188 terms

efficient market hypothesis

stocks reflect all available information

Why type of index is the dow jones?

Price Weighted Average

DJIA is adjusted when?

There are:

Stock splits

Dividends of more than 10%

(It is adjusted so that the index does no change when these events occur)

Stock splits

Dividends of more than 10%

(It is adjusted so that the index does no change when these events occur)

What type of index is the S&P 500?

market-value-weighted index

Major problem with bond market indexes?

true rates of return on bonds are difficult to compute because infrequency of which bonds trade makes reliable up to date prices hard to obtain

derivative assets

- derive their value from other assets

- also called contingent claims because their payoffs are contingent on the value of other values

- also called contingent claims because their payoffs are contingent on the value of other values

futures contract

calls for the delivery of an asset at a specified delivery or maturity date for an agreed-upon futures price

Futures Price

Long Position

Long Position

Held by the trader who commits to purchasing the asset on the delivery date

Futures Price

Short Position

Short Position

Commits to delivering the asset at contract maturity

Buying on margin

the act of taking advantage of broker's call loans

When purchasing securities, investors have easy access to a source of debt called

broker's call loans

The margin in the account is?

the portion of the purchase price contributed by the investor

Regulated by the Board of Governors of the Federal Reserve System, the current initial margin requirement is?

50% meaning at least 50% of the purchase price must be paid for in cash

Maintenance Margin is used to?

Guard against the possibility that the value of the stock collateral falls below the loan value from the broker

If the percentage margin falls below the maintenance margin then?

the broker will issue a margin call

margin call

broker will require the investor to provide more cash or sell some stock to bring the margin back to an acceptable level

shorts sale

an investor borrows stock and sell it now

covering the short position

an investor buys back the share they sold

Can proceeds from a short sale be used for investors?

Exchange rules require proceeds from a short sale be kept in an account for individuals but large institutional investors can

investment Companies

Pool Funds of individual investors and invest in a wide range of securities or other assets

Services provided by investment companies

- record keeping and administration

- diversification and divisibility

- Professional management

- Lower transaction costs

- diversification and divisibility

- Professional management

- Lower transaction costs

Disadvantages of investment companies

- too many with the same investment goals (induces choice paralysis)

- Some charge exorbitant management fees (efficient markets don't justify large fees)

- Some charge exorbitant management fees (efficient markets don't justify large fees)

Net Asset Value is the value of?

value of each share that investors buy in investment companies

Types of Investment Companies

Unit Trusts

Unit Trusts

- Fixed portfolio of uniform assets

- unmanned

- Have decreased in popularity over time

- unmanned

- Have decreased in popularity over time

Types of Investment Companies

Types of managed investment companoes

Types of managed investment companoes

- Open-end

- Close End

- Close End

Types of Investment Companies

Open-end

Open-end

- Fund issues new share when investors buy in and redeems share when investors cash out

- Priced at NAV

- Cannot trade during day - place order during day before end of trading

- Mutual fund

- Priced at NAV

- Cannot trade during day - place order during day before end of trading

- Mutual fund

Types of Investment Companies

Closed-end

Closed-end

- No change in shares outstanding; old investors cash out by selling to new investors

- priced at a premium or discount to NAV

- Trade during the day

- ETF or ETN

- priced at a premium or discount to NAV

- Trade during the day

- ETF or ETN

Advantage of open end funds

- liquidity for investor (buy and sell for NAV)

- Fund is able to grow which is an advantage to the fund or sponsor (management fees are proportional to fund size)

- Fund is able to grow which is an advantage to the fund or sponsor (management fees are proportional to fund size)

Disadvantage of open end funds

- must keep a cash reserve to satisfy redemption

- vulnerable to panics (lots of redemptions forcing them to sell)

- vulnerable to panics (lots of redemptions forcing them to sell)

advantages of closed end funds

- shares are publicly traded likes stocks

disadvantages of closed end funds

- will trade at a premium of discount of NAV

- many use some form of leverage

- many use some form of leverage

Types of Investment Companies

Commingled Funds

Commingled Funds

- partnerships of investors that pool their money together

- designed for large trusts and retirement accounts that can be managed like mutual funds for a fee

- designed for large trusts and retirement accounts that can be managed like mutual funds for a fee

Types of Investment Companies

REITs

REITs

- trade like closed end funds

- typically highly levered

- required to pay out at least 90% of their dividend

- equity REIT invests directly in real estate

- mortgage REIT invests in mortgages and construction loans

- typically highly levered

- required to pay out at least 90% of their dividend

- equity REIT invests directly in real estate

- mortgage REIT invests in mortgages and construction loans

Types of Investment Companies

Hedge Funds

Hedge Funds

- similar to mutual funds but not subject to many SEC regulations (can pursue other strategies not permissible of hedge funds)

- available to high net worth investors and institutional investors

- typically have lock-up periods where investors cannot remove their money

- steep fees

- limited reporting requirments

- Reputation of fund managers is important

- available to high net worth investors and institutional investors

- typically have lock-up periods where investors cannot remove their money

- steep fees

- limited reporting requirments

- Reputation of fund managers is important

Types of Funds

- Money Market Funds

- Equity Funds

- Bond Funds

- Life-Cycle Funds

- Index Funds

- Equity Funds

- Bond Funds

- Life-Cycle Funds

- Index Funds

How Funds are Sold

- Directly Marketed

- Sales force distributed

- Financial Supermarkets

- Sales force distributed

- Financial Supermarkets

How Funds are Sold

Directly Marketed

Directly Marketed

Investors contact the fund directly to purchase shares

(may avoid front end load)

(may avoid front end load)

How Funds are Sold

Sales Force Distributed

Sales Force Distributed

- Recommended by a broker or financial planner

- usually have a front end load

- fund could be revenue sharing with the broker which posses a conflict of interest

- usually have a front end load

- fund could be revenue sharing with the broker which posses a conflict of interest

Sales Force Distributed

Example of Revenue Sharing

Example of Revenue Sharing

- Mutual fund sells directly to high cost broker. Higher payment is compensation for sale of the mutual fund to its clients

- Fund company pays the broker for preferential treatment

- Fund company pays the broker for preferential treatment

Sales Force Distributed

is Revenue sharing illegal?

is Revenue sharing illegal?

Not if the arrangement is disclosed to the investor

How Funds are Sold

Financial Supermarkets

Financial Supermarkets

- Instead of upfront omissions these markets take a share of the management fees (i.e. Charles Schawb and Co)

Cost of Investing in Mutual Funds

- Operating Expenses

- Front-end load

- Back-end load

- 12 b-1 charges

- soft dollar costs

- Front-end load

- Back-end load

- 12 b-1 charges

- soft dollar costs

gross return on a mutual fund excludes

load fees

do 12-b-1 fees affect NAV?

Yes

Mutual Funds

Operating Expenses

Operating Expenses

- recurring

- expenses are deducted from the mutual fund portfolio

- Management fees, admin expenses, and advisory fees for the managers

- expenses are deducted from the mutual fund portfolio

- Management fees, admin expenses, and advisory fees for the managers

Mutual Funds

12-b-1

12-b-1

- Recurring

- Marketing costs paid by the fund holders

- Assessed annually

- Maximum is .75% of assets with a .25% service fee (total 1%)

- Deducted from fund without an explicit bill

- Marketing costs paid by the fund holders

- Assessed annually

- Maximum is .75% of assets with a .25% service fee (total 1%)

- Deducted from fund without an explicit bill

Example of Soft Dollar

Mutual fund Make Rich purchases computer equipment from SuperFast for research and other work related purposes

Rather than paying SuperFast for the computers, MakeRich adds a few cents to the brokerage

fees it pays, YourBroker for executing every transaction. YourBroker buys computer from SuperFast and ships it to MakeRich, calling it a "Free of Charge" provision to MakeRich. This is an example of "soft dollar" purchase. Thus the costs of research services are not

disclosed to the fund's investors.

Rather than paying SuperFast for the computers, MakeRich adds a few cents to the brokerage

fees it pays, YourBroker for executing every transaction. YourBroker buys computer from SuperFast and ships it to MakeRich, calling it a "Free of Charge" provision to MakeRich. This is an example of "soft dollar" purchase. Thus the costs of research services are not

disclosed to the fund's investors.

Mutual Funds

Late Trading

Late Trading

the practice of buying or selling orders after the market closes and NAV is determined

- violates securities laws

- violates securities laws

Mutual Funds

Market Timing

Market Timing

Exploit stale prices based on correlation of markets and time-zone difference

- does not violate securities laws

- The long-term investors pay from dilution this causes to the fund

- does not violate securities laws

- The long-term investors pay from dilution this causes to the fund

Are funds taxed?

no as long as they meet certain diversification requirements and they distribute virtually all income earned to shareholders

(considered pass through entities)

(considered pass through entities)

Mutual Fund an investor is taxed on?

capital gain and dividends

Capital gains are realized in frequency based on the turnover of the fund

Capital gains are realized in frequency based on the turnover of the fund

If you have the fund reinvest do you still pay taxes?

Yes unless you have a tax deferred account

Mutual funds often realize capital gains during?

December

Mutual Fund Turnover

buying new assets to replace assets being sold

High turnover in a mutual fund is considered?

Tax inefficient

Commission costs (brokerage costs) of purchases and sales have what impact on the NAV of a mutual fund?

charged to the fund and reduce NAV

Total transaction expenses are higher in a fund with?

higher turnover

Average Holding Period means

average time period asset is held in portfolio

Average Holding Period = ?

Average holding period = 1 / turnover

If annual turnover is 100% average holding period is?

1 year

Low turnover over generally has no tax bill but?

there is a chance of a very high tax bill when older positions with low cost basis are sold

Exchange Traded Funds examples

spiders, diamonds, and cubes

Exchange Traded Funds

Potential Advantages

Potential Advantages

- Trade continuously like stocks

- Can be sold short or purchased on margin

- Lower Costs

- Tax Efficient

- Can be sold short or purchased on margin

- Lower Costs

- Tax Efficient

Exchange Traded Funds

Potential Disadvantages

Potential Disadvantages

- Prices can depart from NAV

- Must be purchased from broker

- Must be purchased from broker

Mutual Fund Prospectus Describes?

- Investment objectives

- Fund investment adviser and portfolio manager

- Fees and costs

- Fund investment adviser and portfolio manager

- Fees and costs

All information documents on a mutual fund?

- Prospectus

- Statement of additional information

- Fund's annual report

- Statement of additional information

- Fund's annual report

Annual Percentage Rate

Annual rate of interest usually based on compounding more than once in a year

Effective Annual Rate

The annual rate of interest that accounts for the effect of compounding only once a year

Annual Percentage Yield is the same as EAR if you assume?

365 days in a year

To account for compounding best to compute?

EAR

Holding Period Return

The total return earned from holding an investment for a specified holding period

HPR = ?

(Income + Capital Gain) / Beg Value

Advantages of Holding Period Return

- Easy to calculate

- Easy to understand

- Considers income and growth

- Easy to understand

- Considers income and growth

Disadvantages of Holding period Return

- Does not consider time value of money

- Rate may be inaccurate if time period is greater than 1 year and interest rates are higher

- Rate may be inaccurate if time period is greater than 1 year and interest rates are higher

Nominal Rate of Return

The rate of return in dollars that are not adjusted for inflation

Ex-ante measure of reward

Expected Returns

Book to Market Ratio

Book Value of Equity / Market Value of Equity

High BM Ratio stocks are considered?

Value stocks (firms in financial distress have very high BM ratio)

Low BM Ratio stocks are considered?

Growth Stocks

Formula for Book Value of Equity

Total Assets - Liabilities - Preferred Stock - Other Intangible Assets such as Goodwill

Market Value of Equity

Number of Shares * Price per share

Free Float Shares are?

Free Float =

Free Float =

Share publicly available to trade/readily available to trade

Free-Float = # Shares Outstanding - Locked in Share

Free-Float = # Shares Outstanding - Locked in Share

Weights for a portfolio can be bigger than 1 if?

The portfolio is leveraged

Covariance of returns measures?

The average tendency of returns to more in tandem with each other

Covariance captures?

- Size of movements of both assets

- Intensity of comovement

- Intensity of comovement

Correlation -1

perfect negative correlation

Correlation +1

perfect positive corrlation

Correlation 0

no correlation

Issue with arithmatic mean?

It does not account for compounding

Geometric Average is also known as?

time-weighted average return

The greater the volatility in the per-period return data the ________ the difference between arithmetic and geometric returns

higher

Arithmetic Average Returns are __________ higher than Geometric Average Returns

higher

Use geometric average return for?

evaluating or summarizing past performance

Use arithmetic average return for?

Forecasting net period expected returns

Risk

The chance that the outcomes can be different than expected

Standard Deviations measure?

The difference from the mean as well as below the mean

Average is the ________ for a normal distribution

median

Can returns be normally distributed?

They are close by maximum returns are infinite while lowest returns are bound to -100%

Skewness means the tails are?

longer

Kurtosis means the tails are?

Fatter

A left skew distribution

appears right leaning and more of the data is appearing to the left of the center giving it a longer left tail. Large negative returns.

A right skew distribution

appears left leaning and more of the data is appearing to the right of the center giving it a longer right tail. Large positive returns

Leptokurtosis

More outcomes in tail than for a normal distribution

VAR attempts to answer what question?

What is the least or minimum amount of dollars I can expect to lose on my portfolio with X% probability or chance

Risk Premium =

Expected Return of a Risky Asset - Risk Free Rate

Higher risk aversion means?

more dislike for risk

A portfolio and risk aversion is the balance of?

how much risky and risk free assets are held

Investment opportunity Set

different expected return and risk or risk reward trade-offs that can be achieved using a portfolio

What are the differences between the Investment Opportunity Set and the Capital Allocation Line?

They are the same

Slope of the CAL is known at the?

Sharpe Ratio (AKA reward to volatility ratio)

If risk premium on the risky asset is higher then optimal risky investment is?

higher

If risk aversion is higher then optimal risky investment is?

lower

If the risky asset is more volatile or higher in riskiness then the optimal risky investment is?

Lower

Individual investors with different levels of risk

aversion, given an identical capital allocation line, will

choose _________ positions in the risky asset.

aversion, given an identical capital allocation line, will

choose _________ positions in the risky asset.

different

The two step process of the investment decision

- Find the best risky portfolio

- Decide how to split money between the risk free and the risky asset

- Decide how to split money between the risk free and the risky asset

Sharpe ratio measures total reward on a portfolio per

unit of risk in the portfolio

A passive strategy is based on the premise that?

securities are fairly priced and security analysis can be avoided

The Capital Market Line

- the capital allocation line using the market index portfolio as the risky asset

Capital Market Line

The risky and risk free assets used

The risky and risk free assets used

- risk free is commonly the one month t bill

- risky asset is a broad index of common stocks

- risky asset is a broad index of common stocks

Passive investor _______ on the activities of active investors in a competitive investment environment

free rides

Adding more and more independent sources of risk slowly reduces?

portfolio risk

Portfolio expected return equals?

average of the expected returns across all the added assets

All assets are __________ to some extent

correlated

Given the existence of positive correlation between assets portfolio risk can never?

go down to zero

Unique Risk Vs. Market Risk for a specific firm

Unique Risk

Unique Risk

Success and failure of projects of a firm or impact of its management style

Unique Risk Vs. Market Risk for a specific firm

Market Risk

Market Risk

Economics factors such as interest rates or business cycles that affect demand

Market, systematic, or Non-diversifiable risk

risk factor common to the whole economy that exists despite diversification (affects all assets)

Idiosyncratic, Unique, firm-specific, non systematic or diversifiable risk

risk only associated with a particular asset or firm

simply dividend money equally across assets removes?

idiosyncratic risk

most diversifiable risk is eliminated at ______ number of investments in stocks

25

Finance theory tells us you are rewarded for bearing only the?

market risk

Finance theory tells us diversifiable risks command no premium over?

risk free return

Finance theory tells us there is no point in holding onto idiosyncratic risk if it is not rewarded so

diversification is essential

the covariance is a probability weighted sum of?

reinforcements and offsets

Expected returns are best estimated using what strategies?

- macroeconomic tools

- modeling people's behavior

- modeling people's behavior

after creating an investment portfolio set we keep only the portfolios that dominate. We do this by applying the?

mean-variance criterion

mean-variance frontier

portfolios that provide the lowest risk for a given level of return

are the mean-variance frontier and investment opportunity set the same for a 2 asset portfolio?

yes

are the mean-variance frontier and investment opportunity set the same for a 3 or more asset portfolio?

no

minimum variance portfolio is composed of?

An efficient part of the mean-variance frontier and an inefficient part of the mean-variance frontier

perfect positive correlation makes the frontier a _________ through two asset

straight line

perfect negative correlation makes the frontier _______ for two assets

risk free

Mean Variance Frontier: for each level of portfolio

expected return, find the portfolio with the _______

risk

expected return, find the portfolio with the _______

risk

lowest

minimum variance portfolio

portfolio with the lowest variance regardless of return

portfolio that lie below the minimum-variance portfolio in the figure are?

inefficient

Any portfolio on the downward sloping portion of the

curve (including asset B) is "dominated" by the

portfolio that lies

curve (including asset B) is "dominated" by the

portfolio that lies

directly above it on the upwardsloping

portion of the curve

(this is because it has a higher expected return with lower standard deviation)

portion of the curve

(this is because it has a higher expected return with lower standard deviation)

when 2 assets are perfectly positively correlated is the only case when?

there is no benefit for diversification

When correlation is less than 1 then there are benefits for?

diversification

Contruct CAL that passes through the risk free asset and is tangent to?

the efficient part of the mean variance frontier

the best CAL is?

the one with the highest sharpe ratio

the highest sharpe ratio CAL is the one that is?

tangent to the Mean-variance frontier

the portfolio where CAL is tangent to the efficient mean variance frontier is called the?

tangent portfolio

The optimal portfolio lies on the CAL and combines the tangency portfolio with the?

risk free asset

the exact location of the optimal portfolio with the tangency portfolio and the risk free asset depends on?

a person's risk aversion

the slope of the CAL is?

the sharpe ratio

optimal risky portfolio

the best combination of risky assets

Will all investors choose the optimal risky portfolio

yes

how will investors differ in terms of the optimal risky portfolio?

investors will only differ based on risk aversion. how much they allocate to the optimal risky portfolio and how much they allocate to the risk free asset

Single Index Model

uses the rate of return of an index as the proxy for the market

securities with high betas have?

greater sensitivity to the market and enjoy a greater risk premium to compensate for this risk

Beta * Market Risk Premium is known as?

systematic risk premium

alpha is what type of risk premium

a non market risk premium

alpha is large if?

you think the security is underpriced and offers an attractive expected return

if security prices are in equilibrium alpha will be?

0

Advantages and disadvantages to the single-index model

Advantages

- reduces the number of estimates needed

- needed to specialize by industry

Disadvantages

- limiting uncertainty to a macro or micro factors is over simplistic

- Assumes residuals have a correlation of 0

- due to simplistic nature it could lead to creation of a model that is drastically inferior to the Markowitz model (portfolio frontier model)

- reduces the number of estimates needed

- needed to specialize by industry

Disadvantages

- limiting uncertainty to a macro or micro factors is over simplistic

- Assumes residuals have a correlation of 0

- due to simplistic nature it could lead to creation of a model that is drastically inferior to the Markowitz model (portfolio frontier model)

T or F

Betas move towards 1 overtime? Why?

Betas move towards 1 overtime? Why?

Yes. Typically it is because companies become more mature and diversify their business making them more similar to the market

Should we adjust Beta for the assumption it will move towards 1 over time

yes

A Large T stat implies what about alpha?

A large T stat implies that their is a low probability that alpha has a value of zero

Variables that help to predict betas

- Variance of earnings

- Variance of cash flow

- growth in earnings per share

- Market Cap (firm size)

- Dividend yield

- debt to asset ratio

- Variance of cash flow

- growth in earnings per share

- Market Cap (firm size)

- Dividend yield

- debt to asset ratio

Two assumptions CAPM is based on

- investors are mean variance optimizers

- Markets are well functioning with few impediments to trading

- Markets are well functioning with few impediments to trading

mutual fund theorem

If all investors would choose to hold a common risky portfolio identical to the market, why not object to all stocks being put into 1 giant mutual fund

4 things an index portfolio can be used for?

- a diversification vehicle to mix with an active portfolio from security analysis

- a benchmark for performance evaluation and compensation

- a means to adjudicate lawsuits about fair compensation to various risky enterprises

- a means to determine proper prices in regulated industries, allowing shareholders to earn a fair return on their investment (but no more)

- a benchmark for performance evaluation and compensation

- a means to adjudicate lawsuits about fair compensation to various risky enterprises

- a means to determine proper prices in regulated industries, allowing shareholders to earn a fair return on their investment (but no more)

multifactor models

models that allow for several factors

key additions by the fama french model

Factor - small firms minus big firms

Factor - High book to market value minus low book to market value

Factor - High book to market value minus low book to market value

coefficients of multi factor models are also known as?

factor loadings or factor betas

random walk

prices changes of stocks are random and unpredictable

Versions of efficient market hypothesis

- weak

- semistrong

- strong

- semistrong

- strong

efficient market hypothesis

weak form

weak form

stock prices reflect market trading data, past prices, trading volume, short interest

implies there is no value in trend analysis

implies there is no value in trend analysis

efficient market hypothesis

sim-strong form

sim-strong form

all publicly available information regarding the prospectus of the firm is reflected in the stock price

efficient market hypothesis

strong-form

strong-form

states that all information is reflected in the price of the firm including insider information

technical analysis

the search for recurrent and predictable patterns in stock prices

resistence or support levels

part of technical analysis, states that there are price levels will stocks will no longer decrease or no longer increase

price patterns in the stock market ought to be?

self destructing (as more people learn of them they no longer exist)

Fundamental Analysis

uses earnings, dividend, and other information about the firm's fundamentals to make buy predictions

a portfolio of about ___ assets removes all idiosyncratic risk

10

r square of 40% means what about variation

only 40% of the variation is related to the market while 60% is idiosyncratic

Pros and Cons of HPR

Pros

- Easy to calculate and understand

- Considers income and growth

Cons

- Does not consider time value of money (rate may be inaccurate is time period is greater than 1 year and there are higher interest rates)

- Easy to calculate and understand

- Considers income and growth

Cons

- Does not consider time value of money (rate may be inaccurate is time period is greater than 1 year and there are higher interest rates)

for an option are payoff and profit the same?

No.