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Investment Management Test 3
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Key Concepts:
Terms in this set (188)
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)
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
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
Held by the trader who commits to purchasing the asset on the delivery date
Futures Price
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
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)
Net Asset Value is the value of?
value of each share that investors buy in investment companies
Types of Investment Companies
Unit Trusts
- Fixed portfolio of uniform assets
- unmanned
- Have decreased in popularity over time
Types of Investment Companies
Types of managed investment companoes
- Open-end
- Close End
Types of Investment Companies
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
Types of Investment Companies
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
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)
Disadvantage of open end funds
- must keep a cash reserve to satisfy redemption
- 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
Types of Investment Companies
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
Types of Investment Companies
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
Types of Investment Companies
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
Types of Funds
- Money Market Funds
- Equity Funds
- Bond Funds
- Life-Cycle Funds
- Index Funds
How Funds are Sold
- Directly Marketed
- Sales force distributed
- Financial Supermarkets
How Funds are Sold
Directly Marketed
Investors contact the fund directly to purchase shares
(may avoid front end load)
How Funds are Sold
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
Sales Force Distributed
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
Sales Force Distributed
is Revenue sharing illegal?
Not if the arrangement is disclosed to the investor
How Funds are Sold
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
gross return on a mutual fund excludes
load fees
do 12-b-1 fees affect NAV?
Yes
Mutual Funds
Operating Expenses
- recurring
- expenses are deducted from the mutual fund portfolio
- Management fees, admin expenses, and advisory fees for the managers
Mutual Funds
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
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.
Mutual Funds
Late Trading
the practice of buying or selling orders after the market closes and NAV is determined
- violates securities laws
Mutual Funds
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
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)
Mutual Fund an investor is taxed on?
capital gain and dividends
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
- Trade continuously like stocks
- Can be sold short or purchased on margin
- Lower Costs
- Tax Efficient
Exchange Traded Funds
Potential Disadvantages
- Prices can depart from NAV
- Must be purchased from broker
Mutual Fund Prospectus Describes?
- Investment objectives
- 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
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
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
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 =
Share publicly available to trade/readily available to trade
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
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.
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
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
- risk free is commonly the one month t bill
- 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
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
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
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
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
directly above it on the upwardsloping
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)
T or F
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
Two assumptions CAPM is based on
- investors are mean variance optimizers
- 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)
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
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
efficient market hypothesis
weak form
stock prices reflect market trading data, past prices, trading volume, short interest
implies there is no value in trend analysis
efficient market hypothesis
sim-strong form
all publicly available information regarding the prospectus of the firm is reflected in the stock price
efficient market hypothesis
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)
for an option are payoff and profit the same?
No.
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