Investments

1- Risk

Systematic Risk (Beta) – Market risk, Risk that is always present regardless how much a
portfolio is diversified.
• Purchasing Power Risk
• Reinvestment Rate Risk
• Interest Rate Risk
• Market Risk
• Exchange Rate Risk

Unsystematic Risk – Risk specific to a security

• Business Risk
• Country Risk
• Default Risk
• Financial Risk (Leverage)
• Government Risk (Regulation changes)

Systematic Risk + Unsystematic Risk = Total Risk (Standard Deviation)

How to use the chart below for calculating Standard Deviation:

68% of the time, results fall within 1 standard deviation of the mean
95% of the time, results fall within 2 standard deviations of the mean
99% of the time, results fall within 3 standard deviations of the mean

Ex: ABC Stock has a mean return of 6% and standard deviation of 4%

So, 68% of the time the return will range from 2-10%
95% of the time, the return will range from –2% to 14%
99% of the time, the return will range from –6% to 18%

3 2 1 1 2 3
Variance = Standard Deviation squared

Covariance = A measure of how returns on assets move together.

Semivariance = Considers only downside volatility

Coefficient of Variation = Standard Deviation divided by Expected Return. Measures

risk per unit of return. Opposite of Risk adjusted Return, which is Expected Return
divided by Risk.

Correlation ( R ) = Measures the movement between 2 securities. If = 1, then the 2

securities move in perfect unison. If = -1, the 2 securities move in exactly opposite
direction. If = 0 , the 2 securities move independent of each other in any direction.

Coefficient of Determination = Correlation squared

2- Concepts

Risk free rate of return = 90 day Tbills

Market Premium = Difference between the risk free rate and the rate of return of the
market

Efficient Frontier – Portfolios with the highest expected return for a given level of risk
• For any 2 risky assets with the same expected return, choose the one with
the lowest risk
• For any 2 assets with the same risk, choose the one with the highest
expected return
• Choose any asset that has a higher expected return and lower risk

Capital Asset Pricing Model (Macro, total risk)

r(p) = r(f) + { [r(m) –r(f)] / Standard Deviation (m) x Standard Deviation (p)

Security Market Line (Individual, Beta)

R(i) = r(f) + [r(m) – r(f)]x Beta

Sharpe Performance Measure – Uses Standard Deviation as a measure of total risk

Rp -Rf
S=
Stand Deviation p

Treynor Performance Measure – Uses Beta as a measure of systematic or market risk. If

a portfolio is completely diversified, then Sharpe and Treynor will produce equal results.
Rp - Rf
T=
Beta p
Jensen Performance Index – While Sharpe and Treynor are relative measures, Jensen
alpha is a absolute measure of performance.
Rp - [Rf + (Rm -Rf) Beta ]

Arbitrage Pricing Theory – Looks at several factors (not just risk) to profit from price
distortion. Requires no risk to be taken.

Efficient Market Hypothesis – Investors cannot outperform the market consistently.

Markets are efficient and price in all available information. 3 forms:

1. Weak Form – Believes that only fundamental analysis and insider

information will work. Technical analysis will not.
2. Semistrong Form – Believes that only insider information will work.
Technical analysis and fundamental analysis will not.
3. Strong Form – Believes that outperformance is random and indexing is
best practice. Technical analysis, fundamental analysis, and insider information
will not work.

3- Measuring Performance

Holding Period Return

Ending value of investment - beginning value +/- cash flows

HPR =
Beginning value of investment

Arithmetic Mean

Return of Period 1 + Return of Period 2 + Return of Period n + …

AM =
# of Periods

Geometric Mean

GM = (1 + R1)(1 + R2)….(1 + Rn) -1

Real Return (Inflation Adjusted)

Real Return = [ ((11 ++ nominal rate)

inflation rate)
-1 ]
Internal Rate of Return (IRR)

CF1 CF2 CFt

Po = + + … +
(1 + K) (1 + K)squared (1 + K) to the t power
If IRR > Required Return, it is a good investment
If IRR < Required Return, it is a bad investment

Time Weighted versus Dollar Weighted – Dollar weighted takes into consideration the
different cash flows of the investor whereas the time weighted rate of return looks at the
return of an investment over a period of time and assumes there were no cash flows.
Mutual funds report there returns using a time weighted return. Mutual funds are also
required to show the SEC Yield of the fund for standardized reporting.

Tax Adjusted Return

Tax adjusted return = (realized return) x (1 – Tax Rate)

4- Investment Concepts

The investment planning process:

• Means to invest
• Time horizon
• Risk and return
• Investment selection
• Evaluate performance
• Adjust portfolio

Types of returns:
• Expected return – As the level of risk increases the expected return
increases
• Required return
• Realized return (actual)

Liquidity versus marketability

An asset can be marketable but not liquid, however, all liquid assets are
marketable. Liquidity is the ability to sell quickly with little price concession.
Marketability requires there to be a readily available market for an asset.

Bull Market – A positively increasing market

Bear Market – Market trends that a continuously downward

Long Position – Taken with the thought that the security will appreciate
Short Position – Taken with the thought that the security will decline in value.

5- Valuation
Bond valuation
1 basis point = 0.01%
100 basis points = 1%

Ratings:

Agencies Standard & Poor Moody’s

Investment grade:
High grade AAA – AA Aaa – Aa
Medium grade A – BBB A – Baa
Noninvestment grade:
Speculative BB – B Ba – B
Default CCC – D Caa – C
Total Range AAA – D Aaa – C

YTM = Yield to Maturity

CR = Coupon Rate
CY = Current Yield

Bond trading at par: YTM = CY = CR

Trading at a premium: YTM < CY < CR
Trading at a discount: YTM > CY > CR

Three theories about yield curves:

1. Expectations Theory – Believes that long-term rates are merely the average
(geometric mean) between current spot rates and forward rates of short-term
bonds.
2. Liquidity Premium Theory – Believes the investor pays a premium (lower rates)
for short maturities to avoid the interest rate risk associated with longer-term
bonds.
3. Market Segmentation Theory – Believes that yields are the result of supply and
demand along the curve. It segments the curve into 3 markets of independent
supply and demand: short-term (< 1 year), intermediate term (1 – 5 years), and
long-term (> 5 years)

Duration – Number of years until an investment is recovered. There is an inverse

relationship between the coupon and duration of a bond. The higher the coupon, the
quicker the return on investment, resulting in a shorter duration. Zero coupon bond will
have duration equal to maturity.

Convexity – The degree in which duration changes with a change in YTM. Large
convexity implies a large change in duration. Convexity is the greatest with low-coupon
bonds, long-maturity bonds and low-YTM bonds.
Duration Convexity
Coupon Rate Inverse Inverse
Maturity Direct Direct
Yield to maturity Inverse Inverse

Immunization – Protects the bond portfolio from interest rate fluctuations and
reinvestment rate risk. The actual future value of the portfolio must be at least as great as
it is at inception. The investor must match the duration of the portfolio to their time
horizon.

Laddered Portfolio – A bond portfolio with equal dollar amounts invested in years 1
through ten (for example).

Barbell Strategy – Investing half of the portfolio in short-term bonds and the other half in
long-term bonds, resulting in an intermediate duration.

Bullet Strategy – Purchasing specific bonds all of which have a duration tied to a specific
date in the future.

Bond Swaps – Bonds are swapped with a similar bond to increase the overall rate of
return. Examples are substitution, intermarket spread, rate anticipation, pure yield, and
tax swaps. These strategies have become increasingly more difficult to take advantage of
at the private client level as most hedge funds have been established with these strategies
as their goals.

Convertible securities – Allows the investor to convert the bond into shares. The
conversion ratio equals the par value of the bond divided by the conversion price.

Par
Conversion Value = x Market price of common stock
Conversion Price

Equity valuation
Intrinsic value – The present value of future cash flows discounted at a risk-adjusted rate.

Constant dividend growth model

Dividend paid at first period

Value of security =
Required rate of return - growth rate of dividends

Book Value – Assets minus liabilities divided by shares outstanding. Not the best way to
value a company because depreciation can skew the result.

Liquidation Value – If a company sold all assets and paid all liabilities.

Margin – Allows investors to use leverage to purchase more securities. When an investor
purchases on margin, the investor puts up one half of the funds and one half is borrowed
from the broker (50% initial margin)
 Maintenance margin = the percentage of equity that the broker requires the client
to maintain.

Loan amount
A margin call will occur when stock price =
1 - Maintenance margin

Real Estate Valuation

NOI = Net Operating Income = Income less fixed and variable operating expenses before
depreciation and mortgage payments.

NOI
Value of property =
Discount Rate

6- Securities

Money Market Securities

1. Treasury Bills – 13 Week, 26 Week, and 52 Week, in increments of $1000,

auction off using a competitive bidding process,
2. Commercial Paper – Corporate issue of short-term, unsecured notes.
Denominations of $100,000
3. Certificates of Deposit (CDs) –Placed by commercial banks at specific rates
4. Banker’s Acceptances – Securities that act as a line of credit issued by a bank
5. Eurodollars – Deposit in foreign banks that are denominated in US Dollars
6. Repurchase Agreements – Securities dealers sell their inventories at a
predetermined price for a period of 1 – 3 days.

Bonds

Call Provision – Allows the issue to pay off the debt at some point prior to maturity.

Sinking Funds – Usually held by a trustee to ensure repayment of the bond proceeds

Secured Bonds – Bonds that have legal claim to specific assets in the event of missed
payments

Debenture Bonds – Unsecured bonds

Treasury Bonds – Issued by the US Government.

Treasury Inflation Protection Securities (TIPS) – Bonds whose principal value willl
adjust in-line with inflation.

Series E, H, and I Bonds – Issued by US Government

US Government Agency Bonds – Fannie May, Federal Home Loan Bank, etc.

Municipal Bonds – Issued by States and Municipalities.

Corporate Bonds – Issue by corporations

Mortgage Backed Securities and Collateralized Mortgage Obligations

Insurance Products

Guaranteed Investment Contracts (GICs) – Also known as Stable Value Funds, sold to
pension plans and insurance companies. Fixed rate of return is guaranteed foe a period of
time.

Annuities – Issued by insurance companies who make regular payments for specified
time periods

Life Insurance – Depending on the type, may allow for cash value to accumulate.

Equity

Common Stock – Large Cap, Mid Cap, Small Cap, International, Growth, Value, Income,
Cyclical, Defensive, etc.

Preferred Stock – Pays a fixed dividend and shareholders have preferential rights if the
corporation goes into default.

Investment Companies

Unit Investment Trusts – Self-liquidating and passively managed. Invest in stocks,

bonds, or other securities.

Closed-end Investment Companies – After initial offering, no additional shares are

issued. Will then trade in the secondary market.

Open-end Investment Companies – Mutual funds. No limit to the number of shares

issued

Exchange Traded Funds

Baskets of stocks that are traded on the exchange intraday. Usually linked to an index or
sector.
Short Selling

Investor will sell a stock that they do not own (borrowed from broker) and will buy it
back in the future. The short sale must be done on an up tick on the stock trading in the
market. Investors using this strategy have a bearish outlook on the security that they are
selling short.

Derivatives

A security whose value is derived from the value of an underlying security.

Futures Contracts – A contract between two parties to make or take delivery of a

commodity at a specific price and specific future date.

Hedging – Use of futures contracts to lock in current prices of a commodity. Investor can
take a long (purchase) hedge or short (sell) hedge.

Options

Gains / Losses:

Max Gain Max Loss

Buy Call Unlimited Premium
Buy Put Exercise Price - Premium Premium
Sell Call Premium Unlimited
Sell Put Premium Exercise Price - Premium

Black-Scholes Option Valuation Model – Determines the value of a Call Option only

Put / Call Parity Model – Determines the value of a Put Option based on its
corresponding Call Option

Long Straddle – Buy a Put and a Call at the same strike price (expecting a big swing in
price in either direction to profit)

Short Straddle - Sell a Put and a Call at the same strike price (expecting the stock to stay
flat in price to profit)

Collar – Lock in value of underlying stock buy selling a call and buying a put. Upside
profits are sold in exchange for downside protection.
Warrants – Issued by the underlying company. Allows the Warrant owner to purchase a
certain number of shares at a predetermined price by a certain date.

Real estate investment trusts (REITs) – Companies which invest in real estate on behalf
of the shareholders.

Private Placements

Venture Capital for privately held companies typically in the form of convertible
preferred stock

7- Strategies

Investment Policy Statement – Written document that sets forth a client’s objectives and
certain limits for the investment manager. The IPS provides guidance for the manager a a
benchmark for evaluating investment performance.

Dollar-Cost Averaging – The process of purchasing securities over a period of time by

investing a predetermined amount at regular intervals.

Dividend Reinvestment Plans (DRIPs)– Allows dividends to automatically reinvest into

the security.

Asset Allocation – The process of allocating investable funds among various asset
classes. Must consider client’

Allocation Examples:

Aggressive Balanced Conservative

Large Cap Stocks 30% 20% 12%
International Large Cap Stocks 15% 10% 8%
Mid Cap Stocks 10% 5% 5%
Small Cap Stocks 5% 5% 0%
Emerging Market Stocks 5% 5% 0%
Private Placements 15% 5% 0%

Corporate Bonds 10% 25% 25%

Government Bonds 10% 25% 50%
100% 100% 100%
Benchmark’s

• S&P 500 – US Large Cap

• Russel 2000 – US Small Cap
• EAFE – International Index
• Wilshire 5000 – Overall US Market Index

Dealing with concentrated portfolios

• Sell stock outright – tax consequences
• Installment sale
• Collar
• Private annuity or self canceling note
• ESOP
• Charitable Remainder Trust
• Exchange Fund

Monte Carlo Analysis – Makes assumptions to forecasts outcomes. Allows designation

of multiple scenarios and probabilities to create the most likely outcomes. Can calculate
the likelihood of returns that are greater than or less than the mean.

Pink Sheets – Very small, illiquid stocks. Name comes from the color of paper that these
stocks were originally tracked by. Most risky stocks.

US Territories whose bonds that pay interest which is not includable in income:
• Puerto Rico
• Washington, DC
• Guam
• US Virgin Islands