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.

- Prospectus

- Best Efforts
- 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.

- Becomes a market order
- Stop Limit Order
- Become a limit order
*after*hitting a specific price. - Risk is order does not fill if price moves too quickly.

- Become a limit order

- Market Order
- 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**).

- Amount of
- 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.

- Initial 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.

- Ex-Dividend Date
- Dividends
- Cash Dividends
- Qualified dividends taxed as capital gains.
- Taxed upon receipt.

- Stock Dividends
- Not taxed until stock is sold.

- Cash Dividends
- 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.

- Does

- Established SIPC = protects investors from losses due to brokerage firm failures.
- 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.

- Securities Act of 1933
**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.

- Treasury Bills
**Investment Policy Statement***- Establishes:
- Client’s objectives.
- Risk tolerance: to better develop portfolio allocation. (
**critical step**) - Return requirement: specific to a goal.

- Risk tolerance: to better develop portfolio allocation. (
- 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.

- Client’s objectives.
- Measures investment manager’s performance.

- Establishes:
- 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.

- Dow
- 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.

- 4 Basic Premises:
**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.

- Affect Heuristic — mental shortcut that makes decisions based on current emotions like fear, pleasure, surprise.
- 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.

- Deviates from traditional finance by assuming:
- 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

- Normal Distribution
- 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 r
^{2}- Measures the percentage of return that is due to the market
- r
^{2}= Square of the correlation coefficient. - Higher the r
^{2}, the more the return is due to the market and not unsystematic risk. - A test if Beta is a good measure of total “risk”
- r
^{2}>= 0.70, then Beta is an appropriate measure of total “risk” - r
^{2}< 0.70, then Beta is NOT appropriate measure of total “risk” (use standard deviation) - If r
^{2}is too low, then using the wrong benchmark.

- r

- 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.

- Inflation or Purchasing Power Risk

**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.

- Accounting Risk

- 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.”

- Measures excess return, and fund manager consistency,
- 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 — r
^{2}>= 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 r^{2}, 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 — r
^{2}>= 0.70.

- Information Ratio

- Standard Deviation
- 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

- IRR = discount rate that sets NPV to 0
- 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.

- Assets purchased in foreign currency are impacted by growth in the asset and in the foreign currency relative to US dollar.

- 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.

- Values a stock by discounting
- Expected Rate of Return
- Uses the Dividend Discount Model to solve for Rate of Return (r).
- Uses market price in place of Value (V).

- Dividend Discount Model
**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

- Price-Earnings Ratio
- 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.

- Dollar Cost Averaging
- 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.

- Weak Form

- 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.

- Active Strategy
- 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.

- US Treasury Bills
- 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.

- Nonmarketable Treasuries
**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.

- GNMA – Government National Mortgage Association (Ginnie Mae)

- 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.

- Mortgage-Backed Securities (MBS)
- 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.

- Debentures

- Secure Bonds
- 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

- General Obligation Bonds
- 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

- Corporate
- 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

- US Treasuries
- 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

- Coupon Rate
- 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

- Nominal Yield (Coupon Rate)
- 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.

- Liquidity Preference Theory
- 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.

- Duration is inversely related to the coupon rate and yield to 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.

- Assumes linear relationship between interest rate changes and bond price changes (it’s

- 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.

- Tax Swap

- Basics
- 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.

- Closed End
- 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.

- No Load Funds
- 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.

- Equity

- 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
- Stock gain or loss (if owned).
- Options gain or loss.
- Premium paid or received.
- 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.

- Covered Call
**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.

- Determines value of
- Put/Call Parity
- Attempts to value a
**Put**option based on corresponding Call option.

- Attempts to value a
- Binomial Pricing Model
- Values an option based on underlying asset price moving in one of two directions.

- Black Scholes
- 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.

- Call Options

- The
- 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)

- The

- Options