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FINC 3640 - Exam 2 module 2 study guide Exchange Traded Funds (ETFs) -investment company funds -most liquid funds -usually not actively managed (in kind arbitrage keeps the price where it should be) -can have options traded on them -firms: blackrock, vanguard, nasdaq, fidelity, etc. -3000 total, 8T AUM Mutual Funds (Open Ended Funds) -investment company funds -not traded on exchanges (NAV instead of MV or Bid/Ask) -dominant player because of 401Ks -passively (low fees) or actively managed (high fees) -companies like Fidelity, Vanguard, AB, etc. run multiple of these (fund families) -tickers normally have 5 letters and end in X -95% are LONG ONLY -low distribution yields bc they cannot trade options -either loaded or not loaded -morningstar.com -bad tax consequences -about 7300 total and 25T AUM
Net Asset Value (NAV) market value of all assets held in the fund / number of shares in the fund -calculated once per day -the number of shares changes every day because companies can issue more shares or buy back shares every single day -you never know what you are going to buy at because the the price lags until the end of the day when it is recalculated Long Only organizations or strategies that are only permitted by statue or regulation to hold instruments; usually cannot take short positions (short sell) -mutual funds are highly restricted in this way -mutual funds are normally just trying to beat their benchmark (indexes) by simply finding undervalued stocks and buying them Load an extra fee that goes to the financial advisor that bought the fund for the client (usually for smaller clients) -not a management fee; only exists so that the FA can pay themselves Front End Load you are paying an extra fee to the FA at the time that they buy the mutual fund (A Shares) Back End Load you pay an extra fee to the FA when you want to sell the fund (B Shares) Level Loads you pay yearly fees to your FA for the mutual funds (C Shares) No Load a different version of the loaded mutual fund where you pay no fees and buy the funds yourself Closed End Funds -investment company funds
-only accredited investors can invest in these -started in the 1940s (start of short selling) -first was a long short equity fund -regulated by the state -meant for people who want to do more than long sell -various different strategies; 40% of HFs have long - short equity strategies and 14% of HFs have credit strategies (bonds) and the rest have a mix -there are no laws that regulate what strategies and such you can do WITHIN a hedge fund -investors are other HFs, endowments, family offices, pension funds, wealth and asset managers Typical Fee Structure 1.5 15 HWM Management Fees a fee paid to the professional money managers who administer a mutual fund's portfolio -typically 1.5% of a firms AUM Performance Fees fees that give fund managers a share of any positive returns earned -15% of a firms total return High Water Mark (HWM) manager cannot take performance fees if the investor does not make any money from the investment Qualified Hedge Fund Clients -worth $2M minus primary residence (difference >1M) -accredited investor -managers cannot take performance fees if the client is not qualified -accredited investors worth < $2MM can invest in HFs, but HFs don't want their money because they cannot take those performance fees Bernie Madoff -ran largest Ponzi Scheme in history -was the chairman of NASDAQ and an investment company owner
-his company did not have a hedge fund structure, but hedge funds were getting money from their clients and investing it in Bernie -worth $65B and had a legitimate name on wall street (ppl said he could make 1% per month) -wouldn’t tell people his strategy Bond a financial security that represents a promise to repay a fixed amount of funds -investment banks help companies issue this debt to the public from scratch Features of a Bond issuer, maturity, par value, coupon rate, yield Issuer entity that has issued the bond (borrower of money) Types of Bond Issuers Supranational Organizations (international organizations such as the World Bank and IMF( Sovereign Governments (countries and national governments) Non Sovereign Governments (states and municipalities) Quasi Government Entities (agencies funded by the government such as Ginnie Mae) Companies Maturity date at which the last payment is made -< 1 year, it is a money market security -> 1 year, it is a capital market security Par Value the amount that an investor pays to purchase a bond and that will be repaid to the investor at maturity (face value) -when a bonds PV < Par Value (FV), the bond is selling at a discount (interest rate increases, bond price decreases; coupon rate < market rate) -if a bonds PV = Par Value (FV), the bond is selling at par (coupon rate = market rate)
Affirmative Covenant requires bondholder to perform a certain action Source of Repayment Proceeds -Supranational Organizations (repayment of previous loans or paid in capital from members) -Sovereign Governments (tax revenues and printing new money) -Non Sovereign Governments (taxing authority of issuer, project cash flows, special taxes/fees) -Quasi Government Entities -Companies (cash generated by company operations) Debenture a bond not backed by specific collateral Eurobonds bonds issued internationally outside the jurisdiction of any country are denoted in currency other than of which they trade (these bonds subject to less regulation) Bond Tax Considerations -income portion of a bond is taxed at the ordinary income tax rate -short term capital gain (< 1 year) is taxed at a higher rate than long term capital gains -depending on the country, a prorated portion of discount may be included in interest income Bullet Bond principal is paid all at once at maturity; only interest is paid each year and principal remains outstanding until maturity Fully Amortized Bond principal is paid in equal payments over the bonds life so that it is repaid in full by the maturity date Partially Amortized Bond only part of the principal is repaid over the bonds life so that it is partially repaid by the maturity date and the remaining part of the principal is paid at maturity (balloon payment) Sinking Fund Arrangements allows for full or partial amortization prior to maturity; specifies the portion of the principal outstanding that must be repaid yearly → lowers credit risk but increases reinvestment risk; 3 types of arrangements -standard
-accelerated (issuers retire more than the specified portion of the notional principal) -call provision (issuer has the right to repurchase the bond before maturity) Fixed Period Coupons a constant, fixed interest amount is paid annually or semiannually Floating Rate Notes bonds interest rate is based on a specific rate (reference rate), plus a spread (can have floors and caps) Callable Bonds gives the issuer the right to redeem all or part of the bond before the specified maturity rate -investors face reinvestment risk because it isn’t possible to reinvest proceeds at the previous higher interest rate, so issuers often offer higher yields and/or a discount to compensate for that risk -indentures include the call price (price paid to issuer when called), call premium, call schedule (date/price bonds can be called), call protection period (period where bond cannot be called), and call date (earliest date a bond can be called) Purpose of Callable Bonds companies issuing these bonds to protect issuers when market interest rates drop to give the issuer an opportunity to call old bonds and replace them with cheaper bonds and save on interest expenses, and to signal the market about their credit quality 3 Types of Calls and Puts American, European, Bermuda Style American Call the issuer can call the bond at any time after the first call date European Call the issuer can call the bond only once after the first call date Bermuda Style Call the issuer can call the bond only on specific dates after the call protection period Putable Bond gives the bondholder the right to sell the bond back to the issuer at a predetermined price on specified dates; offer a lower yield and sell at a premium
these used to be the largest part of the bond market (until about 2007), even though people didn't understand these bonds Bond Credit Rating Companies Standard and Poor Moodys Fitch (firms pay one or more of these to rate their bonds) Companies With AAA Rating Microsoft and Johnson and Johnson BBB- And Above Rated Bonds have a low yield spread (low risk) and are investment grade bonds BBB- And Below Rated Bonds have a higher probability of default and higher risk causing a larger spread -also called non investment grade bonds, high yield bonds, junk bonds, and speculative bonds -certain institutional investors such as investment banks cannot hold these bonds because of self regulation -this means they have less potential investors and are therefore less liquid rd the required rate of return on bonds from the investors perspective (yield, YTM, interest rate); cost of debt capital from the firm's perspective =r* + IP + MRP + LRP + DRP =value of treasury security of equivalent maturity + yield spread Value of Treasury Security of Equivalent Maturity r* + IP + MRP Rate of Return (r*) the return on a security as a percentage of the initial price -how much does purchasing power increase? if it does not increase at all, there is no benefit Inflation Premium (IP) compensates for the risk of inflation; drives everything relating to bond prices
-expected inflation between now and the maturity of the bond -if there is more inflation (inflationary), bond holders are going to require a higher return Things That Decrease the IP -CPI comes out and is less than expected -GDP comes out and is less than expected (bad economic news, but seen as deflationary in the bond market because in this situation investors expect a lower return which causes bond prices to go up) -job numbers are worse than expected (bad economic news, but seen as deflationary in the bond market because bad news causes interest rates to drop and bond prices to go up) -productivity numbers come out and are higher than expected (more goods and services made per hour of work) -price of oil goes down (good news) Things That Increase the IP -CPI comes out and is greater than expected -GDP comes out and is greater than expected (good news, but bond market considers it potentially inflationary) -job numbers are better than expected (good news, but bond market considers it potentially inflationary) -productivity numbers come out and are less than expected (bad news) -price of oil goes up (bad news) Inverse Relationships What type of relationship does bond price have with interest rates? Maturity Risk Premium risk associated with the maturity length of a bond -long term bonds have more risk than short term bonds, all else equal (ceteris paribus) Interest Rate Risk how much a bond fluctuates in price (long term bonds have more risk than short term bonds) Yield Spread LRP + DRP Liquidity Risk Premium (LRP) based on bid ask spread; less liquid, wider spread Default Risk Premium (DRP)
Normal Treasury Yield Curve this yield curve slopes upwards Inverted Yield Curve this curve slopes downwards; is how our yield curve has been for the past 20 months; happened because the fed raised rates to control inflation and normally means that there is expected to be a recession in the next 6-20 months (recession predictor, not a cause) Technical Analysis technique that uses charts of past trends in prices and other factors to forecast future prices Candlesticks technical analysis tool that consists of a real body and a wick Green Candlesticks candlestick that represents a bullish stance, open price is bottom and close price is top (increased in price) Red Candlesticks candlestick that represents a bearish stance; open prices is top and close price is the bottom (decreased in price) Marbozu candlestick with very short or no wicks -green: x2 --> bullish (increasing) -red: x2 --> bearish (decreasing) Doji candle with basically the same open and closing price (small body, long wicks) -basically telling you to wait and not currently do anything with shares (don't buy or sell atm) Resistance and Support technical analysis tool that identifies price points on a chart where the probabilities favor a pause or reversal of a prevailing trend at these specific points Resistance
point where price will normally stop rising; as the prices are moving higher, there will come a point when selling will overwhelm the desire to buy; it is a price or price zone above the current market that contains the upside movement of an asset (price will not usually go above this amount and when it does the resistance may become the new support) Support point where prices will normally stop falling; area on a price chart that shows buyers’ willingness to buy and at this level demand will usually overwhelm supply, causing the price decline to halt and reverse When The Support or Resistance is Broken... the old resistance will eventually become the new support if the price went above the resistance and if the price goes below the support, the support will become the new resistance eventually Moving Average technical analysis technique that averages a number of recent actual values, updated as new values become available Contrarian technical analysis strategy based on the idea that markets are driven in large part by crowd behavior; an investment strategy that involves bucking against existing market trends to generate profits (bollinger bands) Bollinger Band technical analysis tool that consists of a simple moving average plus upper and lower bands that are calculated by adding and subtracting a specific number of standard deviations from the moving average -sell securities when it reaches upper band and purchase when its at lower band -uses a standard 20 day moving average -used more for ST investing Trend Trader technical analysis strategy that identifies market trends and trades assets accordingly; attempts to capture gains through the analysis of an asset's momentum in a particular direction -golden cross -death cross
Historical Arithmetic Average of Large Cap Stocks 12% Historical Standard Deviation of Large Cap Stocks 20% 4 Methods to Evaluate Fund Performance -CAGR -Sharpe Ratio -Treynor Method -Jensens Alpha Compound Annual Growth Rate (CAGR) annual rate of return that is computed through a geometric average -always lower than arithmetic average unless there is no volatility -“r” when you are doing TVM calculations Variance Sinks volatility sinks returns; more distance between arithmetic average and geometric average means more volatility (volatility is the cause of the distance) Standard Deviation a computed measure of how much values vary around the mean value Variance standard deviation squared
Historical Arithmetic Average of Large Cap Stocks 20% (19.6%) Historical Standard Deviation of Large Cap Stocks . Historical Sharpe Ratio of Large Cap Stocks Sharpe Ratio measures excess return per unit of risk -the larger the better -(fund return - risk free rate) / standard dev Estimated CAGR used for large samples -arithmetic average - .5 * variance
