Investments Exam 1

Investment

The commitment of current resources in the expectation of deriving greater return in the future

Real assets

assets used to produce goods and services, can be tangible or intangible. (Human capital, patents, royalties, knowledge)

Financial Assets

claims on real assets or the income generated by them

Asset Allocation

allocation of an investment portfolio across broad asset classes. (stocks, bonds, real estate, commodities)

Security Selection

Choice of securities within each asset class

Most important determinant of portfolio performance

Asset Allocation (70-90% of performance)

Players in financial markets

Firms, households, governments

Firms

Demanders of capital

Households

suppliers of capital

Governments

borrower and lender

Financial Intermediaries

Bring together suppliers of capital (investors) and demanders of capital (corporations and governments). Provide scale & efficiency.

Banks

take deposits from savers and make loans to borrowers

Investment banks

underwrite securities (debt and equity) and sell to investors

Investment Companies

pool and manage the money of many investors

Investment banks, corporate banks, commercial banks, brokerage firms

Sell side

Asset managers, hedge funds, pension funds, retail investors

Buy side

Financial Instruments

- Fixed Income Instruments (debt)

- Money Market

- Bond Market

- Equities

- Derivatives

Money Market Instruments

A sub sector of the bond market,

types of money market securities

1. Tbills

2. CD's

3. Commercial Paper

4. Banker's acceptances

5. Eurodollars

6. Repos and Reverses

7. Brokers' call

8. Federal Funds

9. Libor

money market vs bonds

Money market instruments are ultra-short-term, low-risk cash equivalents, whereas bonds are fixed-income securities representing loans to issuers for longer periods with potential for price appreciation or loss

money market funds risks

Not FDIC insured, can lose money during crisis

Bond market instruments

•Treasury notes and bonds

•TIPS

•Municipal Bonds

•Federal Agency Debt (implicit backing)

•Corporate Bonds

•MBS and ABS

Muni Tax Equivalent Yield

the pre-tax return a taxable bond must earn to match the after-tax return of a tax-free municipal bond

Municipal Bonds

a bond issued by a state or local government, usually to provide funding for a specified purpose. (Interest is usually exempt from federal income tax)

General Obligation

backed by full faith and credit of the issuer. (typically lower risk)

Revenue Bonds

Used to finance a particular project (airport, water system, toll roads), and revenue is paid out based on success of said projects.

Federal Agency Debt

Debt of mortgage-related agencies such as Fannie Mae and Freddie Mac. (Backing is IMPLICIT)

Corporate Bonds

A debt instrument that is issued by a corporation in order to raise capital which have specified collateral backing them (cash flow or assets)

Types of equities

Common stock, preferred stock, depository receipts (ADR)

Common Stock

represents ownership in corporation. Holder gets right to vote on corporate governance matters and share in finance benefits (dividends). Represents a residual claim in the event of liquidation. Limited liability.

Preferred Stock

Equity ownershio with fixed dividends, priority over common stock. Promise to pay holdr fixed stream of income (dividend). Dividend is typically cumulative. Preference over equity holders, but after bond holders in liquidation. No voting power. Attractive to corporations due to tax treatment.

Depository Receipts (ADR)

certificates traded in the U.S. representing ownership in SHARES OF A FOREIGN COMPANY

Primary Market

the market in which new securities are originally sold to investors. The issuer receives proceeds from sale.

Secondary Market

the market in which previously issued securities are traded among investors. Issuing firm doesn't receive proceeds, is not directly involved.

Why companies go public

Raising money to fund expansion of their business &/or monetizing an asset (cashing out)

Initial Public Offering (IPO)

First sale of stock by a formerly private company. Underwriters: purchase securities from issuing company and resell them. Prospectus: description of firm and security being issued.

Direct Listing

Company employees & investors make existing shares immediately available to the public, meaning employees and investors can buy and sell as they wish. That dispenses with the need for banks to market and sell the company's shares.

SPAC (Special Purpose Acquisition Company)

Empty-shell firms that promise to buy

businesses with the proceeds of their initial public stock offerings and turn them profitable to then sell.

Market order

execute immediately at best price

Price-contingent order

buy/sell at specified price or better

limit order

specified price at which investor will buy/sell

stop order

trade is not to be executed unless stock hits a price limit

Bid-Ask Spread

the difference between the bid price and the asked price. Difference is how wall street makes money.

commission

fee paid to broker for executing transaction

buying on margin

use of debt financing in order to magnify investment returns. (Is a way to magnify gains but also losses)

Initial Margin Requirement (IMR)

% of purchase price of securities that can be purchases on margin that the investor must pay for with his own cash or marginable securities. (Current Min. set under Regulation T is 50%)

Maintenance Margin Requirement (MMR)

Minimum amount equity can be before additional funds must be put into account. (40% is typical)

Margin Call

a demand by a broker that an investor deposit further cash or securities to cover possible losses.

Short Sales

the sale of shares not owned by the investor but borrowed through a broker and later purchased to replace the loan

Short sales risks

•potential gain is 100%

• potential loss is theoretically infinite

Short Squeeze

stock price goes up when you buy back at a loss and other people scramble to cover their short position and the stock goes higher

Investment company

Financial intermediaries that pool and invest the funds of individual investors in securities or other assets.

Mutual funds

Most common type of investment company, typically managing a broad array of funds (large cap, small cap, bonds).

Open-End Mutual Fund

a fund for which the supply of shares is not fixed but can increase or decrease daily with purchases and redemptions of shares. (majorirty of mutual funds)

closed-end mutual fund

Fund with a set number of shares to be issued, determined before the fund is ever established. Raises a fixed amount of capital through an IPO, and is then listed and traded like a stock on a stock exchange

Money Market Funds

Mutual funds that invest in short-term, low-risk securities and allow investors to write checks against their accounts. Alternative to bank deposit but are not FDIC insured.

ETFs

offshoots of mutual funds that allow investors to trade index portfolios

Advantages of ETFs

+Efficient diversification

+Traded like a stock

+Better risk management by having options and futures markets

+Investors know the exact composition of the fund throughout the day

+Low expense ratios

+No worry about trading a a premium or discount to NAV

+Dividends can be reinvested immediately

+Low capital gains tax liability

Disadvantages of ETFs

+Few indices for ETFs to track

+Intraday trading might not matter for long-term investors

+Low volume may result in inefficient markets

+Institutions can get same exposure with lower expenses and tax consequences by investing directly in the index

Holding Period Return

rate of return over a given investment period.

•HPR= [PS − PB + CF] / PB

Rates of Return- Multiple Periods

•Geometric returns are FAVORED over arithmetic returns

-compound rate of growth of an investment that actually occurred

-volatility

•Arithmetic averages

-Tend to overstate returns

•Non contiguous periods- low volatility

Investment Risk

The possibility that an investment will fail to pay the expected return or fail to pay a return at all. This is measured by STANDARD DEVIATION

standard deviation

Used to quantify uncertainty. The higher the uncertainty of an outcome measured by SD, the higher the risk

Value at Risk (VaR)

Measure of downside risk. The worst loss that will be suffered with a given probability, often 5%. Measure in DOLLARS

Risk-Free Rate

the rate of return that can be earned with certainty

Risk Premium

an expected return in excess of that on risk-free securities

Excess Return

ACTUAL rate of return in excess of risk-free rate

Historical equity market risk premium

4-7%

The Sharpe (Reward-to-Volatility) Ratio

ratio of portfolio risk premium to standard deviation. (How much excess return did you get per unit of risk)

Systematic Risk

Risk inherent to the entire market or market segment. (interest rates, economic cycle, wars)

Unsystematic Risk

a risk that affects at most a small number of assets. Also, unique or asset-specific risk

Efficient Diversification

Portfolio risk is reduced the most when the returns of 2 assets most reliably offset each other. That is measure with covariance & correlation

3 Rules of 2 Risky Asset Portfolios

1)ROR on a portfolio is the weighted average of returns on components, with investment proportions as weights

2) ERP is the weighted average of expected returns on components, with portfolio proportions as weights

3) The STANDARD DEVIATION of the ROR on a 2 risky asset portfolio is:

Implication of rule 3

-When the correlation between the component securities is small or negative there will be a greater tendency for returns on the assets to offset each other

Impact of correlation on portfolio risk

•+1 perfect POSITIVE correlation

-No reduction in risk

•Positive correlation-

-Risk REDUCED but not ELIMINATED

•Zero Correlation- no linear relationship in return

-Risk reduced but not eliminated

- -1 perfect NEGATIVE correlation

- offsets all variation around the mean return

sharpe ratios and efficient frontier

The Sharpe ratio measures excess return per unit of volatility, and the efficient frontier represents the optimal mix of assets yielding the highest return for a given level of risk, intersecting at the maximum Sharpe ratio known as the tangency portfolio

CAPM

Capital Asset Pricing Model, a linear model that relates risk and return: Re = Rf + Beta(Rm-Rf).

Required Rate of Return

increase in value you should expect to see based on the inherent risk level of the asset

Beta

A measure of the sensitivity of a given investment or portfolio to movements in the overall market.

Mean Reversion

the tendency for stocks that have recently been earning high returns to experience low returns in the future, and vice versa

technical analysis

research on recurrent and predictable stock price patterns and on proxies for buy or sell pressure in the market

Fundamental Analysis

the study of a company's accounting statements and future prospects to determine its value

Quantitative analysis

the application of mathematical and statistical principles to markets and individual stocks

Random Walk Theory

The theory that there are no predictable trends in securities prices that can be used to "get rich quick."

Efficient market hypothesis

argument that stocks are always priced about right, and that bargains are hard to find because they are closely watched by so many investors

Weak-form EMH

Stock prices already reflect all information contained in history of trading

Semistrong-form EMH

the assertion that stock prices already reflect all publicly available information

Strong-form EMH

the assertion that stock prices reflect all relevant information, including inside information

Behavioral Finance

models of financial markets that emphasize potential implications of psychological factors affecting investor behavior

Loss Aversion

the tendency to care more about avoiding losses than about achieving equal-size gains

Framing Bias

the tendency of decision makers to be influenced by the way a situation or problem is presented to them

anchoring bias

a tendency to fixate on initial information, from which one then fails to adequately adjust for subsequent information

endowment effect

the tendency of people to be unwilling to sell a good they already own even if they are offered a price that is greater than the price they would be willing to pay to buy the good if they didn't already own it

confirmation bias

a tendency to search for information that supports our preconceptions and to ignore or distort contradictory evidence

Snake Bite Effect

refers to the unwillingness of investors to take a risk following a loss

Herding

the human tendency to follow the crowd