TVM & Fixed Income

Question 1

Effective Annual Interest rate (EFF%)

Answer 1

Is the nominal annual interest rate compounded annually

((1 + nominal annual interest rate / number of compounding periods)) number of compounding periods -1

Question 2

Net Present Value (NPV) of an investment

Answer 2

• Is calculated as the PV of cash outflows & cash inflows associated with an investment, using the investor’s required rate of return as the discount rate.
• It is especially useful in comparing investments that generate diff. cash flows patterns.
• If the NPV of an investment using the investor’s required rate of return is zero or greater, the investment is acceptable.
• The cash flows away from an investor are entered as a negative number, while cash flows towards the investor are entered as a positive number.

Question 3

Internal Rate of Return (IRR)

Answer 3

Is the discount rate at which the PV of a stream of regular or uneven future cash flows of an investment is equal to the cost of that investment.

Question 4

Instalment sale

Answer 4

• Is a sale where the vendor owner will receive the proceeds in instalments over a number of years.
• The vendor may claim a capital gains reserve that allows him to defer within limits, reporting a portion of the CG to the year in which he receives the proceeds.
• The max. reserve period is generally limited to 5 years. However, the max. reserve period is 10years for transfers of farming & fishing property to a child/grandchild.

Question 5

Inter Vivos Trust

Answer 5

• Is a trust that the settlor established while still alive.
• A settlor normally creates an inter vivos trust by a trust deed.
• Once an IV Trust is established, it continues to be an IV Trust for tax purposes even after the death of the settlor.
• Any income attributed to an inter vivos trust is taxes at the top, combined federal & provincial income tax rate. This rate varies from province to province. This severely limits the usefulness of IV trusts as an income splitting tool!

Question 6

Alter Ego Trust

Answer 6

• Is an Inter vivos trust where the trust deed specifies that:
  > the settlor of the trust must be entitled to receive all of the income that the trust earns prior to her death;
  > the settlor must be at least 65 yrs old at the time he creates the trust and
  > the only individual who has any access to the trust capital during the settlor’s lifetime is the settlor!

An individual can transfer capital prop. to an alter ego trust without the trf. being considered a disposition for tax purposes.

Question 7

Joint Tenancy

Answer 7

Is a form of ownership in which all co-owners have an equal right to possess and use the whole property, along with the right to dispose of their ownership interests in any way that they see fit during their lifetimes.

Question 8

Right of Survivorship

Answer 8

• Is a right of joint tenants, such that if one of the joint tenants dies, her ownership interest automatically passes to her surviving co-tenants in equal shares.
• She is not able to bequeath her interest to anyone else through her will.
• To avoid a deemed disposition, the registration of joint tenancy must be accompanied by an agreement that denies the new co-tenant a beneficial interest in the property. If such an agreement, is included CRA should consider that NO disposition has taken place for tax purposes.

Question 9

Principal Residence Exemption

Answer 9

• Is a deduction permitted from a capital gain on a principal residence that the owner designated for a particular yr of ownership.
• A taxpayer would designate the property with the highest present value of the annualized deferred income tax.

Question 10

Canada Savings Bonds (CSBs)

Answer 10

• They can be cashed at any time and generally pay a higher rate of interest than bank savings accts. & other low risk investments.
• the bonds pay interest at the end of each month.
• CSBs cannot be sold in the secondary market and are always redeemable for their full face value and hence, not subject to price fluctuations.
• CSBs cashed before 90days fm the date of issue pay no interest to the holder and only the face value of the bond is returned.
• Ownership cannot be transferred, but the bonds may be used as a collateral for a loan.
• Furthermore, only “C” or compound CSBs are available for purchase through a monthly installment or payroll savings plan.

Question 11

T-Bill

Answer 11

• Is a money market instrument that is issued by a federal or provincial government.
• They are sold at a discount to face value, mature at face value and are fully guaranteed by the govt., so they are free of default risk.
• New T-bills are issued every two weeks, with terms ranging from 31 to 364 days.
• Investment dealers purchase the T-bills from the govt. and sell them through the secondary market, and are highly liquid.
• While t-bills are s/t inflation risk & interest rate risk, their exposure to default risk is minimal bcoz they are guaranteed by the issuer, the Govt. of Cda or a provincial govt.
• If held to maturity, the diff. between the face value and the purchase amt. is considered interest income and NOT a capital gain.
• The investor can ONLY realize a CG or CL if he sells the t-bill before maturity and interest rates have changed since he purchased the T-Bill.

Question 12

Risk Premium

Answer 12

• Is the added return over risk-free investments that an investor demands to compensate the investor for taking the added risk involved in the riskier investment.
• the risk premium is calculated as:
  ( return on risky investment - return on risk free investment)

Question 13

There are two types of investment returns to consider when dealing with T-Bills. The nominal annual interest rate or annual yield (NOM%) and the effective annual return (EFF%)

Answer 13

NOM% - represents the quoted rate of interest on an investment, without adjusting for the number of compounding periods.

The NOM% - on a T-bills is calculated as:
(((par value – price) / price x (365/term)).

The EFF% - is the nominal annual interest rate compounded annually.

It represents the rate of interest adjusted for the compounding periods and the reinvestment effects of that money in particular.

Question 14

Selling a T Bill before maturity?

Answer 14

Will result in a capital gain or capital loss, depending on thechange in interest rates over the term of the T-Bill.

• The capital gain or capital loss is the change in the fair market value of the T-bill due to change in interest rates, NOT the change in value due to time remaining until maturity.
• Interest rates on T-bills are given as nominal interest rate or a quoted yield.
• The calculation of FMV with nominal interest rates uses time value of money.

Question 15

To calculate the FMV of a T-Bill at a specific quoted yield and time is calculated as:

Answer 15

The calculation of FMV with quoted yield uses an algebraic formula,

> FMV = (Par Value / (1 + (Quoted Yield x (Term / 365))))
where:

quoted yield = the prevailing interest rate at time of sale; and

term = the number of days until maturity

Question 16

Purchasing a foreign T-bill

Answer 16

• He / she is purchasing an investment that is denominated in foreign dollars.
• As such, the investment is subject to exchange rate risk, in addition to the other risks involved.
• This exposure to exchange rate risk can result in capital gains or capital loss.
• The interest on a US$ T-bill is calculated as:•

((the face value of the T-bill in Canadian funds using the exchange rate at time of purchase) – Purchase Price in CAD Dollars.

Question 17

Calculating CG or CL on a foreign $US T-bill?

Answer 17

The Capital Gain is calculated as:•

• The greater of ($0 and ((the face value of the T-bill in Canadian funds using the exchange rate at time of purchase) – (the face value of the T-Bill in Canadian funds using the exchange rate at time of conversion back to Canadian.)

The Capital Loss is calculated as:•

• The lesser of ($0 and ((the face value of the T-bill in Canadian funds using the exchange rate at time of purchase) – (the face value of the T-Bill in Canadian funds using the exchange rate at time of conversion back to Canadian.)

For transactions that are deemed to be capital in nature, as opposed to business transactions, exchange gains and losses in excess of $200 are deemed to capital gains and capital losses. If the taxpayer is an individual, capital losses from foreign currency exchanges for the taxation year in the excess of (capital gains from foreign currency exchanges for the taxation year plus $200) are capital losses of the taxpayer.

Question 18

Quote yield of a US T-Bill is calculated as:

Answer 18

• T-bill returns are quoted as yield to maturity expressed on an annualized basis. US T-bill calculations use 360-day year, instead of 365 days used in the calculation for the Canadian T-bills.
• The quoted yield of US T-bill is calculated as:•

(((par value – price) / price) x (365/term)In times when inflation in Canada exceeds inflation in the US, the Canadian Dollar tends to depreciate relative to the US Dollar.

If a Canadian investor purchases a US T-bill and the Canadian$ falls against the US $ during the term of the T-bill, the investor will realize a capital gain on the investment be he will receive more Canadian dollars for the face value of the US Denominated T-Bill. As a result, the US T-bill can be used against inflation in Canada.

Question 19

What is an Escalator GIC and how should returns be compared?

Answer 19

• An escalator GIC is a GIC whose interest rate rises each year on the anniversary of the date of the deposit.
• To entice investors, the interest rate in the final year normally is the highest rate offered.
• The investor needs to compare the effective annual yield / interest rate between the different investments over the duration of the holding period when evaluating which escalator GIC to choose, not just the interest rate in the final year.
• The effective annual rate of an escalator GIC is calculated as:•

The internal interest rate of cash flows with differing amounts of interest payments each year.
GICs play a part in several investment strategies.

• The ladder approach is an investment strategy that involves purchasing bonds or GICs that mature at regular staggered intervals. If interest rates fell in a particular year, then the investor only needs to invest a small portion of her total portfolio at these new lower rates, and this reduces her investment risk.

Question 20

What is systematic risk?

Answer 20

• Is vulnerability to events which effect aggregate outcomes such as broad market returns, total economy-wide resource holdings, or aggregate returns.
• The ladder approach used with GIC’s has nothing to do with systematic risk but rather with reducing reinvestment risk!

Question 21

What method do you use to calculate the IRR on a non compounding GIC?

Answer 21

• For non compounding GICs, cannot use Time Value of money to determine effective interest rate.
• You need to use Cash flow analysis to determine IRR (internal rate of return), which is equivalent to the effective rate of return over the entire holding period.

Question 22

Equity Linked GICs

Answer 22

• Equity linked GIC is a GIC with the interest income based upon a rate of interest that is equal to the change in the associated stock index or equity mutual fund.
• The GIC does not earn a specific interest rate or a minimum rate. The maximum return will be capped. Return of principal is guaranteed. However, the deposits do not earn a minimum interest rate.
• If the index or fund has a negative return for the period, no interest would be earned by the investor.
• The interest on an equity linked GIC is only determined and paid upon maturity.
• The Income Tax Act requires a tax payer to accrue interest EARNED, but not paid, on the anniversary of the investment. It appears the CRA is accepting that no interest has been earned until the year of maturity.
• So, ALL of the interest income is taxable in the year of maturity.

Question 23

Eligibilty for CDIC deposit insurance protection

Answer 23

Deposits must be:•

In Canadian Currency, payable in Canada•Repayable no later than 5 years•
Placed at a financial institution that is a CDIC memberProvided they meet the eligibility criteria, CDIC insures the following types of deposits:•

Savings and chequing accounts•Term deposits and GICs•Money orders, drafts, certified drafts and cheques

Some types of deposits and investments offered by member institutions are NOT insurable by CDIC. Among most common types are:•
Foreign currency deposits •Term deposits that mature more than 5 years after the deposit date•Debentures issued by banks•Bonds and debentures issued by governments or corporations•T-bills•Mutual funds•Stocks•Investments in mortgages

Question 24

Max. basic coverage for CDIC

Answer 24

-The maximum basic coverage that is available for all eligible deposits that are held in the name of the depositor at a single member institution is $100,000 (principal and interest combined).

RRSPs & RRIFs are also considered to be separate accounts and are insured upto $100k per individual. However, any investments in mutual funds are not insured by the CDIC.

CDIC provides separate coverage (up to a maximum of $100,000, including principal and interest) for each of the following types of eligible deposits:•

Joint accounts•Trust accounts•RRIF•RRSP

Question 25

What options does the CDIC have when one of its members fails?

Answer 25

When a member institution fails, all customers with deposits with that institution will receive a payment from CDIC for the amount of their insured deposits. The CDIC is an agency which insures deposits against default risk! If a CDIC member fails, the CDIC can either transfer the insurance payments to another member institution OR mail each depositor a cheque for the insured amount. If the funds are transferred to another CDIC mbr, the funds will be held in a savings account until the depositor makes a decision about the investment. The CDIC will auto. make payment of the eligible insured deposits based on the records of the mbr institution. In the case of normal claims, the CDIC usually makes payments within 2 months of the date the claim was made. However, interest is no longer payable on the deposits held by the failed institutions once the court officially closes it. The customers will need to make arrangement to reinvest their insurance proceeds as soon as possible to resume earning interest income.

Question 26

What choice do Investors have when receiving the monthly interest distributions from their MMF(Money market fund)?

Answer 26

The number of shares or units acquired when purchasing a M/Fund is calculated as: (amt. of money invested in a MMF / NAVPS) Money market funds are normally fixed at a constant NAVPS of $10 per unit. The NAVPS remains fixed at $10 bcoz the fund distributes the interest income earned at the end of the month.

Question 27

What is a T-bill?

Answer 27

Tbills are purchased at a discount and mature at their face value. The difference between the purchase price and face amount represents interest income when held to maturity. However, changes in interest rate can result in a capital gain or loss if the Tbill is sold before maturity. If interest rates rise, the Tbill will be sold at a loss, this will result in a capital loss. On the other hand, if interest rates fell, the T-bill will be sold for a gain, which will result in a Capital Gain. As interest rates rise, the return on a money market will rise, but not as sharply as the increase in interest rates. As interest rates fall, the return on a money market fund will also fall, but not as steeply as the fall in interest rates. This is because the return on a money market fund is the average yield of many T-bills and other short-term debt securities that mature at different times, causing the return on money market funds to lag behind any changes in interest rates. There is a direct relationship between the return on a money market fund and interest rates.

Question 28

What is the real rate of return on an investment and how is it calculated?

Answer 28

Real rate of return ((actual return – inflation) / (1+inflation)). If the investor's real rate of return is a negative number, this means that the return on their investment is less than inflation, causing the purchasing power of their investments to erode each year.

Question 29

What is the effective yield of a money market fund and how is it calculated?

Answer 29

The effective yield of a MMF is the annual nominal rate of return that recognizes the daily compounding of interest. It is calculated as: Effective yield of a money market fundis calculated as:•((1+ return) 365/number of days of return

Question 30

What is your ETR (Effective tax rate)?

Answer 30

- A MMF distributes interest income to the unit holders on a monthly basis and capital gains at the end of the year. - At the end of the year, the fund manager issues a T3 supplementary or T5 slip to each unit holder, reporting the interest income and capital gains. - In Income tax planning, your effective tax rate would be the tax rate that would apply to whatever amt. of income OR deduction that you might be considering.

Question 31

What is a Mortgage-backed security?

Answer 31

Mortgage backed security (MBS) is a fixed income security that represents an ownership interest in the cash flow generated by a pool of mortgages. MBSs have an advantage over individual mortgages because of the availability of a secondary market. The individual mortgages may be insured against default by CMHC or one of a number of private sector mortgage insurance providers. The individual mortgages may not be insured by anyone. MBSs provide investors with regular income stream that consists primarily of interest income, but that also includes a small return of principal or tax-paid capital. MBSs are eligible for investments for RRSPs orRRIF purposes. Any interest income generated by MBS while it is within an RRSP would be sheltered from tax.

Question 32

Is interest income fully taxable?

Answer 32

Interest income is fully taxable. For interest bearing investments that have a term less than 1 year (eg. T-bill), the interest income is taxable in the year the interest is received. For bonds that pay regular coupon at least annually and have a term of more than one year, the interest payments are taxable in the year are received or are receivable. For compound bonds that do not pay out interest income annually, the interest income that is earned during the bond year is taxable for the calendar year in which the bond year ends. A bond year is the twelve months between anniversary dates of bonds. When a bond is redeemed, all accumulated interest income is taxable in the year received, unless that income has already been accrued in previous a previous year.

Question 33

Reporting interest income..

Answer 33

- Under the cash basis of reporting interest income, an individual who is entitled to receive interest income must report it as either when it is received (the cash method) or receivable, unless it has already been reported as taxable income in a previous year under the accrual method. - Under the annual accrual basis of reporting interest income ̧ if a taxpayer holds an investment contract on its anniversary day, he must include an amount in his taxable income for the taxation year in which anniversary day falls. The amount that must be included is equal to the total amount that has been earned by the taxpayer up until that anniversary day, but only to the extent that the interest has not been otherwise included in computing the taxpayer’s income for the year or any preceeding tax year. A bond year is a period of 365 consecutive days (366 days over a leap year) beginning with the bond’s original issue date (or the day the anniversary day in subsequent years.) A bond’s anniversary day is the day that is one year after the day immediately preceding the date of the issue of the contract, or that day occurs at every successive one year interval from that date.

Question 34

What is the Adjusted Cost base (ACB) of the property?

Answer 34

The adjusted cost base (ACB) is the cost of the property for tax purposes. In most cases, the ACB is the actual cost of acquiring the property. The ACB includes all of the costs associated with the acquisition, including the purchase price, commissions and brokerage fees. For the shares of a fund that you own, the adjusted cost base is the amount calculated as:• (A + B – C – D) where, ``` A = the total amount paid for the shares of the fund including brokerage fees and commissions B = the amounts of distributions of earnings that were reinvested in shares of the fund; C= any non-taxable distributions, other than the non-taxable portion of any net realized capital gains; and D = The adjusted cost base of any shares of that fund that you have previously redeemed or exchanged. ``` In the case of funds denominated in USD or other foreign currencies, in calculating the ACB of your shares, you must convert the amounts of the various transactions from the US Dollars or other foreign currencies to Canadian dollars using the exchange rate on the dates of the transactions.

Question 35

How to calculate the current yield of a mutual fund

Answer 35

Represents the annualized rate of return on the fund and does not factor in compounding of interest income: -(seven day return x (365/7)

Question 36

How to calculate the effective yield of a mutual fund

Answer 36

is the annual nominal rate of return that recognizes the daily compounding of interest. (1 + 7 day return) to the power of ((365/7) -1)

Question 37

Reporting interest income

Answer 37

For interest bearing investments that have a term of less than one year (eg T-Bills), the interest income is taxable i the year in which the interest is received. For bonds that pay a regular coupon at least annually and that have a term of more than one year, the interest payments are taxable in the year they are received or receivable. Fro compound bonds that do not pay out interest income annually, the interest income that is earned during the year is taxable for the calendar year in which the bond year ends. A bond year is the 12 months between anniversary dates of a bond. When a bond is redeemed, all accumulated interest income is taxable in the year received, unless that income has already been accrued in a previous year.