Ch 15
Efficient Market Theory
investing is a game of chance. the only way for an investor to obtain higher returns is to take on more risk.
Semistrong-Form Efficiency
over the long term, the only way to gain an advantage in this type of market is to have access to nonpublic information.
Event Risk
significant event like 9/11 attack
Net Present Value
the difference between the discounted amount of future cash flows and the cost of the investment or project. If result is positive the project is worth investing in.
Currency (Exchange Rate) Risk
the possibility that the value of foreign investments will be less in the future due to changes in exchange rates. if interest rates in US increase > $ strength increases > increase in imports
The biggest disadvantage of investing in a growth mutual fund is the potential loss of:
the principal.
Total Return or Holding Period Return
(Ending Value - Beginning Value) + Investment Income / Beginning Value calculation takes into account the cash flow from dividends or interest, plus appreciation or depreciation in the value of investment.
Contrarian style of investing.
The Contrarian style of investing is one that bets against market trends and does not adhere to the prevailing consensus opinion. This particular investment style usually focuses on companies that are out of the mainstream and that have low P/E ratios. (74616)
Passive Strategies: buy and hold, systematic rebalancing, and indexing
For investors who subscribe to the efficient market hypothesis. -Buy and Hold: do nothing - transaction costs and tax consequences are minimized. Danger is drift -Systematic Rebalancing: can be based on time or value -Indexing: mirror an index and make fewer trades.
Strong-Form Efficiency
No one can beat the market- not even insiders- so proper asset allocation is an investor's best approach to long-term investing.
The Wilshire Associates Equity Index
The Wilshire Associates Equity Index shows the market value in dollars of roughly 7,000 NYSE, AMEX, and Nasdaq stocks. It would contain the most stocks of the choices listed. One of the largest Indexes
Active Strategies:
The adviser attempts to exceed the performance of the market. Market Timing. -Sector Rotation: follow the business cycle and try and anticipate whats next
Bottom-Up Analysis
find stable companies w/ history of profits to determine whether a company is undervalued relative to its peers.
Monte Carlo Simulation
illustrates the hypothetical performance over time by using randomly selected variable rates of return.
Time-Weighted Return (TWR)
measure portfolio's manager performance over time.
Beta
measurement of the volatility, or systematic risk, of a security or portfolio in comparison to market as a whole S&P 500 has a beta value of 1 greater than 1 = more volatile than market less than 1 = more stable
Standard Deviation
measures VARIABILITY. larger the standard deviation means that the expected results will have more variance
For a bond what is the: nominal yield, IRR and real rate of return?
nominal yield is the stated rate of interest found on the face of a bond, while a bond's internal rate of return is its yield to maturity. A bond's real rate of return is found by subtracting the rate of inflation from the bond's internal rate of return.
Internal Rate of Return (IRR)
rate of interest The internal rate of return is a way of measuring cash flows. The cash flows into or out of a portfolio may be compounded by the internal rate of return to find future value or they may be discounted to find the present value. the most appropriate method to use to determine the profitability of a project. The IRR uses the present value of cash flows to determine whether the project provides a net present value equal to or greater than the initial cash outlay.
Alpha
represents the difference between an asset's expected return and its actual return. if a securities actual return is higher than its beta, the security has a positive alpha, and if the return is lower, it has a negative alpha.
Dollar-Weighted Return (DWR)
return on average. including returns, deposits and withdrawals Dollar-weighted rates of return are used to calculate a client's internal rate of return and take into account how much the client earned based on the amount of money invested.
Sharpe Ratio
risk-adjusted return measurement - indicated the amount of return eared per unit of risk. the greater a portfolio's sharpe ratio, the better its risk adjusted performance has been. Portfolio's Return - Risk Free Rate of Return / the standard deviation of the portfolio
Rule of 72: Number of years
72 divided by the Rate of Return
Interest Rate Risk
-Rising interest rates will cause bond prices to fall -primarily affect current bond holders, since the market value of their investments may decline if interest rates rise. -longer bonds are more vulnerable
Rule of 72: Rate of Return
72 divided by the Number of Years in which you want your money to double
Present Value
= Future Value / (1 + internal rate of return) ^number of compounding periods.
Future Value
= principal amount (1 + internal rate of return) ^number of compounding periods.
An advisory client has a portfolio that consists of a diversified group of domestic securities with different maturities. Diversification protects the client from which of the following risks? Business risk Financial risk Liquidity risk Market risk I only I, II, and IV only I, II, and III only I, III, and IV only
A diversified portfolio that focuses its investments domestically is subject to market risk. In order to reduce this systematic (market) risk, an investor must invest in assets that do not trade in the same marketplace (such as foreign markets). If the U.S. bond or stock market declines, all of the securities within that marketplace will be affected. This portfolio is protected from all of the other risks mentioned. I, II, and III only
An investor purchased an A-rated corporate bond with a coupon of 5%. After one year, the total return is 3.50%. The most likely reason for this is: The credit rating of the bond was raised, lowering the yield of the bond Interest rates in the market dropped to 3.50% for A-rated issues The investor's payment of accrued interest at the time of purchase has lowered his effective return Interest rates have gone up
Answer- D Total return on a bond equals interest received plus appreciation, or minus depreciation in value, divided by the investor's cost for the investment. If a customer purchased a 5% bond at par and sold the bond one year later for $985, he received $50 in interest, but the investment had declined in value by $15. The total return would be $50 minus $15, divided by the cost, which equals 3.50% ([$50 - $15] / $1,000). (74661)
Which of the following statements are TRUE regarding a comparison of strategic versus tactical asset allocation? Strategic asset allocation focuses on the client's investment objectives and risk tolerance, while tactical asset allocation focuses on economic and market conditions. Strategic asset allocation has a long-term outlook, while tactical asset allocation encompasses short-term decisions. Unlike strategic asset allocators, tactical asset allocators believe that investors can time the market. I and II only I and III only II and III only I, II, and III
Asset allocation based on a client's risk tolerance and investment objectives is called strategic asset allocation. In theory, it is the best mix of assets given the client's goals and level of risk aversion, giving it a long-term outlook. Strategic asset allocators tend to view the market as efficient and market timing as ineffective. By contrast, those who believe securities markets are not perfectly efficient may try to use an active strategy to alter the portfolio's asset mix, to take advantage of anticipated economic events. This market timing approach is sometimes called tactical asset allocation. (62060)
Investor Palmer has a diversified portfolio consisting of equity and debt valued at $365,000 at the start of the year. During the year the portfolio returns $3,579 in dividends and $2,783 in interest income. The investor withdraws the interest income while reinvesting the dividends. At year-end the portfolio is worth $389,648. The investor's marginal tax bracket is 35%. Without compounding, what is the investor's return after taxes? 3.8% 5.7% 6.9% 9.2%
At the end of the year, the portfolio is valued at $389,648, which includes the reinvested dividends of $3,579. The interest income of $2,783, however, was taken out by the investor, bringing his value to $392,431. He must pay taxes on the dividends and interest ($3,579 + $2,783 = $6,362 x 35% = $2,226.70). His portfolio, after these adjustments, is valued at $390,204.30. Subtracting the starting point of $365,000, he has an increase of $25,204.30, which is divided by the starting number of $365,000, giving the investor a return after taxes of 6.9% ($25,204.30 divided by $365,000).
Dollar Cost Averaging
Conservative approach allows investors to commit to a fixed dollar amount of an investment on a regular schedule. More shares bought when price is lower. Reduces risk. Lets investors ease into the market over time. average price per share is typically lower. Average price of the securities purchased will be more than the average cost of the securities over a long period
Which TWO of the following are TRUE concerning the relationship between a bond's yield to call and its yield to maturity? When a bond is priced at a discount, the yield to call will be greater than the yield to maturity When a bond is priced at a discount, the yield to call will be less than the yield to maturity When a bond is priced at a premium, a premium call price will increase the yield to call When a bond is priced at a premium, a premium call price will decrease the yield to call I and III I and IV II and III II and IV
I & III When bonds are priced at a discount, the yield to call will be greater than the yield to maturity since the holder will be receiving no less than par value, at an earlier time. When bonds are priced at a premium, yields will decrease, but the yield to call may not fall as far as the yield to maturity if a call premium exists. To a certain extent, the call premium will offset the premium paid for the bond.
An investor who purchases stock in a closely held corporation with a small number of outstanding shares should be MOST concerned about which of the following types of risks?
Liquidity. Investments in thinly traded issues such as the stock described in the question tend to be illiquid. Investors may have trouble finding buyers for their shares if they need to sell them. This can result in investors either being unable to liquidate their holdings, or having to take a large loss to do so.
Systematic (nondiversifiable) Risk
Market Risk In order to minimize systematic (market) risk, modern portfolio theory states that an investor should have different asset classes in his portfolio that have a negative correlation. When securities are negatively correlated, their prices have a tendency to move in opposite directions such as common stock relative to debt instruments.
Mean, Median & Mode
Mean - add all points in data set, divided sum by number of points in set Median - number found in middle Mode - number appears most often
Modern Portfolio Theory vs The Efficient Market Theory
Modern Portfolio Theory (MPT) - assumes that investors are risk-averse. Essentially, this means that if an investor is given two portfolios that offer the same expected return, she will prefer the one presenting less risk. Efficient Market Theory - the only way for an investor to obtain higher returns is to take on more risk.
Modern Portfolio Theory
Modern Portfolio Theory (MPT) defines the expected return of an investment as the possible returns on the investment weighted by the likelihood that returns will occur. - Expected Return, Standard Deviation of returns, and correlation
Inflation (Purchasing Power) Risk
Protection from: equity, variable annuities, real estate, precious metals at risk: fixed income, fixed annuities, bond holders (rising rates cause market price to fall, and the prurchasing power of their interest decreases.)
Top-Down Analysis
Start with a broad analysis of the economy
Strategic asset allocation vs Tactical Asset Allocation?
Strategic Asset allocation: based on client's risk tolerance and investment objectives, best mix of assets given the client's goals and level of risk aversion, long-term outlook. market timing as ineffective. Tactical Asset Allocation: A market timing approach. For those who believe securities markets are not perfectly efficient may try to use an active strategy to alter the portfolio's asset mix, to take advantage of anticipated economic events.
Capital Asset Pricing Model (CAPM)
The Capital Asset Pricing Model (CAPM) is used to find an optimal portfolio by comparing the relationship between RISK (as measured by standard deviation) and the EXPECTED RATE OF RETURN. -Is based on the efficient market theory and assumes all investors act rationally
Holding period rate of return
The return that someone earns over the life of an investment is referred to as the holding period rate of return. (income + capital gains - capital losses) / the value of the initial investment.
Your client has an annual income exceeding $250,000. He tells you that he wishes to retire in 18 years with a lump sum of at least $5,000,000. You tell him he can invest in zero-coupon municipal bonds that have a yield of 4%. If the client buys 5,000 bonds now, how much will he pay for each bond to achieve a yield of 4%? $500 $250 $600 $125
The rule of 72 is a shorthand method of determining how many years it will take an investor's money to double given a fixed rate of interest. If you divide 72 by the rate of interest, this approximates the number of years it will take for the money to double. At 4%, the money would double approximately every 18 years. This means the investor would need to invest $2,500,000 to have $5,000,000 in 18 years. $5 million dollars of bonds is equal to 5,000 bonds at a par value of $1,000. $2,500,000 divided by 5,000 equals $500.
If a bond is selling at a premium and is callable at par, how is the yield generally calculated? -As a percentage of the par value -By dividing the annual income by the current price -To the final maturity date -To the call date
The yield for a bond is generally calculated to the lower of either the yield to maturity or the yield to call. The yield to call measures the yield that would be earned if the bonds were called at the first call date and not held to the maturity date. If a bond is selling at a premium and is callable at par, yield to call will be lower than yield to maturity. If the bond is selling at a discount, the bond is quoted on a yield to maturity basis. If the bond sells at a premium and is callable at a premium, the yield might be to the final maturity or the call date, depending on the results of the calculation.
Perpetuity - what is it, whats the formula
To calculate the required principal, take the annual payment in perpetuity and divide it by the annual rate of return
An investor holds TIPS worth $1000 that have a coupon of 3.5%. Over a five-year period, the annual inflation rate is 4%. After five years, what is the total return? 3.50% 4.13% 20.00% 41.38%
To calculate the total return, the beginning value is subtracted from the ending value. Income (interest) is added and the figure is divided by the beginning value. With TIPS, the principal is adjusted upward each year by the rate of inflation and then multiplied by the coupon rate to determine the annual interest. To solve this problem, use the following method. Beginning value of the TIPS: $1,000 Coupon Rate: 3.5% Annual Inflation Rate: 4% After Year Principal Coupon Interest Paid 1 $1,040.00 3.5% $36.40 2 $1,081.60 3.5% $37.86 3 $1,124.86 3.5% $39.37 4 $1,169.85 3.5% $40.94 5 $1,216.64 3.5% $42.58 Total Interest Received = $197.15 Ending Value: $1,216.64 Beginning Value: - $1,000.00 Total Appreciation: $216.64 Interest Income: + $197.15 Sum of Appreciation & Income: $413.79 Total Return = $413.79 / $1,000 = 41.38%
Lindsay owns 4 Stooges Inc. 6% bonds that, when purchased, had a current yield of 7%. One year prior to maturity, Stooges issued a new bond with a coupon of 5%. Assuming no change in the credit standing of Stooges, if Lindsay sells her 6% bonds in the market and uses the proceeds to purchase the 5% bonds, Lindsay would have: Purchased the 6% bonds at a discount Purchased the 6% bonds at a premium Sold the 6% bonds at a premium Sold the 6% bonds at a discount I and III only I and IV only II and III only II and IV only
answer (A) Since the bonds had a 6% coupon and, at the time of purchase, a current yield of 7%, Lindsay would have purchased the bonds at a discount, i.e., $60 / $857 = 7.0%. When she sold the 6% bonds, interest rates had dropped, as evidenced by the 5% coupon rate of the new offering. Since interest rates had declined, the price of Lindsay's 6% bonds would have increased, and would be priced higher than par value (a premium bond).
Weak-Form Efficiency
believe in fundamental analysis to identify stocks that are undervalued. researching financial statements makes it possible to identify profitable companies
Value analysis
characterized by: low P/E ratio, a history of profits, a high dividend yield, and a low market-to-book ratio.
Correlation
degree to which the movement of different investments is related. perfectly correlated = 1 uncorrelated (random) = 0 negative correlation = -1.0
Risk Premium
difference between the expected return of an investment and the risk-free rate (T-bill rate) Expected Return - Risk Free Rate
Discounted Cash Flow (DCF)
estimating the fair market value of an investment, company or project based in today's dollars. reflects: time value of money and risk premium Discounted cash flow evaluates each coupon payment and the repayment of a bond's principal at a present value, based on a rate of return. This makes it possible to evaluate a bond's value against the investor's desired rate of return. The sum of each of the discounted cash flows, plus the present value of the bond's principal, determine the total value of the bond. By comparing this value to the current price of the bond, the adviser will be able to determine if the bond is an attractive investment for her client. (62599)