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Investment Analysis: Quiz 2 (CH 1-3

Terms in this set (66)

What are 3 types of Average Returns?
1. Geometric Average Return
2. Arithmetic Average Return
3. Dollar Weighted Average Return
what is geometric average return?
average compounding return per year over a multiyear period. Gives real return
what is compounding
growing of money. it is growing because interest is being earned on interest already earned.
Example of geometric return
Susan has owned apple stock over past 4 years. During period, she has experienced an annual return of 10%, 12%, 3%, and 8-9%. What is geometric return
( *-9% means she loss 9% of her return of 1. So, her return was 0.91 (1-0.9).)


ii. This is four separate events, looked at one major event, but it isn't because he gets paid at the end of every year.
iii. This is just returning in dividends/interest earned.

1. Each one represents one quarter of a whole, so it is compounded a quarter.
b. (1.10 x 1.12 x 1.03 x 0.91) ¼ - 1 = 1.03662558 - 1 = 0.0366 = 3.66%
what is arithmetic average return?
The return earned as an average over a multiyear period

Easiest, common, and inaccurate. Simplest average method.
how do you find arithmetic average return
The arithmetic average return adds all total returns earned over the years and divides that total by the number of years.
What is dollar weighted average return ?
Gives compound average return over a multiyear period while taking into account cash inflows and outflows.


The dollar weighted average return takes into account the depositing and withdrawing of money from an account.
Example of dollar weighted average return
Sam has an account through TD that pays 1% each month that the money stays in the account at the end of the 12 months. Over the course of the year the investor did the following
January 1 = deposited $1000
February 1 = withdrew $1000
December 1 = Redeposited $1000

how much did the investor earn in interest?
1% = 10 dollars received on December 31st because he took the money out in February and didn't stay in the account for the whole 12 months.

what is the dollar rate of return?
Dollar rate of return is 6%. 6 x 1 (this is the actual interest paid, if this number was different, you multiply by that number) = 6% if he did this over and over again, he did it 2 times every couple of months. It's assumed they do it the amount of time he deposited.

2 deposits per year in a 12-month period 12/2 = 6 times he makes deposits throughout the year.

1. what is the dollar weighted average return?
1%. This is always the same as the dollar rate of return.
by nature, what are investors?
risk-averse
what is risk adverse?
seek to avoid risk
What 5 constraints affect one's attitude towards risk
1. resources - They're going to be riskier if they have a lot of resources than someone with little resources.As the resources change, level of risk changes

2. Horizon - planned life for an investment, how the money will be used. Changes how someone invests money

3. Liquidity - cash you have on hand changes how you will invest

4. taxes - change your risk tolerance

5. Unique circumstances

personality also plays into your risk tolerance
What does someone need to create if they need to balance the 5 constraints aboce?
create an investment strategy
what is an investment strategy
a plan as to how one will invest
what are the 4 key areas to an investment strategy?
1. investment management
2. Market timing
3. Asset Allocation
4. Security selection
what is investment management?
Time and experience dictate who will manage your investments

Most people will hire a professional because they don't have time or expertise.
What is market timing
When to invest, based on understanding the change in market directions

Timing is everything when to buy or sell.
what is asset allocation
trying to figure out how to spread your money out across assets
what is security selection
choosing the right security within each asset
what does someone do if they don't have experience or time for buying securities?
hire a securities broker
what is a securities broker
one who is licensed to buy and sell securities on behalf of clients
what are the 3 types of security brokers
1. full service broker
2. deep discount broker
3. discount broker
what is a full service broker
One who provides a full array of financial planning

They charge anywhere between 1-2% of the account balance (annually each year)
what is a deep discount broker
They provide execution and maintenance of the securities

No research, no questions, you do it all on your own (Robinhood)

Charge you a commission per transaction.
what is a discount broker
Provide some services (TD meritrade). They will answer questions but won't do it for you. Act as an in-between

Charge commission per transaction
when you hire a broker, they have you open an account, what is the account protected by/
securities insurance protection corporation
what is the securities insurance protection programs
Provide insurance on money that's money deposited in a securities account

$250,000 in cash and 500,000 in both cash and securities
what are two types of securities accounts that can be opened?
Cash account - most common, requires cash to be in the account before you make a purchase


Margin accounts - allows one to make purchases with borrowed money.
what does margin mean
Refers to the portion of the value of an investment that's not borrowed.
what is the interest called when one borrows
money rate - interest charged on money borrowed that's borrowed to buy securities
what are two types of margin?
1. Initial margin
2. maintenance margin
what is initial margin?
the amount of money you must have in the account that's required to make a purchase
what is maintenance margin
money that must remain in the account at all times, similar to a savings account.

The minimum margin that must be present at all times in a margin account. Typically, around 30%
Call money rate
interest charged on money that is borrowed through margin accounts
Example for margin account
i. Example: suppose you have $3,000 in a cash in a trading account with a 50% initial margin requirement. What does this mean? What is the largest order you can place? If the initial margin were 60%, how would you answer this question.
1. The 50% initial margin means that you must supply at least 50% of the funds for all securities

2. The largest order you can place is $6,000 (3,000 from your cash and 3,000 borrowed from the broker)

3. If the initial margin is 60%, your $3,000 must equal 60%
$3,000 / 0.6 = $5,000 (initial margin)


4. If the initial margin is 40%
Means they will put in 60% (you can borrow 60%), and you will have to put in 40%
b. What is the largest order you can make?
$3,000 / 0.4 = $7,500
What happens if the investor's cash falls below the maintenance margin (30%)?
prompt a margin call
what is a margin call?
A demand for more funds to be added to a margin account when it drops below the maintenance margin.
what is a securities market?
markets where debt instruments and equity securities are bought and sold; also known as stock exchanges or stock markets
what are the 2 types of securities market?
1. primary securities market
2. secondary securities market
what is primary securities market?
Markets that sell newly issued securities

includes flotations and initial public offerings (IPOs)
What are flotations?
newly issued securities
what are initial public offerings?
the sale of newly issued stock to the public (never have been sold)
what is a secondary securities market?
markets that sell previously issued (sold) securities
Example of a secondary security market?
Sam purchases Bubbai shrimp shack initial public offerings (IPOs). He holds the stocks for 2 months and sells them.
Who hires investment bankers?
corporation
3 major players are depended on to move the stock to the public, who are they?
1. specialists
2. floor brokers
3. register brokers
what are investment bankers?
an organization that's responsible for raising corporate funds by marketing and selling securities in the securities markets

ex: JP morgan
what 3 primary roles do investment bankers serve?
1. Origination
2. underwriting
3. Selling
what is origination
Refers to identifying if a business will benefit best from a public offering or private placement
what are public offerings?
selling securities to the public
what are private placements?
selling securities to a group of private investors
what is due diligence?
a detail study of the business

done to see if the company can pay back the money and give to public offerings and private placement
what is underwriting?
Refer to the process of determining whether or not to assume the risk that the securities may not be purchased by investors
what does it mean to assume risk?
deciding whether or not to buy the securities. Willing to take the chance of losing money by funding the money.
what is selling?
Best effort selling - selling the securities at the best price.


highest possible price on the behalf of the company
what are specialists
1assigned dealers who have the responsibility of making a market for an assigned


they Buy a spot and bring together buyers and sellers
what are floor brokers?
one who buys and sells securities on the behalf of clients


They earn a commission. They are standing around the specialists
what are registered brokers?
special licensed to buy and sell for their own account and then sell and buy it for the public.


They stand around the specialist
what is T + 3
3 businesses days for a securities transaction to be completed

When you buy and sell you are completing an order.
what are 5 types of securities orders?
1. market order
2. limit order
3. stop-loss order
4. short sale
5. buying on margin
what is a market order?
most common type, an order to buy and sell at the best possible price
what is a limit order
an order to sell at the highest possible price or to buy at the lowest possible price

If someone puts in a limit order to buy Walmart stock, they are saying the broker must watch it until the price until it will be at the lowest possible price then buying/selling
what is stop-loss order
An order to sell when the price falls to a specific level.

Goal is to take advantage of the gains that have been earned

Used to protect gains

Example: Sally buys Walmart stock at $1.00 per share. The stock rises to $2.00 per share. She places a stop-loss at $1.50 per share.

Once the stock has fallen to 1.50, she has protected .5 of her earnings.
what is short sale?
An order to sell securities that the seller doesn't own.


Short sales are used to take advantage of a security that's declining in value.
what is an example of short sale?
Example: sally sales 100 shares of Walmart stock at $1.00 per share ($100) in which she doesn't own. The stock rises to $2.00 per share. She, then, buys 100 shares ($200), replaces the 100 shares she sold, and keeps the $100 profit
what is buying on margin?
An order in which the investor borrows money and invests it along with his own

Buying on margin is used to take advantage of a security that's rising in value.

Exact opposite of a short sale.
what is an example of buying on margin
xsally borrows $50.00 from her broker and combines it with $50.00 of her own money to buy 100 shares of Walmart stock at $1.00 per share ($100). The stock rises to $2.00 per share. She sells the shares ($200), repays the broker ($50), and earns $100 profit.
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