Fundamentals of Investments Summary
- 1. Chapter 1 Total dollar return: the return on an investment measured in dollars that accounts for all cash flows and capital gains or losses. When you buy an asset, your gain or loss is called the return on your investment. This return is made up of two components: The cash you receive while you own the asset (interest or dividends), and The change in value of the asset, the capital gain or loss. The total dollar return is the sum of the cash received and the capital gain or loss on the investment. Whether you sell the stock or not, this is a real gain because you had the opportunity to sell the stock at any time. Total percent returns: the return on an investment measured as a percentage of the original investment that accounts for all cash flows and capital gains or losses When you calculate percent returns, your return doesn't depend on how much you invested. Percent returns tell you how much you receive for every dollar invested. There are two components of the return: Dividend yield, the current dividend divided by the beginning price Capital gains yield, the change in price divided by the beginning price Risk-free rate: the rate of return on a riskless investment. Risk premium: the extra return on a risky asset over the risk-free rate. The rate of return on T-bills is essentially risk free because there is no risk of default. So we will use T-bills as a proxy for the risk-free rate, our investing benchmark. If we consider T-bills as risk-free investing and investing in stocks as risky investing, the difference between these two returns would be the risk premium for investing in stocks. This is the additional return we receive for investing in the risky asset, or the reward for bearing risk. A. The Risk-Return Trade-off If we are unwilling to take on any risk, but we are willing to forego the use of our money for a while, then we can earn the risk-free rate. We can think of this as the time value of money. If we are willing to bear risk, then we can expect to earn a risk premium, on average. We can think of these two factors as the "wait" component and the "worry" component.
- 2. Chapter 2 Investment Management: Hiring a professional manager to manage your investments. Market Timing: Buying and selling in anticipation of the overall direction of the market. Asset Allocation: the distribution of investment funds among broad classes of assets. Security Selection: Selection of specific securities within a particular class. Full service brokers provide many services, including investment advice, research services, account management, and personal service. In addition to telephone and web access, you can usually visit full service brokerage offices. Full service brokers charge the highest fees. These professionals have generally moved to an advisory based relationship, where you pay a fee (say 1%) based on asset value. This covers all costs associated with advice and trading. Discount brokers typically provide more services than the deep discount brokers but fewer than the full service brokers. Their fee is usually in-between the fees of the full service and the deep discount brokers. A deep discount broker provides minimal services, normally just account maintenance and order execution (buying and selling). You usually contact the deep discount broker on the telephone or over the web. The brokerage commissions are lowest for deep discount brokers. Cash Account: A brokerage account in which all transactions are made on a cash basis. Securities can only be purchased if there are sufficient funds in the account. Margin Account: A brokerage account in which securities can be bought and sold on credit. Call Money Rate: The interest rate that is charged on funds borrowed in a margin account. A spread is also charged on the loan above the call money rate. Margin: The portion of the value of the investment that is not borrowed. Initial Margin: The minimum margin that must be supplied on a securities purchase.
- 3. Maintenance Margin: The minimum margin that must be present at all times in a margin account. Maintenance margin is sometimes called the “house” margin requirement. Margin Call: A demand for more funds that occurs when the margin in an account drops below the maintenance margin. Short Sale When an investor buys a stock, the investor is long the stock. The investor makes money when the price goes up, as in "buy low, sell high." When an investor sells short or shorts the stock, the investor is selling the stock with the intent of repurchasing it in the future. When the stock is repurchased, the investor is covering the short position. The short investor profits when the price of the stock goes down. When you short sell a stock, you borrow the stock from the broker. You incur initial margin, must meet the maintenance margin requirements, and must pay any dividends that are paid during the short position. Chapter 3 Interest bearing assets: value of the asset depends on interest rates. The values of all of these assets depend on interest rates; they are a type of loan, and they are all debt obligations. There are many types of interest-bearing assets, and they range from the simple to the very complex. Money market instruments: short-term obligations of corporations and governments that mature in one year or less. Treasury bills (or T-bills): money market security sold by the U.S. Treasury, on a discount basis, with no possibility of default (risk-free). Money market instruments are the simplest form of interest-bearing asset. They are IOUs sold by large corporations or governments, and they mature in less than one year. They are usually sold in large denominations and are very liquid. Treasury bills are the most familiar type of money market instruments. The U.S. Treasury borrows billions of dollars by selling T-bills to the public. They are sold on a discount basis, i.e., sold at a price less than their stated face value. When they mature, the investor receives the full face value, and the difference is the interest earned. The risk of default is very low, so T-bills are essentially risk-free.
- 4. Fixed income securities: These are longer-term debt obligations (over 12 months) of corporations and governments. These securities make fixed payments according to a preset schedule. Fixed income securities are issued by corporations and governments: promise to make fixed payments, are debt obligations, and have maturities that are 12 months or longer. They also are known by the terms “note” or “bond.” Example: Suppose you purchase a $10,000 face value four-year Treasury note with a 5 percent coupon. The notes pay interest semiannually, so you will receive $500 per year or $250 in two semiannual coupon payments for each of the next four years. At the end of year four you will receive both the last $250 interest payment and the $10,000 face value. Equities: Equities consist of common stock and preferred stock. Common stock: This security represents ownership in a corporation. Benefits include cash dividends and potential capital gain in the value of the shares. Neither benefit is guaranteed. Preferred stock: This security is a hybrid security. The dividends and fixed liquidation value are similar to a fixed income security. The gain or loss from the change in value resembles equity. For tax purposes, preferred is treated as equity. Chapter 4 Advantages and Drawbacks of Mutual Fund Investing Advantages Diversification, professional management, and the low required size of the initial investment are among the advantages to investing in mutual funds. Drawbacks Three in particular are risk, costs, and taxes. Fund Types Open-end fund: An investment company that stands ready to buy and sell shares at any time. Closed-end fund: An investment company with a fixed number of shares that are bought and sold only in the open stock market.
- 5. Chapter 6 Dividend discount model (DDM): Method of estimating the value of a share of stock as the present value of all expected future dividend payments. Two-stage dividend growth model: Dividend model that assumes a firm will temporarily grow at a rate different from its long-term growth rate. Residual Income Free Cash Flow FCF = EBIT (1- tax rate) + Depreciation – Capital Expenditures – change in NWC Chapter 7 Forms of Market Efficiency Weak-form efficient market: A market in which past prices and volume figures are of no use in beating the market. Semistrong-form efficient market: A market in which publicly available information is of no use in beating the market. Strong-form efficient market: A market in which information of any kind, public or private, is of no use in beating the market. Chapter 8 Chapter 9 Prime rate: The basic interest rate on short-term loans that the largest commercial banks charge to their most creditworthy corporate customers. 01 0 g)(k gBEPS P T T 3 3 2 21 0 k1 D k1 D k1 D k1 D V 2 20 T 1 T 1 1 10 0 gk )g(1D k1 g1 k1 g1 1 gk )g(1D V
- 6. Bellwether rate: Interest rate that serves as a leader, or as a leading indicator of future trends, e.g., interest rates as a bellwether of inflation. Federal funds rate: Interest rate that banks charge each other for overnight loans of $1 million or more. Discount rate: The interest rate the Fed offers to commercial banks for overnight reserve loans. Call money rate: The interest rate brokerage firms pay for call money loans, which are bank loans to brokerage firms. This rate is used as the basis for customer rates on margin loans. Commercial paper: Short-term unsecured debt issued by the largest corporations. Certificate of deposit (CD): Large denomination deposits of $100,000 or more at commercial banks for a specified term. Bankers Acceptance: This is a postdated check on which a bank has guaranteed payment; commonly used to finance international trade transactions. Eurodollars: These are Certificates of Deposit denominated in U.S. dollars at foreign commercial banks. London Interbank Offered Rate (LIBOR): This is the nterest rate that international banks charge one another for overnight Eurodollar loans. U.S. Treasury bill (T-bill): These are short-term U.S. government debt instruments issued by the U.S. Treasury. Real Interest Rates: This is the term for interest rates adjusted for the effect of inflation, calculated as the nominal rate less the rate of inflation. To compute (an approximation of) the real interest rate: Real interest rate = Nominal interest rate - Inflation rate Fisher Hypothesis: This is an assertion that the general level of nominal interest rates follows the general level of inflation. According to the Fisher hypothesis, interest rates are on average higher than the rate of inflation. Therefore, short-term interest rates should reflect current inflation, and long- term interest rates should reflect expectations of future inflation.
- 7. Traditional Theories of the Term Structure Expectations Theory: In this theory, the term structure of interest rates is a reflection of financial market beliefs regarding future interest rates. Forward Rate: This is an expected future interest rate implied by current interest rates. The implied forward rate, (f 1,1), can be calculated by: (1 + r2)2 = (1 + r1)(1 + f1,1) Maturity Preference Theory: In this theory, long-term interest rates contain a maturity premium necessary to induce lenders into making longer term loans. Market Segmentation Theory: In this theory, debt markets are segmented by maturity, with the result that interest rates for various maturities are determined separately in each segment. Chapter 10 Coupon rate: This is a bond's annual coupon divided by its price. It is also called coupon yield or nominal yield. Current yield: A bond's annual coupon divided by its market price. A bond's coupon rate is expressed as a percentage of face value: Yield to maturity (YTM): This is the discount rate that equates a bond's price with the present value of its future cash flows. It is also called promised yield, or just yield. Yield to maturity is the most important yield measure for a bond. If just the term "yield" is used it means yield to maturity. valuePar couponAnnual rateCoupon priceBond couponAnnual yieldCurrent
- 8. where C = annual coupon (sum of the two semiannual coupons), FV = face value, M = maturity in years, and YTM = yield to maturity. Malkiel's Theorems Malkiel's theorems summarize the relationship between bond prices, yields, coupons, and maturity. Bond prices move inversely with interest rates. The longer the maturity of a bond, the more sensitive is its price to a change in interest rates. The price sensitivity of any bond increases with its maturity, but the increase occurs at a decreasing rate. The lower the coupon rate on a bond, the more sensitive is its price to a change in interest rates. For a given bond, the volatility of a bond is not symmetrical, i.e., a decrease in interest rates raises bond prices more than a corresponding increase in interest rates lowers prices. Duration: A widely used measure of a bond's sensitivity to changes in bond yields. Properties of Duration Longer maturity, longer duration, Duration increases at a decreasing rate, Higher coupon, shorter duration, and Higher yield, shorter duration. Zero coupon bond: duration = maturity Dedicated portfolio: A bond portfolio created to prepare for a future cash outlay. Reinvestment rate risk: The uncertainty about a future or target date portfolio value that results from the need to reinvest bond coupons at yields not known in advance. 2M2M 2 YTM 1 FV 2 YTM 1 1 1 YTM C PriceBond
- 9. As market yields change, the reinvestment rate on bond coupons received also varies. The reinvestment rate risk is the uncertainty about the future value of the portfolio due to its coupons being reinvested at unknown future interest rates. Chapter 11 Expected Return: the weighted-average of possible future returns on a risky asset. The expected return on a security is equal to the sum of the possible returns multiplied by their probabilities, or the weighted average of all the possible returns of the security. The risk premium is the difference between this expected return and the risk-free weight. Calculating the Variance of Expected Returns To find the variance of expected returns, first determine the squared deviations from the expected return. Then multiply each possible squared deviation by its probability. Finally, sum these up, and the result is the variance. A Portfolio is a group of assets, such as stocks and bonds, held by an investor. Portfolios are often described by portfolio weights. Portfolio Expected Returns The portfolio expected return is the weighted average combination of the expected returns of the assets in the portfolio. Markowitz Efficient Frontier: The set of portfolios with the maximum return for a given standard deviation. Chapter 12 Systematic and Unsystematic Risk Systematic Risk: Systematic risk influences a large number of assets. This is also called market risk. n 1i iiP REwRE
- 10. Unsystematic Risk: Unsystematic risk influences a single company or a small group of companies. Unsystematic risk is also called unique or asset-specific risk. Systematic risk usually results from economic or macroeconomic factors, whereas unsystematic risk results from company-specific events. Beta Coefficient (): Measure of the relative systematic risk of an asset. Assets with betas larger (smaller) than 1 have more (less) systematic risk than average. Security Market Line (SML): Graphical representation of the linear relationship between systematic risk and expected return in financial markets. Market Risk Premium: The risk premium on a market portfolio; i.e., a portfolio made of all assets in the market Capital Asset Pricing Model (CAPM): A theory of risk and return for securities in a competitive capital market. The line that results when the expected returns and beta coefficients are plotted is called the Security Market Line (SML). A portfolio made up of all assets in the market is called the market portfolio. The risk premium on a market portfolio is also the slope of the SML, and it is called the market risk premium: The Capital Asset Pricing Model (CAPM) shows that the expected return for an asset depends on: The pure time value of money (as measured by the risk-free rate) The reward for bearing systematic risk (as measured by E(RM) - Rf) The amount of systematic risk (as measured by beta) The equation for the CAPM is: Chapter 13 Sharpe Ratio: Measures investment performance as the ratio of portfolio risk premium over portfolio return standard deviation. This ratio was originally proposed by Nobel Laureate William F. Sharpe. p fp σ RR RatioSharpe fM fM M fM R)R(E 0.1 R)R(ER)R(E SlopeSML fMjfj R)R(ER)R(E
- 11. Treynor Ratio: Measures investment performance as the ratio of portfolio risk premium over portfolio beta. Jack L. Treynor originally proposed this measure. As with the Sharpe ratio, the Treynor ratio is a reward-to-risk ratio. The key difference is that the Treynor ratio looks at systematic risk only, not total risk. Jensen's Alpha: Measures investment performance as the raw portfolio return less the return predicted by the Capital Asset Pricing Model (CAPM). This measure was originally proposed by Michael C. Jensen. The Sharpe ratio is appropriate for the evaluation of an entire portfolio. The Sharpe ration does not require a beta estimate. The Sharpe ratio penalizes a portfolio for being undiversified, because standard deviation measures total risk. Total risk approximates systematic risk only for relatively well-diversified portfolios. The Treynor ratio is appropriate for the evaluation of securities or portfolios for possible inclusion in a broader or master portfolio. The Treynor ratio requires a beta estimate, and betas from different sources can be quite different. Jensen's alpha is appropriate for the evaluation of securities or portfolios for possible inclusion in a broader or master portfolio. Jensen’s alpha is easy to interpret. However, Jensen’s alpha requires a beta estimate, and betas from different sources can be quite different. Chapter 14 Forward Contract: Agreement between a buyer and a seller, who both commit to a transaction at a future date at a price set by negotiation today. Futures Contract: Contract between a seller and a buyer specifying a commodity or financial instrument to be delivered and paid for at a set price at contract maturity. Futures contracts are managed through an organized futures exchange. Exchange trading increases liquidity and reduces counterparty risk, but it eliminates some flexibility associated with being able to set an exact contract size. Futures Price: Price negotiated by buyer and seller at which the underlying commodity or financial instrument will be delivered and paid for to fulfill the obligations of a futures contract. p fp β RR RatioTreynor
- 12. Chapter 15 Option Basics Derivative Security: Security whose value is derived from the value of another security. Options are a type of derivative security. Call Option: On common stock, grants the holder the right, but not the obligation, to buy the underlying stock at a given strike price. Put Option: On common stock, grants the holder the right, but not the obligation, to sell the underlying stock at a given strike price. Strike Price: Price specified in an option contract that the holder pays to buy shares (in the case of call options) or receives to sell shares (in the case of put options) if the option is exercised. The strike price is also called the striking price or the exercise price. American Option: An option that can be exercised any time before expiration. European Option: An option that can be exercised only at option expiration. Note: the option “expires” on the Saturday after the third Friday. Option Payoffs and Profits Option Writing: Taking the seller's side of an option contract. Call Writer: One who has the obligation to sell stock at the option's strike price if the option is exercised. Put Writer: One who has the obligation to buy stock at the option's strike price if the option is exercised. The seller of an option is the writer. The option writer receives the option price and assumes the obligation of satisfying the buyer's exercise rights if the option is exercised. The call writer is obligated to sell the stock at the exercise price, and the put writer is obligated to buy the stock at the exercise price. Option Payoffs The initial cash flow of an option is the option premium. The premium is a cash outflow for the option buyer and a cash inflow for the option writer. Since buyers and sellers have the same cash flows, options are a zero-sum game. Option Payoff Diagrams These graphs show the cash flows from options as the underlying stock price changes for buying and writing call and put options. The payoff diagrams are drawn based upon the value of the option at expiration. That is, payoff diagrams do not include the price of the option itself.