FIN 200 Exam 4

What are the most common reasons for buying mutual funds?

(1) to achieve diversification (2) to obtain the services of professional money managers (3) to generate an attractive rate of return (4) for the convenience

Growth

-Aims for capital appreciation -Involves risk exposure -Viewed as long-term investment vehicles

Growth and income

-Confine investing to high-quality issues -Involve risk due to their emphasis on stocks and capital gains

Equity-Income

-Emphasize current income -Aim to preserve the capital -Viewed as low-risk way of investing in stocks

Types of Real Estate Investment Trust (REIT)

-Equity -Mortgage -Hybrid

Aggressive Growth

-Highly speculative investment vehicles -Seek large profits from capital gains -Volatile in nature

Balanced

-Hold a balanced portfolio of stocks and bonds -Generate well-balanced return of current income and long-term capital gains -Confine investing to high-grade securities

Bond

-Invest in various kinds of fixed-income securities Advantages: -More liquid -Offer a cost-effective way of achieving a high degree of diversification -Automatically reinvest interest and other income

Describe the various types of risk to which investors are exposed.

1. Business risk is the variability surrounding the firm's cash flows and subsequent ability to meet operating expenses on time. 2. Financial risk concerns the amount of debt used to finance a firm, as well as the possibility that the firm will not have sufficient cash flows to meet these obligations on time. 3. Market risk results from the behavior of investors in the securities markets that can lead to swings in security prices. 4. Changes in the general level of prices within the economy also produce purchasing power risk. 5. Fixed-income securities—which include notes, bonds, and preferred stocks—offer investors a fixed periodic cash flow and, as such, are most affected by interest rate risk. As interest rates change, the prices of these securities fluctuate, decreasing with rising interest rates and increasing with falling rates. 6. The risk of not being able to liquidate (i.e., sell) an investment conveniently and at a reasonable price is called liquidity risk. 7. Event risk occurs when something substantial happens to a company and that event, in itself, has a sudden impact on the company's financial condition.

Also known as hidden loads, _________ fees have been allowed by the Securities and Exchange Commission (SEC) since 1980 and were originally designed to help no-load funds cover their distribution and marketing expenses. The fees are assessed annually and can amount to as much as 1 percent of assets under management. The SEC set a 1 percent cap on annual 12b-1 fees and, perhaps more significantly, stated that true no-load funds cannot charge more than 0.25 percent in annual 12b-1 fees (otherwise, they must drop the "no-load" label in their sales and promotional material).

12b-1

Cash Dividends

A cash dividend is money paid to stockholders, normally out of the corporation's current earnings or accumulated profits. Not all companies pay a dividend.

Briefly describe the basic structure and investment considerations associated with a REIT. What are the three basic types of REITs?

A real estate investment trust (REIT) is a type of closed-end investment company that invests money in various types of real estate and real estate mortgages. A REIT is like a mutual fund in that it sells shares of stock to the investing public and uses the proceeds, along with borrowed funds, to invest in a portfolio of real estate investments. REITs have become popular with investors seeking portfolio diversification because these trusts have relatively low correlations with other market sectors, such as common stocks and bonds. They also provide attractive dividend yields—well above the yields on common stocks. (In fact, about 65 percent of the total return from REITs comes from their dividends.)

Blue-chip stocks

A stock expected to have good, long-term growth prospects

Tech stocks

A stock that represents the technology sector of the market

Income stock

A stock whose appeal is the dividends it pays out; offers dividend payments that can be expected to increase over time

Growth stock

A stock whose earnings and/or market price have increased over time at a rate well above average

Defensive stock

A stock whose price movements are usually contrary to movements in the business cycle

Real Estate Investment Trust (REIT)

Accumulates money, by selling shares to investors to invest in various forms of real estate

Bond Income

An income bond is a type of debt security in which only the face value of the bond is promised to be paid to the investor, with any coupon payments being paid only if the issuing company has enough earnings to pay for the coupon payment.

Cash flow and taxes

An investor's cash flow, or annual after-tax earnings, depends not only on the revenues generated from a particular piece of property, but also on depreciation and taxes. Depreciation is an allocation of the total cost of property incurred in the past that is considered an expense for tax purposes even though it involves no actual current outflow of cash. Therefore, it reduces your current taxable income and your taxes. In this case, it is considered a tax shelter.

Name and describe three basic types of orders.

An order to buy or sell a security at the best price available at the time it's placed is a market order. An order to buy at a specified price (or lower), or sell at a specified price (or higher) is known as a limit order. An order to sell a stock when the market price reaches or drops below a specified level is called a stop-loss, or stop order.

12(b) Fee

Annual fee used to offset the promotion and selling expenses

Briefly describe the two basic sources of return to investors.

Any investment vehicle—whether it's a share of stock, a bond, a piece of real estate, or a mutual fund—has just two basic sources of return: current income and capital gains. Current income is generally received with some degree of regularity over the course of the year. It may take the form of dividends on stock, interest from bonds, or rents from real estate. The other type of return available from investments is capital appreciation (or growth), which is reflected as an increase in the market value of an investment vehicle. Capital gains occur when you're able to sell a security for more than you paid for it or when your security holdings go up in value.

_______________________: Spread investors' money across all different types of markets

Asset Allocation:

Briefly describe the concept of asset allocation and note how it works.

Asset allocation involves a decision on how to divide your portfolio among different types of securities.

Bull market vs. bear market

Bull market: Associated with investor optimism, economic recovery, and expansion (going up; a symbol of a good stock market) Bear market: Associated with investor pessimism and economic slowdown; characterized by falling securities prices (Going down)

Index

Buys and holds a portfolio of stocks equivalent to those in a market index

What's the difference between a cash dividend and a stock dividend? Which would you rather receive?

Cash dividends are paid to the stockholder in cash and are taxable at the capital gains rate. Stock dividends paid to the shareholder in stock and are non-taxable. Stock dividends have no current value since they simply give the stockholder more shares, but the percent of ownership does not change. However, historically, the stock price has not adjusted completely for the stock dividend. Thus, the shareholder does receive a slight increase in value for the total shares owned after a stock dividend. Cash is always acceptable and most likely preferred. Receiving cash allows the shareholder to invest in other companies or if desired to purchase more of the same corporation stock. Or consume more.

Load fund

Charges a fee at purchase Low: Consists a low purchase fee Back-end: Commission charged for redeeming fund shares

Convertible bonds

Convertible bonds are a hybrid security that possesses the features of both corporate bonds and common stocks.

Dealer market vs broker market

Dealer market: seller to dealer; dealer to buyer Broker market: Seller sells directly to buyer

Explain why it might be preferable for a person to invest in a portfolio of securities rather than in a single security.

Don't put all your eggs in one basket. In essence, a portfolio is a collection of investment vehicles assembled to meet a common investment goal. But a portfolio is far more than a collection of investments. It breathes life into your investment program as it combines your personal and financial traits with your investment objectives to give some structure to your investments. Seasoned investors often devote much attention to constructing diversified portfolios of securities. Such portfolios consist of stocks and bonds selected not only for their returns but also for their combined risk-return behavior. The idea behind diversification is that, by combining securities with dissimilar risk-return characteristics, you can produce a portfolio of reduced risk and more predictable levels of return.

Automatic investment plan

Enables investor to channel a set amount of money systematically into a given mutual fund

What are fund families? What advantages do these families offer investors?

Family of funds are offered by investment companies in order to offer the investor choices within their company, the hope to keep all of the investor's funds in their house. Fund families—usually provide conversion privileges that enable shareholders to move easily from one fund to another; this can be done either by phone or online. The only limitation is that the investor must confine the switches to the same family of funds.

Mutual Funds and the benefit of investing in mutual funds

Financial services organization that receives money from its shareholders -Invests funds in a diversified portfolio of securities

Automatic reinvestment plan

Gives shareholders the option of electing to have dividends and capital gains distributions reinvested in additional fund shares

From a tax perspective, would it make any difference to an investor whether the return on a stock took the form of dividends or capital gains? Explain.

Historically yes it mattered. However, for tax years beginning after 2012, qualified dividends [basically those from domestic corporations and qualified foreign corporations] are taxed at 20% if the regular tax rate is 39.6% or 15% if the tax rate is 25-35%. If the regular tax rate is 10 or 15%, qualified dividends and long-term capital gains are taxed a 0%.

What effects do market interest rates have on the price behavior of outstanding bonds?

If the market price goes up, the bond value goes down.

Example of Round and Odd Lot if you want 450 Shares

If you want 450 shares you say you want 4 round lots (4 x 100 = 400) and 1 odd lot (50)

International fund

Invest in foreign securities

Value

Invest in stocks that are considered to be undervalued by the market

Socially responsible

Invest only in companies meeting social, ethical, and/or environmental criteria

Exchange Traded Funds (ETFs)

Investment company whose shares trade on stock exchanges -Shares can be bought and sold throughout the day

Money market General purpose

Invests in virtually any type of short-term investment vehicle

No-load fund

Involves no transaction fees charged

_______________ are rated by the rating agencies in the lowest category. These ratings indicate that, although the principal and interest payments on the bonds are still being met, the risk of default is relatively high because the issuers lack the financial strength found with investment-grade issues.

Junk bonds

Use of leverage

Leverage involves the use of borrowed money to magnify returns, which is a big attraction to investing in real estate.

Government securities

Limits its investments to short-term securities of the U.S government and its agencies

Tax-exempt

Limits its investments to short-term, tax-exempt municipal securities

Types of Orders

Market order: To buy or sell a security at the best price available at the time it is placed Limit order: To either buy a security at a specified or lower price or to sell a security at or above a specified price Stop-loss (stop order): To sell a stock when the market price reaches or drops below a specified level

Appreciation in value

Most types of real estate - including everything from raw land to various forms of income-producing properties - have experienced significant growth in value over time. Therefore, an investment evaluation should include expected changes in property value (that is, price appreciation). Price appreciation should be treated as capital gains and included as part of the return from the investment, minus the capital gain taxes paid.

_______________ bonds are issued by a state or a political division of a state. The interest on the bonds are exempt from federal income tax, but any gain from holding the bonds will be taxable. Thus, for a high bracket taxpayer, the tax saving will increase the return making the bond preferable

Municipal

Identify three potential sources of return to mutual fund investors, and briefly discuss how each could affect total return to shareholders.

Mutual funds pay dividends, have capital appreciation, and have gains [and losses] from buying and selling stock. All of these activities are incorporated in the Net Asset Value that is used to value the mutual fund. The dividends and gains [and losses] are pass through to the mutual funds owners who are responsible for paying the income taxes due on these transactions.

What is interest on interest, and why is it such an important element of return?

Note that because the bond was originally bought at par ($1,000), you start off with a 4 percent investment. Where you end up depends, in large part, on what you do with the interest earnings from this investment. If you don't reinvest the interest income at the original 4 percent, then you could end up at the 3 percent line—or even lower. You have to earn interest on interest from your investments in order to move to the 4 percent line.

Management fee

Paid to the professional money managers who administer a mutual fund's portfolio

Primary market vs. secondary market

Primary market: New securities are sold to the public by an issuer Secondary market: Old securities are traded between investors (company does not get any $ out of this)

Round Lot

Quantity of 100 shares of stock or multiples thereof

Odd Lot

Quantity of fewer than 100 shares of a stock

Sector

Restricts investments to particular sector of the market

Liquidity Risk

Risk associated with the inability to liquidate an investment at a reasonably price

Sources of return on stock investments

Sources of returns can include dividends, returns of capital and capital appreciation.

Why is speculating in raw land considered a high-risk venture?

Speculating in raw land is considered a high-risk venture because the key to such speculation is to isolate areas of potential population growth and/or real estate demand (ideally before anyone else does) and purchase the property in these areas in anticipation of their eventual development. This involves a high degree of uncertainty. On the other hand, the supply of land is fixed and if you are able to be patient and wait for some time, the value of your land will most likely increase. This may not be true if you bought a swamp or flood plain unless you are in New Orleans.

Speculative stock

Stock that is purchased on little more than the hope that its price per share will increase

What is day trading, and how is it different from the more traditional approach to investing?

The attraction of trading stocks online is so compelling that some investors have become day traders. The opposite of buy-and-hold investors with a long-term perspective, day traders buy and sell stocks quickly throughout the day. They hope their stocks will continue to rise in value for the short time they own them—sometimes just seconds or minutes—so they can make quick profits.

Relationship between risk and return

The universal rule of investing means that if you want a higher level of return, you should expect greater risk exposure. You can't invest in a high-risk security and expect to earn a high rate of return automatically. Risk by that definition is not that predictable.

What is the desired rate of return, and how would it be used to make an investment decision?

The value of any investment depends on the amount of return that it's expected to provide relative to the amount of perceived risk involved. The minimum rate of return that you believe you should receive in compensation for the amount of risk that you must assume. An investment should be considered acceptable only if it's expected to generate a rate of return that meets (or exceeds) your required or desired rate of return.

How important is general market in affecting the price performance of mutual funds?

When the market takes a plunge, mutual funds do poorly, although some portfolio managers do better than others at managing downside risk.

_____________________ as the name implies, are bonds issued without coupons. To compensate for their lack of coupons, these bonds are sold at a deep discount from their par values and then increase in value over time, at a compound rate of return, so at maturity they're worth much more than their initial investment. Other things being equal, the cheaper the bond, the greater the return you can earn.

Zero coupon bonds

Cyclical stock

a stock whose price movements tend to parallel the various stages of the business cycle

In the stock market, a stock's size is based on its market value—or, more commonly, on what's known as its market capitalization or ____________. Large-cap refers to capitalization of more than $10 billion; mid-cap, from $2 to $10 billion; and small-cap, less than $2 billion.

market cap

A __________________ is a financial services organization that receives money from its shareholders and invests those funds on their behalf in a diversified portfolio of securities. When investors buy shares in a mutual fund or an ETF, they usually become part owners of a widely diversified portfolio of securities.

mutual fund

The term mutual fund commonly denotes an ___________________________________ In an open-end investment company, investors actually buy their shares from, and sell them back to, the mutual fund itself. Buy and sell transactions in an open-end mutual fund are carried out at prices based on the current value of all the securities held in the fund's portfolio. This is known as the fund's ____________________; it is calculated at least once a day and represents the underlying value of a share of stock in a particular fund. Accordingly all transactions are executed at the end of day price—there is no trading during the day, unlike the ETF.

open-end investment company; net asset value (NAV)

Asset Allocation

protecting the portfolio against negative market developments