FP103 Investments

Swaps

A swap is a contractual agreement between two parties in which they agree to swap payments. A will agree to make B's payments and vice-versa. The advantages and disadvantages are two sides of the same coin: whether the agreement proves to be advantageous or disadvantageous to the investor. Examples: - Currency, interest rate swaps, equity swaps

Treynor ratio

- Used to calculate the risk adjusted return of a portfolio - (RR-3 month T Bill Yield)/Beta of the portfolio

Correlation & diversification

- the stronger the negative correlation, the better the diversification

Types of AI in Real Estate

1. investor Managed 2. REITS 3. RELPS 4. CMOS

What are exceptions to EMH?

Anomalies Possible exceptions to the efficient market hypothesis, called anomalies, appear to exist. Empirical evidence of the existence of an anomaly, however, does not mean an investor can take advantage of the anomaly. The anomaly can still exist and the market can be effectively efficient from the individual investor's perspective. Some anomaly examples include: Low P/E stocks tend to outperform; small firms tend to outperform, stock investments made in January tend to do better than those made in other months, neglected firms (not tracked by many analysts) often perform better and stocks tend to overreact to new significant news (causing mis-pricings).

Correlation Coefficient

Correlation coefficient (designated as "ρxy" or "r", ranges between -1 and +1. Perfect positive correlation (a correlation co-efficient of +1) implies that the investment returns are in-sych (both positive or both negative). Alternatively, perfect negative correlation implies that returns are out-of sych (one positive and one negative). If the correlation is 0, returns are said to have no correlation.

Covered Put & protective put

Covered put - sells stock short; (sell) a put to cover short. Protective put - investor owns a long position in a stock, buys a put to protect against decline.

wash rules

can't take the loss if rebuy the security after sale within 31 days

Kurtosis

degree of peakedness relative to a normal distribution. The peakedness property means that there is an excess frequency at the center of the distribution.

how do you reduce SD

having low or negative correlation coefficient

What does total return on any investment equal?

income (or loss) + appreciation/depreciation

current yield equation

income/current price

What does dollar-weighted return equal?

Dollar-Weighted Return (DWR) = Internal Rate of Return (IRR)

liquidity and marketability

Liquid investments are easily converted into cash without a loss of value. Marketability is similar to liquidity, except that liquidity implies that the value of the security is preserved, whereas marketability simply indicates that the security can be bought and sold easily.

Wash sale rule

Often, when a loss is harvested, the intent is to purchase the security back. However, when doing so, one must be aware of the Internal Revenue Service (IRS) rule prohibiting a taxpayer from claiming a loss on the sale of an investment when the same investment was purchased within 30 days before or after the sale date. Also know as the "30-day wash-sale rule". Managers must be cognizant of this rule and be sure to leave enough time between sales for tax losses and subsequent repurchases.

Passive Investing (Indexing)

Passive investing is an investment strategy in which an investor makes as few portfolio changes as possible, in order to minimize transaction costs, including the incidence of capital gains tax (cost savings are a major advantage). One popular method is to "index" which as a portfolio manager means to mimic the holdings of an index and as an investor means to invest in index funds. Passive investors believe in the efficient market hypothesis -- therefore, the only limitation of this strategy is potential forgone opportunity.

Pooled investments

Pooled investments are funds in which multiple investors contribute assets to be held and invested as a single group. Common examples of pooled funds are (ETFs, Unit Investment Trusts, Open & closed end funds, MF, etc.)

NAV of a fund

The net asset value (NAV) of a fund is the total market value of the fund's assets divided by the number of shares outstanding. Open-end funds and ETFs always trade at NAV while closed end funds will trade at, above (premium) or below (discount) NAV depending on the dynamics (supply and demand) of the secondary market.

Straddle

Straddle - simultaneous purchase of a call and a put for the same stock, at the same exercise date, and also at the same strike price. Buyer is Betting on volatility—being able to exercise both contracts at favorable prices. Writer bets on little volatility—move in one direction is OK.

3 profitability ratios usually considered:

measures how much the firm earns on sales before considering operating expenses. The operating profit margin (EBIT/Sales) measures how much the firm earns on sales before considering how the firm is financed or how much it pays in taxes. The net profit margin (Net income/Sales) considers how much the firm earns on sales after interest and taxes. Firms use different amounts of debt financing and may be subject to different taxes. Computing all three ratios lets the analyst determine if differences in net income are the result of differences in cost of goods sold, operations, interest expense, or taxes.

Definition: Cash

- Cash includes paper currency, coins, bank balances and negotiable money orders. - Cash equivalents are ultra safe investments (highly unlikely to lose value) which can be easily converted into cash (highly liquid). - Cash is "legal tender" which means it is a form of payment that must (by law) be accepted by creditors as payment for debts. In the United States, gold coins, silver coins, specie-backed notes (e.g., backed by gold), and paper currency not backed by specie (current system for US dollar) have all at some time been legal tender. -

Stop Limit Order

- Combines Market order and limit order - Constrains the price of execution

Market Efficiency

- EMT is the proposition that the securities markets are efficient, with the prices of securities reflecting their current economic value - people who believe in this adopt a massive efficient

Immunization of a portfolio (ex. bond)

- Match the average weighted duration of the bond portfolio to the investment horizon

Definition: treasury notes and bonds

- Treasury notes are intermediate term (1-10 year) debt in denominations of $1,000 to $100,000+. - Treasury bonds are long term (10 years or more) debt in denominations of $1,000 to $1 million.

statements about calls and puts

- if an investor believes the MP will be stable in the future, they will write calls - the buyer of a call option believes the stock price will increase - write of a put has positive views of the market and the future -

What bonds are susceptible to greater interest rate risk?

- interest rate risk is greatest for a security that has the lowest coupon; longest duration is found in the bond that pays no interest except at the time of its maturity

Dollar cost averaging

- invests the same dollar amount each month over a period of time - lowers the average cost per share overa period of time (assuming share price fluctuations)

Mutual Fund investing strategy

- lower average price per share if prices are variable - purchase more shares when prices are low - predictable investment program - (LT dollar cost averaging is more advantageous and produces lower gains for stock wtih increasing values)

the duration of a bond is a function of:

- market interest rate - number of compounding periods until maturity - coupon rate (not current price --> it's a function of market rate of interest)

Strong Form

- nonactively managed (ex. ETF) - holds that all public and insider info is reflected in the markets price (no actively managed strategy that will outperform the market on a consistent basis) - Passive investing in ETFs will provide equivalent returns over time

characteristics of common stock

- participation in growth via dividends and capital gains - high volatility - no guarantee for cash flows via dividends or returns

risks faced by corporate bond investors

- purchasing power risk (inflation) - liquidity risk - default risk - interest rate

IRR (Internal Rate of Return)

- the discount rate which equates the present value of an investment's expected costs to the PV of the expected cash inflows = a net present value of zero - influenced by the timing of contributions and withdrwals that may be beyond the control of an investment manager - discount rate the equates the PV of cash inflows to the PV of cash outflows - not equal to the time weighted annual return but rather the geometric average

types of US government bonds and agency securities

- treasury notes and bonds - treasury STRIPS - TIPS: Treasury Inflation Protection Securities - Series EE, HH, and I bonds - Mortgage-backed securities

Treynor Index

- uses beta as the measure of risk and graphically displays the risk/return tradeoff - uses SD not beta in estimating expected return and risk displays

when is a call option out of the money

- when the Strike price is greater than the current stock price

What are 4 types of activity ratios?

1. Inventory Turnover Sales/Average Inventory or CGS/Avg Inventory 2. Receivables Turnover Annual credit sales (or sales)/Accounts Receivable 3. Average collection period Receivables/Sales per day 4. Fixed Asset Turnover Annual Sales/Fixed Assets (for long-term "fixed" (property plant & equipment) assets)

What is included in an IPS?

1. application of a client lifecycle analysis 2, client risk tolerance measurement and application 3. asset class definition and correlation

business and financial risk

1. business; The risks associated with the nature of the business. 2. Financial: The risk associated with the firms' source of financing.

Technical analysis

1. technical: based on idea that past price patterns predict future price patterns

Investment Advisory Opinions (sentiment indicator of tech. analysis)

A "Contrarian" Indicator Assumes advisory opinions are wrong Short sales by specialists: Assumption is that they know what is going on - so if ratio of short sales is LOW (few are short) this is bullish (ratio of 40% or less). A ratio of 65% or more is bearish

Collars

A collar is used to protect a long position in a stock and involves buying a put and selling a call. The cash inflow from the sale of the call offsets the cost of the put (and can actually net zero cost, in which case this would be called a zero cost collar). The strategy is used when an investor owns a stock and desires to lock-in a large gain. The basic structure: - Sell a call at one strike price and - Buy a put with a lower strike price The put protects the investor from a decline in the price of the stock. The call will force liquidation of stock price goes up—therefore—you lock-in a range of prices. The advantage of this strategy is clear: No-cost (or low cost) insurance against falling value. The limitation is forgoing investment gains if the stock price goes above the call price.

Normal Distribution

A key assumption is that returns are normally distributed, which means that if we could magically chart the occurrence of all possible investment returns, the chart would be a symmetrical "bell shaped" curve (an equal number of returns fall above and below the mean return designated as "x¯¯¯" The percent of returns we expect to fall within each range of standard deviation designated as "σ" is listed in the chart to the left. For example, in this chart, we would read that 34.1% of future returns should fall between 15% - 25% (one standard deviation above the mean). The normal distribution is the most common type of distribution, and is used extensively in statistics.

Ratio analysis

A key tool used in fundamental analysis is the calculation of financial ratios using data from company balance sheets and income statements. The main objective of ratio analysis is to have comparable statistics on a company which may be used to determine trends—at the company —and within an industry. The ratios are simple and easy to understand—and may be used by both equity investors and creditors. There are two primary types of analyses done when using ratios: Time series analysis: same firm or several firms over a period of time Cross-sectional analysis—several firms in same industry at a given time

Separately Managed Accounts

A privately managed investment account opened through a brokerage or financial advisor that uses pooled money to buy individual assets. This differs from a mutual fund because the investor directly owns the securities instead of owning a share in a pool of securities. Most separate accounts require a minimum investment of $100,000 or more.

Definition: Preferred Stock

A security representing ownership in a corporation - usually without voting rights. However, dividends are usually paid at a much higher % and are usually pretty much guaranteed to be paid, whereas common stock dividends are not.

Definition: Common Stock

A security representing ownership in a corporation. Shareholders usually have voting rights and are entitled to dividends (if and when they are paid).

Short Selling

A short sale is a sale of borrowed (from a broker) securities on the assumption that the price is going to fall. The plan is that, after the security price falls, the security will be purchased by the short seller and returned to the broker from which the security was borrowed. The advantages and disadvantages of this strategy are all about winning vs. losing!

Simple vs. compound return

A simple return is a one-period return. For example, if an investor expects to get a 10% return for a year, then, if he invests $100, he will earn $10 (10% of $100). If an investors is told to expect the following returns over three successive one year periods: 10%, 5%, 8%, then returns will "compound" - which is another word for "multiply" - which means that returns from one period are added to the total investment whereby the next periods' returns are earned on this new total investment. The term "multiply" is also known as a "product" of numbers. Compound returns are calculated as products (multiples of simple returns)

Hedge Funds

Aggressively (higher risk) managed portfolio of investments that uses advanced investment strategies such as leverage, long, short and derivative positions in both domestic and international markets with the goal of generating high returns (either in an absolute sense or over a specified market benchmark). Legally, hedge funds are most often set up as private investment partnerships that are open to a limited number of investors and require a very large initial minimum investment. Investments in hedge funds are illiquid as they often require investors keep their money in the fund for a minimum period of at least one year. For the most part, hedge funds (unlike mutual funds) are unregulated because they cater to sophisticated investors. In the U.S., laws require that the majority of investors in the fund be accredited. That is, they must earn a minimum amount of money annually and have a net worth of over $1 million, along with a significant amount of investment knowledge. You can think of hedge funds as mutual funds for the super-rich. They are similar to mutual funds in that investments are pooled and professionally managed, but differ in that the fund has far more flexibility in its investment strategies. It is important to note that hedging is actually the practice of attempting to reduce risk, but the goal of most hedge funds is to maximize return on investment. The name is mostly historical, as the first hedge funds tried to hedge against the downside risk of a bear market with their ability to short the market (mutual funds generally can't enter into short positions as one of their primary goals). Nowadays, hedge funds use dozens of different strategies, so it isn't accurate to say that hedge funds just "hedge risk". In fact, because hedge fund managers make speculative investments, these funds can carry more risk than the overall market.

Privately Managed Accounts

An investment account that is owned by an individual investor and looked after by a hired professional money manager. In contrast to mutual funds (which are professionally managed on behalf of many mutual-fund holders), managed accounts are personalized investment portfolios tailored to the specific needs of the account holder.

Options

An option is a right to do something. With regard to investing, an option is the contractual right to buy (or to sell) stock at a specified price within a specified time period. One person, called the option "writer" or "seller" sells an option for a price (called a premium) to another investor. The person holding the right does not have to act—he or she simply has the "option" of buying or selling at the contractual price and time. The seller of the option IS obligated to satisfy the contract if the holder wishes to exercise his or her option.

Efficient Market Theory (EMT)

Assuming an investor is not taking more risk than a particular market index (or we adjust returns based on quantitative measures of risk), the only way this investor can "beat" the index (higher risk-adjusted returns) is first, to successfully identify mis-priced securities or asset classes, and second, to effectively exploit these mis-pricings by placing appropriate "bets" (e.g., the investor buys under-valued securities/assets and sells or bets against (with shorts or derivatives) overpriced securities. The efficient market hypothesis (EMH) claims that such an effort is close to if not entirely impossible (depending on which "form" of the EMH you believe)—thus—owning an index or a set of asset class indexes which are optimized to produce the highest return per unit of risk (efficient frontier)—is the only sensible way to invest. The items within this topic largely focus on active management—and the belief that markets are NOT efficient (thus rejecting the EMH) and that superior returns (index beating) are possible.

Definition: Bonds

Bonds are loans whereby the borrower promises in writing to pay back the borrowed money (usually with interest) in the future. The interest is taxable as ordinary income to the lender (also known as the "investor" or "owner" of the bond). However, US government bond interest is not taxed by states or municipalities and municipal bond interest is not taxed by the federal government. Some states do not tax interest paid on municipals issued within the state.

Definition: Zero Coupon Bonds

Bonds which are bought at a discount and receive face value at maturity Major problem: IRS taxes annual interest as if it were received (accrued interest is taxed).

Buy and Hold

Buy and hold is a passive investment strategy in which an investor plans to make NO changes to his portfolio (contrast with indexing whereby if the index changes, the portfolio changes). An investor who employs a buy-and-hold strategy actively selects securities, but once selected, does not make changes. The advantage of this strategy is low cost (transaction and taxes). The limitation is potential poor returns if the selected securities don't perform well.

Types of cash equivalents

Certificate of deposit A promissory note (definition below) issued by a bank. Money market funds Specialized investment companies which make short-term investments in money market instruments (examples are listed in this "cash and equivalents" section). Treasury bills Short term (3-12 months) debt of Federal Government sold at a discount to face value in denominations of $10,000 to $1 million. Commercial paper Unsecured, short term promissory notes issued by highly creditworthy corporations. Banker's acceptances Short-Term promissory note guaranteed by a bank. Eurodollars US dollars deposited in foreign banks (cash or as CD's)

Default risk and duration

Default risk is closely related to the length of time it actually takes to collect all those payments of interest and principal (the longer the time, the more chance of default). This risk is measured by "Duration," which is the weighted average time it takes to collect all cash flows from a bond. Duration weights the present value of each payment by the timing of the payment. Duration is a measure of price volatility or sensitivity to interest rate changes (the sooner you get your money, the less volatile is the value of a bond); the larger the numerical value (duration), the greater is the price volatility. Duration facilitates comparisons of price volatility of bonds with different coupons and different terms to maturity.

CAPM

Despite the name, CAPM (discussed in Topic 35) is not used to price assets but instead to determine the required rate of return for a security. The required rate of return is determined by the following formula: Ri=Rf+βi(Rm−Rf)

Disadvantages of ratio analysis

Different definitions of earnings for different companies Differences in estimated earnings (we value stocks today based on estimated future earnings) Question of the appropriate multiple (is 7 times earnings really appropriate?)

Unsystematic/Nonmarket/Diversifiable

Diversification reduces (or eliminates) unsystematic risk such as tax risk. Unsystematic risk is asset specific. Examples: business, financial, default, country and regulation risk.

Dividend reinvestment plans (DRIPs)

Dividend reinvestment plans allow an investor in mutual fund or stocks to acquire additional shares automatically, usually without a sales charge. Instead of receiving a cash dividend, the investor is issued shares of the fund or stock.

Convexity and duration

Duration may be used to forecast (estimate) change in a bond's price The forecast (estimate) becomes less accurate the greater the change in interest rates

maintenance margin calculation

Equity needed: margin/(1-maintenance %) 2. value per share is equity needed/number of original shares 2. (Equity needed - margin)/equity needed = % of maintenance

Types of closed-end investment companies

Fixed capital structure Shares are bought and sold in the secondary markets Shares may sell for a premium or discount from NAV Tendency for shares to sell at a discount from NAV

Flow of funds indicator (sentiment indicator of tech. analysis)

Flow of funds measures analyze the financial positions of various types of investors to determine their potential capacity to buy or sell stocks. Although flow of funds measures can indicate an ability to buy or sell (called ex-ante), they do not give any sign of the willingness to do so - which relates to whether they actually "do so" (called post-ante) Furthermore, some of the data is reported with a lag and may no longer be relevant by the time it is available. Mutual fund industry total cash (as a percentage of total assets) is a classic example of a flow of funds indicator. The cash is there - so there is capacity to "put it to work" which would increase demand (and prices) of the securities to be invested in. We just don't know when (or if?) this might happen.

Unit Investment Trusts

Formed by brokerage companies, UIT's are a variation of a closed-end fund - however - shares are NOT usually publicly traded. The idea for investors is to simply hold the basket of securities and collect income and principal through time until all principal has been returned. A bond UIT would liquidate as the securities matured. A stock UIT would have a designated liquidation date. The key points - UIT's are: Passive investments Self-liquidating portfolios Generate a flow of funds to investors

Formula investing: what is it and what are the different types?

Formula investing includes strategies designed to take the emotion and/or potentially flawed tactics out of investing. They serve to get an investor "invested" without trying to "time" the market. The limitation of these strategies is the potential of forgone opportunities. - dollar cost averaging, dividend reinvestment plans (DRIPS), Bond ladders bullets and barbells

Fundamental Analysis

Fundamental analysts believe that through intensive study of a company—its management and financial statements (bottom-up analysis)—that mis-priced securities may be identified. Fundamental analysts also believe that mis-priced assets may be discovered by accurately predicting (assuming the market is wrong) the future macroeconomic environment (top down analysis).

Hedging: Futures & Forwards

Futures contracts are standard contracts that trade on a secondary market for commodities, currencies, and financial instruments. They are legally binding contracts to buy or sell something, in the future, at a designated price. 1. Commodities - livestock, wood, foods, metals, oil, and grains. 2. Financial instruments - T Bills, notes, bonds, stock indices, eurodollars. 3.Important: Stock Index futures (unlike all other futures) are settled in CASH (not delivery of the index)! 4. Currencies - all foreign currencies including U.S. dollar Forward contracts are similar to futures EXCEPT they are negotiated and not traded on secondary markets.

Bond ladders, bullets, and barbells

How a bond portfolio performs is largely driven by interest rate changes. Active managers will "play" the yield curve trying to pinpoint the most profitable positions (e.g., bullet strategy) based on their interest rate projections. More passive investors simply spread their investments along the yield curve with either a laddered or barbell strategy (less attempt to predict interest rates). The Laddered strategy: Construct a portfolio of bonds with maturities spread evenly across time This structure can be held and new securities added upon maturity This structure helps protect against portfolio value swings due to interest rate changes Investor can distribute weight evenly or unevenly depending on interest rate expectations Changing weightings is difficult so an alternative strategy is the barbell strategy The Barbell strategy Construct portfolio of long maturities and short maturities (no intermediate maturities) Investor can evenly weight each side or overweight depending on rate expectations The Bullet strategy Investor buys the perceived "sweet spot" on the yield curve.

Lognormal Distribution

If we have a normal distribution of returns, then we will have a log-normal distribution. This simply means that if the returns of stock "X" are normally distributed, then these returns raised to any power are also normally distributed.

Liquidity ratios

Liquidity ratios measure the firm's capacity to meet its current obligations as they come due. In effect, the ratios assume that if a firm has current assets, it will be able to pay off current liabilities on a timely basis. There are two primary ratios: Current Ratio: Current assets/Current liabilities Quick Ratio: (Current assets inventory)/Current liabilities The reason for excluding inventory from current assets is that inventory may not be readily sold and thus may not contribute to the firm's liquidity. (An alternative approach is to include only cash, cash equivalents, and accounts receivable in the numerator. The two definitions are identical unless the firm has other current assets such as prepaid expenses.)

Managed Investments

Managed investments are "actively" (versus passively) managed investments. Index securities are passively managed investments. All pooled and managed investments are considered "pass through" for tax purposes which means that all interest, dividends or capital gains and losses are passed through to the individual investors (after expenses). Interest and dividends are taxed as ordinary income. Capital gains are taxed as capital gains. Pooled investment "funds" may be open-ended or close-ended.

what is margin

Margin is the amount of equity (e.g., cash) contributed by the investor as a percentage of the current market value of the securities held.

Market Structure Indicators (sentiment indicator of tech. analysis)

Market structure indicators are the primary tool of technical analysis. They monitor the trends of various price indexes, market breadth, volume, etc. Technical analysts use them to monitor the health of the prevailing trend. The focus is on the general direction of the market: The theory is that since security prices move together (high correlation), the direction of the market is a primary factor in the decision to buy or sell securities. Market structure indicators include moving averages, patterns, trendlines and peak/trough analysis. Most of the time, trends for various indicators move together. When indicators diverge, or offer different signals, it is often a sign that a trend reversal will take place. **Moving averages, the dow theory, volume, advance/decline

Market Timing

Market timing is the strategy of making buy or sell decisions of financial assets (often stocks) by attempting to predict future market price movements. The prediction may be based on an outlook of market or economic conditions resulting from technical or fundamental analysis. This is an investment strategy based on the determination of an aggregate market or asset class mis-pricing (either too high or too low), rather than for a particular financial asset. The danger of market timing is in mis-timing with large amounts of capital committed to a position (e.g., 100% in stocks that keep getting cheaper!) The advantage is realized in outsized returns when the timing is spot-on.

Key tenents of Technical Analysis:

Market value is determined by supply and demand Stocks tend to move in trends which persist over time A change in trend is a signal to change from bull to bear or vice versa Uses historical price and volume data to forecast the direction of stock prices Employs a variety of figures and charts The indicators can be applied to: The market, and/or To individual firms.

Definition: Municipal Bonds (2 types)

Marketable (trade on secondary markets) debt of (issued by) states, cities or municipalities General obligation Municipal bond backed by the credit and "taxing power" of the issuing jurisdiction rather than the revenue from a given project. General obligation bonds are issued with the belief that a municipality will be able to repay its debt obligation through taxation or revenue from projects. No assets are used as collateral. Revenue Municipal bond whose interest payments are supported by the revenue from a specific project, such as a toll bridge, highway, or local stadium. Payment is subject to successful collection of sufficient revenue.

Corporate Bonds: Definition: 6 types

Mortgage bond Bonds secured by specific property—commonly real estate (e.g., power plants). Mind you, the bond holders would not want to have to take over a power plant, so the collateral, while nice, is not terribly marketable. Debenture Unsecured bonds supported by the general creditworthiness of the issuing firm Riskier than secured debt. Subordinated debentures are even more risky (only would be redeemed after other general debt). Investment grade Low risk bond whose credit rating is BBB or better. High-yield A higher risk bond whose credit rating is BB or below; as a consequence has a higher yield than an investment grade bond. Convertible A bond which may be converted into (exchanged for) common stock of the issuing corporation. They are technically debt with a fixed obligation and maturity date. However, holders have the option to convert the bonds into common stock. Callable A bond which may be retired prior to maturity.

Taxable Equivalent Yield (TEY)

Municipal bond interest is exempt from federal income taxation. To decide whether a taxable (e.g., corporate) or non-taxable bond (municipal) has a higher after-tax yield, we must convert the municipal interest rate to a "taxable equivalent yield" tax-exempt bond is better for the investor (higher after-tax return)

Series EE, HH, and I bonds (definitions)

Non-marketable federal government debt (redeemable at commercial banks). No taxable income is reported until bonds are redeemed. Series EE (Patriot) bonds - small denomination discount bonds $25 - $100. Series I bonds - replaced HH bonds in 1998. Denominations of $50 - $10,000. Pay a guaranteed fixed rate plus an adjustment for inflation (variable rate set every six months)

What does active risk correspond to? What are the different types of this risk?

Omega = unsystematic risk 1. business risk 2. financial risk

Open-ended vs. Closed-end funds

Open ended funds have a variable capital structure which means money may be added to or withdrawn from the funds by investors. Money added creates new shares of the fund while money withdrawn eliminates shares. Closed end funds have a fixed capital structure whereby investor money is collected and held for some definite period of time - no assets may be added to or withdrawn from the fund. Shareholders of the fund may sell their shares in the secondary markets if they wish to liquidate.

efficient frontier & how to read it

Optimal combination of two assets classes produces a mean-variance optimized portfolio—one which produces the highest return per unit of risk. Any portfolio (e.g., A) below line XY is inefficient - offers a lower return for the level of risk Any portfolio (e.g., C) above line XY is unobtainable Any portfolio on the efficient frontier is acceptable The investor can have only one of the efficient portfolios

Portfolio Immunization

Portfolio immunization occurs in a bond portfolio and refers to matching the portfolios duration with the duration of the cash needs of the investor. The result is to minimize the impact of fluctuations in interest rates on the investor. The advantage of this strategy is that it minimizes interest rate risk. The disadvantage is that rebalancing may be required (as rates change) to manage duration.

Price/Earnings ratio

Price to earnings is a measure of how much an investor is paying per dollar of earnings.

Profitability Ratios

Profitability ratios measure how profitably the firm is being run or how efficiently they are using assets—how much the firm is making relative to some base.

Qualified dividends

Qualified dividends refers to corporate dividends which are currently taxed at 15%. Dividends paid by some organizations may not be qualified—and therefore taxed at a higher rate. This should be taken into consideration in managing for after-tax returns.

REITS

REITs are publicly traded closed-end investment companies that invests in a diversified portfolio of real estate or real estate mortgages. Equity trusts owns properties, mortgage trust hold mortgages

Real estate limited partnerships (RELPs)

RELPs are limited partnerships that invests in real estate. The partnership buys properties such as apartment or office buildings, shopping centers, industrial warehouses, and hotels and passes rental income through to limited partners. A General Partner manages the partnership, deciding which properties to buy and sell and handling administrative duties, such as distributions to limited partners. The Tax Reform Act of 1986 introduced the principle of Passive Losses meaning that investors could no longer use real estate partnership losses to offset their income from salaries and other investments. Since the mid-1980s, partnerships have been designed to produce high current income and long-term capital gains through appreciation in the underlying real estate, not tax benefits.

Geometric Average Vs. Arithmetic Average Return

Returns that compound are said to be "geometric." Returns are geometrically "linked" via multiplication and because multiplication is used - averages of geometric returns are calculated by taking "roots" of the multiplied numbers (with the root equal to the number of periods). This is very different from the calculation of arithmetic averages - which are calculated using addition and division. *Therefore, any diversifying action that reduces a portfolio's variability, but maintains the same expected arithmetic return, will increase a portfolio's geometric returns.

Political (Sovereign)

Risk of loss due to unexpected political changes

Reinvestment Rate Risk

Risk of reinvesting at a lower interest rate (you may be forced to reinvest at maturity when rates are low)

Investment Manager

Risk of selecting an investment manager with poor performance

Purchasing Power

Risk that inflation will erode purchasing power of invested assets.

Risk adjusted return

Risk-adjusted returns are investment returns which are modified by the level of risk taken to achieve the returns. The modifiers are the "quantitative investment concepts" (e.g., standard deviation and beta). When comparing the returns of two or more potential investments, an investor should adjust these returns for risk so that apples to apples comparisons may be made. Coefficient of Variation is a risk adjusted return. We learn more about this topic in the modules discussing Modern Portfolio Theory and performance measures.

Systematic/Market/Nondiversifiable

Risks impacted by broad macroeconomic factors that influence all securities. Diversification does not reduce systematic risk Examples: Market, interest rate, reinvestment, purchasing power, exchange rate, political and tax risk.

what are the three forms of EMH

Strong Form (nothing works) The market is completely efficient—all known information is priced into stocks. Even inside information will not help produce superior (market beating) investment returns. As you can probably guess, this form is generally not supported by empirical evidence. However, the next two forms are supported by empirical evidence. Semi-strong Form (inside information works) Publicly-held information cannot be used to an investor's advantage. In other words, while inside information may be used to produce superior returns, fundamental analysis of companies will not. Weak Form (inside information and fundamental analysis works) Stock price changes are independent of one another. This form says that both inside information and fundamental analysis may be used to produce superior returns. However, technical analysis, which is the use of past price and volume data (historical data) to determine future price action does not work (will not lead to superior investment results).

what does successful market timing depend on?

Successful market timing (primarily through top-down fundamental or technical analysis) depends on the accurate identification of mis-priced asset classes (as opposed to individual securities) which as a class prove to perform better (or worse) than expected by the market. The extreme classic example would be holding 100% stocks when the investor believes stocks will go up in the immediate future (stocks are under-priced)—or—holding 0% stocks and 100% cash when stocks are perceived to be over-priced (and are expected to go down). The obvious danger with this approach is mis-"timing" and being in the wrong place at the right time with 100% of one's capital (e.g., 100% in stocks that keep getting "cheaper" or 100% in cash when the market suddenly jumps higher—before expected!).

What type of risk does beta correlate to? What corresponds to this risk?

Systematic (non-diversifiable risk) Types: 1. market risk 2. interest rate risk 3. reinvestment risk 4. purchasing power risk 5. exchange rate risk

Definition: TIPS

TIPS are available in 5 year, 10 year, and 30 year maturities. Notes (10 year maturity issued twice a year) and Bonds (30 year maturity issued once per year) which offer investors a "real yield"—the yield remains the same but the principal amount is adjusted annually by the increase (or decrease) in inflation as measured by the CPI (Consumer Price Index.) In the unlikely case that deflation erodes the principal to a value below par, the government will pay original par at maturity—although the interest rates will have been lower. TIPS eliminate purchasing power risk. Taxation: Interest income AND increases in principal due to CPI are taxed as ordinary income even though you don't get the increased principal until the security matures.

Tangible assets

Tangible assets include collectibles, natural resources and precious metals. The primary source of investment return is capital appreciation. Tangible assets tend to not be very liquid (not easily converted to cash).

Tax-free income

Tax-free income is income which is not taxed—US debt interest is not taxed by states. Municipal income is not taxed by the Federal Government. Many states exclude their own municipal bonds from state income tax (Massachusetts does this). So, Massachusetts municipal bonds are tax-free (Unless subject to Alternative Minimum Tax!)

Technical Analysis

Technical analysis is the belief that future stock prices and superior returns come from predictions using past price behavior as well as human behavioral concepts. Technical analysis seeks to identify securities for possible purchase primarily by analyzing past price behavior for trends and patterns. It also uses similar techniques to determine the direction of the market on the premise that individual stocks will follow the market. Some forms of technical analysis use various charts and figures. Hence the users of these types of analysis are often referred to as "chartists" or "technicians."

IPS

The IPS will include an analysis of the client (often within the framework of a lifecycle analysis); total return expectations, a statement of risk tolerance; and a list of asset classes to be used (note that this is a "constraint" in terms of developing an efficient frontier) - with the target percents of the portfolio to be invested in each class specified. The IPS will also state how often the portfolio should be rebalanced (periodic realigning of portfolio asset weight to be in line with the strategic asset allocation) and to what extent tactical asset allocation may be utilized. Finally, the IPS will list benchmarks against which active managers will be evaluated (using the performance measures discussed in Topic 40).

Debt Ratios

The debt ratio measures the extent to which a firm uses financial leverage (i.e., debt financing). The usage of debt is measured by the ratio of debt to total assets or debt to equity. Usage of debt financing is one of the sources of diversifiable, unsystematic risk (i.e., financial risk). While increased use of debt financing may result in higher earnings per share (EPS), the higher EPS may not produce a higher stock price if investors believe that the higher EPS are insufficient to compensate for the additional risk. (The debt ratio is sometimes defined as long-term debt to assets instead of total debt to assets. The possibility of differences in definitions raises a major question concerning comparing the values of ratios obtained from different sources.)

Mutual Funds

There are two types of mutual funds: (both usually called a mutual fund): Closed-end and Open-end. Mutual funds (each one organized technically as an "investment company" which hires a manager to manage its assets) raise money by selling shares of the fund to the public, much like any other type of company can sell stock in itself to the public. Mutual funds then take the money they receive from the sale of their shares (along with any money made from previous investments) and use it to purchase various investment vehicles, such as stocks, bonds and money market instruments. In return for the money they give to the fund when purchasing shares, shareholders receive an equity position in the fund and, in effect, in each of its underlying securities. For most mutual funds, shareholders are free to sell their shares at any time, although the price of a share in a mutual fund will fluctuate daily, depending upon the value of the securities held by the fund. (Note the capital structure differences between open and closed end funds) Benefits of mutual funds include diversification and professional money management. Mutual funds offer choice, liquidity, and convenience, but charge fees and often require a minimum investment.

Mortgage-backed securities (definition)

These are securities (bonds) backed by mortgages whereby the investor receives interest and principal. These bonds generate a flow of payments, but the amount of each payment is uncertain (e.g., if underlying mortgages are refinanced)

Price/Free Cash Flow

This is a measure of how much we are paying per dollar of free cash flow. Free cash flow is total operating cash flow less cash spent on capital expenses. The advantage of this ratio over P/E is that it focuses on the firm's ability to generate cash, may be applied when firm does not pay a dividend and can be used even if the firm operates at a loss.

Tactical Asset Allocation

This is a portfolio strategy that rebalances the percentage of assets held in various categories in order to take advantage of perceived market pricing anomalies (mis-pricings) or strong market sectors (market timing). The allocation of the portfolio is returned to the "strategic asset allocation" as per investment policy once the anomaly has come and gone.

Dollar cost averaging

This is one method for averaging an investor's purchase price whereby the investor invests the exact same dollar amount each time a purchase is made. Accordingly, more shares will be purchased when the stock price falls and fewer when the stock price rises - leading to a lower average cost of acquiring the stock Contrast this to share averaging whereby the same number of shares is purchased each time the investor invests (regardless of cost).

Limited Partnerships

Two or more partners united to conduct a business jointly, and in which one or more of the partners is liable only to the extent of the amount of money that partner has invested. Limited partners' liability is limited to the money they have invested. General Partners' liability is NOT limited (they may be sued personally). Limited partners do not receive dividends, but enjoy direct access to the flow of income and expenses.

Examples of benchmarks for different classes

US Large Cap Stocks S&P 500 Mid-Cap US stocks S&P Midcap 400 Index Small Cap US stocks Russell 2000 Index Developed Foreign stocks EAFE Index (Europe, Australasia (Asia & Australia), Far East Index)

Real estate mortgage investment conduits (REMICs)—now called "CMO's"

US Mortgage agencies Freddie Mac, Fannie Mae and Ginnie Mae issue REMIC securities, which are groups of mortgages or pieces of different mortgages (guaranteed ultimately by the US government) which are packaged into "securities" and sold to investors around the world. The REMIC was initially created as a type of collateralized mortgage obligation (CMO). Because of changes in the 1986 Tax Reform Act, most CMOs are now issued in REMIC form as pass-through investment vehicles (organized as an association, corporation, partnership, or trust) which produce income that is not subject to double taxation. The terms REMIC and CMO are now used interchangeably. REMIC securities group interest and principal payments into separately traded securities. By redirecting the cash flow from the mortgage-backed security, a security can be created that has different classes (also called tranches) that may have different interest-rate payments, maturities, stipulations for prepayment and risk levels (senior and subordinated classes). The variety of investment options enables these securities to meet the needs of different investors—offering investor flexibility.

Dividend Growth Models

Usually, the return to owners (stockholders) of a business comes through dividends. Thus, instead of using earnings (as we do in the capitalized earnings valuation above), we can use dividends to estimate the value of a stock. The valuation concept is the same:

Why do we use geometric means?

When evaluating investment managers (where the timing of dollars invested by individual investors must be adjusted-out), geometric average returns (Time Weighted Returns) must be used. Geometric returns are actually a means of "linking" holding period returns to produce an annual compounded rate of return (AKA CAGR = cumulative annual growth rate) which is not affected by the timing of investment dollars. CAGR is the rate at which a lump sum, invested in an investment strategy at the beginning with no additions or subtractions, would have grown (on average) each year.

Capital Market Line (CML)

When you consider these two possible investments, you don't have a series of "best portfolios", you have ONE optimal portfolio("Z" in chart below). This portfolio (Z) is often referred to as the "market portfolio" and can be thought of as a diversified portfolio of risky assets. You can change your risk and return by splitting your money between the Treasury bills and the market portfolio, e.g., 40% of your money in T-bills and 60% in the market portfolio. If you change this ratio to 50/50, you increase both the risk and return of your investment. By choosing the ratio that is most attractive to you, you can maximize your return relative to the risk incurred. --Different combinations of the risk free asset and risky assets (portfolio Z) fall along the line. To boost return above that expected at Z, an investor may borrow money (use leverage) to buy more of "Z"—thus boosting investment in "Z" above 100%. The assumption is made that we borrow at the risk free rate (which is not realistic—but just remember this key assumption).

Security Market Line (SML)

William Sharpe (1964) developed the idea that a stock portfolio's total risk (standard deviation) can be broken down into two parts: Unsystematic risk, called alpha (which can be reduced to near zero with diversification) and Systematic risk, called beta (market risk which cannot be reduced by diversification). He postulated that since alpha can be reduced to almost zero, then the only relevant risk is beta. He (and two others working simultaneously and independently of one another) derived an equation (called the Capital Asset Pricing Model "CAPM") that measures quantitatively the amount of return that an investment security (e.g., stock or mutual fund) must earn (required rate of return) in order to fairly compensate the investor for the risk incurred. Note that this calculated required rate of return may be used in the Dividend Growth Model to calculate the intrinsic value of a stock. The equation and the graph of the equation (called the Security Market Line or SML) are below: CAPM and the Security Market Line (SML) explains risk and return for individual securities and is used to calculate the required rate of return of an investment.

YTM vs. YTC vs. current yield

YTM: the IRR (internal rate of return) of a bond, which is the yield earned on a bond from the time it is acquired until the maturity date. Remember that a key assumption is that the interest payments are reinvested at the yield to maturity rate. The inputs using a financial calculator are PV, FV, N and PMT. Then, you solve for "i" YTC: the IRR (internal rate of return) of a bond assuming it will be called, which is the yield earned on a bond from the time it is acquired until it is called. Current yield is annual income (interest paid) divided by the current price of the bond.

Calculation Margin Call (price)

[(1-Initial Margin %)(1- Maintenance Margin)]*Stock Purchase Price

Variance calculation and SD

[sum(r-Average(r))^2]/(n-1) - SD is the square root of this

Skewness

a measure of the asymmetry of the distribution. Positive skew means that more data is found to the left of the mean while negative skew means that more data is found to the right of the mean. This is caused by "outlier" data skewing the arithmetic averages (caused by the long "tails.")

How is interest on cash balances taxed?

as ordinary income

negative skewness

bell curve whose left side is longer than the right side

Comparable debt

is debt with the same term to maturity and same risk class. Comparable bonds can have different coupons and prices—but will have the same yields.

Standard Deviation

measures how much (on average) an investment's return varies or deviates from the mean return. Standard deviation "σ" is the square root of Variance "σ2." Variance is a measure of the average distance between each of a set of investment returns and their mean value; equal to the sum of the squares of the deviation from the mean value.

LEAPS

options with expiration dates that are longer than one year (most options expire in 3-9 months)

long strangle

purchase of out of the money call and put options

Definition: Stock

represent an ownership interest in a company. - Dividends paid to stockholders are taxed as ordinary income and capital gains are taxed as "capital gains.

What is superior security selection

selection depends on correctly identifying and exploiting mis-priced securities (primarily through bottom-up fundamental analysis) which prove to perform better than expected by the market (or worse than expected if you bet against the security).

What option strategy could incur the greatest loss?

selling a naked call option - selling a naked put option involves a lower loss potential than selling a naked call; max the seller of the option can lose is the full value of the stock

Which government backed investment adjusts interest rates for inflation every six months

series I bonds - Series EE adjusts interest rates every 6 months but not tied to inflation - TIPS adjust principal

semi-strong form

states that neither technical nor fundamental analysis produces excess returns

Hedging in the commodities market; ex. falling prices

take a short position to hedge against lower corn prices

Efficient Market Hypothesis: EMH (definition)

the market prices of securities fully reflect ALL relevant and available information (market is completely efficient), and, therefore, it is difficult (or impossible) to consistently outperform the market by selecting undervalued securities. An investor can only reasonably expect to earn a return consistent with the market and the amount of risk taken. In other words, expensive computer models and/or highly knowledgeable and dedicated professional investors will do no better than a widely diversified portfolio of randomly selected stocks. Under Fama's classification, the Efficient Market Hypothesis has three parts or "forms"—which differ in their acknowledgement of exactly how impossible is it to "beat the market" which is another way of stating the degree of efficiency in the market:

margin requirement

the portion (percentage) of an investment that is required to be equity. Initial requirement (% of total to initiate position) = set by Federal Reserve Board.

Equation for SD

σ2=∑(xn−Avg(x))^2)/(n−1)

Real (Inflation-Adjusted) Vs. Nominal Return

"Nominal Returns" = Total Returns before inflation "Real Returns" = Inflation-adjusted returns (increase or decrease in our purchasing power) Real Return= (1 + Nominal Return)/(1+ Inflation Rate)=−1×100

what could decrease the coupon of a bond

- put option - warrants - convertible ** these are attractive to bonds which would decrease the coupon - a call option will increase the coupon because it will make it less attractive

Net Asset Value

(Market Value of portfolio-liability)/shares

Information ratio used to compare returns

(Return on Portfolio - Return on Benchmark)/(SD of portfolio-SD of benchmark)

Calculating margin callls

(Shares *MV)*Initial Margin % = y(initial margin) - If drops below: use new MP*number of shares = X - (X-Y)/X = % (if this is less than the margin call percentage) --> - Margin Call % * X = necessary - (X-Y) = what's needed to put up to support margin requirements

Sharpe Ratio Formula

(return of portfolio-risk free rate)/Standard deviation of portfolio

Ladder Portfolio

- A strategy that involves an assortment of bonds or CDS with staggered maturities; staggered in a way that integrates interest rate projections

Characteristics of ETF

- Actively managed - can be bought on margin - may not be equal to NAV due to supply and demand for the shares - can be sold short

Modern Portfolio Theory

- Modern Portfolio theory expands the universe of risky assets to include ALL risky assets—not just S&P 500 stocks, but also, small and mid-cap US stocks, foreign stocks, emerging market stocks, real estate, gold, US and foreign bonds, etc. By taking different asset classes (each of which represent fully diversified portfolios on their own) and combining them, we can reduce risk and produce better returns per unit of risk. -quantifies the relationship between different "risky" asset classes (e.g., categories of stocks, bonds, commodities, etc) using asset class average "Mean" returns (arithmetic or geometric average), risk (measured by standard deviation of average returns) and correlations between each set of asset class. Note: a "risky" asset is an investment whose returns vary. Contrast this with a non-risky asset (e.g., 90-day T-bill) where returns are fixed and not variable.

What is the criteria for rejecting a project under the IRR

- Reject if: IRR < Required Return -

the dow theory

- This is an attempt to identify market tops and bottoms (turning points) - Emphasizes movements in the industrial and transportation averages (ignores utility average) -Movement in one average confirmed by movement in the other average indicates a trend If not moving in tandem, the market is sending a "signal": - Buy signal: If one of the two starts to rise after a period of falling prices. - "Confirmation" would come when the second average starts to rise as well - Sell Signal: If one of the two starts to decline after a period of rising prices "Confirmation" would come when the second average starts to fall as well Problems: - Single stock may not track market (be sure to use a market index) - False signals: you act on a "signal" only to see it "reverse" - Time lag: by the time you get "confirmation," much of the money has already been made

CAPM: capital market theory

- relates the required rate of return for any security with the risk for that security as measured by beta - allows us to measure the relevant risk of an inidivudal security as well as to assess the relationship between risk and returns expected from invest - portfolio of all risky assets, with each asset weighted by the ratio of its market value to the market value of all risky assets

Investment risks

- beta is a measure of systematic non diversifiable risk - rational investors will for portfolios and eliminate unsystematic risk - systematic risk is the relevant risk for a well-diversified portfolio

intrinsic value of an option

- can only occur when a position is "in the money" meaning that it can be exercised (or at it's strike price)

Risks of revenue municipal bonds

- default risk - reinvestment risk ( all munis are subject to this due to coupon payments that must be reinvested at the same rate in order to maintain the yield-to-maturity) - unsystematic risk: specific attributes related to the revenue structure that is backing these types of bonds

IPS

- establishes framework for a client's investment goals and objectives, risk tolerance and time horizon -

Systematic risks

- factors that affect the returns on all similar investments - cannot be diversified away

Active management

- focused on individual security selection - assumes that markets are not totally efficient and by using reserach, investors are able to outperform passive strategies - more trading involved which results in higher trading and research costs

Alternative investments

- have the potential to generate higher returns -categorized by low liquidity of the underlying investments; usually highly leveraged and have high fees

open end fund vs. index funds

- high turnover with a open end fun whereas index funds have a lower turnover - turnover is not a factor for individual stocks & bonds

weak form

- holds that fundamental analysis may produce superior returns, but not technical analysis

analyzing the CML

- if above, fund's position is superior - if below, fund's position is inferior ( less than optimal return is being earned for the risk being taken) -

What are problems with using the IRR?

1. Assumes all cash flows are reinvested at IRR (often NOT the case) 2. NOT appropriate for judging performance of an investment manager because addition or subtraction of investment dollars affects the return

Arbitrage: definition

1. Buying in one market and simultaneously selling in another market to take advantage of price differentials (same security is selling at different prices on two different markets) 2. Assures there can be only one price (because when there is not, investors jump at the opportunity) 3. Assures that portfolios with the same risk will have the same returns (because they have the same price!) Arbitrage Pricing Theory has led to the development of multifactor models (not covered in this course).

7 common profitability ratios

1. Gross Profit Margin (Revenues - CGS)/Sales 2. Operating Profit Margin Earnings Before Interest & Taxes/Sales 3. Net Profit Margin Net Income/Sales 4. Return on Assets Net Income/Total Assets 5. Return on Equity Net Income/Equity 6. Return on Common Equity Net Income -Preferred stock dividends/Common Equity

Top down analysis vs. bottom up analysis

1. Top-down analysis: Economy → Sectors → Industry → Individual companies This investing strategy begins with a look at the overall economic picture (and predictions for the future) and then determines (based on this prediction) which sectors should perform well (outperform the market) and within these sectors which specific industries will flourish. The final step is selecting the best companies within the sectors—and this is done through analysis of the fundamentals of a given security. 2. Bottom-up analysis This is an investment strategy in which companies are considered based simply on their own merit, without regard for the economic outlook. A person following this strategy will be looking very closely at the company's management, history, business model, growth prospects and other company characteristics. Followers of this strategy believe that some companies are superior to their peer groups, and will therefore outperform regardless of industry and economic circumstances. The purpose of bottom-up investing is to identify such companies.

Tax Efficiency considerations and ratios

1. Turnover 2. Timing of capital gains and losses 3. Wash sale rule 4. Qualified Dividends 5. Tax Free Income

Five variables used to determine the Price or Value (Premium) of an option:

1. Volatility of underlying stock (standard deviation) 2. Current price of underlying stock 3. Strike price of option 4. Time to expiration 5. Risk free rate of interest

CAPM: calculate the required rate of return

= Risk free rate + (market return-risk free rate) * beta of a stock

Constant dividend growth model

= next years divident/(required RR- Growth Rate)

Purchases and Sales of Odd LotsM: (sentiment indicator of tech. analysis)

A "contrarian" indicator (can be applied to the market as a whole or to single securities) Based on small investors being wrong—especially right before a shift in the market (top or bottom) Normal range of odd lot purchases to sales ratio 1.4 to 0.6 Bearish = ratio approaching 1.25 - 1.3 = increases in odd lot purchases Bearish = High number of purchases by "dumb" money Bullish = ratio approaching 0.6 = increases in odd lot sales (securities are passing from "weak hands" to "strong hands") Bullish = Low level of purchases by "dumb" money Problems Indicates a tendency but little evidence exists to support whether this works Assumes the little guys are the fools—there are plenty of big fools as well

Derivatives

A derivative is a security whose price is dependent upon or "derived" (ala derivative) from one or more underlying assets. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Types of derivatives include: options (Puts and Calls), futures contracts, forward contracts, and swaps.

Holding Period Return

A measurement, expressed as a percent, of return (or loss) (realized or expected) on an investment during a single period (usually one year). It is one of the simplest measures of investment performance. Compare this to Multiple Period Rate of Return (calculating average annual returns) There are three common ways investment returns are calculated over multiple periods Arithmetic Average Return (Arithmetic mean) = simple return Dollar-Weighted Return (DWR) = Internal rate of return (IRR) Geometric Average Rate of Return (TWR) (Time-Weighted Average Return)

Index Securities

A passively managed fund (security) that tries to mirror the performance of a specific index, such as the S&P 500. Since portfolio decisions are automatic and transactions are infrequent, expenses tend to be lower than those of actively managed funds.

Activity Ratios

Activity ratios show how rapidly assets flow through the firm. For example, a high inventory turnover means a firm sells its inventory rapidly, and thus the funds tied up in inventory move up the balance sheet into accounts receivable or cash. Activity measures like liquidity ratios give an indication of the firm's capacity to meet its current obligations as they come due because more rapid turnover generates the cash to meet current liabilities on a timely basis

Coefficient of Determination

Also called r-squared—is simply the square of correlation coefficient (always a positive number) and is the proportion of the movement in one investment (e.g., "A") that is associated with (explained by) the movement in another investment (e.g., "B"). R2 = square of ρ = (ρ2) (simply the square of "r")

Barron;s Confidence Index (sentiment indicator of tech. analysis)

An index designed to identify investors' confidence in the level and direction of security prices Index is based on the difference in the yields paid by high-quality debt and low-quality debt Increasing spread is bearish (savvy investors are selling low quality and moving to high quality) Decreasing spread is bullish (vice versa) Problems: Time lag Inconclusive signals (interpretation is so subjective)

Book Value Analysis

Another way to calculate the value of a company and its stock is to calculate book value, which is simply: Assets—Liabilities—preferred stock—intangible assets like goodwill. Book value is usually considered the bare-bones minimum value of a company and is usually close to the companies "liquidation value."

Control of Volatility

As discussed in many instances above, mean-variance optimization is all about reducing variance (standard deviation) of a portfolio—which includes reducing volatility (variance relative to a benchmark). This is accomplished through diversification both within and across asset classes.

beta

Beta is a measure of Volatility - which is the movement or variability of a single security or portfolio relative to the overall market (m), which by definition has a Beta of one (1.00). Example: A stock with a Beta Coefficient of 1.20 is more volatile than or more sensitive to the market. If the market went up 10%, the stock would be expected to go up 10% × 1.2 = 12%. If market went down 10%, the stock would be expected to go down 12% NOTE: While "relative variability" is the pure definition of volatility, be aware that in practice, the terms (variability and volatility) are used interchangeably. Recall from section 35, that Beta is systematic risk (theoretically the only risk which remains in a fully diversified portfolio)

Beta: when greater than or less than 0

Beta is the total risk of security "i" (σi) relative to the total risk of the market "m" (σm) times the correlation of x to the market. β > 1.0: more risk than the market portfolio β = 1.0: the risk of market portfolio by definition β < 1.0: less risk than the market portfolio β < 0.0: the portfolio and market tend to move in opposite directions

Technical analysis: Charting

Charting refers to using charts to visually identify changes in the supply and demand for a single security or market. The idea is that you want to visually "catch" and exploit these changes in their early stages. For example, if demand for a security appears to be increasing - a chartist would invest in the security. Here are some samples of how charts are used to determine changes in demand: Point-and-Figure Charts — attempt to visually identify changes in the supply and demand for a security/market. 1. Identifies price levels that support or resist price changes.2 Breaking support or resistance levels are buy and sell signals Bar Graphs: Show similar patterns as point-and-figure charts Use support and resistance Give similar signals

Coefficient of Variation

Coefficient of variation is the beginning of the topic of risk-adjusted returns. Assuming an investor is risk averse, the best (Most Efficient) investment is one which produces the highest return per unit of risk OR lowest risk per unit of return. Total risk per unit of return expected (or realized) from an investment (e.g., A or B below) can be calculated with a ratio called Coefficient of Variation - which is simply the standard deviation divided by the expected or actual return from an investment. The resulting number may be used to determine the best risk-adjusted return.

Strategies for Dealing with Concentrated Portfolios

Concentrated portfolios are portfolios which contain investments representing a high percentage of the portfolio (e.g. greater than 10%). High concentrations increase risk and cause a portfolio to be inefficient (NOT mean-variance optimized). The simple solution is to sell the concentrated position and diversify. However, if the value of the position is well above the tax cost, realizing a large gain and paying the tax may not be advisable. So, the question is: How do we reduce risk without realizing a huge taxable gain? There are two primary ways to do this. The first is to use derivatives (e.g., zero cost collar) to lock-in the value. Another option is to pool the large position with holders of different large positions to create a diversified pool (called exchange funds) to be shared by all investors. This is a great option so long as the other holdings collectively create a truly efficient portfolio.

Price/Sales Ratio

Conceptually the same as using P/E ratios

3 common debt ratios

Debt to Equity Debt/Equity Debt to Total Assets Debt/Total Assets Coverage ratio (Times interest Earned) Earnings before interest and taxes/Interest expense

ETFs (definition, advantages vs. disadvantages)

ETFs are closed-end funds (usually index securities) which do NOT sell at a discount or premium because large institutional investors are permitted to exchange ETF shares for individual securities and vice-versa - which creates an arbitrage opportunity that should theoretically keep the price of an ETF on target with the index it is tracking. In a sense, ETF's are "open" ended funds in that institutions may add money or with draw money from the funds. To the investing public, ETF's are closed-ended funds. Shares available to the investing public are bought and sold in the secondary markets. Advantage over open-ended mutual funds: Trade during the day (you can set a price target) Capital gains may be managed (none incurred by the activities of other investors) Low cost (due to low operating costs) Disadvantage: Commission to buy or sell shares

Top- Down Analysis

Economy → Sectors → Industry → Individual companies This investing strategy begins with a look at the overall economic picture (and predictions for the future) and then determines (based on this prediction) which sectors should perform well (outperform the market) and within these sectors which specific industries will flourish. The final step is selecting the best companies within the sectors - and this is done through analysis of the fundamentals of a given security. Fundamental analysts believe that through intensive study of a company - its management and financial statements (bottom-up analysis) - that mis-priced securities may be identified. Fundamental analysts also believe that mis-priced assets may be discovered by accurately predicting (assuming the market is wrong) the future macroeconomic environment (top down analysis).

Semi-Variance

For most people, risk is the probability of not realizing expected returns—or even worse—losing money. The statistics listed above measure variation above and below mean returns. However, most investors are more concerned about returns below expected returns—so they want to measure the risk of earning less than expected. Calculating "Semivariance" is one way to examine what we call "downside risk." Semivariance is calculated in the same manner as variance but only those observations that fall below the mean, expected or required return are included in the calculation. For skewed distributions, the semivariance can provide additional information that variance does not. Positively skewed distributions are less risky (less downside) than negatively skewed distributions.

Definition: Foreign bond

Foreign bonds A bond issued in one country and denominated in that country's currency by a foreign issuer. For example—a US company issues bonds in the UK denominated in the British Pound

Definition: American depositary receipts (ADRs)

Foreign stocks which trade on a US exchange. HOWEVER, the way it works is that a US Bank buys the shares on a foreign exchange and then issues an "ADR" version of the shares which are backed by the actual shares held by the US Bank.

what form of analysis does EMT support

Fundamental analysis only (not technical)

Guaranteed Investment Contracts (GICs)

Guaranteed investment contracts (GICs) are insurance contracts that guarantee the owner principal repayment and a fixed or floating interest rate for a predetermined period of time.

Hedging: Short and long terms

Hedging involves making an investment (futures or forward contracts) to reduce the risk of adverse price movements in an asset you either hold or intend to purchase in the future. The opposite of a hedger is a speculator, which is an investor who buys or sells contracts in anticipation of price changes. A Short hedge is used by someone who is long (owns) a commodity, stock, or currency and will need to sell in the future. Example: A wheat farmer can use a short hedge to protect from a decrease in the price of wheat (once he has harvested and is ready to sell/deliver). A Long hedge is used by someone who is waiting to invest funds, or by someone who has to buy in the future (said to be short). Example: A manufacturer of wheat crackers can use a long hedge to protect from a price increase in wheat.

what is the IRR?

IRR is the rate (aka discount rate) that equates the cost of an investment (cash outflow) with the returns cash inflows generated = IRR gives the true annualized (compound) rate of return on invested cash = How much money was made (or lost) for ALL the dollars invested

maintenance margin

Maintenance margin (% of total "equity" can drop to before a margin call).

Exchange Rate

Risk that a loss will be caused by a change in exchange rates (relative value of currencies)

rebalancing

Rebalancing is simply the process of bringing portfolio asset class percentages back in-line with the strategic asset allocation policy. This may be done either ad-hoc or more preferably on a set schedule (e.g., at a particular time each year). The net affect is that positions in winning asset classes are sold with the proceeds reinvested in asset classes which have performed less well during the preceding period. The idea is to sell high and buy low - through a disciplined non-emotional methodology.

Tax RIsk

Risk of loss due to changes in the tax code (or loss due to taxes)

SML corresponds to what ratio?

Security Market Line corresponds to the Treynor Index

Sentiment indicators of technical analysis

Sentiment indicators monitor the activity of market participants such as floor traders, insiders, mutual fund managers, etc. The premise behind such indicators is that certain types of investors will have similar reactions to future market events as they have had to past events. These reactions may prove useful for identifying market turning points. Sentiment indicators are used to determine the levels of optimism or pessimism present in various markets. For example, some indicators will account for all the long and short positions on a particular exchange in order to determine a bearish or bullish market. - use of the barron's confidence index vs. the purchase and sales of odd LotsM

Covariance

Similar to correlation coefficient, covariance is a measure of the degree to which returns on two investments move in tandem. In fact, there is some circular logic here because the mathematical definition of correlation coefficient contains covariance.

total book value equation

TBV = assets - liabilities- preferred stock

Black Scholes Option Valuation Model

The Black-Scholes option valuation model is a complex mathematical formula created by Fischer Black and Myron Scholes, used to calculate the theoretical present value of a stock option at the grant date using the five variables listed below. This model, or equation, allows an investor to determine the fair value of a financial option, such as a call. Since virtually all financial securities have some characteristics of financial options, the model was a breakthrough in properly valuing securities. The main advantage of the Black-Scholes model is speed -- it lets you calculate a very large number of option prices in a very short time. The Black-Scholes model has one major limitation: it cannot be used to accurately price options with an American-style exercise as it only calculates the option price at one point in time -- at expiration. It does not consider the steps along the way where there could be the possibility of early exercise of an American option.

Arbitrage Pricing Theory

The Capital Asset Pricing Model relies on two variables to determine the required return of an investment (Beta and market risk premium). APT is the belief that the return on a stock or portfolio is not based on these two variables alone but instead is a function of several additional systematic variables, the most influential of which include: - Inflation, Industrial Output, Risk Premiums (Rm - Rf) & Beta. Interest Rates -APT states that the price of an investment is derived from the expected future values of many different systematic variables. The focus of APT is on unexpected changes to these systematic variables (the investment is "re-priced" based on unexpected changes). In other words, we can test the sensitivity of a security to unexpected changes in the factors listed above. You might think of this as the Macro Surprise Pricing Theory (because the factors are Macroeconomic concepts) or Systematic Surprise Pricing Theory as macroeconomic factors are systematic factors.

How do you determine an appropriate benchmark comparison?

The best benchmarks for evaluation of active management are those which closely approximate the investment objectives and style of the subject portfolio. A high R-squared (above 80% but above 90% preferred) between the benchmark and the portfolio is important: The direction and variability of the benchmark must be explained or closely related to the direction and variability of the subject portfolio.

Binomial Option Pricing

The binomial option pricing model overcomes the limitation of the Black-Scholes model in that it may be used to value American Options. Instead of valuing based on a fixed end-date, it values the security at select periods throughout the life of the option, using an iterative process to build a binomial tree. The model is simple mathematically when compared to the Black-Scholes model, and is therefore relatively easy to build and implement with a computer spreadsheet. However, because it uses an iterative process, the model works very slowly. It's great for half a dozen calculations at a time but even with today's fastest PCs it's not a practical solution for the calculation of thousands of prices in a few seconds.

Capitalized Earnings

The capitalized earnings concept of business (stock) valuation is simply the perpetuity valuation model with earnings in the numerator and the required rate of return in the denominator.

Bond duration and convexity

The price (value or "intrinsic" value) of a bond is equal to the present value of future cash flows (interest and principal). Interest and principal are discounted back to the present at the going "yield" (IRR) on comparable debt*. In practice, we often say that when interest rates in general "go up" then required yields must go up (and the value of bonds must go down).

Interest Rate

The risk of loss due to changing interest rates

SML: how to read it

The risk premium for a security is (Rm - Rf) * Beta Which is the product of the market risk premium (Rm - Rf) and the Beta of the security: The risk premium is the slope of the Security Market Lin β = 1.0 Stock's return has same volatility as the market β > 1.0 Stock's return is more volatile than the market High Beta Stocks may be appropriate for high-risk tolerant (aggressive) investors β < 1.0 Stock's return is less volatile than the market return Low Beta Stocks may be appropriate for low-risk tolerant (defensive) investors Betas tend to change over time and move closer to 1.0

Price/earnings ÷ growth (PEG)

The value of a stock with higher expected future earnings growth should be more valuable than a stock with low future expected earnings growth—therefore a straight comparison of P/E ratios might lead one to make the wrong conclusion. Some investors will adjust P/E by the growth rate so that expected growth is part of the valuation metric.

How do we value stocks?

The value of any investment may be expressed as the present value (Net Present Value or NPV) of all expected future cash flows discounted using the required rate of return (Internal Rate of Return or IRR) The basic concept is that a set of future cash flows may be discounted back to the present at the required IRR (internal rate of return) to calculate an NPV (Net Present Value), which is the intrinsic value of that future set of cash flows—or intrinsic value of the investment. NOTE that since the future in unknowable, all estimates of current value are simply estimates—which could prove to be very wrong in retrospect.

Time-Weighted Vs. Dollar-Weighted Return

Time-weighted and dollar-weighted returns are "geometric" returns. Time-weighted returns are simple geometric returns which assume that a fixed dollar investment was made and held (no money was added to or withdrawn during the multi-periods of investment). Dollar-weighted returns are actual dollar returns experienced by investors who don't hold a fixed investment, but instead add to or withdraw investment funds over time. The timing, direction (in or out) and amounts of their additions or withdrawals affect their actual returns on invested cash.

Sources of risk

Total risk = Active risk & Beta

Properties of an appropriate benchmark

Unambiguous - the identities and weights of securities or factor exposures should be clearly defined Investable - easy to invest in the benchmark itself rather than being managed actively Measurable - the return should be readily available or calculable Appropriate - the benchmark should reflect the manager's style or expertise Reflective of current investment opinions - the investor researches and has opinions on the securities in the benchmark Specified in advance - We know what is in the benchmark before an evaluation period begins Owned - the manager is willing to accept responsibility for performance relative to the benchmark

Coefficient of Variation

Used to determine the level of risk in comparing investments - SD/expected return --> more risk per unit of return

Promissory Notes

Written, dated and signed two-party instrument containing an unconditional promise by the maker to pay a definite sum of money to a payee on demand or at a specified future date. When a bank is the maker promising to repay money it has received plus interest, the promissory note is called a certificate of deposit (CD).

Definition: Treasury STRIPS

Zero coupon (definition below) bonds issued by the Federal Government

What debt instrument has the greatest volatility

Zero coupon bond: longest duration equal to its maturity so greatest volatility

What do active managers try to do?

trying to beat their "benchmarks" either through superior security selection and/or market timing.

What causes the largest increase in the price of a diversified stock

unexpected corporate earnings growth - in an efficient market, expecged market developments (dividends, prime interest rate increases, etc.) would have no impact on the securities

Debenture

unsecured corporate debt; has no specific assets pledged as collateral