Cheat sheet Investment PDF

Preview

Summary

Cheat sheet for final exam...

Description

Topic 1 Investment: Current commitment of $ for a period to derive future payments that will compensate for, time funds are committed, expacted rate of inflation, uncertainty of future flow of funds. why ppl invest, trade off present C for larger future C. AM vs GM: ROR are = for all year if AM = GM, if ROR is ≠ AM > GM. AM used for “expected value” for 1 year. GM for long term performance. Asset Allocation: process of deciding how to distribute an investor’s wealth among different countries and asset classes for investment. Investment strat is based on 4 decisions, 1. Asset classes 2. Policy weights to assign 3. Allocation allowed based on policy 4. Specific securities to purchase for port. Different investors invest differently (i.e individual/institutional investors) Port management process: 1. Setting investment policy [port constraints refer to ___, Return obj(I.e capital gains, income) Risk obj(i.e ability/willingness] 2. Study current financial and economic condition (i.e Market risk premium – $ needed to invest for level of risk) 3. Formation of diversified investment port (chapter __) 4. Monitor and update (performance eval) Asset management structure: 1. Privately managed fund, asset manager, 2. Commingling of investments, mutual funds(pooling of funds) Differences: ① Develops personal relationship, ② offers a general solution. CE – stocks trades on secondary market, fund doesn’t issue or redeem shares , price is different from NAV. OE – fund issues and repurchase shares @ NAV, sales charge(load), i.e mutual funds. (load vs no open load) There are two types of open-end funds or mutual funds; 1) load mutual funds and 2) no load mutual funds. The difference between these two is: no-load funds are those which investors can buy or sell without paying a sales charge and load funds carry sales charge and are typically available to those invest through broker or financial advisor. So basically, a load fund charges a fee for the sale of shares (front end load) and/or redeeming shares (back end load). It will sell shares at its net asset value plus the sales charge. A no-load fund has no initial sales charge, so it will sell its shares at its net asset value. Fund management fees: Charges to compensate professional fund managers, typically 0.25 to 1% of fund. Investing in alternative assets: 1. Hedge funds, less restricted, less correlated hence diversification, less liquid, high water mark (go read), no comparison. 2. Private equity, invest in private cpy i.e capital venturist, ownership in asset that is not tradable in the public market. Viewed as High returns, low liquidity, for diversification. J-curve effect Agency problem: When a principal hires an agent to carry out specific tasks, the hiring is termed a "principal-agent relationship" When a conflict of interest between the principal and those of the agent arises, the conflict is called an "agency problem." In financial markets, agency problems occur between the stockholders (principal) and corporate managers (agents). While the stockholders call on the managers to take care of the company, the managers may look to their own needs first. Incentive Compensation Schemes: - Causes competitiveness - People who win competitions based on their own skill can develop a sense of entitlement: they start to believe they deserved to win even when they didn’t, they might bend or break the rules to assure themselves victory, all because they won a competition in the past. Soft Dollar Arrangements: Commissions, way of paying brokerage firms Topic 2: Markowitz – combining number of possible combinations is infinite, the solution is the efficient frontier – choose max return for given level of risk AND/OR lowest risk for given level of returns. Assumptions: maximise return for same level of risk, port includes ALL asset and liabilities, Risk averse – risk should be compensated w something more than RFR, probability distribution of expected returns, maximize expected

utility, estimate risk based on volatility of returns, decisions based on returns and risk. RATIONALE INVESTOR Efficient frontier: rep set of port w max return for every given level of risk/min risk for every level of return. Are portfolio of investments, expect assets w highest return and lowest risk. THE EFFICIENT FRONTIER IS THE SET OF MEANVARIANCE COMBINATIONS FROM THE MNIMUM-VARIANCE FRONTIER WHERE FOR A GIVEN RISK NO OTHER PORTFOLIO OFFERS A HIGHER EXPECTED RETURN. (considered efficient if no higher returns for given level of risk) anything in the MIN-VAR frontier is feasible set. Utility curve: specifies the trade-off between expected return and risk. Optimal portfolio: is the efficient port that has the highest utility for a given investor, it is the point of the tangency between the efficient frontier and the utility curve. Topic 3: CAPM – extension of Marko and develops a model for pricing all risky assets to determine the RRR (include RFR) Assumptions (+ marko assum) : Can borrow/lend at RFR, Homogeneous expectations(all investors will have the same expectations), same one period horizon, infinitely divisible (trade any amount) , no tax or transactions costs, no inflation/I/R, markets are in equilibrium. CML: risk – return relationship between E(r) and σ of port. Holds every combination of the risk-free asset with any risky asset. linear relationship between efficient frontier and the Market port. W the CML line leverage is possible, allowing you to attain higher expected returns than the Markowitz. (I.e you can borrow at RFR to dominate points on the Markowitz). All investors should be investing in the CML, the only thing that should defer is the position on the CML, which depends on their risk preferences, (I.e CML becomes the efficient frontier.) Separation theorem: 1. Determining the optimal risky portfolio (market port), 2. The allocation of asset, how you plan to finance your investment either to borrow or to lend to a attain position on CML. CML cannot be used to measure return on an asset, only used for portfolios that are already fully diversified SML: “CML” measure with β instead of σ, it is the RFR + risk premium, Risk premium = β(Rm+RFR) CML VS SML: CML measure risk w σ, SML measures with β considering only the systematic component. Due to measure of risks CML can only be applied to portfolios which are FULLY diversified, SML can be applied to ANY individual asset or collection of assets Anything Above the SML is undervalued, below is overvalued. β of Market port = 1. Stability of β: β as a risk measure was not stable for individual stocks, but was stable for a portfolio of stocks, the larger the portfolio and the longer the period, the more stable the β estimate is, β tends to regress towards mean of 1. Choosing the right Market port(Mp): Mp should include all the risky asset in the world but it is not possible to find one that includes all risky assets. Hence, there is a benchmark error, as returns on market port is used as a benchmark for active managers. Choosing the wrong market proxy would result in 1) wrong β, 2) SML will differ if there is an error in selecting RF

asset and error in selecting Mp. There is no unanimity about which proxy to use and different proxies have been used. Limitations of CAPM: many unrealistic assumptions and difficulties in selecting appropriate proxy/benchmark Topic 4: Multifactor asset pricing models – fewer assumptions Assumptions: Capital markets are perfectly competitive, investor prefer more wealth, stochastic process generating returns can be expressed as a linear function of a set of K factors. DOES NOT ASSUME, normally distributed returns, quadratic utility function and a mean-variance efficient market portfolio. APT VS CAPM APT is multi factor pricing model, unlike CAPM that identifies the market port as the return factor, APT model does not specifically identify these risk factors in application. Have to decide on what variables you use. (e.g inflation, GDP growth, political issues, change in I/R). λ – risk premium, β – Sensitivity. Multifactor model & risk estimation: the investor chooses the number and identity of risk factor. Multifactor models in practice: 1) risk factors can be view in a macro nature, attempt to capture variations in the underlying reasons an asset price changes (eg. Inflation) In addition, they used different macro factors 1)confidence, Δ willingness to take on risk 2)time horizon, Δ desire to receive pay out 3)inflation risk 4)business cycle, Δ business activity 5)market-timing risk,

2) risk factors can be view in a micro nature, by focusing on relevant characteristics of the securities themselves, such as size of the firm or some financial ratios. (FAMA and French) SMB captures risk associated with firm size HML distinguish risk differentials associated w growth (low p/b) and value (high p/b) firms (CONTINUE ON THE FUCKING MACRO AND MICRO SHIT) TOPIC 5 FUNDAMENTAL ANALYSIS Generally accepted accounting principles (GAAP): provides choices of accounting principles, financial statement footnotes must disclose which accounting principles are used by the firm. Financial statements Balance Sheet: Shows resources of the firm and how it has financed these resources (Asset, liabilities and equities) Income Statement: contains information on the operating performance of firm. (sales, expenses and earning for a period) Cash Flow Statement: money in, money out for one period, (cash flow from operating/investing/financing)

Purpose of financial statement analysis: Evaluate the profitability, efficiency and risk Why we use ratios: so we can establish a relationship between values in financial statements(Relative) and compare w Aggregate economy: firms are influenced by business cycles(expan/contract) analysis helps to estimate future performance of firm during business cycles Industries: different industries affect the firms within them differently, but there is always a relationship (industry has strongest influence on – homogenous products) Competitors (Cross sectional) Past performances (Time series) Five categories of Financial ratios: 1) Common size statements – normalized balance sheet and income statement to allow easier comparison of firms. Common size balance sheet, % of assets. Common size income statement, % of sales 2) Internal liquidity – indicates the ability to meet future short-term financial obligations 3) Operating performance – to measure how well management is operating a business, Efficiency ratios – how management uses its asset and capital measured in terms sales $ generated, Profitability ratios, analyse profits as a % of sales and as a % of the assets and capital employed 4) Risk analysis – examines the uncertainty of cash flow for firm and sources of capital(debt, equity), defined as 1) Business risk- due to the firms industry, measured by the variability of the firm income over time 2) Financial risk – Additional uncertainty of returns to equity holders due to a firms use of fixed obligation debt securities. It is the additional uncertainty in addition to business risk.(WHAT THE FUCK)relationship between business and financial risk. The acceptable level of financial risk for a firm depends on its business risk. If there is low business risk (i.e stable operating earnings) investors are willing to accept higher financial risk. Proportion of Debt (Balance sheet) Ratio: indicates what proportion of the firm capital is derived from debt compared to other sources(equity). 1) debt-equity ratio 2)long term debt/total capital 3) total debt-total capital ratio Earnings and cash flow coverage Ratio: relates cash flow available to meet the required interest and lease payments. 1)interest coverage ratio 2)cash flow coverage ratio (DO SLIDE 36 IN FORMULA SHEET, LOOK AT PG 300) External market liquidity risk: the ability to buy or sell an asset quickly with little price change from prior transaction assuming no new information. (source of risk to investors) Determinants of external market liquidity: is the number of shares or the dollar value of shares traded(I.e trading turnover, the % of outstanding shares traded during a period of time), measure of market liquidity is the bid-ask spread, smaller spread greater liquidity, main determinant of the bid-ask spread(besides P) is the dollar value of trading. Importance of growth analysis: sustainable growth potential examines ratios that indicate how fast a firm should grow. This is important for both lenders and owners. Value of firm depends on growth in earnings, cash flow and dividends(owners). Firms future success is a major determinant of its ability to pay obligations(Lenders). Determinants of Growth: 1) resources retained and reinvested in the entity, 2) the rate of return earned on the reinvested funds (go read pg 293) Value of financial statement analysis: financial statements are backwardlooking; an efficient market would have already incorporated these past results. But markets are never efficient, and the analysis provides knowledge of a firm’s operating and financial structure which aids in estimating future returns. TOPIC 6 TECHNICAL ANALYSIS – for tech to profit mark must adjust slow to news(ineff) Assumptions: 1) the market value of any stock is determined solely by the interaction of supply and demand.

2) supply and demand are governed by numerous factors, both rational and irrational 3) disregarding minor fluctuations, the prices for individual securities and the overall value of the market tend to move in trends, which persist for appreciable lengths of time 4) prevailing trends change in reaction to shifts in supply and demand, these shifts, no matter why they occur, can be detected sooner or later in the action of the market itself Advantages of Tech Analysis: 1) Not heavily dependent on financial statements, the issue about financial statements is the lack of information, GAAP allow firms to choose their reporting procedures hence it might differ for each firm, non-quantifiable factors do not show up. 2) Fundamental analyst must process new information to quickly determine new intrinsic value, tech just has to recognize a movement. 3) technicians trade when a move to a new EQ is underway but fundamental analyst finds undervalued securities that may not adjust their prices as quickly, hence tech is more likely to experience ideal timing. Challenges to technical analysis: (Assumption) Empirical test of efficient market hypothesis show that prices DO NOT move in trends. (trading rules) past may not be repeated, patterns become a self-fulfilling prophecy. A successful rule gains follower and becomes less successful in the end. Tech analysis requires a great deal of subjective judgment. Technical trading indicators: a typical stock price cycle for the market or a stock goes through a peak and trough as well as trends, by analysing the trend patterns, a trader can decide what trade is needed. Tech Trading rules(4): Contrary Opinion Rules (DO THE FUCKING OPPOSITE) many analysts reply on tech trading rules that assume that majority investors are wrong as the market approaches peaks and troughs, concept of mean reverting(hold long enough will return to avg). They determine if investors are bearish/bullish and do the opposite. There are 5 indicators. 1. Mutual fund cash positions, buy when fund cash is high, sell when low. 2. Credit Balances in brokerage accounts, buy when credit balances increase, sell when balances fall. 3. Investment advisory opinions, buy when market is bearish, sell when market is bullish. 4. Chicago board options exchange (CBOE) put/call ratio, buy when option purchases are bearish (when put/call ratio increase) 0.6 and above are bearish, 0.3 and below are bearish. 5. Future stock trades bullish on stock index futures, sell when speculators are bullish, buy when speculators are bearish. Follow the smart money, ^ assume most investors are not smart, this indicator seeks to follow the path of the sophisticated and assume investors are smart. (3 indicators) 1. Barron confidence index, measure the yield spread between highgrade bonds and a large cross section of bonds, declining(increasing) yield spread increases(decrease) this index and are a bullish(bearish) indicators. 2. Tbill euro dollar yield spread, decrease(increase) in spread indicates confidence and is bullish(bearish). 3. Debit balance in brokerage accounts, balances represent buying on margin, which is assumed to be done by sophisticated investors, increase(decrease) is bullish(bearish). Momentum indicators (2) – focus on past trends, assume past trends will continue. 1. Breadth of market, measure the number of stock increased and the number of stock declined each day, the advance-decline index is a cumulative index of net advances and net declines.

2. Stocks above their 200-day moving average, is considered to be overbought, subject to –‘ve correction when more than 80% of stocks are trading above their 200 day moving average. Stock price and volume techniques: The Dow Theory - stock prices move in trends analogous to the movement of water, major trends are like tides in the ocean, intermediate trends resemble waves, short run movements are like ripples. The importance of Volume: Technicians watch volume change along with price movements, as an indicator of changes in supply and demand. Techs look for price increase on heavy vol relative to stock normal trading as an indication of bullish activity. Price decline with heavy vol is considered bearish. Use a ratio of upside-downside vol as an indicator of short-term momentum for the stock market. Support and resistance level: Support level(floor) is the price range at which the tech would expect a substantial increase in the demand for a stock. The resistance level(ceiling) is the range where the tech expects an increase in the supply of stock and a price reversal. It is also possible to envision a rising trend of support and resistance level for a stock. Moving average lines: Meant to reflect overall trend for a period of time, the shorter the MA line the shorter the trend. If prices reverse and break through the moving average line from below accompanied by heavy vol, it is a positive change. If the 50 day MA line cross 200 day MA from below on good vol, it is bullish Relative Strength(RS): stock/industry index divide by market index(S&P 500), ratio increase(bullish), shows stock/industry index is outperforming the overall market.(if got space add in the bar char shit) Tech analysis of foreign markets: technique is limited to price and vol data because detailed info on the US market is not always available for other countries. Topic 7: intro to equity valuation – Two approaches, top down or bottom up, different perceived importance of economic and industry influence on firms/stocks. (LINKED TO TOPIC 8 FUND STRAT) Top down 3 step: 1) examine general economic influence 2) industry influence 3) company analysis. Only way to out perform market is to forecast the future accurately.

Empirical evidence for 3 steps: An analysis of rln btwn rate of return for the aggregate stock market, alternative industries and individual stocks showed/indicate that: Changes in a firms earning can be attributed to changes in aggregate corporate earning and changes in firm industry. There is a rln btwn aggregate stock prices and various economic variables(i.e employment, income). Changes in rates of return can by explained by changes in rate of return for aggregate stock market and stock’s industry

Bottom up approach: emphasizes on selection of securities without any initial market or sector analysis, forms port that can be purchased at discount w their valuation models Theory of valuation: value of an asset is the PV of its E(R). Need to discount E(R) at ROR. Need to estimate, cash flow stream and ROR. Cash flow streams – earnings, cash flow, dividend, interest payment, capital gains. Need to know when cash flow occur and rate of growth. ROR – reflects uncertainty of cash flow, determined by RFR + expected inflation(nominal risk free). Risk premium determined by business, financial, liquid, exchange rate risks. Need to compare intrinsic value to prevailing market price. If intrinsic > market price, buy, in intrinsic < market price, don’t buy. Valuation of common stock: why DCF(3)? – PV of expected cash flow, is the epitome ...