1 Topic 24: Investment Vehicles  CDs  Money market funds Money market mutual funds temporarily insured  T bills  Commercial paper  Bankers acceptances Bank guaranteed notes to assure payment for exports  Eurodollars Dollar denominated deposits  Municipal bonds No federal income tax on interest; cap gains taxed General obligation versus revenue bonds  Treasury STRIPS Separates interest payments and principal payment

2 Topic 24: Investment Vehicles  TIPS Principal increased twice a year to reflect CPI All income is ordinary income  Series EE bonds Issued at a discount (half maturity face amount) Rate fixed Income not taxed until redeemed Income never taxed if used for college tuition  Subject to rules to qualify  Ginnie Maes Pool of mortgages guaranteed by U.S. government  Freddie Mac/Fannie Mae Not guaranteed until 09/08; higher rate than Ginnie Mae Risk of falling interest rates will cause mortgage loans to be repaid early

3 Topic 24: Investment Vehicles  CMOs Investors can select tranches of various maturity, risk levels  Zero coupon bonds Pricing Use in retirement accounts  ADRs Foreign stocks trading on U.S. exchange Still have currency risk  Privately/separately managed accounts High minimum to start Actually own stocks, bonds (not mutual funds) More control over tax consequences  Precious metals ETFs versus physical possession

4 Topic 24: Investment Vehicles  Limited partnerships Limited partners vs. general partners  Privately/separately managed accounts Own shares of stock rather than mutual funds  Removes layer of fees  Control timing of sales; taxable gains/losses  GICs: insurance company guarantees rate  REITs: own diversified portfolio of real estate

5 Topic 24: Investment Vehicles  Unit investment trusts: Typically buy a portfolio of bonds Not actively managed Liquidates over time  Distributions typically return of capital  Closed-end mutual funds Trade on exchange; no additional shares issued Shares sell at premium/discount to underlying value of assets

6 Topic 24: Investment Vehicles  Mutual funds: Pool funds from investors to invest in stocks, bonds and/or other types of securities Each share represents investor’s proportionate interest in portfolio Priced at the end of trading Advantages  Low minimum investments Automatic investment programs  Diversification  Professional management

7 Topic 24: Investment Vehicles  Open-end mutual funds Grow by issuing shares  Unless fund is closed if it gets too large Costs  Load Class A: load but lower 12b-1 and annual expenses Class B: no front-end load but higher annual expenses Class C: lower load than Class A or B  No load  Deferred sales charges Holding of funds  Management fees Equities: 1 – 1.5%; bonds.5%, for example  12b-1 fees: brokers, advertising  Portfolio turnover: commissions

8 Topic 24: Investment Vehicles  Open-end mutual funds Distributions of realized capital gains  Generally in December  Reinvest  Closed-end mutual funds Trade on exchange; no additional shares issued  Traditional open-end mutual funds grow by issuing shares  Unit investment trusts: Portfolio of bonds; not actively managed  REITs: own diversified portfolio of real estate  Privately/separately managed accounts Own shares of stock rather than mutual funds  Removes layer of fees  Control timing of sales; taxable gains/losses

9 Topic 24: Investment Vehicles  Corporate bonds Debenture Convertible: income and growth Callable Yankee: issued by foreign banks in U.S. $  ETFs Match performance of index: S&P 500, GSCI  Diversification or specific industry  Can be traded like stocks: limit order; short Features not available with traditional mutual funds  Hedge funds Short/long; leveraged; principal protected notes High fees: 2 and 20. 2% fee plus 20% profits Low correlation with equities?

10 Topic 24: Investment Vehicles  Puts Right to sell at exercise price  Calls Right to buy at exercise price  Collar Buy put; sell call  LEAPs: long-term options  Warrants: right to buy additional shares

11 Topic 25: Investment Risk  Systematic: can’t diversify away  Purchasing power: inflation; fixed income assets  Interest rate: bonds; equities  Unsystematic: can diversify away Business: typewriters Financial: GM Liquidity: banks Marketability: 10,000 shares First-Mid Reinvestment: bonds

12 Topic 25: Investment Risk  Political: Nigeria  Exchange rate: international equities Calculating return on foreign investments  Impact of rising/falling dollar  (Ending value in dollars – beginning value in dollars) / beginning value in dollars  Tax: increase in capital gains tax rates  Investment manager: change/style drift

13 Topic 27: Quantitative Investment Concepts  Standard deviation: one: 68%; two: 95% Mean return 11%, how often fall in range of 8 – 14% if standard deviation 3%? Computing standard deviation  Skewness: tails aren’t symmetrical  Correlation coefficient: 1, 0, -1  R 2 :extent portfolio return explained by market return.90 means only 10% of portfolio return not due to market (<.7 indicates lack of diversification)  Coefficient of Variation: Standard deviation/average return Measures risk to reward Same in efficient market?

14 Topic 27: Quantitative Investment Concepts  Beta: measures systematic risk. 1.0; 0; -1.0 Portfolio beta  Covariance: impact of security on portfolio’s risk Portfolio standard deviation: not weighted average  Semivariance: measures downside risk

15 Topic 27: Investment Returns  Arithmetic average: sum/n  Geometric mean: Less than arithmetic as it factors in compounding  Time weighted: evaluate portfolio manager Ignores cash flows in/out of portfolio by investors Includes capital gains, and dividends received by portfolio Geometric average  Dollar weighted: evaluate investor’s performance Factors cash flows in/out of portfolio IRR calculation  Underperformance by mutual fund investors More frequent/pronounced in volatile funds  Holding period:

16 Topic 27: Investment Returns  Real return= Nominal return – Inflation rate Nominal 13% Inflation 3%  I = ((1+Nominal)/(1+Inflation))-1  Internal Rate of Return Present value of -0- If IRR>required return, present value positive Assumes cash flows reinvested at IRR Favors projects generating cash flows early

17 Topic 27: Investment Returns  Total return:(capital gain + dividend)/investment  YTM: return on bonds Compute using semi-annual periods for zero coupon bonds  Yield to call: assumes bond is called in YTM calculation  Current yield: annual income/current price After-tax: dividends currently taxed at 15%  Taxable equivalent yield (munis): tax-free yield/(1- tax rate)  After-tax rate of return: Taxable return x (1 – tax rate)

18 Topic 28: Asset Allocation  Strategic asset allocation: asset class is most important decision. Stocks vs. bonds; not Google vs. Intel Life cycle: older investors should take less risk? Risk tolerance: loss felt more than gain?  Rebalancing: sell winners and buy more losers How often?  Tactical asset allocation: search for undervalued assets  Concentrated portfolios: Recipe for success; collars

19 Topic 28: Asset Allocation  Dynamic hedging strategy: Move between risky assets and T bills  Correlations 1.0 vs. 0.0 vs -1.0 Stocks and bonds? Moderately low per book

20 Topic 29: Bond and Stock Valuation  Stocks: Value = PV of cash investor expects to receive Dividend growth model  No growth: Price = Dividend/Required Return Same as preferred stock valuation  Constant: Price = D1/Required Return – Growth Rate  Multiple: Price = PV of Dividends P/E ratio: high versus low PEG: high versus low Book value: Assets – Liabilities / Number of Shares

21 Topic 29: Bond and Stock Valuation  Bonds: Bond duration: time to receive PV of securities cash flows  Lower duration: > coupon rate; < maturity  Always < maturity except zeros Modified duration:  Measures impact of change in interest rates on bond price Duration of portfolio is weighted average of component’s duration Reinvestment risk Interest rate risk

22 Topic 29: Asset Pricing  CAPM CML: slope is reward to risk ratio for market (stan dev) SML: slope is reward to risk ratio for one stock (beta)  Arbitrage Pricing Theory: Gold prices in London versus New York  Black Scholes: pricing options Calls:  Stock price increases; option price increases  Strike price increases; option price decreases  Expiration time increases; option price increases  Stock volatility increases; option price increases  Risk free rate increases; option price increases

23 Topic 30: Portfolio Development  Modern Portfolio Theory Create portfolio with highest expected return for acceptable level of risk  Efficient frontier: highest return given risk level Inside frontier: inefficient. Return too low for level of risk Outside frontier: can’t obtain desired return while only taking desired level of risk  Multidimensional diversification Diversify across asset classes; not within Selection of asset class determines majority of return

24 Topic 30: Portfolio Development Capital Market Line: Investor’s required return =  Risk free + Portfolio Stan Dev x (Market Ret – Risk Free) / Stan Dev Mkt  Formula provided  Uses standard dev: includes systematic/unsystematic

25 Topic 30: Portfolio Development  Security Market Line: Investor’s required return =  Risk free + (Market Ret – Risk Free) x Beta  Formula provided  Uses beta so only measures systematic risk Beta:  Changes over time  May not have predictive value  If market risk increases, value of all assets would fall  Reward for risk: spread between returns for AAA corporate bonds and junk bonds

26 Topic 30: Portfolio Development  Efficient Market Hypothesis Strong form  Prices reflect public and insider info Unable to outperform market All assets fairly priced reflecting all known info Index Semi strong  Prices reflect public info Weak  Prices reflect price/volume data  Technical analysis has no value But fundamental analysis can improve returns

27 Topic 30: Portfolio Development  Market Anomalies Strategy that seems to outperform market  Low P/E ratios  Small cap stocks  January effect  Value Line: 1 recommendations  Behavioral finance Investors are not rational  Loss avoidance  Desire to break even  Automatic 401(k) enrollment

28 Topic 30: Portfolio Analysis  Fundamental Analysis Emphasis on financial statement trends Top-Down  Start with economic conditions impacting entire market Bottom-Up  Look for companies with attractive characteristics Ratio analysis  Liquidity: acid-test, current  Activity: inventory turnover (sales/inv); A/R turnover (sales/A/R)  Profitability: ROE, ROA  Solvency: debt to equity; debt to assets

29 Topic 30: Portfolio Analysis  Technical Analysis Past movement of security prices predict future  Breaking through 50 day moving average  Dow Theory: Transports confirm Industrials Overall market  Dow Transports confirms move in Dow Industrials  Barron’s confidence index: spread between junk and investment grade corporate debt  Odd-lot: contrarian Specific securities  Moving average  Put/call: contrarian  Short-interest: future buyers

30 Topic 30: Portfolio Analysis  Investment policy statement Guidelines for selecting portfolio assets  Appropriate levels of risk; bond duration, etc.  Benchmarks Comparable to portfolio’s objective/risk S&P 500; Wilshire 5000; EAFE  Monte Carlo Simulations generally using past price movements  Probability of outliving portfolio

31 Topic 30: Portfolio Analysis  Tax Issues Turnover  Short-term capital gains; commissions  Index funds: little turnover  Mutual fund distributions Wash sales: sale of security at loss  Can’t repurchase 30 days before/after sale Dividends: currently taxed as capital gains if hold stock 60 days  REITs not eligible Tax-free income  State and muni interest not taxed on federal  Treasury interest not taxed on state

32 Topic 30: Portfolio Analysis  Performance measures Sharpe: (portfolio return – risk free) / portfolio stan dev  More appropriate if R 2 <.7, not diversified If R 2 = 1, portfolio is diversified Stan dev measures variability versus mean of stock More appropriate for one stock than Treynor  Have unsystematic risk Treynor: (portfolio return – risk free) / portfolio beta  More appropriate if R 2 >.7  Topic 40, P. 18  Beta measures volatility versus mean of market Jensen: Alpha = Realized Return – SML  Excess return generated without taking additional risk

33 Topic 31: Investment Strategies  Strategic asset allocation: return determined by asset class selected  Tactical asset allocation: buy undervalued assets and sell overvalued  Market Timing: active; typically technical  Passive: index. Efficient markets. Core and satellite. Indexes:  Stock: S&P 500; Russell 5000; MS EAFE  Buy/hold: markets are efficient.  Contrarian: run up the stairs in World Trade Center  Bond swaps: take advantage of “mispriced bonds” GMAC: junk bond status  Collars: sell call and buy put

34 Topic 31: Investment Strategies  Dollar cost averaging: same amount every month. Makes sense. Academics: it doesn’t.  DRIPs: reinvest dividends. Compounding Taxable  Bond ladders: bonds have different maturities Less interest rate risk over time longer than investment horizon  Bond bullets: noncallable; will have lower coupon  Bond barbells: buy short-term and long-term bonds. Active management required.  Immunization: match weighted average duration of portfolio with cash needs

35 Topic 31: Investment Strategies  Margin trading Initial margin: can only borrow 50% of initial purchase Maintenance margin: (FMV – Debt)/FMV  Must be at least 25% 100 shares at $40 = $4,000. Borrow $2,000. Maintenance 25%.  What price margin call? Price= (1-Initial Margin %)/(1-Maint Margin %) x Initial Price P = (1-50%)/1-25%) x $40

36 Topic 31: Investment Strategies  Margin trading  Amount of margin call if price falls to $22? Current Value of Stock x Maint Margin % = Equity Needed $2,200 x 25% = $550 Present Equity = $2,200 Current Value - $2,000 Debt = $200 Margin Call = $550 - $200 =$350

37 Topic 31: Investment Strategies  Short selling: sell borrowed stock; buy back at lower price Uptick rule eliminated June 2007  Reinstated for financial stocks during 2008 Stock owner gets dividends Must have margin account; broker determines maintenance margin

38 Topic 31: Investment Strategies  Hedging: protect against price moves in assets own. Buy a $3.50 put on December corn.  Options Puts: buy and sell  Naked Calls: buy and sell  Covered  Topic 41, Problems 25 and 32 LEAPS: as long as three years

39 Topic 31: Investment Strategies Straddle: buy put/call on same stock at same strike price  Anticipate big move either way Collar: sell call, buy put  Concentrated positions Spread:  Buy and sell a call at different prices or expirations Taxation of options  Buy call, exercise: add to basis  Buy call, expires: short-term capital loss  Sell call, exercised: add to proceeds  Sell call, expires: short-term capital gain

40 Topic 31: Investment Strategies Taxation of options  Buy put, exercise: add to basis  Buy put, expires: short-term capital loss  Sell put, exercised: reduce basis  Sell put, expires: short-term capital gain