Investment Planning Study Guide

Contains the notes on the Investment Planning study book material for the CFP Board Exam. Topics range from investment characteristics and risks, valuation basics, portfolio theory, and behavioral finance.

The Notes

Starred (*) topics are more likely to be on the exam (2021).
Underwriting
- Best Efforts
  - Underwriter agrees to sell as much offering as possible.
  - Risk is with the company making offering.
- Firm Commitment
  - Underwriter agrees to buy entire offering from company.
  - Risk is with the underwriter.
- Key Docs
  - Prospectus
    - Outlines risks, management, operation, fees, expenses
    - Must be issued.
  - Red Herring
    - Preliminary prospectus filed by company with SEC.
  - 10K & 10Q
    - 10K = annual report filed with SEC – audited.
    - 10Q = quarter report – not audited.
Liquidity
- How quickly an asset can be turned into cash, with little concession.
Marketability
- When an asset has a ready-made market for it.
Order Types
- Market Order
  - Order is executed at next best available price.
  - Speedy execution is more important than price.
  - For stocks not thinly traded.
- Limit Order
  - Sets a limit on the max price paid (buy) or min price received (sell).
  - For volatile and thinly traded stocks.
- Stop Order
  - Becomes a market order after hitting a specific price.
  - Risk is paying too much or receiving too little if the price is moving too quickly.
- Stop Limit Order
  - Become a limit order after hitting a specific price.
  - Risk is order does not fill if price moves too quickly.
Short Selling
- Borrowing stock to sell at high price in hopes of buying it back at a lower price.
- Bet on a decline in price.
- Must have a margin account.
- Dividends paid on borrowed stock must be covered by short seller.
Margin*
- Initial Margin
  - Amount of equity needed to enter a margin transaction.
    - Ex: stock bought on 75% margin = 25% loan = (1 – margin)
  - Reg T, established by the Fed, set initial margin at 50% (assume 50% on exam, unless stated otherwise).
- Maintenance Margin
  - Minimum amount of equity needed before a margin call.
- Margin Position = (Price – Loan)/Price
- Margin Call
  - Margin Call Formula = Loan/(1-Maintenance Margin)
  - finds the price investors will receive a margin call.
  - If price falls below margin call price, investor must add money to the account to get back to the maintenance margin.
Research Reports*
- Value Line – ranks stocks on a scale 1 – 5 (1 is highest).
- Morningstar – ranks mutual funds on a scale 1 – 5 stars (5 is highest).
Dividend Dates
- Ex-Dividend Date
  - Date stock trades without (ex) the dividend
  - Sell on the ex-dividend date = receive the dividend
  - Buy it on or after ex-dividend date = NOT receive the dividend
  - One business day before the date of record.
  - Tip: must buy a stock one day before the ex-dividend date to get the dividend.
- Date of Record
  - Day you must be a registered shareholder to receive the dividedn.
  - One business day after the ex-dividend date.
Dividends
- Cash Dividends
  - Qualified dividends taxed as capital gains.
  - Taxed upon receipt.
- Stock Dividends
  - Not taxed until stock is sold.
Splits
- Increases shares outstanding and reduces stock price.
- A 2 for 1 split doubles shares outstanding, but cuts the price in half.
  - Ex: 100 shares at $60 per share become (100 x 2/1) or 200 shares at ($60 ÷ 2/1) or $30 per share after a 2 for 1 split.
- A 3 for 2 split
  - Ex: 100 shares at $60 per share becomes (100 x 3/2) or 150 shares at ($60 ÷ 3/2) or $40 per share after a 3 for 2 split.
Security Regulation*
- Securities Act of 1933
  - Regulates issuance of new securities.
  - Requires new issues come with a prospectus.
- Securities Act of 1934
  - Regulates the secondary market and securities trading.
  - Created the SEC.
- Securities Act of 1940
  - Allowed SEC to regulate investment companies — open, closed, unit investment trusts.
- Investment Advisers Act of 1940
  - Required investment advisors register with SEC.
- Securities Investors Protection Act of 1970
  - Established SIPC = protects investors from losses due to brokerage firm failures.
    - Does not protect investors from losses due to stupid investment decisions.
- Insider Trading and Securities Fraud Enforcement Act of 1958
  - Defines insider as anyone with info not available to the public.
  - Insiders cannot trade on that info.
Money Market Securities*
- Treasury Bills
  - Maturity up to 52 weeks.
  - $100 increments through Treasury Direct up to $5 million per auction.
- Commercial Paper
  - Short term loans between corporations.
  - Maturities of 270 days or less and not register with SEC.
  - Sold at a discount.
- Bankers Acceptance
  - Facilitates imports/exports.
  - Maturity of 9 months or less.
  - Held till maturity or traded.
- Eurodollars
  - Deposits in foreign banks denominated in US dollars.
Investment Policy Statement*
- Establishes:
  - Client’s objectives.
    - Risk tolerance: to better develop portfolio allocation. (critical step)
    - Return requirement: specific to a goal.
  - Constraints on investment manager.
    - Time horizon: help determine portfolio allocation.
    - Taxes: determines account types – tax-deferred, tax-free, or taxed account.
    - Liquidity: linked to time horizon and helps determine portfolio selection.
    - Legal: unique laws pertaining to clients like trusts or custodial accounts.
    - Unique circumstances: anything unique to the client’s situation.
- Measures investment manager’s performance.
Market Indices
- Dow
  - Price-weighted average.
- S&P 500
  - Value-weighted or market-cap weighted average.
- Russell 2000
  - Value-weighted average of smallest 2000 stocks in the Russell 3000.
- Wilshire 5000
  - Value-weighted average of over 3000 stocks — the broadest index.
- EAFE
  - Value-weighted index tracking stocks in Europe, Australia, Asia, and Far East.
Traditional Finance
- 4 Basic Premises:
  - Investors are Rational — investors make logical decisions about goals using all available information.
  - Markets are Efficient — stock’s trade at their fair value, at any given time, reflecting all available information.
  - Mean-Variance Portfolio Theory — states that investors choose portfolios by evaluating mean returns and variance of their entire portfolio.
  - Returns are Determined by Risk — CAPM links return with risk for all assets from an efficient market standpoint.
Behavioral Finance*
- Deviates from traditional finance by assuming:
  - Investors are “Normal” — investors commit cognitive errors and can be misled by emotions while trying to achieve wants and needs.
  - Market are NOT Efficient — price and fundamental value can deviate creating opportunities to buy at a discount and sell at a premium.
  - Behavioral Portfolio Theory — states investors divides their money into mental accounting layers — by goals — rather than viewing their portfolio as whole. So risk preferences can differ by goal or situation.
  - Risk Alone Does NOT Determine Returns — BAPM (Behavioral Asset Pricing Model) links return to investor likes/dislikes, fundamental ratios, momentum and other factors, beta, social status, and more.
- Biases & Heuristics
  - Affect Heuristic — mental shortcut that makes decisions based on current emotions like fear, pleasure, surprise.
    - Judging a company based on non-financial issues.
  - Anchoring — decisions are tied to a reference point that may have no logical relevance to the issue in question.
  - Availability Heuristic — decisions are tied to the most readily available knowledge in a person’s memory.
    - Overweight recent events or patterns while overlooking long-term trends.
  - Bounded Rationality — decisions are rational but severely limited by available information, the complexity of the problem, limits of the mind, and time.
    - Investors are limited by their own ability. So much so that more information does not improve the decision.
  - Confirmation Bias — people filter information, only focusing on the things that support their opinions.
  - Cognitive Dissonance — tend to misinterpret information that runs contrary to existing opinions or only pay attention to information that supports an opinion.
  - Disposition Effect or Regret Avoidance — investors base decisions on purchase price even after market prices and information has changed.
    - Leads to selling winners and holding onto losers.
  - Familiarity Bias — overestimate/underestimate the risk of investments are they are familiar/unfamiliar with.
  - Gamber’s Fallacy — the irrational belief that prior outcomes in a series of independent events affect the probability of a future outcome.
    - due to a lack of understanding probabilities.
  - Herding — the tendency to follow the masses.
    - Buy what others are buying and sell what others selling. This leads to buying high and selling low.
  - Hindsight Bias — looking back after an event occurs and believing it was more easily predictable than it was at the time.
  - Illusion of Control Bias — overestimate the ability to control the outcome of events.
  - Overconfidence Bias — people tend to have more confidence in their own abilities.
    - lead to confusing lucky gains with skill and overstating one’s risk tolerance.
  - Overreaction — react emotionally toward news or information.
  - Prospect Theory or Loss Aversion — people value gains and losses differently, putting more weight on perceived gains than perceived losses.
    - lead to avoiding higher return investments or choosing low deductibles insurance.
  - Recency — putting too much weight on recent events like short-term past performance.
  - Similarity Heuristic — decisions are made based on similar situations even though the situations may have different outcomes.
- Common Mistakes
  - Naive Diversification — invest in every option available.
  - Representativeness — thinking a good company is a good investment without regard to fundamentals.
  - Familiarity — only invest in what we know like a company we’re familiar with.
  - Loss Aversion — investors feel more pain from losses than enjoy gains. Can lead to holding on to losers with the hopes of breaking even.
Portfolio Theory
- Standard Deviation
  - Measures of “risk” and variability of returns
  - Higher standard deviation = higher variability and “risk”
  - Best used for a non-diversified portfolio.
  - Calculate Probability of Return (normal distribution)*
    - 68% probability actual return falls within +/- 1 standard deviation
    - 95% probability actual return falls within +/- 2 standard deviation
    - 99% probability actual return falls within +/- 3 standard deviation
    - Ex: If Average Return = 10%, Standard Deviation = 17%
      - 1 standard deviation = -7% and 27% (68% probability return falls in that range, 32% chance it falls outside it, 16% chance it’s less than -7%, 16% chance it’s greater than 27%)
      - 2 standard deviation = -24% and 44% (95% probability return falls in the range, 5% chance it falls outside it, 2.5% chance it’s less than -24%, 2.5% chance it’s greater than 44%)
      - 3 standard deviation = -41% and 61% (99% probability return falls in the range, 1% chance it falls outside it)
- Coefficient of Variation
  - Probability the actual return is close to the average return
  - CV = Standard Deviation/Average Return
  - Higher Coefficient = more “risky” an investment per unit of return.
  - Used to compare relative “risk” of two or more investments
- Distribution of Returns
  - Normal Distribution
    - To consider a range of investment returns
  - Lognormal Distribution
    - To consider portfolio value at a point in time.
  - Skewness
    - Normal distribution curve shifted to the left or right
    - Positive Skewness = shifted to the left
    - Negative Skewness = shifted to the right
  - Kurtosis
    - Variation of returns
    - Positive Kurtosis = higher peak, little variation of returns
    - Negative Kurtosis = lower peak, wider variation of returns
  - Leptokurtic* = high peak, fat tail — high chance of extreme events
  - Platykurtic* = low peak, thin tail — low chance of extreme events
- Mean Variance Optimization
  - Combining asset classes that provide the lowest variance measured by standard deviation
- Monte Carlo Simulation
  - Gives probability distribution of events occurring like running out of money in retirement based on different withdrawal rates.
- Covariance
  - Measures how prices between 2 securities move relative to each other
  - Measures relative “risk”
  - Correlation Coefficient
    - Measure movement of one security relative to another.
    - Measures relative “risk”
    - Ranges for +1 to -1
    - +1 = perfectly positively correlated
    - 0 = uncorrelated
    - -1 = perfectly negatively correlated
    - Diversification benefits at less than 1
- Beta
  - Measures volatility of individual security relative to the market (systematic or market “risk”).
  - Best used to measure volatility of a well-diversified portfolio.
  - Market beta = 1
    - Beta of 1 = expected to fluctuate with the market
    - Beta higher than 1 = expected to fluctuate more than the market
    - Beta lower than 1 = expected to fluctuate less than the market
  - Can be calculated by dividing security risk premium by market risk premium
    - Ex: Fund return = 15% and market return = 10% then Beta is 15/10 or 1.5
- Coefficient of Detemination or r²
  - Measures the percentage of return that is due to the market
  - r² = Square of the correlation coefficient.
  - Higher the r², the more the return is due to the market and not unsystematic risk.
  - A test if Beta is a good measure of total “risk”
    - r² >= 0.70, then Beta is an appropriate measure of total “risk”
    - r² < 0.70, then Beta is NOT appropriate measure of total “risk” (use standard deviation)
    - If r² is too low, then using the wrong benchmark.
- Portfolio Risk (Portfolio Deviation Formula)
  - Measures how the returns of two securities fluctuate over time.
  - Shortcut: portfolio deviation < the simple weighted average of standard deviation of two securities
- Systematic Risk*
  - Risk inherent in the system or market risk.
  - Lowest level of risk to expect in a diversified portfolio.
  - Types
    - Inflation or Purchasing Power Risk
      - Risk inflation erodes purchasing power.
    - Reinvestment Risk
      - Risk of not being able to reinvest at same rate of return currently earning.
    - Interest Rate Risk
      - Risk that changing interest rates impact price of assets.
      - Asset prices are inversely related to interest rates.
    - Market Risk
      - Risk that impacts all securities in the market.
    - Exchange Rate Risk
      - Risk that a change in currency exchange rates impacts international securities.
- Unsystematic Risk*
  - Risk specific to a security or investment.
  - Can be eliminated (reduced) through diversification.
  - Types
    - Accounting Risk
      - Risk of low-quality accounting or improper audits.
    - Business Risk
      - Risk a company inherently faces doing business in its industry.
    - Country Risk
      - Risk a company faces doing business in a country.
    - Default Risk
      - Risk a company defaults on debt.
    - Executive Risk
      - Risk tied to the moral/ethical character of management.
    - Financial Risk
      - Risk tied to the amount of leverage used by a company. More debt = more risky
    - Regulation or Government Risk
      - Risk of tariffs/regulations being placed on a company/industry impacting business.
- Modern Portfolio Theory
  - Assumes investors seek the highest return possible for a given level of risk
  - Assumes investors are risk-averse — want the lowest level of risk at any level of return.
- Efficient Frontier
  - Most “efficient” portfolio based on risk-reward relationship.
  - Portfolios below the efficient frontier are “inefficient.”
  - Portfolios above the efficient frontier are “unattainable.”
- Capital Market Line
  - Is the optimal relationship between “risk” and return for all possible portfolios.
  - Inefficient portfolios are below the line and unattainable above the line.
  - Intersect y-axis at risk-free rate — assumes investor at least earns risk-free rate of return.
  - Uses standard deviation as its measure of “risk.”
- Capital Asset Pricing Model*
  - Calculates the relationship of risk and return of individual security.
  - Uses Beta as its measure of “risk.”
  - Market Risk Premium = Market Return – Risk-Free Return
- Security Market Line
  - Shows relationship between “risk” and return as defined by CAPM.
  - Intersects y-axis at risk-free rate — assumes investor at least earns risk-free rate of return.
  - Uses Beta as its measure of “risk.”
- Performance Measures*
  - Information Ratio
    - Measures excess return, and fund manager consistency, relative to a benchmark.
    - Relative performance measure.
    - Higher is better.
    - Uses standard deviation as a measure of “risk.”
  - Treynor Index
    - Measures the amount of return relative to a unit of “risk.”
    - Relative performance measure.
    - Higher is better.
    - Uses Beta as its measure of “risk.”
    - Best used when considering a well-diversified portfolio — r² >= 0.70.
  - Sharpe Index
    - Measures a portfolio’s return relative to a unit of “risk” or total variability.
    - Relative performance measure.
    - Higher is better.
    - Uses standard deviation as a measure of “risk.”
    - Tip: if exam does not give r², then use Sharpe.
  - Jensen’s Alpha
    - Measures a portfolio’s performance to the market.
    - Absolute performance measure.
    - Positive Alpha = more return than expected for the risk undertaken.
    - Negative Alpha = less return than expected for the risk undertaken.
    - Higher is better.
    - Uses Beta as its measure of “risk.”
    - Best used when considering a well-diversified portfolio — r² >= 0.70.
Return Formulas
- Holding Period Return*
  - HPR= (Sell Price – Buy Price +/- Cash Flow)/Buy Price or Equity Invested
  - Not compounded return
  - Adds dividends in numerator
  - Subtract margin interest paid from numerator
  - Margin purchase — denominator is the margin amount (equity invested) in the trade.
- Effective Annual Rate
  - EAR = (1 + i/n)^n – 1
  - i = annual interest rate
  - n = number of compounding periods
  - Measures annual rate earned when there’s more than 1 compounding periods per year.
- Arithmetic Average
  - Simple average = add the numbers then divide by the number of observations.
  - Ignores effect of compounding.
- Geometric Average
  - Compound rate of return
- Weighted Average
  - Used to measure weighted average share price, expected return, beta, or duration.
  - Weighted Average Return = (Return for X x Weighting of X) + (Return for Y x Weighting of Y) + (Return for Z x Weighting of Z)
- Net Present Value
  - NPV = Present Value of Cash Flows – Initial Cost
  - Positive is a good investment, negative is bad.
  - NPV = 0, make investment
- Internal Rate of Return (IRR)
  - IRR = discount rate that sets NPV to 0
    - If NPV is positive, IRR > Discount Rate
    - If NPV is negative, IRR < Discount Rate
    - If NPV is 0, IRR = Discount Rate
  - Also the compounded rate of return
- Dollar-Weighted Return
  - Calculates IRR using investor’s cash flows.
- Time-Weighted Return
  - Calculates IRR using security’s cash flows.
  - Mutual Funds report on a time-weighted return basis.*
- Arbitrage Pricing Theory*
  - Assumes pricing imbalances can’t exist for a significant time, because investors will exploit imbalance.
  - Multi-factor model that attempts to explain return based on factors.
  - Factors are inputs like inflation, risk premia, expected return and the sensitivity to those factors.
  - Standard deviation and beta are NOT inputs.
- Foreign Currency Translation
  - Assets purchased in foreign currency are impacted by growth in the asset and in the foreign currency relative to US dollar.
    - Convert U.S. dollars to foreign currency.
    - Calculate the return.
    - Convert foreign currency back to U.S. dollars.
Stock Valuation
- Dividend Discount Model
  - Values a stock by discounting future dividend cash flows.
  - Use next year’s dividend in the formula.
    - Next Year’s Dividend = Current Dividend (1 + Growth Rate)
  - Tips:*
    - If rate of return decreases, stock price increases.
    - If rate of return increases, stock price decreases.
    - If dividend increases, stock price increases.
    - If dividend decreases, stock price decreases.
  - Disadvantages
    - Requires constant growth rate for dividends.
    - Not all stocks pay dividends.
    - Growth rate can not exceed expected return.
- Expected Rate of Return
  - Uses the Dividend Discount Model to solve for Rate of Return (r).
  - Uses market price in place of Value (V).
Stock Ratios*
- Price-Earnings Ratio
  - P/E = Price per share/EPS
  - Might be asked to solve for P/E, Price, or EPS
- PEG Ratio
  - Compares a stock’s P/E Ratio to 3-to-5 year growth rate in earnings
  - PEG = P/E Ratio/Earning Growth Rate
  - Measures whether stock price is keeping pace growth in earnings.
  - PEG = 1 — stock is fairly valued.
  - PEG > 1 — stock is overvalued.
- Book Value
  - Is the amount of shareholder equity in a company or amount shareholders get if liquidated.
  - High Book Value/Share = overvalued
  - Low Book Value/Share = undervalued
- Dividend Payout Ratio
  - The portion of earnings per share paid out as dividends.
  - Dividend Payour Ratio = Dividend/EPS
  - A high payout ratio may be a warning that dividends may be reduced.
- Return on Equity (ROE)
  - Measures the profitability of a company.
  - ROE = EPS/Equity per Share
  - Direct relationship between ROE, earnings, and dividend growth.
- Dividend Yield Formula
  - Annual dividend as a percentage of stock price.
  - Dividend Yield = Dividend/Stock Price
Strategies to Reduce Risk
- Dollar Cost Averaging
  - Invests same dollar amount on a periodic basis like montly.
  - Buys more shares when price is high, fewer shares when price is low.
- Fundamental Analysis
  - Analyzes balance sheet and income statement to determine future performance
  - Ratio analysis looks at liquidity, activity, profitability, valuation.
  - May look at economic data.
  - Assumes that securities can be mispriced.
- Technical Analysis
  - Analyzes stock price charts — price movement and trading volume — to forecast future price moves.
  - Ex: Dow Theory, Charting, Odd Lots, Market Breadth, Advance Decline Line, etc.
Efficient Market Hypothesis (EMH)
- Investors cannot consistently beat market returns.
- Price reflects all available information.
- Believed a passive strategy is best.
- Stock prices follow a “random walk.”
- Random Walk Theory
  - Stock prices resemble a random walk.
  - Prices are unpredictable but not arbitrary.
  - Prices reflect all information and the true value of the security.
  - Prices are in equilibrium.
- 3 Forms of EMH*
  - Weak Form
    - Price reflects historical information.
    - Advantage through fundamental analysis to earn above-average returns.
    - Rejects technical analysis.
  - Semi-Strong Form
    - Price reflects all historical and publicly available information.
    - Advantage through inside information to earn above-average returns.
    - Rejects fundamental and technical analysis.
  - Strong Form
    - Price reflects all historical, public, and private information.
    - No advantage.
    - Rejects fundamental, technical analysis, and insider trading.
Market Anomalies
- Exceptions to the EMH.
- January Effect
- Small Firm Effect — small caps outperform large caps.
- Value Line Effect
- Value Effect — Low P/E stocks outperform high P/E stocks.
Investing Strategies
- Active Strategy
  - Believe markets are inefficient.
  - Attempt to earn above-average returns through active investing and/or market timing.
  - Examples:
    - Tactical Asset Allocation
    - Strategic Asset Allocation
- Passive Strategy
  - Believe markets are efficient and/or it’s difficult to beat the market.
  - Buy-and-hold strategies are best like laddered bonds, barbell bond strategy, index funds, ETFs, UITs.
Bonds
- US Treasuries
  - Nonmarketable Treasuries
    - Series EE or Series E Bonds*
      - Nonmarketable, nontransferable
      - Offered at half of face value and only through Treasury Direct.
      - Does NOT pay interest — increases in value over 20 years based on a fixed rate.
      - Redeemable after 1 year — 3-month interest penalty if redeemed in before 5 years.
      - Not subject to federal taxes until redeemed.
        
        If used for education expenses, may qualify as tax free.
      - Not taxed at state/local level.
    - Series HH or Series H Bonds
      - Pays interest semi-annually.
      - Not issued since 2004.
    - Series I Bonds
      - Inflation-indexed bonds.
      - Sold at face value.
      - No guaranteed rate of return.
      - Interest consists of:
        
        Fixed rate or return.
        
        Inflation component adjusted every 6 months.
  - Marketable Treasuries
    - US Treasury Bills
      - Maturity less than 1 year.
      - Do Not pay interest — sold at a discount to par, mature at par value.
    - US Treasury Notes
      - Maturity from 2 to 10 years.
      - Pays interest semi-annually.
    - US Treasury Bonds
      - Maturity greater than 10 years.
      - Pays interest semi-annually.
  - Treasury Inflation-Protected Securities (TIPS)
    - Offer inflation or purchasing power protection
    - Principal/par value adjusts for inflation, then coupon rate is applied to new principal amount.
    - Coupon rate is fixed.
  - Original Issue Discount (OID)
    - Issued at discount to par — increases in value until matures at par value.
    - Zero-Coupon Bond
      - Must recognize interest income each year (imputed income), though none is received.
  - Separate Trading of Registered Interest and Principal Securities (STRIPS)
    - Coupon payments are separate from the bond — each coupon payment, including par value, trade seperately.
    - Highly liquid with specific time horizon.
- Federal Agency Securities*
  - Bonds issued by federal agencies but NOT backed by full fail and credit of US government.
  - Exception: GNMAs
  - On-Budget Debt
    - GNMA – Government National Mortgage Association (Ginnie Mae)
    - FMA – Farmers Home Administration
  - Off-Budget Debt of Agencies
    - FNMA – Federal National Mortgage Association (Fannie Mae)
    - FHLMC – Federal Home Loan Mortgage Corporation (Freddie Mac)
    - SLMA – Student Loan Marketing Association (Sallie Mae)
    - FFCB – Federal Farm Credit Banks
    - FICB – Federal Intermediate Credit Banks
    - FHLB – Federal Home Loan Bank
  - Mortgage-Backed Securities
    - GNMA – Government National Mortgage Association (Ginnie Mae)
      - Pool of FHA/VA guaranteed mortgages.
      - GNMA distributes interest and principal payments each month.
        
        Interst subject to state and federal taxes
        
        Return of principal not taxed.
    - FHLMC – Federal Home Loan Mortgage Corporation (Freddie Mac)
    - Biggest Risk: falling interest rates — mortgages get repaid/retired early.
- Corporate Bonds
  - Secure Bonds
    - Mortgage-Backed Securities (MBS)
      - Backed by pool of mortgages.
      - Paid interest and principal.
      - Biggest risk is prepayment.
    - Collateral Trust Bonds
      - Backed by asset owned by company issuing the bond.
      - Asset is held in trust.
      - Default — bondholders entitled to asset.
  - Collateralized Mortgage Obligations (CMOs)
    - Divided into short, mid, long term tranches to decide who gets paid first.
    - Interest is paid pro-rata, principal payments used to retire tranches.
    - Meant to mitigate prepayment risk.
  - Unsecured Corporate Bonds
    - Debentures
      - Unsecured debt not backed by any asset.
      - Backed by “belief” in creditworthiness.
    - Subordinated Debentures
      - Lower claim on assets than other unsecured debt.
      - Lower claim = higher risk if defaults.
    - Income Bonds
      - Interest is only paid when a specified level of income is reached.
- Bond Rating Agencies
  - Moody’s = rating Aaa to C
  - Standard & Poor’s = rating AAA to D
  - Higher rating = lower yield
  - Analyze liquidity, total debt, earnings and earnings stability.
- Guaranteed Investment Contract (GIC)
  - Issued by insurance companies.
  - Guaranteed rate of return.
- Municipal Bonds*
  - Nontaxable at federal level.
  - Nontaxable at state/local level if live in the state.
  - 3 Types:
    - General Obligation Bonds
      - Backed by the full faith, credit, and taxing authority of municipality
    - Revenue Bonds
      - Backed by the revenue of the funded project.
      - NOT backed by the full aith, credit, and taxing authority of municipality
    - Private Activity Bonds
      - Used to fund stadium construction
  - Insured Municipal Bonds
    - Insured bonds in default are paid by insuring company
    - Insuring Companies:
      - AMBAC – American Municipal Bond Assurance Corp.
      - MBIA – Municipal Bond Insurance Corp.
- Bond Risks*
  - Corporate
    - Default Risk
    - Reinvestment Risk
    - Interest Rate Risk
    - Purchasing Power Risk
  - US Goverment
    - Reinvestment Risk
    - Interest Rate Risk
    - Purchasing Power Risk
- Tax-Equivalent Yield
  - Yield a corporate bond must pay to be equal to the yield on a municipal bond.
  - If muni bond is double or triple tax free, combine federal, state, and local tax rates.
  - Tax-Equivalent Yield = r/(1 – t)
    - r = tax exempt yield
    - t = marginal tax rate
- Tax-Exempt Yield
  - After-tax rate a taxable corporate bond pays.
  - Above formula solved for r.
  - Tax-Exempt Yield = (Corp. rate) x (1 – t)
    - t = marginal tax rate
Bond Valuation
- Basics
  - Coupon Rate
    - Interest paid as a dollar amount
    - Keystroke = PMT
  - Par Value
    - Amount repaid at maturity.
    - Principal amount = $1,000 on bonds, unless stated otherwise.
    - Keystroke = FV
  - Time to Maturity
    - Time remaining or number of periods until par is repaid.
    - Keystroke = N
  - Market Interest Rate
    - Yield earned at bond’s current market price.
    - Keystroke = I/YR
- Conventional Yield Measures
  - Nominal Yield (Coupon Rate)
    - Coupon Rate = Coupon Payment/Par
  - Current Yield
    - Current Yield = Coupon Payment/Bond Price
  - Yield to Maturity (YTM)
    - Compound return if bond is held to maturity.
    - Assumes interest is reinvested at same rate.
    - N = periods to maturity (adjust for # of periods compounded per year)
    - I/YR = YTM (adjust for # of periods compounded per year)
    - PV = current bond price
    - PMT = coupon payment (dollar amount)
    - FV = par value
    - Assume semi-annual compounded unless stated otherwise*
  - Yield to Call (YTC)
    - Compound return if bond is held until called.
    - Use periods until bond called.
    - N = periods till callable (adjust for # of periods compounded per year)
    - I/YR = YTC (adjust for # of periods compounded per year)
    - PV = current bond price
    - PMT = coupon payment (dollar amount)
    - FV = Callable value
- Accrued Interest
  - Buyer pays seller of bond any interest accrued since last interest payment when buying a bond.
  - Buyer receives next interested payment in full.
  - 1099-INT reflects full interest paid, buyer can deduct accrued interest amount paid to seller.
- Yield Curve
  - Liquidity Preference Theory
    - Results in lower yields for shorter maturities because investors prefer and will pay for liquidity.
    - Long-term yields should be higher than short-term yields because higher risk with longer maturities.
  - Market Segmentation Theory
    - States that yield curve depends on supply and demand at different maturities.
    - Supply is greater than demand = lower rates
    - Demand is greater than supply = higher rates
  - Expectation Theory
    - States that yield curve reflects investor inflation expectations.
  - Unbiased Expectations Theory (UET)
    - States that long term rates have expectations of future short term rates embedded in them.
    - Long term rates are the geometric average of the current and expected future short term rates.
- Bond Duration
  - Duration is the weighted average maturity of all cash flows.
  - As duration increases, bonds become more sensitive to interest rate changes.
  - When duration = investor’s time horizon, the bond portfolio is immunized.
  - Calculating Duration:
    - Duration is inversely related to the coupon rate and yield to maturity.
      - As coupon rate or YTM increases (decreases), duration decreases (increases).
    - Duration is directly related to the term of a bond.
      - As term increases (decreases), duration increases (decreases).
    - Note: Zero-coupon bonds — duration = maturity.
  - Estimating Bond Price
    - Duration is used to estimate bond’s change in price based on interest rate changes.
  - Assumptions:
    - Assumes linear relationship between interest rate changes and bond price changes (it’s NOT linear, it’s curve-linear).
    - It works well for small changes in interest rates. NOT well for large changes in interest rates.
      - Understates price appreciation when interest rates fall.
      - Overstates price depreciation when interest rates rise.
    - Convexity: the difference between the duration estimated price and the actual price change of a bond.
- Bond Strategies
  - Tax Swap
    - Sell a bond with a gain and a bond with a loss to offset each other, or
    - Sell a bond with a loss and buy a new bond.
  - Barbells
    - Owning both long-term and short-term bonds, but not intermediates.
    - When interest rates move, only one position needs to be restructured.
  - Laddered Bonds
    - Owning bonds with varying maturities.
    - As bonds mature, new bonds are purchases with maturities longer than what’s in the portfolio.
    - Helps reduce interest rate risk.
  - Bullets
    - Designed to have few interest payments in the interim, then a lump sum at a specific future date.
    - Most bonds mature at the same time.
    - Relies on zero-coupon, treasuries, and other no coupon bonds.
Convertible Bonds
- Conversion value is based on the price of the stock that it converts to.
- Benefits: if the stock does poorly, the bond still has a floor built-in = par value at maturity.
- Conversion Value = (Par/Conversion Price) x Stock Price
  - # numbers of shares it converts to = 1000/Conversion Price
Preferred Stock
- Has both equity and debt features.
- Equity
  - Trades like a stock on a exchange.
  - Price may move with the common (convertible preferred).
- Debt
  - Has par value.
  - Dividend rate stated as percentage of par.
- Differences:
  - Dividend is fixed.
  - Not maturity date.
  - Price is tied more to interest rate changes.
- Tax Advantages:
  - Corporations get a 50% or 65% deduction of dividends — preferred and common — based on its percentage ownership of the company paying the dividend (for tax years 2018 and beyond).
Property Valuation
- Capitalized Value = Net Operating Income/Capitalization Rate
- Net Operating Income (NOI) = Net Income + Depreciation and Interest Expense
Investment Companies
- Closed End
  - Closed-end funds trade on an exchange.
  - Can trade above/below NAV.
  - No new shares are issued.
- Open End
  - Open end funds have an unlimited number of shares.
  - Shares are bought/redeemed through fund company.
  - Trade at NAV.
  - NAV = (assets – liabilities)/shares outstanding
- Unit Investment Trusts (UIT)
  - Self-liquidating passively managed fixed portfolio of stocks or bonds. Typically, bonds.
Mutual Funds
- Money Market Fund — highly liquid securities with maturity less than 90 days.
- Balanced Fund — seeks balanced return in income and capital appreciation.
- Growth and Income Fund
- Growth Fund
- Aggressive Growth Fund
- Value Fund
- Bond Fund
- Index Fund — tracks a market index.
- Sector Fund
- International Fund
- Global Fund — invests in international and US.
- Lifecycle Fund — broadly diversified portfolio where the asset allocation adjusts as it gets closer to a specific date — date is tied to a goal like retirement.
Fund Expenses
- No Load Funds
  - Charges NO sales commission
- Load Funds
  - Charge sales commission when bought or redeemed.
  - A Shares
    - Front-end load
    - Small 12b-1 fee (marketing fee)
    - NO back-end load
    - Best held for long term
  - B Shares
    - Back-end load
    - High 12b-1 fee (max of 1%)
    - NO front-end load.
    - Can be converted to A shares.
    - Not really offered anymore.
  - C Shares
    - Small back-end load and max 12-b1 fee (1%).
    - No front-end load.
    - Do NOT covert to A shares.
Exchange-Traded Funds (ETFs)
- Typically track a market index.
- Traded on an exchange.
- Tax-efficient — low portfolio turnover and passive strategy.
Real Estate Investment Trusts (REITs)
- Must distribute 90% of investment income to shareholders.
- Diversification benefits due to low correlation to stocks/stock market.
- Types
  - Equity
    - Invests in real estate for capital appreciation and rental income.
    - Inflation hedge.
  - Mortgage
    - Invests in mortgages and/or construction loans.
  - Hybrid
    - Mix of both.
American Depository Receipts (ADRs)
- Represent foreign stock held in domestic bank’s foreign branch.
- Trade on US exchanges in US dollars.
- Dividends paid in US dollars.
- Do NOT eliminate exchange rate risk.
Alternative Investments
- NOT cash, stocks, or bonds.
- Characteristics:
  - Higher fees
  - Large minimum purchase
  - Actively managed, possibly leveraged, illiquid.
- Examples:
  - REITs
  - CMOs
  - Limited Partnerships
  - Hedge Funds
  - Collectibles — art, antiques, baseball cards — risk of fraud, subject to changing consumer taste and demand.
    - Net long-term gains taxed @ 28%
  - Precious Metals — gold, silver, etc.
Derivatives
- Options
  - The Right (or “option”) to buy or sell a security at a later date.
  - Value of the option depends on the value of the underlying security.
  - 1 option contract is 100 shares of the security.
  - Call Options*
    - Right to buy a set number of shares at a specific price (strike or exercise) within a specific time period (American options) or specific future date (European options).
    - Buyers — believe the underlying stock price will rise.
    - Sellers — believe the underlying stock price will fall or stay the same.
    - Tip: “Buy a Call” — maximize gain if stock price rises.
  - Put Options*
    - Right to sell a set number of shares at a specific price (strike or exercise) within a specific time period (American options) or specific future date (European options).
    - Buyers — believe underlying stock price will fall.
    - Sellers — believe the underlying stock will rise or stay the same.
    - Tip: “Buy a Put” — maximize gain if stock price falls.
  - Option Premium*
    - Option premium consists of intrinsic value and time premium.
    - Expiration is typically up to 9 months.
      - Time Value = Premium – Intrinsic Value
      - Intrinsic value can not be less than 0.
    - Call Option
      - Premium = Stock Price – Strike Price
      - In the Money: Stock Price > Strike Price
      - At the Money: Stock Price = Strike Price
      - Out of the Money: Stock Price < Strike Price
    - Put Option
      - Premium = Strike Price – Stock Price
      - In the Money: Stock Price < Strike Price
      - At the Money: Stock Price = Strike Price
      - Out of the Money: Stock Price > Strike Price
  - Steps to Calculate Gain or Loss
    1. Stock gain or loss (if owned).
    2. Options gain or loss.
    3. Premium paid or received.
    4. Shares controlled or owned.
  - Trading Strategies
    - Covered Call
      - Sell call options on a currently owned security.
      - Used to generate income on a stock in a “trading range” or to generate additional dollars and sell the stock.
    - Married Put
      - Buy a put option on a currently owned security.
      - Used for portfolio insurance — “protecting profits” or “locking in gains”
    - Long Straddle
      - Buy a put and call option on same stock.
      - Used when expect volatility and unsure of direction.
    - Short Straddle
      - Sell a put and call option.
      - Used when do not expect volatility and want to capture the premium.
    - Collar or Zero-Cost Collar
      - Sell call option at a strike price slightly higher than the current stock price. Creates premium received.
      - Then buy a put option below the current stock price. Premiums received from sold call option used to buy the put option.
      - Used when own underlying stock but want to protect downside without paying the entire cost of the put option.
  - Option Pricing Model*
    - Black Scholes
      - Determines value of Call option
      - Variables:
        
        current price of underlying asset
        
        Time until expiration
        
        Risk-free rate
        
        Volatility of underlying asset
      - All variables are directly related to option price, except strike price. As strike price increases, option price decreases.
    - Put/Call Parity
      - Attempts to value a Put option based on corresponding Call option.
    - Binomial Pricing Model
      - Values an option based on underlying asset price moving in one of two directions.
  - Taxes on Options
    - Call Options
      - If contract lapses/expires = premium paid is short-term loss and premium received is short-term gain.
      - If contract exercised = premium is added back to stock price to increase basis
        
        If stock held <= 12 months = short-term gain or loss.
        
        If stock held > 12 months = long-term gain or loss.
    - Put Options
      - If contract expires = premium paid is short-term loss and premium received is short-term gain.
- Long Term Equity Anticipation Securities (LEAPs)
  - Have longer expiration periods — 2 years or more — than normal options.
  - Higher premium due to longer expiration.
- Warrants
  - Long-term call options issued by corporations.
  - Longer expiration periods — 5 to 10 years.
  - Terms are NOT standardized.
- Futures Contracts
  - The Obligation to buy or sell an underlying asset at a later date.
    - Holder must make or take delivery
  - Commodity Futures Contracts
    - Copper, wheat, pork bellies, oil
  - Financial Futures Contracts
    - Currency, interest rate, stock index.
  - Price is determined by supply and demand.
  - Used for hedging and speculating.
  - Hedging Positions
    - Long commodity, short the contract (sell futures)
    - Short the commodity, long the contract (buy futures)

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