66mod_8

Mrs. Robinson has invested $20,000 in a high-risk investment, hoping to double her money in three years. What compounded interest rate will she need to receive in order to meet her investment goals in three years? A. 12% B. 22% C. 24% D. 33.33%

24%. To answer this question, you must use the "Rule of 72." Since Mrs. Robinson is looking to double her investment in three years, you simply take the number 72 and divide it by 3 to determine the compound interest rate needed. In this case, 72 divided by 3 = 24, or 24%. [Module 8, Risk and Evaluation, Section 3.10]

The current ratio and the quick ratio are liquidity tests for the company. The quick ratio is so named since it nets out inventory that may not easily be converted to cash in a timely manner; it is also referred to as the?

ACID TEST. What is the acid test ratio (quick asset ratio) for TYLNL Corporation? (45,000,000 - 15,000,000) ÷ 5,000,000 = 6 to 1

This is a measurement of a stock or portfolio's return independent of market-related factors. It is the return in excess of the expected return and is used to determine the value of a company's management team or a portfolio manager.

ALPHA Alpha is a risk-adjusted measure of active return. A stock or portfolio is assigned an expected return per the capital asset pricing module (CAPM). CAPM uses beta to measure relative volatility and expected return compared to the market. If a stock or portfolio's return equals this expected return, it is said to have an alpha of 0. A positive alpha indicates excess return for the risk borne and a negative alpha indicates excess risk for the realized return. Example If Jenson Enterprises has a beta of 1.2 and returned 15% in a year that the S&P 500 returned 10%, Jenson would be said to have an alpha of 3%. Jenson's expected return, given its beta, would be 1.2 times the return of the S&P, or 12%. As Jenson actually returned 15%, there was 3% return in excess of what was expected for the amount of risk taken. This would indicate that factors within the company attributed to better-than-expected performance.

Perpetuity Example Example An investor wishes to set up an account on behalf of her grandchild. She wants to know what the present value needed today in a lump sum payment would be with an annual rate of 8% if she wishes her grandchild to receive $3,000 in monthly payments into perpetuity. How much does she need to deposit?

Answer: $450,000 The annual payment that the investor is looking for her grandchild to receive is $36,000, i.e., ($3,000 × 12 months = $36,000). The annual compounded interest rate is 8%. 36000 ÷ .08 = $450,000

Real rate of return example Stefanie Jones invested $10,000 in a portfolio of common stocks. She expected to earn about 5% in annual dividends and enjoy annual appreciation of around 10%. At the end of two years, she had received $500 in dividend income, and the value of her portfolio was $13,500. During the two-year period, the annual rate of inflation was 3%, and she was in a 30% tax bracket. a. What is her expected rate of return? b. What is her total return in dollars? c. What is her total rate of return? d. What is her annualized rate of return e. What is her after-tax rate of return? f. What is her real rate of return?

Answers a. Expected rate of return is 15%: 5% in annual dividends and 10% growth in value. b. Total return is $4,000: $500 in dividends and $3,500 of growth. c. Total rate of return is 40%: $4,000 ÷ $10,000. d. Annualized total rate of return is 20%: 40% ÷ 2 years. e. After-tax rate of return is 34%: 40% × (100 - 15% = 85%). f. Real rate of return is 34%: 40% - the 6% inflation rate (3% × 2 years = 6%).

LADDERED DURATION applies to fixed income investments in which the securities mature every year or two throughout the course of a specific time horizon. The investor receives attractive yields on the longer investments, but continues receiving the principal on the shorter investments in the meantime.

BARBELL DURATION is when an investor has some securities that will mature in the near future and others that mature much later in the time horizon. An investor who owns securities with a barbell duration is not seeking liquidity and is not concerned with inflation risk.

These are used to compare the relative performance of an actual portfolio against a model portfolio.

BENCHMARK PORTFOLIOS •Often the more popular indexes are used as benchmark portfolios. The benchmark should reflect the same classes of securities and industry sectors that make up the actual portfolio. For example, the S&P 100 is largely made up of blue chip industrial stocks and might be used as a benchmark for an actual portfolio of similar securities. The Russell 2000 might be a suitable benchmark for a portfolio of small cap stocks. •The ACTIVE RETURN is a measurement of the difference between the actual return and the benchmark, and is a good indicator of the portfolio manager's ability to supervise the portfolio. Sometimes the benchmark return is referred to as a PASSIVE RETURN, because an index is not a managed portfolio. A managed portfolio will be adjusted by the manager through the selection of better performing securities over time. The company sponsoring and monitoring the index, such as Standard & Poor's, Russell, and others, sets an index.

This is a measurement of the volatility of a stock or portfolio compared to the volatility of the stock market as a whole, a stock within its industry, or a portfolio of stocks with an index to which it is similar.

BETA •Again, "1" is the starting point. A beta of 1 indicates that the stock's price (or a portfolio's market value) will go up and down as the market index rises and falls by the same percentage. If the beta is other than 1, the stock will move up and down in proportion to the beta (sometimes referred to as systematic risk.) A beta of 1.5 indicates that the stock's price will be 50% more volatile than the index (when the index value increases by 50%, the stock's price will increase by 75%, but if the index declines by 10%, the stock's price will decline by 15%). •The beta coefficient may be used in assembling a portfolio of securities. By mixing high-beta stocks with low-beta stocks, the investor can seek higher returns in rising markets (high-beta portion) and reduce downside losses in declining markets (low-beta portion). The betas for most stocks are available from research organizations such as Value Line.

A ________ ________ is the opposite of the top-down approach, in that the investor/analyst looks for outstanding performance of individual stocks in determining how a particular industry might perform.

BOTTOM-UP APPROACH

This is the very real risk that the business an investor chooses to invest in may go out of business.

BUSINESS RISK •Publicly owned businesses can go bankrupt, leaving investors with worthless stock. The degree of business risk usually increases inversely with the size of the company. As a generalization, a high amount of business risk usually results in a low market price for a company's stock. •Smaller and newer companies go bankrupt more often than large, well-established companies. •Business risk might be diversified in an investor's portfolio through the purchase of different types of securities of different types of companies. •In the liquidation of a company, holders of secured bonds have prior claim over holders of unsecured (debenture) bonds, and holders of preferred stock have priority over holders of common stock. •An investment in insured CDs and government-guaranteed obligations is the best way to avoid business risk, but this usually comes with a reduced opportunity for income and capital gain.

Which of the following is a measure of the volatility of a stock in relation to the rest of the market? A. Alpha coefficient B. Beta coefficient C. Standard deviation D. Correlation coefficient

Beta coefficient. Beta measures the volatility of a stock or portfolio against the volatility of the market as a whole. Alpha measures volatility independent of market-related factors. Standard deviation is used to compare the amount of fluctuation of a stock's annualized total return to the average return for that type of stock. Correlation coefficient is a measure of two investments and how each is performing compared to the other. [Module 8, Risk and Evaluation, Sections 5.1 - 5.7]

Which of the following is true, assuming a positive investment return? A) $100,000 to be received in 16 years has a present value of less than $100,000. B) $10,000 to be invested today has a future value of greater than $10,000. C) Both are true. D) Neither is true.

Both are true. $100,000 to be received in 16 years has a present value of less than $100,000. $10,000 to be invested today has a future value of greater than $10,000.

This is a method used to compare risks with expected returns

CAPITAL ASSET PRICING MODEL (CAPM)

This is the amount of cash available to a company after the deduction of taxes, but with the addition of depreciation. Depreciation is added back in because it is a deduction from income without the actual expenditure of money. (Nobody writes a check to "depreciation.")

CASH FLOW CASH FLOW = NET INCOME (after taxes) + DEPRECIATION

What is the current ratio for the corporation?

CURRENT RATIO = TOTAL CURRENT ASSETS/ TOTAL CURRENT LIABILITIES What is the current ratio for TYLNL Corporation? 45,000,000 ÷ 5,000,000 = 9 to 1

Which of the following theories states that an investment must generate enough return over and above an available risk-free return to justify the additional risk? A. Correlation Coefficient B. Capital Asset Pricing Model C. Risk-Free Return D. Risk-Adjusted Return

Capital Asset Pricing Model. According to the CAPM theory, investors can earn risk-free return by investing in savings accounts, bank CDs, and T-bills. Since most other investments carry at least some risk, CAPM states that an investment must create a return greater than the risk-free return in order to justify the additional risk involved. The correlation coefficient is a statistical measure of how two or more measurements relate to each other, (e.g., how interest rates affect the market values of certain bonds); risk-free return is return with little or no risk, (resulting in little or no growth), such as savings accounts, T-bills and CDs; this is an element of CAPM. Risk-adjusted return is the difference between the actual risk and the risk-free rate of return. [Module 8, Risk and Evaluation, Section 1.1]

What is the arithmetic measure used in determining the future value of an investment purchased today? A. Compounding B. Discounting C. Accretion D. Deduction

Compounding. An investment that a person will try to determine the future value of compounds the specific rate of return that will be generated until that point in the future. Discounting is the pricing of a security, usually a debt instrument, below its face value. Accretion is the accounting process of increasing the value of an asset over the life of the asset. An example of accretion is the yearly adjustment of the difference between the discounted price at which a bond was purchased and the par value. This amount is added to the value each year. Deduction is the amount that is subtracted from an amount received. [Module 8, Risk and Evaluation, Section 2.2]

Which of the following is a measurement of the volatility of the performance of one investment with another? A. Alpha B. Delta C. Sharpe Ratio D. Correlation Coefficient

Correlation Coefficient. The Correlation Coefficient is a statistical measure of the degree of how two investments are related. The Sharpe Ratio compares a stock's risk adjusted rate of return to its volatility, as measured by standard deviation. Alpha measures a stock's price volatility independent of the market as a whole, and Delta is a measurement used to compare option premium movements with the price movements of the stocks underlying the option contract. [Module 8, Risk and Evaluation, Section 5.1, 5.4, 5.6, & 5.7]

What is the debt/equity ratio?

DEBT/EQUITY RATIO = TOTAL LONG-TERM DEBTS (BONDS) / TOTAL NET WORTH What is the debit/equity ratio for TYLNL Corporation? 30,000,000 ÷ 40,000,000 = 75%

This is a volatility measurement used to compare option premium movements with the price movements of the stocks underlying the option contract.

DELTA •Again, "1" is the standard if the option premium moves dollar-for- dollar with movements in the underlying stock. A delta of 1.25 indicates that every time the price of the underlying stock increases by $1, the option premium of a call on the stock would increase by $1.25.

The purpose of ________ _________ __________ analysis is to estimate the amount of money an investor would receive on an investment and to adjust that amount based on the time value of money

DISCOUNTED CASH FLOW (DCF) The DCF is used to determine the attractiveness of an investment by arriving at its present value. Future value, interest received, and the discount rate are all necessary components in determining the discounted cash flow of a bond.

This is an accounting method that factors in any deposits or withdrawals of capital to a portfolio and considers them part of the return, along with capital gains and losses.

DOLLAR WEIGHTED RETURN

This is a measurement of how sensitive a bond's market price is to small changes (usually 1% or less) in interest rates.

DURATION Bonds with the longest duration are affected the most by interest rates; if all bonds are relatively the same (within months), the bond with the lowest coupon is affected the most.

Which of the following volatility measurements compares option premiums with the price movements of the stocks underlying the option contract? A. Alpha B. Beta C. Delta D. R - squared

Delta. Delta compares price fluctuations in option premiums to those of the underlying stock. Alpha compares a stock's price against fundamental changes within the company and its industry sector. Beta compares the volatility of a stock to the volatility of the market as a whole, and compares the stock to an index. [Module 8, Risk and Evaluation, Section 5.0]

This is the return an investor anticipates earning from an investment when the investment is made. This is the basic formula (income + appreciation ÷ the cost of the original investment), looking forward for the time the investment will be held.

EXPECTED RETURN It is all of the "expected" income (from dividends and/or interest) plus any "expected" appreciation (or minus loss) that will occur, divided by the original investment. An investor's required return is the return required by investors before they will commit to an investment. The expected return should always exceed a client's required return; if it does not the investment is unacceptable. The expected return is the yield the investor is looking "forward" to making on the investment. Think of this as, "What is the total return I shall see in the coming years on my investment?"

R-SQUARED example

Example If we project the average Nasdaq stock to appreciate from $25 to $36, the square root of the average stock has moved from $5 (the square root of $25) to 6 (the square root of $36), making the square root adjustment $1. The rule then assumes that we could determine the amount the prices of other Nasdaq stocks would appreciate by adding $1 to the square root of their starting prices. A $4 stock has a square root of $2; $1 + $2 = $3. $3 squared (multiplying a number by itself is "squaring" the number) results in an expected market price of $9. A $100 stock has a square root of $10; $1 + $10 = $11. $11 × $11 = $121 as the expected price. This rule assumes that all stocks in the index are moving in the same direction, which of course doesn't happen. However, the more broadly diversified the portfolio, the more accurate the square root rule becomes.

interest rate risk examples Example If a client owns a bond with a coupon rate of 6% ($60 annual income), and the rate of inflation is 3% ($30 per year loss in purchasing power per $1,000 of income), the investor's real rate of return is only 3%.

Example If a client purchases a bond with a coupon rate of 3%, and inflation averages 5% during the term of the bond, the investor didn't lose money, but they have lost purchasing power as the real rate of return is -2%. Over time, the stock market has outperformed inflation; however, the stock market occasionally has periods when market performance (rate of return) is less than the rate of inflation. In order to invest in the stock market and expect a rate of return higher than inflation, one should invest for the long term.

Which term is used when referring to the anticipated return that will be realized on an investment ? A. Expected return B. Actual return C. After-tax return D. Total return

Expected return. Expected return is the anticipated total return an investor can expect from an investment. Actual return is the return that an investor actually realizes, and it cannot be determined until after the time period has ended. This question is asking you for the return that the investor plans to realize (expects). Total return is similar to actual return and cannot be determined until the time period has expired. [Module 8, Risk and Evaluation, Section 3.1]

This is used to determine the value of an investment at a point in the future.

FUTURE VALUE To find future value, determine how much an investor can invest today (present value) and calculate a future value by compounding at a specific rate of return.

This refers to appreciation in the value of the investment.

GROWTH OF CAPITAL A CAPITAL LOSS refers to a decrease in the value of the investment.

This is the return an investor has received from an investment for the specific years that the investment was held. This is very similar to the total return, but for a specific period of time during which the investment was held, rather than for the full life of the investment. It is all of the "actual" income (from dividends and/or interest) in that time period plus any "actual" appreciation (or minus loss) that occurred in that time period, divided by the original investment.

HOLDING PERIOD RETURN This is the yield the investor is looking "backward" at regarding the return on the investment for certain periods of time while the investment was held. Think of this as, "The total return I have seen for the years two through five, or for the last three years of the 10 years. It is the return on just a specific amount of time from my investment."

Place the business risk of the following investors in the proper sequence from highest to lowest. I. Holders of common stock II. Holders of mortgage bonds III. Holders of debentures IV. Holders of preferred stock V. Customers A) I, II, III, IV, V B) I, IV, III, II, V C) V, IV, I, II, III D) III, IV, I, V, II

Holders of common stock stand to lose the most if a company is liquidated, followed by holders of preferred stock, debenture holders, mortgage (secured) bondholders, and customers.

Duration is a measurement of which of the following? A. How sensitive a bond's market price is to small changes in interest rates B. How much the value of securities may decline for any reason C. The risk that a company may go out of business D. The risk that the rate of return on a new investment may be lower in the future

How sensitive a bond's market price is to small changes in interest rates. Duration is the weighted average of a bond's cash flows to maturity, including the final maturity payment. The higher the duration, the more price volatility exists due to changes in interest rates. In other words, when interest rates change, bond prices change in the opposite direction. As interest rates go down, bond prices go up, and vice versa. The decline in valuation is a description of market risk. A company going out of business is description of business risk. The rate of return on a future investment is a description of reinvestment risk. [Module 8, Risk and Evaluation, Section 4.6]

Which of the following is used in the measurement of volatility? I. Alpha II. Beta III. Delta IV. R-squared A. I and II only B. I and III only C. I, II, and III only D. I, II, III, and IV

I. Alpha II. Beta III. Delta IV. R-squared All of these terms measure volatility. Alpha measures volatility of a stock price independent of market-related factors. Beta measures volatility of a stock price relative to the stock market as a whole. Delta measures the volatility of options premiums against the price of the underlying stock. R-squared determines the volatility based on the market price using the square root of the market price plus a constant. [Module 8, Risk and Evaluation, Sections 5.1 - 5.4]

Which two of the following would represent the greatest risks to an investor who purchases and holds a 10-year corporate bond? I. Reinvestment risk II. Interest rate risk III. Business risk IV. Liquidity risk A. I and III B. I and II C. II and III D. II and IV

I. Reinvestment risk III. Business risk Reinvestment rate risk is the risk of reinvesting at maturity and not achieving the same rate of return as was achieved on the previous investment, and reinvesting interest paid and achieving the same rate. For the test, always look to see if the investor is intending to hold or to sell the bond. This person is holding the bond, so the risk is reinvestment rate risk. If the person were selling the bond, the risk would be interest rate risk. Of the four choices, the next greatest risk to a bondholder is the business risk, or the concern that the company may go out of business. Liquidity risk is present, in as much as are there enough people interested in this particular bond. [Module 8, Risk and Evaluation, Sections 4.0 - 4.6]

This refers to payments from the investment that does not diminish the capital invested, such as ordinary dividends, interest, annuity payments, and rental income.

INCOME

Many formulas are available for determining the different returns, but they can all be summed up in one equation. It may have adjustments for risk, taxes, or inflation, but this one formula is used as the base:

INCOME + APPRECIATION / ORIGINIAL COST The three main returns that use this formula are: •Expected return •Total return •Holding period return

This is the risk that the rate of inflation will exceed the rate of return, or nominal return, of an investment causing the investor to lose purchasing power over time. Fixed income securities are particularly prone to inflation risk. The longer the maturity, the greater the risk.

INFLATION RISK is also referred to as PURCHASING POWER RISK. •It is of greater concern to long-term bondholders than short-term bondholders or stockholders . •Purchasing power risk is the risk that the real return of the investment may be less than its nominal return. •It is also the risk that the principal, when returned to the investor, will purchase less in the form of consumer goods than it would have when it was first invested

The U.S. Treasury first introduced TREASURY ____________ ____________ in 1997 as a variable rate government security.

INFLATION-PROTECTED SECURITIES (TIPS) TIPS are the newest of the securities issued by the U.S. government, and are effective in protecting an investor from inflation risk. The name variable rate is really a misnomer, in that the securities are issued with a fixed rate of interest. When adjusted by the U.S. Treasury, the principal is adjusted according to inflation yet the interest rate remains the same.

This is the risk that an investor has when attempting to sell a debt security (bond) prior to the maturity date. The risk that occurs is that as interest rates change in the marketplace, the value of the bond fluctuates inversely. The fluctuations that occur with these changes in interest rates are the "interest-rate risk" that the investor encounters.

INTEREST-RATE RISK •For the test, it is not the length of the bond that determines the interest rate risk; rather, it is the decision to sell the bond that causes the interest-rate risk. •If a test question states that the bond will not be sold prior to maturity, ELIMINATE interest-rate risk as a possible answer. •Do not try to determine if the bond is long or short term, but look to see if the bond is going to be held or sold prior to maturity. •All bonds, long and short-term, have interest-rate risk. But they only have interest-rate risk if they are to be sold. •The market price of bonds may be affected by business risk and supply and demand in the market, but the most common factor that affects the prices of bonds are changes in interest rates. •The coupon interest rates for companies with high business risks are higher to compensate for this increased risk. •Changes in interest rates can also affect the stock market, especially preferred stock. For this reason, preferred stock also has interest-rate risk, due to the fact there is no maturity date. This has a two-fold effect: Rising interest rates increase the cost of borrowing for companies, which lowers their returns and the rising interest rates make bonds less attractive to investors.

Of the following, which represents the greatest risk to an investor who holds a 20-year government bond until it matures? A. Liquidity risk B. Inflation risk C. Market risk D. Interest rate risk

Inflation risk. Investments in long-term debt securities always have inflation risk, more commonly called purchasing power risk. Interest rate risk is found when an investor is selling the bonds. Market risk is the risk of the investment being affected by overall market movement. The risk is that the market in general will go down, and therefore, the investor's securities will decrease in value. Liquidity risk refers to the possibility that an investor may not be able to liquidate a position at a time when needed to due to marketability or other factors. [Module 8, Risk and Evaluation, Sections 4.5]

This is the rate that will discount all of an investment's future cash flows (interest, dividends, and capital gains/losses) to an amount that will offset the current cost of the investment -- in other words, to a net present value of zero.

Internal rate of return (IRR), The IRR is the rate "implied" by the cash flows, both positive and negative, and is referred to as the "internal" rate as it is calculated independent of outside factors such as inflation or taxes. In order for an investment to be feasible, the IRR must exceed the cost of capital or the required return. When selecting investments, the investment with the highest IRR would be most desired (everything else being equal). On the exam, you will not be asked to compute the internal rate of return; however, you are likely to see conceptual questions testing your understanding.

What return is the equivalent of cash inflows and cash outflows? A. Internal rate of return B. Total return C. Expected return D. Holding period return

Internal rate of return. To calculate IRR, add all dividends and interest that will be received throughout the lifetime of the investment, deduct any costs involved with the investment (such as interest paid), and discount this amount back to the present value to equal the initial investment. Find total return by adding income plus capital growth (or subtracting capital losses) over a particular period of time. Expected return is the return that an investor can anticipate receiving sometime in the future. Holding period return is the return one receives during the time an investment is held. [Module 8, Risk and Evaluation, Section 3.9]

"Quantitative" refers to that which can be measured mathematically. The following investment terms refer to the various ways securities analysts evaluate investments and investment portfolios.

Investment returns can be categorized into the following types of return: •Income •Growth of capital

Yield to Call Calling a bond (unless it is trading at par) will affect the investor's yield, because the call is effectively changing the maturity date.

Know the following three points: 1.The yield to call moves in the same direction as the yield to maturity. 2.When a bond trades for less than par (at a discount price), the yield to call will be higher than the nominal yield (a profit at maturity that must be taken into consideration). 3.When a bond trades for more than par (at a premium price), the yield to call is lower than the nominal yield (there is a loss at maturity).

This is the risk of an investor being able to convert an investment into cash in a short period of time. Liquidity risk is also known as "marketability risk" and can be tested as such on the exam.

LIQUIDITY RISK •Marketability is often a factor in determining liquidity. CDs, savings accounts, and Series EE savings bonds are not marketable, but are highly liquid. •Stocks of smaller, less well-known companies that are not traded on the stock exchanges or the Nasdaq system may be difficult to sell quickly without losing value in the stocks. When these stocks are sold, investors may lose significant value if they have to sell in a hurry. •Thinly traded stocks of closely held companies are much less liquid than securities of large, well-known companies whose stocks are listed on the New York Stock Exchange.

This is the risk that all the securities that belong in the same asset class (e.g., stocks and bonds) will be affected similarly by changes in prices in the market.

MARKET RISK •The decline might be caused by many factors that may or may not be related to the actual profitability or expected performance of a company. •Market risk cannot be reduced through diversification within an asset class. •Market risk is an example of SYSTEMATIC RISK, a risk that affects an asset class systematically as opposed to a particular company, individually. Systematic risk cannot be reduced through diversification within an asset class, though allocating assets among different asset classes that have a low or negative correlation coefficient can reduce exposure to the systematic risk. •NONSYSTEMATIC RISK is when a company's stock price fluctuates according to changes that are not related to the stock market. It is a company-specific, security-related risk. Unsystematic risk can be reduced through diversification in an investor's portfolio. •Investors can avoid nonsystematic risk by purchasing mutual funds rather than individual stocks. The advantage of any mutual fund is that they are professionally managed vs. investors choosing individual stocks themselves.

This is a method of quantifying risk and return on an investment portfolio, developed by Nobel Prize winner Harry Markowitz. Instead of focusing on individual securities, it focuses on the risk/reward relationship of a total portfolio. This includes: •Assessing the risk/reward factors of individual securities in the portfolio •Asset allocation between the classes of securities in the portfolio •Selecting the best return for the acceptable level of risk •Measuring portfolio performance

MODERN PORTFOLIO THEORY

One method used to analyze how an investment will perform in the future is the? It can be used to estimate personal financial goals or expected values of options. This complex simulation technique uses several variables (interest rates, inflation rate, expected return, and past performance) combined in several scenarios to attempt to calculate expected outcomes. The simulation involves calculating possible outcomes for thousands of sets of variables.

MONTE CARLO SIMULATION

Sometimes, a security will decline in value for no other reason than the entire market is in decline or its sector of the market is in decline. This kind of risk is called which of the following? A. Inflation risk B. Market risk C. Business risk D. Regulatory risk

Market risk. Market risk, sometimes referred to as systematic risk, is common to all equity securities (stock), and it usually cannot be eliminated by diversification. It is the biggest risk when investing in equity securities. Inflation risk exists for all long-term debt securities, but not for equity securities. Market risk can pertain to both. Business risk is the chance that a company may go bankrupt due to changes in the economy and /or the industry of that company. The company could be forced to liquidate its assets and the investor would lose all, or part, of their investment. Regulatory risk exists for all securities that are subject to governmental regulation, such as municipal bonds that could lose their tax-exempt status, or companies that are heavily regulated by the government, such as airlines. [Module 8, Risk and Evaluation, Sections 3.2 - 3.6]

The RISK-ADJUSTED RETURN Example

Mr. Jones is reviewing his portfolio investment return for the past year. T-bills are currently yielding 6%, so he uses this as his risk-free rate of return. His target rate of return is 15%, so his risk premium is 9% (15% target rate of return - the 6% risk-free rate of return). The actual portfolio return was 14%, making his risk-adjusted return 8% (14% actual, 6% risk-free return). The risk premium is the "looking forward" to see how his return will do compared to the risk-free return. The risk-adjusted return is the "looking back" at what he actually made over and above the risk-free return.

This is a calculation used to determine the present value of an investment based on the future value at a given rate of return (discount rate). It involves calculating the differences between the discounted present value of the expected cash flows from the investment (both in the form of dividends or interest and capital appreciation) and the current amount invested.

NET PRESENT VALUE Only if the net present value calculation of an investment is greater than $0, is it considered a good investment. The higher the discount rate (assumed rate of return) used, the lower the net present value. The lower the discount rate used, the higher the net present value. Example If Joe Schmo, an investor, calculates that the present value of $1,000 invested at 8% for five years is $1,100, he would probably make the investment since the present value of the future cash flow exceeds his initial investment. (Net present value is found by subtracting the current amount to be invested -- $1,000 -- from the calculated present value of $1,100. The net present value of the investment is $100.)

This is simply the fact that once an investor has committed funds to an investment, the opportunity to invest them in some other area with potentially higher returns has been lost.

OPPORTUNITY COST Example Ms. Jones is very risk averse and invested all of her money in government bonds paying 6%. That same year, the stock market as measured by the S&P 500, rises 14%. The opportunity cost was the difference of 8%.

Ms. Nelson has invested all of her money in government bonds because she is very concerned about risk. The bonds pay her 9%. At the same time, she sees that the stock market, as measured by the Standard & Poor's 500 index, has risen 15% for this same time period. The difference in these investment performances could be called what type of loss for Ms. Nelson? A. Inflation risk B. Interest rate risk C. Opportunity cost D. Liquidity risk

Opportunity cost. Ms. Nelson could have invested her funds in the market, and potentially made almost twice as much as her investment in government bonds. The opportunity was lost because she preferred a more conservative approach. Thus, her opportunity cost was 6%. Inflation risk is the risk that an investment will lose value due to inflation, also called purchasing power risk. Interest rate risk is the risk of prior to maturity and having the value of the bond decrease. Liquidity risk refers to the possibility that an investor may not be able to liquidate their position when needed, due to marketability and/or other factors. [Module 8, Risk and Evaluation, Sections 4.9]

This is the risk that an investment's return could be affected negatively by any political changes or by the instability of a particular country's government.

POLITICAL RISK, also referred to as "geopolitical risk," This could include a change in government or its legislative bodies, military control, or a change in certain foreign policy concepts such as trading. Political risk would be a factor mainly in any government securities (more so with the securities of a traditionally economically unstable country) and would be greater in investments with longer time horizons. Political risk could result in an investor being unable to withdraw capital from an investment. Political risk can be offset through the insurance of international agencies or government bodies.

This is determined by assuming an investment rate of return and a target amount (goal) to be reached at the end of a period of years, and then calculating how much would have to be invested today to achieve that goal.

PRESENT VALUE •A parent may determine that $100,000 will be needed in 16 years to finance a child's education. By DISCOUNTING at various rates of return, the parent can determine how much must be set aside today (present value) to achieve the goal (future value).

This refers to the volatility of stocks in relation to the market prices of those stocks.

R-SQUARED •Low-priced securities are usually more volatile than high-priced securities. •The "square root rule" says that if the market advances, all stocks advance in price by adding a constant amount to the square root of their market price. Or, more simply, the lower the price of a stock, the greater its percentage gain (or loss) when the market moves.

This is total return less (minus) the inflation rate

REAL RATE OF RETURN Real rate of return is used to determine whether an investment's return is keeping pace with inflation. Note: The real rate of return is also referred to as the "INFLATION-ADJUSTED RETURN" in some questions on the exam. •The Consumer Price Index (CPI) is a commonly used measure of the inflation rate, since this index is used to estimate the increasing (or decreasing) costs of goods of and services at the retail level. The Producer Price Index is said to measure "wholesale inflation" as it measures the prices of goods at the wholesale level. The gross domestic product (GDP) measures the total value of goods and services produced within a country and is also considered a touchstone of the inflation rate. •The real rate of return should be calculated based on an after-tax return, since most people have to pay taxes. However, for test purposes, the questions do not require that you calculate the after-tax return before applying the inflation rate.

This is the risk that an investment's value may be affected by regulatory changes in the law.

REGULATORY RISK •The perception is that those who invest in municipal bonds or other securities that are tax-code sensitive, are more susceptible to regulatory risk, but many investments involve regulatory risk. Deregulation of an industry, as occurred with the airline industry, or invocation of antitrust laws, such as the breakup of AT&T, have had a major investment impact on the value of securities that are not usually considered sensitive to regulatory risk.

This is the combination of the risk associated with investing the periodic payments from a debt security with the risk of reinvesting the principal at maturity.

REINVESTMENT RISK •For the test, think of reinvestment risk as debt issues that are held to maturity, regardless of the length of the bond, and the fact these bonds are held and are not intended to be sold. •If the test question does not state whether the bond is held or sold, reinvestment risk is the correct choice for bonds with maturities under 20 years. •Because most debt securities have a fixed yield, when interest is received and principal is returned from the debt security, these amounts must be reinvested. The risk that the rate of return will be lower in the future is referred to as REINVESTMENT RISK. •All debt issues have a maturity date, from one month to 30 or more years. When a person invests in short-term securities, the investor may have high reinvestment risk -- the risk that interest rates will be lower when being reinvested than when initially purchased. •Reinvestment risk also pertains to interest income received from debt issues. Semiannual interest payments on a 20-year bond are subject to reinvestment risk because the interest that might be received if the interest payments were reinvested may be lower. •The debt securities with the least reinvestment risk would always be zero-coupon bonds, because these bonds do not pay interest and the discount takes into the consideration the reinvestment required.

This is the difference between the EXPECTED RETURN and the RISK-FREE RETURN. The premium is the reward the investor expects for taking the risk. This is a forward-looking return, with an expectation of, "How much will I get for the risk I am taking?"

RISK PREMIUM This can be in anticipation of the investment, and therefore, a means of determining which investment to use. In determining investment suitability, investment advisers should determine how much risk their client will tolerate in return for an expected investment return. If an investor does not want to assume any risk, the investor's choices should be limited to those investments with little risk, such as a T-bill or a savings account.

This is the expected return on T-bills or other risk-free investments

RISK-FREE RETURN The yield for a three-month T-bill is commonly used as a representative risk-free return.

To calculate the compounded interest rate, one needs a high tech calculator, much like an HP or a TI calculator. However, on the test you will not be able to use one of these calculators, but you could be asked to determine the compounded interest rate. To calculate the compounded interest rate, use the "RULE OF 72."

RULE OF 72 •Total years of investment × interest rate = 72 The Rule of 72 is an easy formula that takes the expected interest and divides it into 72 to determine how many years it will take to double the amount of the investment. Conversely, take the number of years an investment has taken to double and divide that into 72 to determine the compounded interest rate that was achieved. The formula is an approximation, and should not be used as a specific guide. If you are asked to find the compound interest rate for an investment, apply this method. Look to see how many years total as well as how many times the investment doubled. Using the 72 and dividing by the years will give you the first doubling, and then multiply by the amount of times the investment has doubled.

Which of the following represents the greatest risk to an investor who holds a 10-year government bond? A. Reinvestment risk B. Inflation risk C. Market risk D. Interest rate risk

Reinvestment risk. A person who is HOLDING the bond to maturity has reinvestment risk, due to having to reinvest the periodic interest payments when paid as well as the principal payments when the bond comes due. If the question had stated to "sell" the 10-year bond then the risk would be interest rate risk. Interest rate risk is the risk that the interest rates will be higher than the current investment when the investor sells the bond, thus causing the bond to lose value. Long-term bonds have inflation, or purchasing power, risk. Market risk is the risk that the market will drop when investing in stock. [Module 8, Risk and Evaluation, Section 4.4]

Which of the following risk factors are associated with holding short-term debt (under five years) issues to maturity? A. Market risk B. Business risk C. Regulatory risk D. Reinvestment risk

Reinvestment risk. The secret to look for is the investor holding to maturity or selling prior to maturity. Debt issues have an inverse relationship between interest rates and prices. As interest rates change, so do the prices of bonds. For investors who hold their debt securities, the biggest risk they must assess is that future investments will not receive an interest payment that is as high as the investment they have at present. Investors benefit from short-term debt issues because the prices remain very steady, but each future investment may not be as high in interest rate as the present one. Regulatory risk only arises if there are legal changes in the works. [Module 8, Risk and Evaluation, Section 4.4]

This is a statistical measure of how spread out points in a data set are. It is used to compare the fluctuation of an investment's annualized total return with its average return over a specific period.

STANDARD DEVIATION Standard deviation can be stated simply as the average variance from the average return of the investment. The more a stock's price deviates from its mean (average) return, the higher the volatility, or risk, associated with the stock. Standard deviation is one of the risk measures used by modern portfolio theory and is used to calculate the Sharpe Ratio.

All of the following are measurements of volatility, except: A. Standard deviation B. R-squared C. Correlation coefficient D. Sharpe Ratio

Standard deviation. Standard deviation is a statistical measurement range used to compare the fluctuation of an investment's annualized total return with its average return over a specific period. It is a range of volatility and not a measure of the volatility of a specific investment. R-squared, correlation coefficient, and the Sharpe ratio are all measurements of volatility. [Module 8, Risk and Evaluation, Section 5.5]

Which of the following does not measure volatility? A) Sharpe ratio B) Alpha C) Standard deviation D) Beta

Standard deviation. Standard deviation is not a volatility measurement. It is a range of volatility, not a measurement. The Sharpe ratio is a comparison of a stock's return with its volatility, and is a measure of volatility. Alpha measures the stock price change relative to changes within the company and industry sector, while beta measures the stock or portfolio change relative to changes in the market as a whole.

Diversification can be used to protect an investor in against all of the following, except: A. Regulatory risk B. Business risk C. Interest rate risk D. Systematic risk

Systematic risk. Diversification can protect an investor against regulatory risk, business risk, and interest rate risk because the investor would not have all their eggs in one basket. If one particular investment lost a significant amount of money, the investor may still have other investments that were unaffected by the risk that caused the decreased investment to drop in price. With systematic risk, however, the entire market is affected thus seeing a decrease in value. The only way investors can protect themselves against market risk is by buying put options. [Module 8, Risk and Evaluation, Section 4.2]

Money can increase in value if it is invested in something that produces a return (interest). The value of money (present value) can decrease over time (future value) if the return does not keep up with inflation. This is known as the

TIME VALUE OF MONEY.

A _______ ______to investing is an investment method in which the investor or analyst first looks at the general economy as a whole, then to a particular industry, and finally selects an individual security within that industry that will most likely benefit from the trends in the general economy. For example, if investors see that inflation is stable, making the retail industry attractive, they would look towards specific retail companies to invest in.

TOP-DOWN APPROACH

What is the basic formula underlying a "double-entry balance sheet?"

TOTAL ASSETS = TOTAL LIABILITIES + NET WORTH

What is the QUICK RATION for the corporation?

TOTAL CURRENT ASSETS - INVENTORY / TOTAL CURRENT LIABILITIES

This is the return an investor has received from an investment for the years that the investment was held. This is the return that is calculated after the time period has ended. It is all of the "actual" income (from dividends and/or interest) plus any "actual" appreciation (or minus loss) that occurred, divided by the original investment.

TOTAL RETURN This is the yield the investor is looking "backward" at regarding the return on the investment. Think of this as, "The total return I have seen for the last few years from my investment."

This is the total return less (minus) any taxes. Investors are concerned about after-tax returns.

The AFTER-TAX RETURN, or NET YIELD After-tax return (expressed as a percentage) can be calculated by subtracting an investor's tax rate from 100%, and then multiplying that percentage by the total return to arrive at the after-tax return. For example, if an income tax rate is 28%, then 100 - 28 = 72%. 72% of the investor's taxable yield would be the after-tax return. After-Tax Return = Taxable Yield (100% - Tax Bracket) There could be a concern for the different tax rates regarding income and long-term capital gains. The tax rate on long-term capital gains (investments held for longer than one year) and qualified dividends is currently 15% for most investors (see table below). On these questions, you will need to multiply the total return by 85% (100 - 15) rather than the investor's tax bracket. Though not yet tested, starting in 2013, the new tax rate for long-term capital gains and qualified dividends for investors in the top income tax bracket (39.6%) is 20%. If you encounter a question on the exam that requires you to use the long-term capital gains rate but doesn't indicate which tax bracket the investor is in, use the 15% rate.

This is a statistical measure of the degree of how two investments are related. It is a measure of volatility and can be used to compare the performance of one investment with another.

The CORRELATION COEFFICIENT It is used in selecting different investments for a portfolio of investments. It is also used to compare predicted performance with actual performance. You may encounter a question or two that includes the term correlation coefficient. This term can be used to describe how the actual return matches the predicted return for an investment. As an example, if you compare the investment performance of a mutual fund with its predicted return and the actual matches the predicted return, the correlation between these two would be equal to a correlation coefficient of one. If, on the other hand, the actual return did not match the predicted return, the correlation coefficient may be zero. Correlation coefficients are between +1 and -1. Zero correlation means the returns are not related; a +1 means that a close or perfect relationship exists; and a -1 means that the investments are close to or almost a perfect relationship, but they move in opposite directions. An investment adviser may strive for a correlation coefficient of zero to achieve total diversification.

This is the financial picture of the company over the year, and shows the aggregated business transactions in the form of income, expenses, and other disbursements for the time period involved.

The INCOME STATEMENT The income statement is also known as the PROFIT AND LOSS STATEMENT. An income statement lists the amounts received from selling goods and services, plus other items, and matches them against all the costs and outlays incurred to operate the company. The result is either a net loss or net profit for the year.

This is the difference between an investor's TOTAL RETURN and the RISK-FREE RETURN. This is a backward-looking return, with the analysis of, "How much extra did I make compared to if I did not take the extra risk?"

The RISK-ADJUSTED RETURN •After determining what return clients wish to gain versus the amount of risk they are willing to assume, an investment adviser can estimate a client's risk-adjusted return.

This compares a stock's risk-adjusted rate of return to its volatility. It is used to measure the incremental reward of assuming risk -- the higher the ratio, the better the risk-adjusted performance.

The SHARPE RATIO SHARPE RATIO = PORTFOLIO RETURN - RISK-FREE RETURN/ STANDARD DEVIATION The Sharpe ratio measures an investment's return per unit of risk.

This is a measure of the compound rate of growth in a portfolio. This method eliminates the effects of additions and withdrawals of capital, or cash flows, which may distort a DOLLAR-WEIGHTED RETURN, by assuming that all deposits and withdrawals occur simultaneously at the midpoint of a reporting period (creating a net amount). This concept is used to determine the performance of investment advisers and portfolio managers in comparison with one another.

The TIME-WEIGHTED RETURN, or GEOMETRIC MEAN According to the time-weighted return, performance will equal return on the value of assets at the beginning of a measuring period, plus the return on the net amount of any deposits or withdrawals during the period, divided in half. The periods (usually quarters) are then linked to produce a compound average total return. This time-weighted method is considered to provide a "truer" measurement of how the investments in a portfolio are performing as a whole, as they will not be as influenced by larger deposits or withdrawals in the calculation period.

Which of the following defines the risk-free return? A. Add income and capital growth over a specific time-frame B. The expected return on T-bills C. Subtract inflation rate from total return D. Difference between the actual return and a benchmark portfolio

The expected return on T-bills. T-bills are "risk-free" investments. If you add the risk-free return to the risk premium the result is the expected rate of return; the risk premium being the "reward" that an investor expects for taking the risk of a given investment. The addition of income and capital growth over a specific timeframe is the definition of total return. The difference between inflation rate and total return is the real rate of return; and the difference between the actual return and a benchmark portfolio is the active return. [Module 8, Risk and Evaluation, Section 3.4]

When investment advisers look at investments for their clients, they take into consideration the compounding of interest and dividends as they are received and reinvested in the respective investments.

To determine this compounding effect, most advisers look at the income and assume that the investment will generate the same yield on the income if the money remains in that same investment.

If a dollar is invested, any investment returns must exceed the loss in value due to inflation so that it will be worth more than a dollar received tomorrow.

To make this easier to understand, let's look at 10 years from now as an example. A dollar saved will be worth less than it currently is due to inflation. Conversely, if we look at the value of a dollar in 10 years, what is the value of that same dollar today if it were in an investment that produced a rate of return? Discounted cash flow techniques such as calculating net present value or the internal rate of return take the time value of money into consideration to determine if an investment is worthwhile.

Risk-adjusted return is which of the following? A. Total return divided by risk-free return B. Total return minus risk-free return C. Risk-free return divided by actual return D. Risk-free return minus actual return

Total return minus risk-free return. Risk-adjusted return is the difference between the total return and the return the investor could have achieved by investing in a risk-free investment, such as T-bills and savings accounts. Note the phrase, "risk-adjusted" return. The other answer choices mix up of the components of the risk-adjusted return. [Module 8, Risk and Evaluation, Sections 3.6]

All companies publish a balance sheet and income statement, and distribute it to all stockholders each quarter. At the end of the financial statements are the auditor's notes. In these notes, any irregularities or items not explained in the balance sheet or income statement are noted and explained. One of these items is called UNFUNDED LIABILITIES.

UNFUNDED LIABILITIES are any liabilities on the balance sheet that must be paid in the current year, but there is no money set aside. These are items like pension plans, which the company has an obligation to pay, but has not completely funded. This puts the company at risk, as well as the employee's pensions, if the company does not do well in the future. •An example is United Airlines. The company had a pension plan which was not fully funded.

Order of Liquidation When a company goes bankrupt, it is important to remember that the creditors come before stockholders in the distribution of whatever value is remaining. The order of liquidation is as follows:

When The Ship Goes Down Serve Pina Coladas 1.Taxes -- must be paid first 2.Secured bondholders -- those who have their bonds backed by an asset, such as land 3.Secured creditors -- those who have sold the company goods, and thus the goods are the collateral for the creditor 4.Debenture bondholders -- those bondholders who have no security for the bond. The bond is only backed by the good name of the company. A debenture bond is only backed by whatever assets are left to pay the bondholders with. 5.Unsecured creditors -- those who have provided services to the corporation with no collateral, such as utility and phone companies 6.Subordinated debenture holders -- similar to the debenture bondholders above, except they are subordinated to all other creditors, which means they come after all other creditors and bondholders 7.Preferred stockholders 8.Common stockholders

The following is an example of a dollar weighted return: Example: Jim Investor has opened an account with $10 million and invested the assets accordingly. A week before the end of the quarter, Jim deposits another $3 million to his account and leaves it as cash. At the end of the quarter, Jim's investments are valued at $9 million while his cash value remains $3 million, making the total account value $12 million. Since Jim's beginning balance was $10 million and his ending balance was $12 million, Jim's dollar weighted return is 20% for the quarter.

in the above example, Jim's dollar weighted return is 20%, even though his investments went down 10%. This is due to the recent influx of cash. While the dollar weighted return allows an investor to compare absolute dollars with investment goals, adviser-to-adviser comparisons are not possible, as cash flows are too much of a factor in trying to determine actual performance.

This is a series of equal payments over an infinite time period in the future. If an investor is looking to receive a monthly payment with the same dollar amount for the rest of his/her life, you will have to determine how much money needs to be contributed using a specific annually compounded interest rate. Another scenario in which a ___________ calculation would be used is if an investor wants to leave behind a specific monthly payment for a beneficiary, for eternity.

perpetuity CONTRIBUTION NEEDED FOR PERPETUAL PAYMENTS = ANNUAL PAYMENT TO BE RECEIVED/ ANNUAL COMPOUNDED INTEREST RATE

TIPS are characterized as follows:

• The interest rate is set at the time the TIPS is issued and will remain the same until maturity. • The principal amount of the TIPS is adjusted for inflation and/ or deflation, but never below the par amount. • The value of the principal at maturity is the amount that is paid, even if it is more than the original amount paid. • The semiannual interest payments are based on the inflation-adjusted principal at the time the interest is paid, and when the interest rate is applied to the adjusted principal value, the amount of the payment increases. • The inflation rate is based on the Consumer Price Index (CPI). At maturity, the securities are redeemed at the greater of their inflation-adjusted principal or par amount at original issue.

The CAPM theory assumes that investors can earn risk-free return by investing in savings accounts, bank CDs, or Treasury bills, and that most other investments carry risk.

•CAPM theory states that an investment must generate enough return over and above an available risk-free return to justify the additional risk involved. •When the increased return matches the increased risk, it is known as an EFFICIENT INVESTMENT (the investment is on the "efficient frontier"). •If the return does not equal the additional risk, it is known as an INEFFICIENT INVESTMENT. CAPM theory indicates that investments must involve risk in order to have a high return. In other words, no investment exists with a low risk and a high return.

INTEREST-RATE RISK For the exam, know some of the interest rates for use by the consumer. Two that they are testing are:

•Interest rates on house loans are based on bank district funds. •Banks and other lending institutions base their home loans on the bank district funds in the geographical area of the house. •Automobile rates are based on the prime rate by banks. •On the other hand, loans for automobiles are directly from the bank itself, so the loans are at the rate the bank can borrow the money, plus a profit for the bank. This is called the prime rate.

(Monte Carlo) For investment advisors to determine what chance their clients have of meeting their retirement goals, they must request the following information

•The amount of money needed at retirement -- this should be within 60% to 80% of the person's pre-retirement income •The age and number of years before the client plans to retire •The amount of money that can be set aside each year for retirement •The amount of risk the client is willing to take Monte Carlo simulation is an effective method used in predicting a series of possible outcomes based on the information given.