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

Investment Planning Flashcards

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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
Random Walk
Stock Movement is utterly unpredictable and lacks any pattern that can be exploited by an investor
26
Efficient Frontier
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
27
Sharpe Ratio
Measures Risk adjusted performance of portfolio in terms of standard deviation Only use if R^2 < .70 comparative value
28
Sharpe Ratio Formula
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
29
Treynor Ratio
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
Treynor Ratio Formula
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
Capital Asset Pricing Model (CAPM)
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
Capital Asset Pricing Model Formula
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
Jensen Performance index (alpha)
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
Jensen Performance index Formula
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
The Yield Curve
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
Valuation of Bonds
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
Calculating Valuation of Bonds
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
Bond and Yield Pricing
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
Duration
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
Change in Bond Prices
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
Margin Call (federal Minimums)
Initial margin requirements = 50% minimum maintenance requirements = 25% Broker can be more restrictive but not less
42
Margin Call Price Formula
(1-initial margin %)/(1-maintence margin %) * initial purchase price
43
Stock Options "Players"
Buyer- aka the holder or the long Seller- aka the writer or the short
44
Buyer of Options: Call Contracts
The right to purchase shares at a specific price before a specific date
45
Options: Buyer of put contracts
The right to sell shares at a specific price
46
Options: Premium
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
Options Clearing Corporation's (OCC) Job
Guarantees the performance of both parties eliminates counterparty risk
48
Options Grid Buy Sell Call Put
Buy Sell Call Bull Bear (Going up) (going down) Put Bear Bull (going down) (going up)
49
2 Variables make up options premiums
Intrinsic Value Time Premium Neither can even be less than 0
50
Stock Options: Intrinsic Value Variable
Market Price of the Stock Exercise price of option contract
51
Stock Option: Time Premium Variables
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
Intrinsic Value formula for call options
COME Call Option = Market value - Exercise price
53
Intrinsic Value Formula for Put Options
POEM Put Option = Exercise price - Market value
54
Covered call writing
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
Naked Call writing
Does not own the underlying stock writer bears unlimited risk
56
Protective put
Long the Stock- Long the put This is the essence of portfolio insurance
57
Protective call
Short the stock- Long the call Used to protect a short position in the stock
58
Covered Put
Short the Stock - Short the Put Writer uses the sock put to cover their short position
59
Collar (zero cost collar)
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
Straddle
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
Spread
Involves purchasing and selling the same type of contract Benefits from stability
62
Futures contracts
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
Spot Price
What the current market value of the item is in today's market
64
Futures hedging, long and short
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
Short Hedge: Futures contracts
If you are long you need a short hedge selling a futures contract establishes a short hedge
66
Long Hedge: Futures contracts
Anyone who is short needs a long hedge Buying a futures contract establishes a long hedge
67
Futures vs. Forwards contracts
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
Net Present Value (NPV) vs. Internal Rate of Return (IRR)
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
Wash Sale Time Period
61 days 30 days before the sale the day of the sale 30 days after the sale
70
Wash Sale; where do losses go?
Losses are added to basis and will be allowed when underlying stock is sold and not repurchased
71
Wash Sale; common triggers
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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