Investment Planning

Conservative Allocation

3-5 years, 50% fixed income 30% cash, 15% large-cap, 5% international

Moderately Conservative Allocation

5 years, 50% fixed income, 25% large cap, 10% international, 10% cash, 5% small cap

Moderate Allocation

10 years; 35% large cap, 35% fixed income, 15% international, 10% small cap, 5% cash

Moderately Aggressive

>10 years; 45% large cap, 20% international; 15% fixed income; 15% small cap; 5% cash

Aggressive

15+ years; 50% large cap, 25% small cap, 20% international, 5% cash

St Dev Buckets

68% +- 1 st Dev, 95% 2, 99% 3

Skewed right, positively skewed

Most values to left, outliers to right

Kurtosis

How prone data is to producing outliers

Mesokurtic

Normal Distribution

Leptokurtic

Slender; more extreme values because most crowded around average

Platykurtic

Broad; less extreme values

EMT efficient market theory forms

Strong, semi-strong, Weak

Do anomalies disprove the EMT

No

Sharpe Ratio

Measures risk adjusted performance in terms of st dev.

Sharpe ratio formula

(Rport - Rrf) / St Dev

Ratio when R² < 0.7

Sharpe Ratio (correlation with stock market less so can’t use Beta)

Traynor Ratio

Sharpe but with Beta instead of St Dev

CAPM pricing model

Quantify expected return given market return and beta; quantify investors required rate of return; plot the Security Market Line (SML)

CAPM formula

Ri = Rf + (Rm - Rf)*Beta

Market risk premium

Rm - Rf

Stock Premium

(Rm - Rf) * Beta

Jensen’s performance Index (alpha)

Evaluate benefit of portfolio manager

jensen’s portfolio index (alpha) formula

Alpha = Rportfolio - CAPM formula

When/how to use Alpha

R² is 0.7 or higher; it is a plot above or below SML line

Money markets

Exchange of short-term debt instruments

Capital Markets

Long-term debt and equity instruments

Primary Market

IPOs, issuing firm receives proceeds, Securities act of 1933

Secondary Market

Organized exchange (NYSE), OTC market, Securities act of 1934

Holding period return

Ending price - Beg Price + Dividends / Beg price

Time-weighted-return

Geometric. 1.02 × 0.98 ^ (1/2). TVM use initial price purchased, then average price sold for, solve for I

Dollar-weighted-return

For specific client cash flows. IRR of cash flows

Systematic Risk

CANNOT be eliminated through diversification

PRIME for systematic risk

Purchasing power risk

Reinvestment Risk

Interest Rate risk

Market Risk

Exchange Rate Risk

Unsystematic risk / firm-specific

Business Risk, financial risk, default risk, regulation risk, sovereignty risk

The yield curve

Plots rates of fixed income securities from short-term to 30-year ones. Typically upward sloping

Downward sloping yield curve

Sign of looming recession, anticipate rate cuts

Bond PV Calculations

Assume $1,000 FV and semi annual compounding (divide by 2)

Nominal yield

Coupon yield

Current yield

Annual income / market price

Bond duration

Time to recoup money on a bond investment, in years.

For coupon bonds, always shorter than maturity. For zero-coupon, duration=maturity.

YTW

Yield to worst (lower of YTM & YTC). Use this when available

Duration other feature

Measures sensitivity to rate changes.

1% change in rates results in a duration% change in PV

Do you want a higher or lower duration in a high interest rate environment?

Higher, more sensitive to price increase as rates drop

Longer duration, lower coupon

More sensitive to rate changes

Duration overestimate or underestimate sensitivity

Overestimate, is too linear

Convexity

More complex indicator of price but accurate

Change in bond price formula

-D x (change in yield / 1 + yield)

Multi-stage dividend discount model

Enter first few years dividends as cash flows. Then, find the annuitized value with D*g / (r-g). Add that to the prior year’s CF value

Minimum fed stock initial margin req

50%

Minimum fed maintenance margin req

25%

Margin Call Price

1 - IM / 1- MM x initial Purchase price (add portion of commission)
This makes a demand for more cash/equity to be deposited

Initial margin %

Initial cash that must be fronted

Maintenance margin requirement

Minimum equity in margin acct after using margin

Margin holding period return

(Sale - purchase price - interest on margin) / Initial cash up front

Option premium

Price per share paid to seller for contract. Maximum possible loss for buyer, maximum possible gain for seller

# of shares in options contract

100

What corp guarantees performance of both parties in options contract

Options Clearing Corporation (OCC)

Option premium intrinsic value

Can never be < 0

Covered call

If you own enough shares to cover all contracts and sell calls

Naked call

Do not own enough shares to cover all contracts and sell calls, bear unlimited risk

protective put

Buying a put against owned stock to insure against downside risk

Protective call

Short stock and buy a call to protect against a price surge

Covered put

Short stock and sell puts. Neutral to moderately bearish

Collar

Long the stock - long the put - short the call. Put protects against stock decrease and call premium offsets cost of put.

Straddle

Long a put and call, everything the same. Capitalizes on any volatility

Spread

Purchasing and selling same contract type, benefits from stability

Futures contract

Agreement to buy or sell something on stipulated future date

Spot price

Current FMV of item for futures contract

Short hedge

Anyone who is long needs a short hedge like selling a futures contract

Long hedge

Anyone who is short needs a long hedge like buying a futures contract

Forward

Independent futures contracts not executed through a clearinghouse