Module 3: Investment Planning
NAV (net asset value)
(assets - liabilities) / Shares outstanding = NAV -the market value of all the assets held by the investment company is determined at the end of each trading day.
Synthetic Long Position (options)
-an options trader who writes a put and buys a call on the same underlying security at about the same strike price -same gain/loss potential as being long on the underlying stock, but this requires less initial cash -no cash divs of course, and when they expire additional costs need to be make to open the position again.
Options Trading
-contract between two people wherein one person grants the other person the right to buy a specific asset at a specific price within a specific time period (alternative is to sell) -zero sum gains: whatever the buyer gains the writer loses, and vice versa. option buyer: The person who purchases the option for a premium price receives the right to exercise the contract. The option will either be the right to buy at the exercise (strike) price or the right to sell. option writer: The person who receives a premium for creating the option contract has sold the right, and thus must respond to the buyer's decision. If the buyer exercises the right to buy shares, then the writer of that option must deliver the shares. If the buyer exercises the right to sell, then the writer must come up with the money to purchase the shares. **Option contracts give buyers the right to exercise, not an obligation to deliver. Futures contracts require the buyers to deliver according to the contract terms.
Options Spreads
-created by the purchase of one option and sale of a similar but different option. The options can be either puts or calls but not puts and calls. Vertical Spread: options with different exercise prices but the same expiration date. Bull & bear spread Horizontal (time) Spread: combinations of options having different expiration dates but the same exercise price. Diagonal Spread: mixtures of vertical spreads and horizontal spreads. They include options in which both the expiration dates and the exercise prices differ. -Credit spreads are spreads that generate premium income that exceeds their related costs. --Debit spreads initially cost the investor a net cash outflow.
Closed End Funds
-don't stand ready to purchase their own shares. Instead, shares of closed-end investments are traded either on an organized exchange or in the over the counter market. Closed-end fund quotations: the market prices of the shares of closed-end funds that are published daily in the financial press, provided that the funds are listed on an exchange or traded actively in the over-the-counter market Prices of shares: that are above their net asset values are said to sell at a premium. share prices that sell below their net asset value are said to sell at a discount. Investing in Fund shares: enables an investor to earn more than just the change n the company's NAV by purchasing closed-end fund shares at discount. Even if the company's discount remains constant, the effective dividend yield will be greater than that of an otherwise similar no-load, open-end investment company. Exchange traded funds: traded throughout the day on an exchange. ETFs are a new kind of closed-end investment company which offers the same trading flexibility of a stock and with lower expense ratios. **discount when their mkt price per share is less than their NAV. premium when the shares' market price is greater than the NAV **most closed end funds that invest in stocks sell at a discount **closed fund when NAV is different than it's market price. Price is based on supply and demand
Preferred Stocks
-form of equity investment that receives only a stipulated dividend. right to earnings before common stock shareholders -many issues of a preferred stock are callable at a stated redemption price. **biggest benefit to investing in preferred stock is their promise to pay dividends. call feature is also an advantage, characteristics: par value, callable and convertible to common stocks Types: some have cumulative rights (receive dividends in arrears) while others do not. Some may be convertible while others have different divided rates.
ETFs
-low cost compared to MFs because of indexing rather than active management -mostly institutional customers -traded in the secondary market -more tax efficient bc the forced sale of securities for investor redemption request results in fewer capital gains being distributed.
Capital Asset Pricing Model
-major implication is that the expected return of an asset is related to the measure of market risk for that asset known as beta. Assumptions behind CAPM 1. Investors evaluate portfolios by looking at the expected returns and standard deviations of the portfolios over a one-period time horizon. 2. Investors are never satiated. When given a choice between two portfolios with identical standard deviations, they will choose the one with the higher expected return. 3. Investors are risk-averse. When given a choice between two portfolios with identical expected returns, they will choose the one with the lower standard deviation. 4. Individual assets are infinitely divisible. An investor can buy a fraction of a share if he or she so desires. 5. There is a risk-free rate at which an investor may lend, invest or borrow money. 6. Taxes and transaction costs are irrelevant. 7. All investors have the same one-period horizon. 8.The risk-free rate is the same for all investors. 9. Information is freely and instantly available to all investors. 10. Investors have homogeneous expectations. It means that they have the same perceptions in regard to the expected returns, standard deviations and co-variances of securities.
Corporate Bonds
-mortgage bonds: debt that is secured by the pledge of a specific property. If default, bondholders obtain property and sell to satisfy their claims on the firm. -collateral trust bonds: backed by other securities that are usually held by the trustee. common situation of this sort arises when the securities of a subsidiary firm are pledged as collateral by the parent firm. -equipment obligations: backed by specific pieces of equipment, for ex, railroad cards and commercial planes. most common is trustee initially holds the equipment and issues obligations and then leases the equipment to a corporation. Money received from lessee is used to make int and principal payments. -debentures: general obligations of the issuing corporation and thus represent unsecured credit. to protect holders of these bonds, the indenture will usually limit the future issuance of secured debt as well as any additional unsecured debt. -subordinated debentures: when more than 1 issue of debentures is outstanding, a hierarchy may be specified. ex: subordinated are junior to un-subordinated...in bankruptcy, junior claims are to be considered only after senior claims are satisfied -asset-backed securities: are much like the participation securities. People pool loans and sell securities that represent part ownership of the pool. susceptible to default risk and prepayment risk -convertible bonds: are securities that can be converted into different securities of the same firm under certain conditions.
Straddles
-occur when an equal number of puts and calls are bought on the same underlying asset with the same maturity and strike price. -Straddle buyers pay the total of the two premiums when they believe the price of the optioned security will fluctuate substantially. On the contrary, if the investor thinks the price will be stable, then he or she may sell a straddle instead. aggregate profitable price movements in one or both directions need to break even = put premium + call premium
Probability Analysis - curves and types
-one of the most common applications used is a normal distribution or normal curve. it's a bell shaped probability curve used to interpret standard deviation, semi-variances and downside risk -normal distribution: bell shaped normal distribution curve. mean-variance model of portfolio selection (mean and median are equal)....skewness is what would cause it to be non-symetrical
Treasury Inflation-adjusted securities (TIPS)
-similar to U.S. Treasury Bonds in every way, except their principal amount increases by the change in the Consumer Price Index (CPI) and their coupon payments are then calculated based on the inflated principal. -gives investors protection against inflation eroding the purchase power of future payments of interest and principal.
Types of Muni Bonds
1) General Obligations (GOs): issued by state and local agencies and are backed by the full faith and credit of the agency. backed by their full taxing power which means they're safer than other muni bond types 2) Revenue: backed by revenues from a designated project, authority, or agency or by the proceed from a specific tax. only creditworthy as the enterprise associated with the issuer. They can be issued for the following reasons: -financing publicly owned utilities -financing quasi-utilities, like transportation -financing by levying tax on properties that benefit from the expenditure, for example a new sewer system -industrial development bonds are used to finance the purchase or construction of industrial facilities that are to be leased to firms on a favorable basis
Asset Allocation Process - quick guide
1. gain understanding 2. set realistic expectations 3. Policy statements 4. forecasting 5. allocating assets 6. investing the allocation funds 7. performance reports and feedback
Portfolio Insurance (using options)
1. purchase a protective put: provide protection against declines in portfolio value. "married put". buying puts on a stock market index. -Protective puts are also useful to guard against significant loss resulting from a concentrated position in a single stock in a client's portfolio 2. create a synthetic put:
The premiums that put and call buyers pay for their contracts are determined by 6 factors:
1. the length of time remaining in the options life: farther out = higher premium 2. the standard deviation or riskiness of the underlying asset: higher premiums for riskier contracts 3. the market price of the underlying asset: Option writers charge higher premium to assume the risks related to high-priced stocks. 4. the option's strike price: 5. the risk-free rate of interest 6. cash dividend payments
Correlation between two stocks
= co-variance (A, B) / (std div A * std div B) measures how closely the data points fir the characteristic line (characteristic line is a time specific linear regression used to measure an investments beta and residual variance. Used to show how an asset's return relates to the market's return).
Repurchase agreement
A financing transaction in which one firm lends assets to another firm in exchange for cash with a simultaneous agreement to purchase the assets back at a later date -investor loans the issuer money -issuer puts up tbills as collateral and issues the buyer a repo agreement -Issuer pays off the loan with interest -buyer returns the tbills
why invest in a MF?
Advantages: diversification, professional management, minimal transaction costs, liquidity, flexibility, service Disadvantages: Lower than market performance, costs, risks, systematic risk (not protected in a mkt crash), taxes, unrealized capital gain, style drift, poor for estate planning, transaction price
Futures Contracts
Agreement to purchase specified amounts of a commodity (or stock) at a given price on a set future date.
Profit and losses with buying options contracts
Call buyer's gain or loss = Intrinsic value of call - Call option's premium Call writer's intrinsic gain = Intrinsic value of call + Call option's premium Put buyer's intrinsic gain = Intrinsic value of the put - Put option's premium Put writer's gain = Intrinsic value of put writer's position + Price of put
Call vs Put Options
Calls: contracts where the writer gives the buyer the right to purchase a set quantity of securities at the exercise price from the writer. Buyer wants asset: increase beyond strike + premium Writer wants asset: decrease below strike + premium Puts: contracts where the writer gives the buyer the right to sell a set quantity of securities at the exercise price to the writer. Buyer: decrease below strike - premium Writer: increase beyond strike - premium
Tax Investment Models
Current Model: the earnings on the investment are taxed annually (currently). Thus, the reinvested earnings grow at the after-tax rate of return. Deferred Model: earnings on investment are taxed only at the end of the investment period. That is when the investor cashes out of the investment, thus taxation of these earnings is deferred. Exempt Model: earnings on the investment are exempt from explicit taxation. The Exempt Model can also be considered as a special case of either the Current Model or the Deferred Model with the tax rate equal to zero. Roth and Muni's Pension Model: the entire accumulation, not just the earnings, is taxed at the end of the investment period. Thus, the Pension Model provides two levels of deferred taxation. So salary or earned income and earnings on the underlying investment escapes taxation when contributed while in the plan and are taxed later upon withdrawal. Multi-period Strategies: This strategy considers investors' likelihood in investing certain amounts in different time period. This way, investors can optimize their after-tax accumulation by investing in one type of investment in early years and another type investment in later years.
Dollar vs Time weighted return
Dollar Weighted Return: based on the initial value plus investments versus ending value. Internal rate of return Time-weighted return: return based on portfolio growth from one period to the next.
Risks of purchasing foreign bonds
Exchange rate risk political risk tax risk
Three methods of determining cost basis
FIFO LIFO specific share identification: allows investors to limit capital gains by identifying shares that cost the most to be sold first.
Measures of Portfolio Return
Holding Period: fails to take time val of money into account Dollar-weighted return (IRR): best way to measure an individual investor's results. breaks up holding period so that the mkt val of the account after a change will be compounded by the amont of time it was earning the interest. factors in deposits and withdrawals Time-weighted return: calculated the return for the amount prior to a change caused by deposit or withdrawal. individual returns are added today. more accurate than annualized returns. Annualized Returns: add the returns of the quarters together. could be misleading bc it does not consider how long each dollar was in the investment.
capitalization of income method of valuation
The intrinsic value of any asset is based on the discounted value of the cash flows that the investor expects to receive in the future from owning the asset.
Different components of asset allocation
Simple Asset Allocation: Constrained Asset Allocation: Markowitz Portfolio Theory: •The maximum expected return available at its level of risk, and •The minimum risk at its level of expected return. Selecting Efficient Asset Allocation: based on risk score
Other Bonds?
Income bonds: more like preferred stock than bonds. Payment of interest in full and on schedule is not absolutely required, and failure to do so need not send the corporation into bankruptcy. Interest on income bonds may not qualify as a tax-deductible expense for the issuing corporation. Guaranteed bonds: are issued by one corporation but backed in some way by another. Participating bonds: require stated interest payments and provide additional amounts if earnings exceed some stated level. Voting bonds: unlike regular bonds, give the holders some voice in management. Serial bonds, with different portions of the issue maturing at different dates, are sometimes used by corporations for equipment financing. Convertible bonds may, at the holder's option, be exchanged for other securities, often common stock. Putable bonds: give the holders an option, but this time it is to exchange their bonds for cash equal to the bond's face value. This option generally can be exercised over a brief period of time after a stated number of years have elapsed since the bond's issuance.
money rates listing
Interest rates on money market instruments are often reported on what is known as a bank discount basis
Bond Ladders, Bullets & Barbells
Ladders: portfolio of bonds that mature at regular intervals throughout the various maturities of the yield curve. most effective when the yield is normal or sloping upward and interest rates are fairly stable. treasury securities or CDs Bullets: benefits when the yield curve is expected to steepen. A bullet structure usually weighs heavier around intermediate term assets. Barbells: holding more bonds at the short and long end of the yield curve with intermediate bonds being underweighted. This allows a portfolio's price to match the volatility of an intermediate-term liability. When there is a likelihood that the Federal Reserve will loosen monetary policy in the near term, a barbelled portfolio may increase a bond portfolio's return.
Tax Investment Strategies:
Mutual Funds: High turnover rates within mutual funds could lead to taxable distributed capital gains for shareholders. Index funds have low turnover rates. There are mutual funds that are managed specifically for after-tax returns. Bonds: High turnover rates within mutual funds could lead to taxable distributed capital gains for shareholders. Index funds have low turnover rates. There are mutual funds that are managed specifically for after-tax returns. Stocks: Tax management strategies regarding stocks revolve around capital gains. One strategy is to buy and hold stocks to make sure the capital gains are at least taxed on a long-term basis. Another strategy is to make sure that there are realized capital losses to offset realized capital gains. However, the wash sale rule will disallow certain realized capital losses to be deducted.
Asset Allocation Process
Phase 1 - Written Policy: Requires the planner and the client to work together to create a written policy statement. The policy statement guides the remainder of the asset allocation process, and it furnishes a standard against which the performance of the investment manager can be evaluated. Step 1: Gain understanding Step 2: Expectations Step 3: Policy statement: sets forth investment goals & policies (benchmark, constraining policies, asset allocation policies, panic attack) Phase 2 - Managing the Money: Requires the investment manager to manage the client's money. This phase begins with the preparation of needed forecasts. Then the investment funds are allocated to asset classes and the appropriate investment orders are executed. This phase ends with a periodic performance report. The investment manager and the client discuss the performance report and, if necessary, update the written policy statement.
Asset Allocation Process, Phase 1, Step 3
Policy Statement Benchmark: benchmark portfolio or market index to guide the planner and serve as a standard for evaluating performance. Constraining Policies: beliefs, opinions, etc. that they want excluded from the plan. Asset Allocation Policies: determining the mixture of asset classes that will provide a combination of risk and return that is optimal given an investor's financial situation and investment objectives. Panic Attack:
Par val / premium / discount
Premium bond: when interest rates decrease below the stated interest of the debt (coupon rate), the security is worth more since newer debt pays less interest. market price will be ABOVE par value! Discount bond: when interest rates increase above the stated interests of the debt (coupon rate), the security is worth less since newer debt will pay a higher interest rate. market price will be BELOW par value
Price vs Value Weight
Price Weight (DJIA Index): HIGHEST PRICED STOCK INFLUENCES INDEX. add all the prices of the stocks in index, divide this sum by the divisor to calculate an avg price Value Weighting (S&P 500 Index): assigns each security a weight that is proportional to the market value of all that issue's outstanding shares. weights correspond to the investment opportunities that exist in the U.S. stock market. LARGEST COMPANY INFLUENCES INDEX -S&P 500 a useful standard of comparison for evaluating the performance of other U.S. common stock investments.
Muni Bond Insurers
Private companies insure municipal bonds against default, resulting in the issue receiving an AAA Credit rating - this enhances marketability and reduces interest cost -Muni Bond insurers 1. AMBAC - American Municipal Bond Assurance Corp 2. FGIC - Financial Guaranty Insurance Corp
Time diversification formula
Sd (annual standard deviation) / square root of N (holding period)
US Savings Bonds
Series EE: Series EE bonds have no secondary market, therefore they must be redeemed and cannot be used as gifts or as collateral. An attractive feature is that these bonds are not subject to state and local taxes. Series HH: acquired through an exchange of Series E bonds, which the Treasury issued prior to July 1, 1980. Like EE bonds, HH bonds are not marketable securities. no adjustment for inflation. Series I: sold in denominations ranging from $50 to $10,000. The Treasury sets the interest every May and November for the next six-month period. The interest rate is based on a fixed rate plus an additional amount, which is determined by the Consumer Price Index. maturity is 20 years with option to extend interest payments for an additional ten years. Interest is exempt from state and local taxation, and may also be exempt from federal taxation as long as the interest is used to pay qualified higher education expenses.
CAPM-based measures of portfolio performance
Sharpe ratio: reward to variability index, which defines a single parameter portfolio performance index that is calculated from both the risk and return statistics. Treynor ratio: reward-to-volatility ratio, is a metric for determining how much excess return was generated for each unit of risk taken on by a portfolio Jensen ratio:
Asset Allocation Process Phase 2: Managing the Money
Step 4: Forecasting (likely outcomes based on past data) Fundamental analyst: company facts to find intrinsic value tech analyst: historical market data, graphs, studies stock prices to seek patterns that will return in the future. risk-return analyst: historical means & variances & correlations between investments. study an index rather than a price Step 5: allocating assets...review step 3 and 4 Step 6: Investing the allocation funds -maybe need to liquidate old assets, may be a large transaction to work over days (like FSI) Step 7: Performance Reports:
US treasuries
T-Bills: less than 1 yr, essentially risk free Current Price = Face Value X [1 - ((Days to Maturity/360) X Discount Yield)] T-Notes: 1-10 yrs, semiannual coupon payments. Treasury Notes are issued in denominations of $1,000 or more. Coupon payments are set at an amount so that the notes will initially sell close to par value. T-Bonds: 10-30 yrs; The bonds are sold on a yield to maturity (YTM) basis. The income received from the bonds is subject to federal income tax. have call provisions
Tax Equivalent Yield (TEY)
TEY = tax free rate / (1 - tax bracket) helps investors determine whether or not they are better off investing in the lower yielding but tax-free muni bond or in a higher yielding taxable bond
Taxation of Bonds
U.S. Government: subject to federal taxes (income, estate, excise). Interest is exempt from state and local tax Agency: Fannie Mae, Freddie Mac, etc. Interest is taxable for federal income. Interest is exempt from state and local taxation for the agency issues other than Fannie Mae and Freddie Mac, which will be subject to both federal and state taxes. Municipal: free of federal tax. if you live in state that issued bond, exempt from state and local tax as well. market discount is not tax-exempt for a muni bond Zero Coupon: holder is taxed as though receiving int, even though they're not (phantom income). subject to federal, not state tax. TIPs: fixed income option that protects against inflation. default free, no purchasing power or inflation risk. fixed coupon rate, but the principal grows at the same rate as prices. adjusted every 6 months. federally taxed, but no state or local
Taxation of other investments
US Savings Bonds: Interest earned on U.S. Savings Bonds is exempt from state and local income tax. You can also defer paying federal income tax on the interest until the bond is cashed or until it stops earning interest in 30 years. Annuities: Individuals receiving an annuity are permitted to exclude their cost (tax-favored income), but are taxed on the remaining portion of the annuity. (taxed on the remaining portion of the annuity) The expected return is the life expectancy in years times the annual distributions.The exclusion ratio is the cost of the annuity divided by the expected return. The annual exclusion amount is the exclusion ratio times the annual distribution amount. Limited Partnerships: allow partners to share in taxable profits of the company as well as use their losses to offset other gains and income. A limited partnership is a pass-through entity where all the partnership's profits and losses are passed on to the partners.
Unsystematic (diversifiable risk)
risk that can be eliminated through diversification. it results from factors unique to a particular stock. ex: business risk, financial risk, default or credit risk total risk = 1 - Rsquared
Warrants & Rights
Warrants: may be distributed to stockholders in lieu of a stock or cash dividend or sold directly as a new security issue. They give shareholders the option to purchase stocks at a specified exercise price Rights: issued to give existing stockholders a right to subscribe to a new issue of common stock before the general public is given an opportunity. each share of stock receives one right. *both similar to call options in that they give the holder the right to purchase shares of the underlying security at a stated price. They derive their value from the underlying security.
Covered Call
When the writer of a call also owns the stock he is obligated to sell; -Used to increase income in a time when you do not expect the stock price to increase; -Can be written out of the money to add insurance that the stock won't get called away; -Trading away chance of stock appreciating in future for income now
Market Indices
allow you to understand how the market is doing based on the average performance of a group of stocks. dow jones industrial average: one of the most widely followed indicies, and is a price weighted index. It involves the prices of 30 stocks that generally represent large-size firms. S&P Corp: financial information company that developed its first stock market indicators in 1923. S&P 500 uses the value weight method to calculate its index. This method adjusts for the weight of each stock's market value within the composite along with their prices. Others: There are other indices that represent the broad market, markets specific to large companies, markets specific to medium size companies, markets specific to small companies, markets specific to a country, or markets specific to an industry or a sector.
Banker's Acceptance
an order to a bank by a customer to pay a sum of money at a future date -buyer promises to make payment at later date upon delivery of goods -bank accepts the promise to pay. The bank can sell the promise as a bankers' acceptance
Classifications of Common Stock
blue chip: common stocks that are issued by large companies with solid dividend growth records. (JNJ) growth stocks: sales and earnings growth well above the industry average Income stocks: mature firms that pay relatively high dividend with little increase in earnings value stocks: out of favor but there is some intrinsic value that may cause them to regain favor speculative: risky and difficult to forecast future profits cyclical stocks: earnings tend to move with the economy (car company's) Defensive stocks: earnings that are not affected by swings in the economy (tobacco) Large, mid and small caps: refer to the size of the firm issuing the stock, and to the level of its capitalization or market value. larger companies are perceived as more conservative.
Risk estimates
calculated by measuring standard deviation and the variance of an asset's rate of return.
MFs; closed end vs open end funds
closed-end: make an initial offer of a set number of shares that are then traded exclusively in the secondary market. open-end funds: continuously offer new shares to the public at the fund's net asset value.
Integrated Asset Allocation
considers the investor's goals and policies and capital market conditions, and then uses these data as inputs to some kind of optimizer. The optimizer's solution becomes the new inputs that are reconsidered along with the investor's latest goals and policies and most recent market conditions when revising the asset allocation.
Lognormal distributions
defined by the mean and the variance of the underlying normal distribution itself
Pooled Investments
investment that collects (pools) the money of many investors who share similar goals, time horizons and risk tolerances. -assets are given to money manager, combining money by all investors amplifies investment power. -enables small investors to experience the same benefits of investing in the securities market that were once exclusive to large investors. -examples: UITs & mutual funds Unit Investment Trust: investment company that owns a fixed set of securities for the life of the company. Rarely alters portfolio. most hold fixed income securities that expire after the last security has matured. Mutual funds: investment companies that take the pooled assets of multiple investors and purchase a variety of securities in accordance with stated objectives.
Expected rate of return
is the weighted average of various rates of return in one probability distribution
Re-balancing the portfolio
it's important to look at the account over time, and track performance of stocks to see if you have to make the portfolio more conservative, or change the asset mix.
Guaranteed Investment Contracts (GICs)
large denomination debt instruments offered by insurance companies -contract between an insurance company and a corporate profit sharing or pension plan that guarantees a specified rate of return -life of the contract is 1-5 years -highly conservative and essentially risk free -many 401K plans offer this contract
time to maturity
longer term bonds are considered to be more risky, so the coupon rates tend to be higher than short term bonds. higher the coupon, the shorter the duration
Systematic Risk (non-diversifiable)
market risk. It is variability that cannot be eliminated through diversification. -interest rate risk, reinvestment risk, exchange rate risk, inflation risk
Coefficient of Determination (R-squared)
mathematical square of the correlation coefficient. It predicts the accuracy of beta and represents the portion of the asset's return that is non-diversifiable (systematic). It is important to know that 1 - Rsquared shows the amount of an assets return that is due to unsystematic (diversifiable) risk. •R-squared = 1, then the asset's return is perfectly correlated with the return of the market. •R-squared = 0, then the asset's return has nothing to do with the market's return.
Modern Portfolio Theory
maximize return for given level of risk, minimize risk for given level of return, invest in risky assets and t bills in some proportion Investor should view the rate of return associated with any one of these portfolios as random variable such as: -expected (or mean) value: measure of the potential reward associated with any portfolio -Standard deviation: measure of the risk associated with any portfolio *base portfolios off of these things
Asset's total risk
measured by its variance of returns. it is split into two components, diversifiable risk and non-diversifiable risk. The only measure of an asset's total risk is standard deviation.
Co-variance
measures the tendency for two random variables to move together. considers the joint probability distribution of two random variables.
Stock Value: par, book & market
par value: when a corp is first chartered, it is authorized to issue up to a stated number of shares of common stock, each of which has a specified par value. Typically lower than the initial sales price of the stock, and is capital contributed in excess of par value or paid in capital. *the value of common stocks listed in shareholder's equity book value = net worth of company / number of shares outstanding. total value of of the company on the books includes retained earnings, par value of shares, & the capital in excess market value: dependent on the demand and supply of shares
Alternative Minimum Tax
personal income tax rate that applies to cases where taxes would otherwise fall below a certain level. since they are less attractive bonds, they tend to have a higher nominal yield than other muni bonds with similar risk
Original Issue Discount
purchase price of a bond is less than the face value, the holder will received a refund for the difference between the purchase price and the face value. Considered a form of interest.
Dollar Cost Averaging
purchasing a fixed dollar amount of stock at specified intervals. Logic is that by investing the same dollar amount each period instead of one lump sum, you'll be averaging out price fluctuations by buying more shares of common stock when the price is lower, and fewer shares when the price is higher. **only doesn't work when the stock only increases in value, with absolutely no decrease over a certain period of time.
Skewness in distribution
refers to the extent to which a distribution is not symmetrical. Real-world distributions are usually skewed, either positively (to the right) or negatively (to the left)
Mortgage backed securities
securities that are backed by pools of mortgage loans. Because the underlying mortgages can be prepaid, prepayment risk is a major concern for MBS investors -Mortgage pass-through securities: represents a claim against a pool of mortgages. 3 major types: Ginni Mae (GNMA), Fannie Mae (FNMA), Freddie Mac (FHLMA) -Collateralized Mortgage Obligations (CMOs): means to allocate a mortgage pool's principal and interest payments among investors in accordance with their preferences for prepayment risk. CMO tranches. Each tranche represents a different investment -Stripped mortgage-backed securities: principal and interest of stripped instruments is not allocated to the bondholders on a pro rata basis. offer investors a significantly different price/yield relationship as compared to the traditional mortgage pass-through securities. **two types of stripped MBS are principal-only (PO) and interest-only (IO) strips.
Derivative security
security that's value is derived from the value of another asset (underlying asset) -most portfolio managers use derivatives to hedge their bets most common examples: options and futures contracts
Synthetic Short Position
selling (shorting) a call, and buying a put with a similar strike on the same underlying. -often more desirable than a traditional short position because: 1. the call that was sold should bring the call writer more premium income than is spent to pay for the put's premium. 2. less initial capital commitment 3. does not have to pay cash dividends like you would on shorted stock downfall - could be exposed to unlimited losses
Commercial Paper
short-term unsecured debt issued by large corporations -denominations of $100K or more -maturities of up to 270 days -large institutional investors -terms are non-negotiable -issuer may prepay the note
Stock Splits
splits: add shares based on a ratio, therefore the price per share declines. reverse split: combine shares and therefore raise the price per share *stock splits can signal that the firm's management believes the stock will grow.
Asset Allocation Policies (SAA & TAA)
strategic asset allocation: identifies asset classes and the proportions for those asset classes that would comprise the normal portfolio mix. tactical asset allocation: after SAA, as it involves planning for deviations from normal asset allocation (think one stock is going to do well right now because the market is in dis-equilibrium). Establishes policies to govern dynamic re-allocations of a temporary nature -after these two are complete, market timing or security selection may be integrated.
Normal distributions
symmetrical, bell-shaped distributions used in financial risk management to determine the likelihood of actual returns lying in a particular range, as well as below some predetermined amount in applications such as semi-variance and downside risk
maintenance margin
the investor must keep the accounts equity equal to or greater than a certain percentage of the amount deposited as initial margin. typically 65% of the initial margin
marking to market
the process of adjusting the equity in an investors account in order to reflect the change in the settlement price of the futures contract
Beta
the slope coefficient of the characteristic line. Illustrates how much more or less aggressive an asset is compared to its market. Beta only measures systematic risk, and therefore if an asset's R-squared is low, then Beta and everything that uses Beta would be a meaningless stat. beta * market movement = how much (%) fund is expected to increase) B = 1 asset has same volatility as the market B > 1 asset is more volatile than the returns from the market (aggressive asset) B < 1 asset rate of return is less volatile than the market (defensive asset)
Alpha
the value on the vertical axis where the characteristic line intersects that axis. It represents the residual risk of the asset •alpha > 0, the positive value represents the extra return that an investor is rewarded for taking on risk beyond the market. •alpha < 0, the negative value represents the return that was less than what the market itself performed.
Strangle (Options)
uses a put and a call, typically with the same expiration date, but with different exercise prices. A strangle is a vertical spread that is like a straddle with an exercise price that is "points away," or is different, from the current market price of the underlying security. -A long strangle is a debit transaction because the component options must all be purchased and no premium income from option writing is involved. -Short strangles or reverse strangles are credit transactions that reap premium income without incurring any initial outlays for premiums.
Standard Deviation and Variance
variance or an asset's rate of return is a statistic that measures the asset's wideness. standard deviation squared. it represents the amount of risk associated with an asset Standard deviation = square root of the variance. measures the degree to which the asset may vary from the mean (the expected return) of the probability distribution of returns. The greater the degree of dispersion from the mean (expected return) equals the greater the degree of risk.
