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%







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 2Concepts

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
S= Rp -Rf 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.
T= Rp - Rf 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. 3Measuring Performance

Holding Period Return
HPR = Ending value of investment - beginning value +/- cash flows Beginning value of investment

Arithmetic Mean
AM = Return of Period 1 + Return of Period 2 + Return of Period n + … # of Periods

Geometric Mean
n GM = (1 + R1)(1 + R2)….(1 + Rn) -1

Real Return (Inflation Adjusted)
Real Return = 1 rate) [ ((1 + nominal rate) + inflation


CFt (1 + K) to the t power

Internal Rate of Return (IRR)
Po = CF1 (1 + K)


CF2 (1 + K)squared

+ … +

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) 4Investment 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. 5Valuation

Bond valuation 1 basis point = 0.01% 100 basis points = 1% Ratings: Agencies Standard & Poor Investment grade: High grade AAA – AA Medium grade A – BBB Noninvestment grade: Speculative BB – B Default CCC – D Total Range AAA – D 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 Moody’s Aaa – Aa A – Baa Ba – B Caa – C Aaa – C

Yield to maturity



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.
Conversion Value = Par Conversion Price

x Market price of common stock

Equity valuation Intrinsic value – The present value of future cash flows discounted at a risk-adjusted rate. Constant dividend growth model
Value of security = Dividend paid at first period 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.
A margin call will occur when stock price = Loan amount 1 - Maintenance margin

Real Estate Valuation NOI = Net Operating Income = Income less fixed and variable operating expenses before depreciation and mortgage payments.
Value of property = NOI Discount Rate



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 Unlimited Premium Exercise Price - Premium Premium Premium Unlimited Premium Exercise Price - Premium

Buy Call Buy Put Sell Call Sell Put

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



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:
Large Cap Stocks International Large Cap Stocks Mid Cap Stocks Small Cap Stocks Emerging Market Stocks Private Placements Corporate Bonds Government Bonds Aggressive Balanced Conservative 30% 20% 12% 15% 10% 8% 10% 5% 5% 5% 5% 0% 5% 5% 0% 15% 5% 0% 10% 10% 100% 25% 25% 100% 25% 50% 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

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