned with price movements and volume. Support levels are price ranges where an increased demand for a stock pushes up price and volume; resistance levels are price ranges where a decrease in demand (and an increase in supply) for a stock reverses a preceding price increase. Charles Dow examined two indices to chart the market's direction: The Dow Jones Industrial Index and the Dow Jones Rail Index (now the Transportation Index). These two indices indicate technical confirmations or divergences of the primary market trend. A confirmation indicates the major trend is (still) in place; a divergence indicates the major trend may be changing or already has changed.

Bullet structure

A bullet-structured portfolio benefits when the yield curve is expected to steepen. A bullet structure usually weighs heavier around intermediate term assets. A bulleted maturity tends to outperform a barbell structure when the yield curve steepens because in a rising rate environment, intermediate-term securities usually hold up better than long-term securities. Also, in a declining interest-rate environment, intermediate securities produce significantly greater price appreciation than do short-term securities.

The January Effect

A study that looked at the average monthly returns on NYSE-listed common stocks, found significant seasonalities. In particular, the average return in January was higher than the average return in any other month.

Small Firm Effect

An investor buys firms which have the ability to generate super normal growth from quarter to quarter.

Odd Lot Activity

An odd lot is a trade that takes place for an amount of shares that is less than 100. When the net activity of odd lot orders is for purchases, this will be a sell signal for a technician. When the net odd lot activity is for sale orders, this will be viewed as a buy signal.

If the standard deviation of Stock A is 20% and the standard deviation of Stock B is 15%, what is the correlation coefficient (r i,j) if the covariance of the returns is -0.0150? a. -1.0 b. -0.5 c. -0.3 d. +0.015

B Covariance = r ij x σi x σj Covariance / ( σi x σj) = r ij -0.015 / (0.20 x 0.15) = -0.5

Which of the following is not a passive asset allocation technique? a. Dollar-cost-average b. Advance / decline line c. Laddered bonds d. Indexed portfolios

B The advance / decline line is a technical indicator. Technical indicators are active not passive.

How would you position $150,000 using the "barbell" strategy? a. $150,000 in long-term maturities, reposition yearly. b. $75,000 in short-term maturities, $75,000 in long-term maturities. c. $62,500 in short-term maturities, $25,000 in intermediate maturities and $62,500 in long-term maturities. d. $50,000 in short-term maturities, $50,000 in intermediate maturities and $50,000 in long-term maturities.

B When using the barbell strategy, the investor acquires a portfolio of very long-term and very short-term maturities.

Those who expect the yield cure to flatten will pick the ___________ strategy

Barbell strategy

Which of the following interest rate environments are beneficial for the buyer of a collar? a. rates go below floor b. rates remain between cap and floor c. rates go above cap

C

What is the beta of the following stock? Standard deviation of the stock is 12%. Standard deviation of the market is 10%. Correlation coefficient of the stock to the market is -0.8. a. -0.40 b. 0.66 c. -0.96 d. 0.80

C Beta = (Correlation Coefficient x SD of stock) / SD of market Beta = (-0.8 x 12%) / 10% = -0.96 The beta is negative. Can the Beta be negative? Absolutely! Would a client want a stock that had a negative Beta? Yes, it should move opposite the market and reduce volatility his/her portfolio.

How do portfolio measures offset Multiple Nonparallel Shifts in a Non-horizontal Yield Curve risk?

Cash matching involves the purchase of bonds so that the cash received each period from the bonds is identical in size to the promised cash outflow for that period. Such a cash-matched portfolio of bonds is often referred to as a dedicated portfolio.

Margaret has two bond types in a portfolio. Forty percent of the portfolio is in a zero coupon bond which will mature in 10 years. The other sixty percent is invested in a 30-year bond with a duration of 27. What is the average duration of this portfolio? A. 27 B. 20.2 C. 37 D. 10.1

Correct Answer: B. 20.2 Explanation: Zero coupon bonds have a duration that equals its maturity. (40%)(10)+(60%)(27) = 20.2

Which of the following statements is true about a normal yield curve? 1. Short-term yield is lower than long-term yield. 2. A portfolio with a bullet strategy is best suited to this environment. 3. A portfolio with a ladder strategy is best suited to this environment. 4. A portfolio with a barbell strategy is best suited to this environment.

Correct Answers: 1, 3 Explanation: A ladder structure will be the most beneficial in a normal upward sloping yield curve indicating higher yield at longer maturities, with a stable interest rate environment. Barbells work better in a flat yield curve while bullet works better for a steep yield curve.

Which of the following would describe a contrarian investor? A. Buys securities that are doing well B. Sells securities that are doing well C. Buys securities that are doing poorly D. Sells securities that are doing poorly

Correct Answers: B. and C. Explanation: Contrarians invest in a manner that is completely opposite to momentum investors. They tend to buy stocks that have had recent bad news and sell the ones that have recently performed well.

You have two funds in your portfolio. Their correlation coefficient is 0.25. Fund A has a return of 5.5% and a risk of 7.5%. Fund B has a return of 3% and a risk of 15%. If your portfolio value consists 45% of Fund A and 55% of Fund B, what is the standard deviation of your portfolio? a. 6.5% b. 11.625% c. 7.9% d. 9.66% e. 8.5%

D COV12 = 7.5 x 15 x 0.25 = 28.13 [(.45)2 (7.5)2 + (.55)2 (15)2 + 2(.45)(.55)(28.13)]0.5 = [11.39 + 68.06 + 13.92]0.5 = [93.37]0.5 = 9.66% Shortcut: 7.5% + 15% = 22.5% / 2 = 11.25% Then look for the next lowest answer.

Susan Cole, age 28, just inherited $250,000 from her aunt. Susan, a college graduate, is teaching grade school in a small town. She is contributing a small amount each month to a 403(b). At this time, she has no immediate plans to get married and rents a nice apartment. How do you suggest she invest the $250,000 in mutual funds? a. 50% in municipal, 50% in natural resources b. 25% in balanced, 25% in growth, 25% in international, 25% in gold c. 50% GNMA, 25% in growth, 25% in tech d. 50% in high yield corporate bonds, 25% in growth and income, 25% in international

D Muni's will not do her any good, she is in low tax bracket. The two answers with 25% in specialty funds are wrong. You may disagree with the answer, but remember this is strictly a writer's opinion answer. Note: The high yield bonds are not necessarily "junk bonds".

You have two funds in your portfolio. Their correlation coefficient is 0.5. Fund A has a mean of 10% and a risk of 20%; Fund B has a mean of 8% and a risk of 12%. If your portfolio value consists of 50% of each fund, what is the standard deviation of your portfolio? a. 18% b. 12% c. 16% d. 14%

D Simply add the risks (20% + 12% = 32%). Divide by 2 (32% / 2 = 16%). Since the correlation coefficient is less than 1, choose the next lowest answer under 16%. If the correlation coefficient were exactly 1, the portfolio standard deviation would have been exactly 16%.

Short Sale Interest

Every month, the financial newspapers publish the amount of open interest of stocks that have been sold short. When short selling reaches record levels (or even high levels) that will be viewed as an extremely bullish signal. You may be tempted to think that many investors have short stock positions, so therefore stock prices must be headed lower. Actually, since short selling represents a contractual obligation to buy back the underlying securities, this represents a certain demand for those securities. Therefore a technician would view record levels of short selling as a very bullish signal

Fundamental analysts forecast, among other things, the following?

Future levels of the economy's gross domestic product, Future sales and earnings for a number of industries, and Future sales and earnings for an even larger number of firms.

Multiple Nonparallel Shifts in a Non-horizontal Yield Curve

Immunization (and duration) are also based on the assumption that the yield curve is horizontal and that any shifts in it will be parallel and will occur before any payments are received from the bonds that were purchased. In reality, the yield curve will not be horizontal at the start, and shifts in it are not likely to be either parallel or restricted when they occur. Indeed, there is evidence of greater volatility in yields of shorter-term securities. If these kinds of shifts occur, then it is possible that the portfolio will not be immunized.

Those who are neutral or uncertain about the future of the yield curve will use the _________ strategy

Ladder strategy

contingent immunization

One method of bond portfolio management that has both passive and active elements is contingent immunization. In the simplest form of contingent immunization, the portfolio will be actively managed as long as favorable results are obtained. However, if unfavorable results occur, then the portfolio will be immunized immediately.

Investment Advisors Bullish/Bearish Index

Periodically, professional investment advisors are polled in order to obtain their opinions as to where the major market indices will be in a year. If more than 50% of the advisors polled are bullish, that will be a sell signal for a technician. If more than 50% of the advisors polled are bearish, that will be a buy signal. The irony is that professional investment advisors do not seem to know any more than small, independent investors!

Portfolio Immunization

Protects bond portfolio from interest rate risk and reinvestment rate risk The duration of a portfolio should match the investor's time horizon Rebalance every 6 months to one year, matching time horizon and duration

How do portfolio measures offset default/credit risk?

Solve for the effective (modified) duration that measures against embedded options within a bond such as default or call, rather than the normal duration.

Neglected Firm Effect

Stocks that are not followed by any (or very few) analysts have been shown to generate superior performance.

Low P/E Effect

Stocks that have low price to earnings ratios (the so-called value stocks) out perform all other types of stocks (including growth stocks) over the business cycle.

The Day-of-the-Week Effect

Studies that looked at the average daily return on NYSE-listed securities found that the return on Monday was quite different from returns on other days. In particular, the average return on Monday was found to be much lower than the average return on any other day of the week.

Dow Theory

The Dow Theory has three trends: major trends, intermediate trends, and short-term run movements. Technicians will look for reversals and recoveries in major market trends. Price alone does not tell the story. Market sentiment and changes in supply and demand (volume) are factored in as well. In general, when the following ratio (volume of stocks that have increased / volume of stocks that have decreased) is 1.50 or more, it indicates a bearish sign. When the ratio is 0.75 or lower is a bullish sign.

Money Flow Index (MFI)

The MFI is a momentum indicator that is very rigid in that it is volume-weighted, and is therefore a good measure of the strength of money flowing in and out of a security. It compares "positive money flow" to "negative money flow" to create an indicator that can be compared to price in order to identify the strength or weakness of a trend. The MFI is measured on a 0-100 scale and is often calculated using a 14-day period.

Value Line Phenomenon

The Value Line Investment Survey is stock research that is available through subscriptions. The service ranks 1,700 widely held securities according to their projected performance over a 6-12 month period. Since the mid 1960s, the Value Line portfolio of stocks ranked 1 have out performed the S&P 500 Index 17 fold! This statistic does not include taxes and transaction costs.

Top-down

The financial analysts are first involved in making forecasts for the economy, then for industries, and finally for companies.

Bottom-up

The financial analysts begin with estimates of the prospects for companies and then build to estimates of the prospects for industries and ultimately the economy.

bond swapping

The goal of bond swapping is to actively manage a portfolio by exchanging bonds to take advantage of any superior ability to predict such yields. In making a swap, the portfolio manager believes that an overpriced bond is being exchanged for an underpriced bond. Some swaps are based on the belief that the market will correct for its mispricing in a short period of time, whereas other types of swaps are based on a belief that corrections either will never take place or will take place, but over a long period of time.

Intermarket spread swap

This swap involves a more general movement out of one market component and into another with the intention of exploiting a currently advantageous yield relationship. The idea here is to benefit from a forecasted changing relationship between the two market components.

Substitution swap

This swap is an exchange of a bond for a perfect substitute or "twin" bond. The motivation here is temporary price advantage, presumably resulting from an imbalance in the relative supply and demand conditions in the marketplace.

Rate anticipation swap

This swap is geared toward profiting from an anticipated movement in overall market rates.

Pure yield pickup swap

This swap is oriented toward yield improvements over the long term, with little heed being paid to interim price movements in either the respective market components or the market as a whole.

If the covariance between two stocks is 0.0055, the correlation is 0.5 and the standard deviation of stock #1 is 10%, what is the stand deviation of stock #2 using the covariance formula? a. 5% b. 11% c. 15% d. 22%

b. 11% If the covariance is COV = r12 x σi x σ2 then COV / (r12 x σi) = σ2 0.0055 / (0.5 x 0.10) = 0.0055 / 0.05 = 0.11 or 11% NOTE: The exam likes to use the formula in different ways.

Those investors who anticipate the yield curve to become steeper will use a ___________ strategy

bullet strategy

Barron's Confidence Index (BCI)

every week in the laboratory section. The index shows the relationship between the yield on high quality corporate bonds and the yield on average quality bonds. The average yield on the high quality bonds is divided by the average yield on the average quality bonds. (Yield on High Quality Corporate Bonds) / (Yield on Average Quality Corporate Bonds) Index will fall in value during bearish markets & rise in value during bullish markets

Ladder structure

is a portfolio of bonds that mature at regular intervals throughout the various maturities of the yield curve. To perpetuate a ladder structure, as each bond matures, the proceeds are used to purchase a bond that will mature at the next interval after the one with the longest maturity in the portfolio. Ladders are most effective when the yield is normal or sloping upward and interest rates are fairly stable. Ladders are typically constructed using U.S. Treasuries or even CDs at a local bank.

econometric model

is a statistical model. This model provides a means of forecasting the levels of certain variables, known as endogenous variables. In order to make these forecasts, the model relies on assumptions that have been made in regard to the levels of certain other variables supplied by the model user, known as exogenous variables. For example, the level of new homes projected to be built next year is a derivative of the level of GDP and interest rates. Therefore, the endogenous variable of housing starts is dependent of the exogenous variables of the GDP and interest rates.

Barbell structure

is a strategy of holding more bonds at the short and long end of the yield curve with intermediate bonds being underweighted. This allows a portfolio's price to match the volatility of an intermediate-term liability. When there is a likelihood that the Federal Reserve will loosen monetary policy in the near term, a barbelled portfolio may increase a bond portfolio's return. High-yield municipal and corporate bonds have two advantages that can be utilized in a barbelled portfolio. First, high-yield bonds help diversify a portfolio. Their performance is largely isolated from what's happening with government interest rates because their yields depend almost entirely on default risk. Second, compared to equity alternatives, they are often undervalued. If the yield curve continues to flatten, the return on a barbelled portfolio is optimized.

interest rate floor

is an agreement by one party to make payments to another party when interest rates fall below a certain level or "floor." This is analogous to receiving the present value of the expected floating rate benefit for the term of the floor. Floors can reduce the initial cost of the financing by generating current income. However, they limit the benefits of variable rate exposure without reducing the risk.

interest rate cap

is an agreement by one party to make payments to another party when interest rates rise above a certain level or "cap." For example, an issuer may purchase a cap to insure against spikes in variable rates for one year. If interest rates rise above the cap level during that time, the issuer will receive the difference between the actual market and the cap level.

interest rate collar

is essentially the combination of a cap and a floor. An issuer that wants to limit variable rate exposure will simultaneously purchase a cap and sell a floor. Interest rate collars provide protection against rising rates while limiting the benefits of declines in rates. Collars can finance themselves: the cost of the cap can be offset by the proceeds from the sale of the floor. Despite relatively inefficient pricing, a collar may be desirable for a pilot variable-rate program until the issuer has a good sense of where its short-term debt will trade in the market.

Technical analysis

is the study of the internal stock exchange information. The word technical implies a study of the market itself, the "push" and "pull" of supply and demand forces on the market. Technical analysts track market statistics such as price levels and the trade volume in the exchanges. The technician usually attempts to predict short-term price movements and thus makes recommendations concerning the timing of purchases and sales of either specific stocks, groups of stocks (such as industries), or stocks in general. The methodology of technical analysis rests upon the assumption that history tends to repeat itself in the stock exchange.