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CFP Exam Prep (July 2023) > Investment Planning > Flashcards

Investment Planning Flashcards

1
Q

Financial Markets

A

Provide for the exchange of capital and credit in the economy

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2
Q

Money Markets

A

Concentrate on short term debt instruments

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3
Q

Capital Markets

A

Trade in long term debt and equity instruments
Include Stock market, bond market, commodities and foreign exchange

2 types- primary and secondary

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4
Q

Primary Capital Markets

A

New Securities issued and sold for the first time
Registered with the SEC and sold through IPO
Issuing firm receives proceeds
Regulated through Securities Act of 1933

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5
Q

Secondary Capital Market

A

Where previously issued securities trade among investors
Issuing company is not directly involved

2 forms- Organized - i.e. NYSE
Over the counter - NASDAQ

Regulated by Securities Act of 1934 (this also created the SEC)

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6
Q

Holding Period Return Formula

A

HPR=(Pe-Pb +D)/Pb or Profit/cost

Pe= Ending Value
Pb= Initial Value
D= income generated or lost. Includes dividends call/put premiums, and loses for margin interest

Not time indexed and assumes dividends were not reinvested

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7
Q

Time Weighted Returns (TWRR)

A

Global standard for fund performance

Based solely on the appreciation or depreciation of the portfolio from period to period

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8
Q

Dollar Weighted Return (DWRR)

A

Appropriate for a specific client with their own particular cash flows
accounts for when (and at what price level) investments are made and when withdrawals occur

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9
Q

Investment Risk

A

Experiencing an outcome different than the outcome that was expected
Total risk = systemic risk + Unsystemic risk
measured by standard deviation

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10
Q

Systemic Risk

A

Can not be eliminated through diversification
PRIME
Purchasing power
Reinvestment
Interest rate
Market
Exchange rate

Quantified by the β (beta) statistic

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11
Q

Unsystemic Risk

A

Can be eliminated through diversification
Also called specific risk
Business
Financial
Default or credit
Regulatory
Sovereignty

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12
Q

Risk and Return

A

The Greater the expected risk, the greater the expected return

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13
Q

Risk

A

Realizing an outcome different than then expected outcome
Measured by standard deviation
The greater the Standard deviation, the greater the variance around the expected return
Investments with greater standard deviation require a greater expected return

Investors are paid for Risk

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14
Q

Investment Options - Low to High Risk

A

Treasury Bills (T-Bills)
CDs
Government Bonds
Corporate Bonds
Preferred Stock
Common Stock
Options & Futures

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15
Q

Factors that Influence Risk Capacity

A

Time Horizon
Liquidity Needs
Total Investable Assets

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16
Q

Distribution Curve

A

A Normal distribution curve is used in probability analysis of expected returns around an average return

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17
Q

Standard Deviation and Variance

A

+/- 1 = 68%
+/- 2 = 95%
+/- 3 = 99%

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18
Q

Skewness

A

The extent to which a distribution curve is not symmetrical
- positively skewed distributions have many outliers in the upper (right tail)
Negatively skewed distributions have many outliers in the lower (left tail)

Stock Market tends to be positively skewed

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19
Q

Kurtosis

A

When a distribution is more or less peaked that a normal distribution

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20
Q

Mesokurtic

A

Normal distribution (peakedness)

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21
Q

Leptokurtic

A

More Peaked than noramal

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22
Q

Platykurtic

A

Less peaked than normal

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23
Q

Efficient Market Theory (EMT)

A

Stock Markets are efficient and therefore all stock prices reflect all relevant information and are priced in equilibrium
3 forms- strong, semi strong, weak
strong- always true
semi strong- always true except insider information
Weak- insider information and fundamental analysis can beat markets

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24
Q

Anomalies that EMT does not explain

A

Low P/E effect
Small Firm Effect
Neglected Firm Effect
January Effect
Value Line Effect

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25
Q

Random Walk

A

Stock Movement is utterly unpredictable and lacks any pattern that can be exploited by an investor

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26
Q

Efficient Frontier

A

Identifies optimal amount of return given a unit of risk
uses standard deviation to measure risk
below curve is inefficient
above curve is impossible
curve is plotted based on risk tolerance
risk adverse clients have a steep curve
Risk tolerant have a flat curve

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27
Q

Sharpe Ratio

A

Measures Risk adjusted performance of portfolio in terms of standard deviation
Only use if R^2 < .70
comparative value

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28
Q

Sharpe Ratio Formula

A

Sp= (Rp-Rf)/σp
Sp- Sharpe Ratio
Rp- Return of the portfolio
Rf- Risk free rate of return
σp- standard deviation of the portfolio being measured

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29
Q

Treynor Ratio

A

Measures risk adjusted performance of a portfolio manager
Only use if R^2 > .7
Comparative to similar investments
Higher Treynor = higher risk adjusted return

30
Q

Treynor Ratio Formula

A

Tp = (Rp-Rf)/βp

Tp=Trenor ratio
Rp- return of the portfolio
Rf= Risk free rate of return
βp= Beta of the portfolio being measured

31
Q

Capital Asset Pricing Model (CAPM)

A

Foudation for all other modern portfolio theory (MPT)
Quantify expected returns given market returns and a beta to the market
used to plot security market line (sml)
Alpha = actual return - CAPM

32
Q

Capital Asset Pricing Model Formula

A

Ri = Rf+ (Rm-Rf)βi

Ri= expected return of invesment
Rf= Risk free rate of return
Rm = expected return for the market
βi= beta of the investment

(Rm-Rf) = also called the market risk premium
(Rm-Rf)βi = also called stock premium

33
Q

Jensen Performance index (alpha)

A

A measure used to evaluate the benefit of a portfolio manager
quantifies risk adjusted rate of return
R^2 > .70
Alpha is an absolute value
α > 0 - good, better then expected performance
α < 0 - bad, worse than expected performance
α = 0 - Good, Expected performance

34
Q

Jensen Performance index Formula

A

αp = Rp - [Rf+(Rm-Rf)βp]

αp- Jensen
Rp- Return of the portfolio
Rf- Risk free rate of return
Rm- Return of the market
βp - beta of the portfolio

35
Q

The Yield Curve

A

Under normal circumstances the short term rates are lower than the long term rates
Inversion in the yield curve indicates a looming recession
Depends on business cycle and Fed Policy
Fed Policy has a larger effect on short term rates
Anticipated economic conditions have larger impact on long term rates

36
Q

Valuation of Bonds

A

Valuation is a function of
The bonds coupon payment
the market rate of interest for comparable bond
amount of time remaining to maturity
maturity value (assume $1,000 unless stated otherwise)

37
Q

Calculating Valuation of Bonds

A

PMT- Coupon Payment
i- Market Rate of interest
n- Time Remaining (assume semi annual payments)
FV- Maturity Value
PV (solve) - Present value of bond

38
Q

Bond and Yield Pricing

A

Normal Yield- Stated yield of coupon yield
Current Yield - the annual income paid divided by current market bond price
Yield to maturity and yield to call can be calculated - yield to worst is the lower of the two

39
Q

Duration

A

Always in years
The weighted average of the present value of the future cash flows of a bond portfolio
the time to recoup your money or a bond investment

40
Q

Change in Bond Prices

A

Inverse relationship between interest rates and bond prices.
as rates decrease bond prices increase
as rates increase bond prices decrease
longer duration and lower coupon lead to more sensitivity to rate changes
shorter duration and higher coupon lead to less sensitivity in rate changes

41
Q

Margin Call (federal Minimums)

A

Initial margin requirements = 50%
minimum maintenance requirements = 25%

Broker can be more restrictive but not less

42
Q

Margin Call Price Formula

A

(1-initial margin %)/(1-maintence margin %) * initial purchase price

43
Q

Stock Options “Players”

A

Buyer- aka the holder or the long

Seller- aka the writer or the short

44
Q

Buyer of Options: Call Contracts

A

The right to purchase shares at a specific price before a specific date

45
Q

Options: Buyer of put contracts

A

The right to sell shares at a specific price

46
Q

Options: Premium

A

The dollars/share the buyer pays to enter the contract
Represents the maximum the seller can make and the maximum the buyer can lose

47
Q

Options Clearing Corporation’s (OCC) Job

A

Guarantees the performance of both parties

eliminates counterparty risk

48
Q

Options Grid
Buy Sell
Call

Put

A

Buy Sell

Call Bull Bear
(Going up) (going down)

Put Bear Bull
(going down) (going up)

49
Q

2 Variables make up options premiums

A

Intrinsic Value
Time Premium

Neither can even be less than 0

50
Q

Stock Options: Intrinsic Value Variable

A

Market Price of the Stock
Exercise price of option contract

51
Q

Stock Option: Time Premium Variables

A

Risk free rate of return
Time till expiration
Variability of stock (as measured by standard deviation)

It is greatest at creation and then declines

52
Q

Intrinsic Value formula for call options

A

COME
Call Option = Market value - Exercise price

53
Q

Intrinsic Value Formula for Put Options

A

POEM

Put Option = Exercise price - Market value

54
Q

Covered call writing

A

Long the underlying stock- Short the call

Only considered covered if you own enough shares to cover all contracts sold

Used to generate income for a portfolio

55
Q

Naked Call writing

A

Does not own the underlying stock
writer bears unlimited risk

56
Q

Protective put

A

Long the Stock- Long the put

This is the essence of portfolio insurance

57
Q

Protective call

A

Short the stock- Long the call

Used to protect a short position in the stock

58
Q

Covered Put

A

Short the Stock - Short the Put

Writer uses the sock put to cover their short position

59
Q

Collar (zero cost collar)

A

Long the stock - Long the Put - short the call

The put is used to protect against a stock price decrease and the call premium is used to offset the cost of the put

60
Q

Straddle

A

Long a put and a call on the stock with the same expiration date and strike price

Used to capitalize on volatility regardless of direction

61
Q

Spread

A

Involves purchasing and selling the same type of contract
Benefits from stability

62
Q

Futures contracts

A

An Agreement to buy or sell a specific amount of a commodity. currency, or financial instrument at a particular price on a stipulated future date

63
Q

Spot Price

A

What the current market value of the item is in today’s market

64
Q

Futures hedging, long and short

A

Long position- anyone who owns something (farmer growing corn is long corn)

Short position - Anyone who has to buy something is said to be short (a construction company that needs to build is short lumber)

65
Q

Short Hedge: Futures contracts

A

If you are long you need a short hedge
selling a futures contract establishes a short hedge

66
Q

Long Hedge: Futures contracts

A

Anyone who is short needs a long hedge

Buying a futures contract establishes a long hedge

67
Q

Futures vs. Forwards contracts

A

Futures are standardized and go through a clearing house (no counterparty risk)

Forwards can take any form the parties agree to (not standardized) and do not go through a clearing house (carry counterparty risk)

68
Q

Net Present Value (NPV) vs. Internal Rate of Return (IRR)

A

NPV- Present value of cash flow, absolute sum, and can be used where there are cash flow changes
Positive of 0 NPV = accept the project

IRR- Discount rate (5) that makes NPV of cash flow to zero, relative measure, can not be used for changing cash flows.
Accept project when IRR exceeds the required rate of return

69
Q

Wash Sale Time Period

A

61 days

30 days before the sale
the day of the sale
30 days after the sale

70
Q

Wash Sale; where do losses go?

A

Losses are added to basis and will be allowed when underlying stock is sold and not repurchased

71
Q

Wash Sale; common triggers

A

Convertible Bonds for the same stock

purchasing a call option that can be exercised into the same stock that was sold for a loss

CFP Exam Prep (July 2023) (6 decks)

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