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Topic 24: Investment Vehicles CDs Money market funds
Money market mutual funds temporarily insured T bills Commercial paper Bankers acceptances
Bank guaranteed notes to assure payment for exports Eurodollars
Dollar denominated deposits Municipal bonds
No federal income tax on interest; cap gains taxed General obligation versus revenue bonds
Treasury STRIPS Separates interest payments and principal payment
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Topic 24: Investment Vehicles TIPS
Principal increased twice a year to reflect CPI All income is ordinary income
Series EE bonds Issued at a discount (half maturity face amount) Rate fixed Income not taxed until redeemed Income never taxed if used for college tuition
Subject to rules to qualify Ginnie Maes
Pool of mortgages guaranteed by U.S. government Freddie Mac/Fannie Mae
Not guaranteed until 09/08; higher rate than Ginnie Mae Risk of falling interest rates will cause mortgage loans to be
repaid early
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Topic 24: Investment Vehicles CMOs
Investors can select tranches of various maturity, risk levels Zero coupon bonds
Pricing Use in retirement accounts
ADRs Foreign stocks trading on U.S. exchange Still have currency risk
Privately/separately managed accounts High minimum to start Actually own stocks, bonds (not mutual funds) More control over tax consequences
Precious metals ETFs versus physical possession
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Topic 24: Investment Vehicles Limited partnerships
Limited partners vs. general partners Privately/separately managed accounts
Own shares of stock rather than mutual funds Removes layer of fees Control timing of sales; taxable gains/losses
GICs: insurance company guarantees rate REITs: own diversified portfolio of real estate
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Topic 24: Investment Vehicles Unit investment trusts:
Typically buy a portfolio of bonds Not actively managed Liquidates over time
Distributions typically return of capital Closed-end mutual funds
Trade on exchange; no additional shares issued Shares sell at premium/discount to underlying value of assets
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Topic 24: Investment Vehicles Mutual funds:
Pool funds from investors to invest in stocks, bonds and/or other types of securities
Each share represents investor’s proportionate interest in portfolio
Priced at the end of trading Advantages
Low minimum investments Automatic investment programs
Diversification Professional management
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Topic 24: Investment Vehicles Open-end mutual funds
Grow by issuing shares Unless fund is closed if it gets too large
Costs Load
Class A: load but lower 12b-1 and annual expenses Class B: no front-end load but higher annual expenses Class C: lower load than Class A or B
No load Deferred sales charges
Holding of funds Management fees
Equities: 1 – 1.5%; bonds .5%, for example 12b-1 fees: brokers, advertising Portfolio turnover: commissions
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Topic 24: Investment Vehicles Open-end mutual funds
Distributions of realized capital gains Generally in December Reinvest
Closed-end mutual funds Trade on exchange; no additional shares issued
Traditional open-end mutual funds grow by issuing shares Unit investment trusts:
Portfolio of bonds; not actively managed REITs: own diversified portfolio of real estate Privately/separately managed accounts
Own shares of stock rather than mutual funds Removes layer of fees Control timing of sales; taxable gains/losses
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Topic 24: Investment Vehicles Corporate bonds
Debenture Convertible: income and growth Callable Yankee: issued by foreign banks in U.S. $
ETFs Match performance of index: S&P 500, GSCI
Diversification or specific industry Can be traded like stocks: limit order; short
Features not available with traditional mutual funds Hedge funds
Short/long; leveraged; principal protected notes High fees: 2 and 20. 2% fee plus 20% profits Low correlation with equities?
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Topic 24: Investment Vehicles Puts
Right to sell at exercise price
Calls Right to buy at exercise price
Collar Buy put; sell call
LEAPs: long-term options Warrants: right to buy additional shares
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Topic 25: Investment Risk Systematic: can’t diversify away Purchasing power: inflation; fixed income assets Interest rate: bonds; equities Unsystematic: can diversify away
Business: typewriters Financial: GM Liquidity: banks Marketability: 10,000 shares First-Mid Reinvestment: bonds
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Topic 25: Investment Risk Political: Nigeria Exchange rate: international equities
Calculating return on foreign investments Impact of rising/falling dollar (Ending value in dollars – beginning value in
dollars) / beginning value in dollars Tax: increase in capital gains tax rates Investment manager: change/style drift
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Topic 27: Quantitative Investment Concepts
Standard deviation: one: 68%; two: 95% Mean return 11%, how often fall in range of 8 – 14% if standard
deviation 3%? Computing standard deviation
Skewness: tails aren’t symmetrical Correlation coefficient:
1, 0, -1 R2:extent portfolio return explained by market return
.90 means only 10% of portfolio return not due to market (<.7 indicates lack of diversification)
Coefficient of Variation: Standard deviation/average return Measures risk to reward Same in efficient market?
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Topic 27: Quantitative Investment Concepts
Beta: measures systematic risk. 1.0; 0; -1.0 Portfolio beta
Covariance: impact of security on portfolio’s risk Portfolio standard deviation: not weighted average
Semivariance: measures downside risk
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Topic 27: Investment Returns Arithmetic average: sum/n Geometric mean:
Less than arithmetic as it factors in compounding Time weighted: evaluate portfolio manager
Ignores cash flows in/out of portfolio by investors Includes capital gains, and dividends received by portfolio Geometric average
Dollar weighted: evaluate investor’s performance Factors cash flows in/out of portfolio IRR calculation
Underperformance by mutual fund investors More frequent/pronounced in volatile funds
Holding period:
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Topic 27: Investment Returns
Real return= Nominal return – Inflation rate Nominal 13% Inflation 3%
I = ((1+Nominal)/(1+Inflation))-1
Internal Rate of Return Present value of -0- If IRR>required return, present value positive Assumes cash flows reinvested at IRR Favors projects generating cash flows early
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Topic 27: Investment Returns Total return:(capital gain + dividend)/investment YTM: return on bonds
Compute using semi-annual periods for zero coupon bonds Yield to call: assumes bond is called in YTM calculation Current yield: annual income/current price
After-tax: dividends currently taxed at 15% Taxable equivalent yield (munis):
tax-free yield/(1- tax rate) After-tax rate of return:
Taxable return x (1 – tax rate)
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Topic 28: Asset Allocation Strategic asset allocation: asset class is most
important decision. Stocks vs. bonds; not Google vs. Intel Life cycle: older investors should take less risk? Risk tolerance: loss felt more than gain?
Rebalancing: sell winners and buy more losers How often?
Tactical asset allocation: search for undervalued assets
Concentrated portfolios: Recipe for success; collars
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Topic 28: Asset Allocation Dynamic hedging strategy:
Move between risky assets and T bills
Correlations 1.0 vs. 0.0 vs -1.0 Stocks and bonds? Moderately low per book
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Topic 29: Bond and Stock Valuation
Stocks: Value = PV of cash investor expects to receive Dividend growth model
No growth: Price = Dividend/Required Return Same as preferred stock valuation
Constant: Price = D1/Required Return – Growth Rate Multiple: Price = PV of Dividends
P/E ratio: high versus low PEG: high versus low Book value: Assets – Liabilities / Number of Shares
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Topic 29: Bond and Stock Valuation Bonds:
Bond duration: time to receive PV of securities cash flows Lower duration: > coupon rate; < maturity Always < maturity except zeros
Modified duration: Measures impact of change in interest rates on bond price
Duration of portfolio is weighted average of component’s duration
Reinvestment risk Interest rate risk
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Topic 29: Asset Pricing CAPM
CML: slope is reward to risk ratio for market (stan dev) SML: slope is reward to risk ratio for one stock (beta)
Arbitrage Pricing Theory: Gold prices in London versus New York
Black Scholes: pricing options Calls:
Stock price increases; option price increases Strike price increases; option price decreases Expiration time increases; option price increases Stock volatility increases; option price increases Risk free rate increases; option price increases
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Topic 30: Portfolio Development Modern Portfolio Theory
Create portfolio with highest expected return for acceptable level of risk Efficient frontier: highest return given risk level
Inside frontier: inefficient. Return too low for level of risk
Outside frontier: can’t obtain desired return while only taking desired level of risk
Multidimensional diversification Diversify across asset classes; not within Selection of asset class determines majority of return
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Topic 30: Portfolio Development Capital Market Line: Investor’s required return =
Risk free + Portfolio Stan Dev x (Market Ret – Risk Free) / Stan Dev Mkt
Formula provided Uses standard dev: includes systematic/unsystematic
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Topic 30: Portfolio Development Security Market Line: Investor’s required return =
Risk free + (Market Ret – Risk Free) x Beta Formula provided Uses beta so only measures systematic risk
Beta: Changes over time May not have predictive value
If market risk increases, value of all assets would fall Reward for risk: spread between returns for AAA corporate bonds
and junk bonds
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Topic 30: Portfolio Development Efficient Market Hypothesis
Strong form Prices reflect public and insider info
Unable to outperform market All assets fairly priced reflecting all known info Index
Semi strong Prices reflect public info
Weak Prices reflect price/volume data Technical analysis has no value
But fundamental analysis can improve returns
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Topic 30: Portfolio Development Market Anomalies
Strategy that seems to outperform market Low P/E ratios Small cap stocks January effect Value Line: 1 recommendations
Behavioral finance Investors are not rational
Loss avoidance Desire to break even Automatic 401(k) enrollment
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Topic 30: Portfolio Analysis Fundamental Analysis
Emphasis on financial statement trends Top-Down
Start with economic conditions impacting entire market Bottom-Up
Look for companies with attractive characteristics Ratio analysis
Liquidity: acid-test, current Activity: inventory turnover (sales/inv); A/R turnover
(sales/A/R) Profitability: ROE, ROA Solvency: debt to equity; debt to assets
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Topic 30: Portfolio Analysis Technical Analysis
Past movement of security prices predict future Breaking through 50 day moving average Dow Theory: Transports confirm Industrials
Overall market Dow Transports confirms move in Dow Industrials Barron’s confidence index: spread between junk and
investment grade corporate debt Odd-lot: contrarian
Specific securities Moving average Put/call: contrarian Short-interest: future buyers
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Topic 30: Portfolio Analysis Investment policy statement
Guidelines for selecting portfolio assets Appropriate levels of risk; bond duration, etc.
Benchmarks Comparable to portfolio’s objective/risk S&P 500; Wilshire 5000; EAFE
Monte Carlo Simulations generally using past price movements
Probability of outliving portfolio
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Topic 30: Portfolio Analysis Tax Issues
Turnover Short-term capital gains; commissions Index funds: little turnover Mutual fund distributions
Wash sales: sale of security at loss Can’t repurchase 30 days before/after sale
Dividends: currently taxed as capital gains if hold stock 60 days REITs not eligible
Tax-free income State and muni interest not taxed on federal Treasury interest not taxed on state
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Topic 30: Portfolio Analysis Performance measures
Sharpe: (portfolio return – risk free) / portfolio stan dev More appropriate if R2 <.7, not diversified
If R2 = 1, portfolio is diversified Stan dev measures variability versus mean of stock More appropriate for one stock than Treynor
Have unsystematic risk Treynor: (portfolio return – risk free) / portfolio beta
More appropriate if R2 >.7 Topic 40, P. 18 Beta measures volatility versus mean of market
Jensen: Alpha = Realized Return – SML Excess return generated without taking additional risk
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Topic 31: Investment Strategies Strategic asset allocation: return determined by asset class
selected Tactical asset allocation: buy undervalued assets and sell
overvalued Market Timing: active; typically technical Passive: index. Efficient markets.
Core and satellite. Indexes:
Stock: S&P 500; Russell 5000; MS EAFE
Buy/hold: markets are efficient. Contrarian: run up the stairs in World Trade Center Bond swaps: take advantage of “mispriced bonds”
GMAC: junk bond status Collars: sell call and buy put
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Topic 31: Investment Strategies Dollar cost averaging: same amount every month. Makes sense.
Academics: it doesn’t. DRIPs: reinvest dividends.
Compounding Taxable
Bond ladders: bonds have different maturities Less interest rate risk over time longer than investment
horizon Bond bullets: noncallable; will have lower coupon Bond barbells: buy short-term and long-term bonds. Active
management required. Immunization: match weighted average duration of portfolio with
cash needs
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Topic 31: Investment Strategies Margin trading
Initial margin: can only borrow 50% of initial purchase Maintenance margin: (FMV – Debt)/FMV
Must be at least 25% 100 shares at $40 = $4,000. Borrow $2,000. Maintenance 25%.
What price margin call? Price= (1-Initial Margin %)/(1-Maint Margin %) x
Initial Price P = (1-50%)/1-25%) x $40
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Topic 31: Investment Strategies Margin trading
Amount of margin call if price falls to $22? Current Value of Stock x Maint Margin % = Equity Needed $2,200 x 25% = $550 Present Equity = $2,200 Current Value - $2,000 Debt = $200 Margin Call = $550 - $200 =$350
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Topic 31: Investment Strategies Short selling: sell borrowed stock; buy back at lower price
Uptick rule eliminated June 2007 Reinstated for financial stocks during 2008
Stock owner gets dividends Must have margin account; broker determines
maintenance margin
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Topic 31: Investment Strategies
Hedging: protect against price moves in assets own. Buy a $3.50 put on December corn.
Options Puts: buy and sell
Naked Calls: buy and sell
Covered Topic 41, Problems 25 and 32
LEAPS: as long as three years
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Topic 31: Investment Strategies
Straddle: buy put/call on same stock at same strike price Anticipate big move either way
Collar: sell call, buy put Concentrated positions
Spread: Buy and sell a call at different prices or expirations
Taxation of options Buy call, exercise: add to basis Buy call, expires: short-term capital loss Sell call, exercised: add to proceeds Sell call, expires: short-term capital gain