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Investment Vehicles Certificates of Deposit Certificates of deposit, also known as CDs, are time deposits with specified dates of maturity. A certificate of deposit may be either negotiable or nonnegotiable. Negotiable CDs are those that can be sold by the depositor in the open market at any time before the CD reaches maturity. A nonnegotiable CD is one in which the maturity date must be reached before the initial depositor may receive the funds. There is an early withdrawal penalty when the funds in a nonnegotiable CD are withdrawn before they reach maturity. If an investor has more than $100,000 to invest, a depository institution may sell him or her a negotiable or jumbo CD. The maturities on these tend to be up to one year; for the most part, certificates of deposit of less than $100,000 are nonnegotiable. Money Market Mutual Funds and US Treasury Bills Money market mutual funds are primarily short-term securities and are offered as an alternative to other money market instruments. These mutual funds are typically made up of a group of the short-term instruments available in the open market, such as Treasury bills, commercial paper, banker’s acceptances, certificates of deposit, and repurchase agreements. US Treasury bills are issued by the federal government and are sold in denominations of $1,000 to $1,000,000 and have maturity periods of three to twelve months. These treasury bills are usually sold at a discount. The interest acquired through them is subject to federal income tax, but not state or local tax. Commercial Paper, Banker’s Acceptances, and Repurchase Agreements Commercial paper is the unsecured short-term promissory notes that are issued by corporations. There is a small risk of default on these, because only firms with excellent credit ratings are allowed to issue them. Commercial paper is usually sold at a discount, and has a maturity period of less than 270 days. Banker’s acceptances, on the other hand, are the short-term promissory notes that a bank guarantees. The bank takes responsibility for repaying these loans, which are generally sold on a discounted basis and used during international trade. Repurchase agreements, or repos, are sales of short-term security in which the seller pledges to buy it back at a specified price and date. The price at which the seller pledges to buy it back is higher than the original sale price. Treasury Notes and Bonds Treasury notes are sold in denominations ranging from $1,000 to $1,000,000 and have maturity periods of between 2 and ten years. Treasury bonds are the government’s long-term debt; they have maturity periods longer than ten years. Treasury notes and bonds are both offered as coupon securities and are considered to be the safest medium- and long-term investments because the government backs them up. Because they offer such safety, they generally have yields lower than high-quality corporate bonds. The interest earned on treasury notes and bonds is subject to federal income tax but is exempt from state and local taxes.
US Government Savings Bonds
There are a few kinds of US government savings bonds. The Series E bond was established to encourage more saving; it was offered in small denominations, at a discount, and paid no interest. The Series EE bond replaced the Series E, adding a variable rate of interest that allowed investors to benefit from rising interest rates. The interest on E and EE bonds is not taxable until they either reach maturity or are cashed in.
Treasury Inflation Protected Securities (TIPS) and Treasury STRIPS
Treasury inflation-protected securities are issued by the federal government and have coupon payments that periodically adjust to changes in the inflation rate. These changes in inflation are represented in the principal rather than the coupon. The appropriate coupon payment is calculated by multiplying the inflation-adjusted principal by the real rate (which represents the fixed coupon rate net of inflation). Treasury STRIPS (separate trading of registered interest and principal securities) are zero coupon bonds that constitute direct obligations of the federal government. STRIPS do not pay a coupon, but the interest will be taxed as it accrues. These are considered more risky than other government bonds during periods in which interest rates fluctuate widely.
Municipal Bonds General Obligation Bonds and Revenue Bonds General revenue bonds are not considered to be very risky because they are backed by the taxing power of the issuing government. Revenue bonds, on the other hand, are only supported by the revenue of a project, and so are considered a bit more risky. Often, municipal bonds suffer from poor marketability and liquidity. There may be a very small market for them. Most of the time, state and local governments issue debt that is long-term serial issue because these give the buyer the comfort of knowing when they will mature. The federal government does not tax the interest earned on municipal bonds. Also, many states exempt the bond interest on municipal bonds.
Investment Grade Corporate Bonds Investment grade bonds are those that offer debt of high quality. There are a few different types. Secured bonds have a claim to the assets of a corporation in the event of insolvency, liquidation, or default. Unsecured bonds, on the other hand, are not backed by collateral. Debentures are promissory notes not backed by collateral but by the reputation of the firm. During bankruptcy, debentures can only be redeemed after all other secured debt has been paid off. Zero coupon bonds are sold at a discount with no coupon and are redeemed for face value at maturity. Interest is accrued over the life of a zero coupon bond. Individuals cannot avoid tax by buying zero coupon bonds, though the taxes earned on accrued interest can be avoided in retirement accounts because the tax is deferred until the money is withdrawn.
High-Yield and Convertible Corporate Bonds High-yield corporate bonds, often referred to as junk bonds, are low-quality bonds that have many of the same features as investment grade debt but offer higher yields. These bonds are usually rated below triple B. High yield securities may have a call feature and a sinking fund; they are often debentures but some do have collateral. Convertible bonds are those that give the holder the right to convert a bond into shares of common stock. Investors will have to pay for this privilege. Investors like these bonds because they offer the safety of debt along with the potential for capital gains. Both the underlying stock and interest rates will cause changes in the price of convertible bonds. The conversion ratio is the number of shares a bond may be converted into; it is calculated by dividing the face value of the bond and by the conversion price.
Corporate Bonds Callable Bonds Firms will usually place a call provision on their bonds that allows them to buy the bonds back at a specified price before maturity. Call provisions are often used after a period of high interest rates, when it makes sense for firms to refinance new debt at a lower interest rate. The call price is typically less than the market price; otherwise it doesn’t make sense for the issuer to call the bonds. Purchasing a callable bond carries with it an increased interest rate risk and an increased reinvestment risk along with a reduced potential for capital appreciation. Basically, in a time of falling interest rates the call price will act as a ceiling. The price of bonds without call provisions will continue to rise as interest rates fall. Ways to Retire Debt Serial bonds are issues in which specified bonds will mature every year. Interest is paid off at different intervals. These nonamortizing securities are popular among local governments seeking to finance capital improvements. When a corporate bond is said to have bullet maturity, this means that the entire principal is paid off in one payment at the maturity date. Amortizing securities make both interest and principal payments. Sinking funds are a series of staggered payments that retire a portion of the bond issue prior to maturity. When new debt is issued in order to generate proceeds for paying off old debt, it is known as refunding. Some bonds are nonrefundable, though they may still be callable. Embedded Options Corporate bonds may include a number of different embedded options, which are rights given to the issuer or to the bondholder. A call provision, whereby the issuer may call the bond at any point before maturity, is one common option. Many bonds will contain a prepayment provision, allowing the borrower to pay off the loan balance before maturity. These are often used with home mortgages and car loans. An accelerated sinking fund provision allows the issuer to retire more bonds than required under a sinking fund. A put provision gives the bondholder the option to sell the bonds back to the issuer at a predetermined price. This option is common when bonds are trading below average because of high interest rates.
Promissory Notes and Insurance-Based Investments Promissory notes are documents that have been signed by a borrower pledging to repay a loan under certain stated terms. Promissory notes are unsecured and may be made for the short term or the long term. Insurance-based investments may be either guaranteed investment contracts or annuities. Guaranteed investment contracts, commonly known as stable value funds, are securities sold to pension plans by insurance companies. The rate of return for these is guaranteed over a certain amount of time. Annuities are contracts issued by insurance companies. The holder of an annuity receives a regular payment from the insurance company. Annuities may be either fixed or variable.
Common Stock Types of Common Stock There are six basic categories of common stock. Blue chip stocks are those that are highly regarded for investment. Blue chip stocks will consistently pay dividends. Income stocks pay regular and steady dividends and typically appreciate enough to keep up with inflation. Growth stocks are those for firms whose sales, earnings, and market shares tend to grow at an above-average pace. Cyclical stocks are those that perform in a manner consistent with the market. Interest-sensitive stocks are affected greatly by changes in interest rates. Insurance companies, utilities, and banks all have interest-sensitive stock. Defensive stocks are generally unaffected by changes in the market. Control and Stock Price Adjustment When common stock is said to be noncumulative, then each share gives the holder one vote for each member of the board of directors. If the stock is cumulative, then the shareholder has a number of votes that is equal to the number of positions on the board multiplied by the number of shares owned. These votes can be allocated however the shareholder likes. Cash dividends, the payments made to the shareholders of a corporation, will be paid as the stock price is adjusted. The price of the stock will decrease by the amount of the dividend per share on the ex-dividend date. The balance sheet of the firm will also be affected by dividend payments, as the levels of cash and retained earnings will decline by the amount of the dividends paid. Process of Paying Dividends There are a few important dates in the process by which dividends are paid to shareholders. The declaration date is the date on which the board of directors passes a resolution to pay a dividend. The ex-dividend date is set two business days before the date of record; if the stock was purchased before the ex-dividend date, then the holder of the stock is entitled to a dividend. The date of record is the day on which the holders of record are supposed to receive the dividend. The corporation will draw up a list of all the individuals believed to be stockholders in order to determine who is to receive the dividend. Finally, the date of payment is the day when dividends are mailed to the stockholders. Stock Split, Stock Dividend, and Effects on Balance Sheet Sometimes dividends on common stock will not be paid out in cash. When a stock split is made, for instance, the firm has increased the number of shares it has outstanding, so every shareholder now owns more individual shares. A stock dividend, on the other hand, is a payment made by the firm in the form of additional stock. There is no value gained by a shareholder through a stock split or stock dividend, since the price of the stock will decline by the same percentage as the stock split or dividend. Stock dividends, then, do not alter the stockholder’s total equity. Stock splits reduce the par value of the stock but do not affect the common equity part of the balance sheet. There is no overall change in equity after a stock split.
Preferred Stock Preferred stock typically pays a fixed dividend that is not guaranteed. This dividend is expressed as a percentage to par or dollar amount. Dividends are paid from earnings and are given priority over common stock dividends. In cumulative preferred stock, dividends are not paid but accumulate. In noncumulative preferred stock, dividends do not accumulate and are paid. Investors who are seeking a fixed stream of income usually purchase preferred stock. Unlike bonds, preferred stock is perpetual, and so a firm does not have to generate a certain amount of funds in order to retire it. Preferred stock is considered to be less risky than common stock; it also has a greater market fluctuation than do bonds.
Warrants Warrants are equity call options issued directly by a corporation that give the purchaser the right to purchase stock at a specified price over a specified period. Unlike with ordinary call options, the exercise of a warrant increases the number of outstanding shares of stock, and this dilutes the firm’s earnings. Typically, an individual warrant will give the right to buy one share of stock, though this is not always the case. The actual price paid for a warrant is usually higher than the theoretical price, as investors will often flock around warrants if they anticipate that the underlying stock price is going to rise above the exercise price. Warrants tend to have more percentage change in price relative to the underlying stock because of the leverage effect.
Rights There are a few different kinds of rights that may be purchased with respect to corporate stock. Preemptive rights are the rights held by current stockholders to maintain their proportion of ownership in the firm. If a firm decides to issue new stock, it will hold what is known as a rights offering, in which existing shareholders are allowed to buy new shares before those shares are made available to the general public. Rights, then, are simply the options held by stockholders to buy additional shares of stock at a specified price during a specified time period.
Derivatives Options Derivatives are securities that have a value tied to the value of some underlying securities. Options are contracts that give the owner the right to trade in an asset for a predetermined price at a later date. The price paid for an option is referred to as a premium. Options may be classified as either a call or a put. A call gives the holder of the option the right to buy an asset at a predetermined price; a put gives the holder the right to sell the asset at a predetermined price. The person who sells an option contract is called an option writer: that person is obliged to buy or sell the asset at the predetermined price. The strike price of an option is the predetermined price. The expiration date is the date at which the option can no longer be exercised. An option with value is said to be in-the-money; an option with negligible value is said to be out-of-the-money; and an option with minimal value is said to be at-the-money. All listed stock options expire on the Saturday after the third Friday of the expiration month. American stock options may be exercised at any point, though European options can only be exercised at the date of expiration. The intrinsic value of an option is defined as the minimum price for which it can be bought. The intrinsic value of a call option is calculated as stock price less strike price; the intrinsic value of put options is calculated as strike price less stock price. The time value of an option is the premium less the intrinsic value. Futures Futures contracts are formal agreements between a buyer, a seller, and a commodity exchange. When purchasing a futures contract, the buyer agrees to accept a specific commodity at a predetermined date. When a futures contract is sold, the seller agrees to deliver a specified commodity at a specified date. The buying position, also known as the long position, will increase in value if the underlying commodity increases in value. Future price is the price in the contract for the future delivery of a commodity; spot price is the current price of the commodity. The daily limit is the maximum daily change allowed in a commodity future’s price. In order to purchase a futures account, one must have a margin account with an initial deposit and a minimum balance.
Exchange Traded Funds and Index Securities With exchange traded funds (ETFs), investors can invest in a bundle of stocks that all closely reflect an underlying benchmark index. These stocks trade daily on stock exchanges and are continuously being priced. ETFs can be bought and sold on margin and charge lower annual expenses than index mutual funds, though investors must pay a commission to buy or sell these shares. ETFs offer flexibility, low cost, and are not subject to taxation other than changes to capital gains. Index securities, on the other hand, are a portfolio of underlying equities or bonds that attempt to reflect the performance of a particular index. Index securities offer low costs, lower taxes, and manage to keep pace with the index, but they cannot hold cash, so there is no ability to mitigate losses in a down market, and owners may be forced to sell shares when investors become nervous.
Investment Companies Investment companies come in a variety of forms. Unit investment trusts are sold in $1,000 packages and contain a fixed portfolio of assets. The assets of such an investment trust are frozen, and so no new securities can be purchased. Unit investment trusts are self-liquidating; after a while, such a trust is sold and funds are distributed to stockholders. These funds are set up to perform particular functions, like earning interest. Open-end mutual funds do not trade on the secondary markets; these shares are purchased straight from the fund at net asset value plus any applicable sales charge. Closed-end investment companies, on the other hand, issue a specified number of shares of stock or a combination of stock and debt. Shares issued by a closed-end investment company cannot be redeemed, and new shares will not be offered after the initial offering.
Real Estate Investment Trust A real estate investment trust (REIT) is a closed-end investment company that is publicly traded. These trusts invest in managed, diversified portfolios of real estate or real estate mortgages and construction loans. REITs can be sold for premiums or discounts to the net asset value. They are traded on exchanges. There are three basic types of REITs: equity REITs, which acquire ownership interests in commercial, industrial, and residential properties; mortgage REITs, which lend the funds for construction and mortgages; and hybrid REITs, which are a combination of the other two types. REITs offer limited liability, no corporate-level tax, the ability to leverage, and liquidity, but they also give investors little control, lower potential returns, and no flow-through of tax benefits.
Real Estate (Investor-Managed) Real estate properties may be either income properties (residential or commercial) or speculative properties (raw land and investment). To determine value in a real estate investment analysis, a financial planner must consider the objectives of the investor, the features of the property (including geographic area, time horizon, and property rights), the determinants of value (supply and demand, the local property transfer process), and the local valuation of property. The cost approach to estimating market value works best for evaluating newer properties; it evaluates the value of property by considering the cost of rebuilding it. The comparative sales approach evaluates a piece of property by comparing it to similar and nearby properties that have recently sold. The income approach evaluates a property at the present value of all future cash flows.
Private Placement Private placements operate by selling securities directly to high-level investors. They may only operate for a predetermined length of time, in which case they do not require a SEC license. Rule 505 of Section D exempts the issuance of securities of up to $1 million in a year to an unlimited number and type of investors; Rule 505 of Regulation D exempts issuance of up to $5 million in a year; Rule 506 of Regulation D exempts the issuance of an unlimited amount of securities in a private placement. Investors who are not accredited and seek to make purchases through a private placement must be sophisticated, meaning that they have special knowledge and experience in financial matters.
Limited Partnerships and Asset-Backed Securities A limited partnership is a business owned by both limited and general partners. In such an arrangement, the general partners manage the business and can be held accountable and liable for the actions of the business. Limited partners are considered to be investors and are only liable for the amount of their investment. Limited partners may lose their liability protection if they take an active management role. Asset-backed securities stand for pools of asset-linked debts. In these arrangements, investors receive payments on a monthly basis that consist of a scheduled principal and interest; they may also receive any prepayments. Prepayments for asset-backed securities are mainly unaffected by changes in the market interest rates, which result in predictable cash flows.
Mortgage Pass-Through Securities Mortgage pass-through securities represent a self-amortizing pool of mortgages. The payments for these are made on a monthly basis and are composed of a scheduled principal and interest. If no prepayments are made, then monthly cash flows will be consistent. There are several benefits of mortgage pass-through securities, especially for fixed-income investors: they may have yields up to 200 basis points higher than comparable government and corporate fixed-income debt; they are considered to have a higher quality of credit than AAA corporate bonds because they are issued by federal agencies; they tend to be very liquid in the marketplace; and they are a good source for investors interested in receiving a monthly income. There is a bit of reinvestment rate and interest rate risk associated with these policies.
Collateralized Mortgage Obligations and Natural Resources Collateralized mortgage obligations (CMOs) are derivatives of pass-through securities that are held by a trust and in which prepayment and reinvestment risk are reduced. CMOs are divided into different classes (called tranches) that receive different cash flow payments. Principal repayments are directed to the first tranche until it is retired and then paid into the next tranche. Investors in the longer tranches accept a higher rate of interest when they accept a later repayment of capital. Another investment vehicle is natural resources; individuals may invest in resources like timber and oil. Natural resources have an elastic demand and are therefore price sensitive to demand. Increases in demand will cause the value to rise, and decreases in demand will cause their value to drop.
Tangible Assets and American Depositary Receipts Tangible assets are things, like collectibles, that have a strong secondary marketplace with little or no government regulation. The risk of liquidity and fraud can be very high in the tangible assets marketplace. American depositary receipts (ADRs) are a means for foreign firms to get their shares traded on American exchanges. There are two ways to do this: firms can make their shares directly available for trading by listing them on the exchanges, or firms may issue American depositary receipts. ADRs stand for indirect ownership in the shares of a foreign company. US banks have possession of the physical shares, which are held on deposit in foreign banks. The US bank will then issue receipts for these shares to investors. ADRs provide a means of investing in foreign countries without having to worry about currency problems.
Inflation Risk and Interest Rate Risk Inflation risk, also known as purchasing power risk, occurs when the cash flows from a security vary because of inflation. Another kind of risk associated with investment is interest rate risk. When market interest rates go up, the prices of stocks and bonds tend to go down, and vice versa. This inverse relation between market yields and bond prices also applies to the bond’s coupon. If the market yields should fall beneath the value of the bond’s coupon, the price of the bond will always exceed par value. At this point, the bond is said to trade at a premium. When the market yield is above the coupon, the price of the bond will always be less than par value. In this scenario, the bond is said to be trading at a discount. When investors believe that interest rates are going to rise, they are also anticipating that bond prices will fall. If they predict that interest rates are going to fall, they also predict that bond prices will rise. The maturity and coupon of a bond will affect the magnitude of change in the price of a bond; those bonds that have long maturities and low coupons are subject to more price volatility than others. As the yield for a bond increases, the price curve will become flatter, and so changes in the yields will have a smaller effect on the bond’s price when the yields increase. If the yields should drop, the price curve will get steeper and any changes in yields will have a smaller effect on the price of the bond. In other words, yields are proportional to the volatility of price.
Systematic Risk, Business Risk, and Liquidity Risk
Systematic risks affect the entire market and therefore cannot be avoided through diversification. Systematic risk can be determined by beta when calculating risk for a diversified portfolio. Unsystematic risks, then, are those that only affect a particular business or industry, and therefore can be avoided through diversification. It has been demonstrated that unsystematic risk can be avoided by having a portfolio with as few as 10 or 15 stocks. Marketability risk is the relative ease with which a security may be bought or sold. Liquidity risk, on the other hand, refers to the relative ease with which a security can be sold at a fair price without the risk of loss. The best measure for liquidity is the size of the spread between bid and ask. A larger spread is indicative of an illiquid market.
Reinvestment Risk, Political Risk, and Exchange Risk Reinvestment risk results when amortizing securities repay their principal, exposing investors to the hazards of investing these funds at a lower interest rate. Political risk, which is also known as regulatory or country risk, is the chance that changes in government, restrictions imposed on foreign exchange flows, and/or environmental and other regulations may expose a firm to unforeseen costs. Exchange (currency) risks occur when the interest and dividend payments of a particular security are set up in a foreign currency and the value of that currency changes in relation to the home currency. If the value of the foreign currency increases in relation to the home currency, then each unit will be worth more, and if the value of the foreign currency decreases in relation to the home currency, each unit will be worth less.
Coefficient of Determination, Covariance, and the Correlation Coefficient
The coefficient of determination, often referred to as R-squared, is often used in investing. Typically, R-squared is systematic risk, and one minus R-squared is unsystematic risk. The volatility of a given return relative to the market is given by the beta coefficient, and the strength of this relationship is given by R-squared. Covariance, meanwhile, is the degree to which any two variables move together over time. If the two variables move together, they have a positive covariance; if they move apart, they have a negative covariance. Large numbers indicate a strong relationship, and small numbers a weak relationship. The correlation coefficient measures the relationship of returns between two stocks. A correlation coefficient of +1 indicates that returns move in the same direction and are perfectly positively correlated; a correlation coefficient of -1 means the returns move oppositely, and are perfectly negatively correlated; a correlation coefficient of zero indicates two uncorrelated returns.
Variance, Semivariance, and Standard Deviation The standard measure of total risk is variance; this is the measure of the dispersion of returns around the expected return. Semivariance, on the other hand, is a measure of downside risk, the dispersion of returns that occur below a certain target return like zero or the T-bill rate. Standard deviation is the measure of the variability of returns of an asset compared with the mean or expected value of that asset. It is a measure of total risk: the larger the dispersion around some mean value, the greater the risk and the larger the standard deviation. There is usually a bell-shaped curve for standard deviation, meaning that readings will tend to cluster around the expected mean.
Calculation of Historical Standard Deviation In order to calculate the historical standard deviation for a given security, take the difference between the individual observation and the average return, square the difference, and then sum the squared differences. For a sample with a certain number of observations, then, divide the sum by one less than the total number of observations and then take the square root. It should be noted that the average of the standard deviations for the individual stocks in a portfolio is not the same as the standard deviation of the portfolio. In fact, the standard deviation of a portfolio is usually less than the average standard deviation of the stocks that make up the portfolio.
Coefficient of Variation and Beta The coefficient of variation is a measure of relative dispersions (unlike standard deviation, which is the measure of absolute dispersions). The coefficient of variation can be calculated by dividing the standard deviation by the mean. A larger value for the coefficient of variation will indicate a greater dispersion relative to the arithmetic mean of the return. The beta coefficient is the most common measure of systematic risk. It is generally used for analyzing a diversified portfolio. A well-diversified portfolio will only contain systematic risk, and so the beta coefficient can be described as the measure of volatility for a diversified portfolio. A beta of 1.0 indicates that the stock is moving exactly with the market; anything higher indicates that the stick is more risky than the market, and anything less indicates that the stock is less risky than the market. The beta coefficient for individual securities may be risky over time, but it will be fairly stable for a portfolio.
Annualized Return, Real (Inflation-Adjusted) Return, and Risk-Adjusted Return One common method of comparing companies is to use the annual rate of return, or annual percentage rate (APR). APR is calculated by multiplying a given rate by the number of compounding periods needed to annualize it. Real (inflation-adjusted) return is the earnings from an investment that are above inflation.
The real rate of return is calculated as An approximation of the real rate of return is to simply subtract the inflation rate from the nominal rate, but such an answer is not precisely correct. It should be noted that when evaluating the returns of a portfolio, a particular high return may not be good and a particular low return may not be bad. The major composite performance measures are the Treynor index, the Sharpe index, and the Jensen index. These indices are used to see whether a given stock actually beat the market.
Required Rate of Return The required rate of return for a risky asset can be calculated using the capital asset pricing model. This states that the return an individual receives on an investment will depend on the return the individual earns on a risk-free asset and a risk premium.
Risk-adjusted return can be expressed as: In which is the risk-free asset and is the return of the market. Risk premium, which is the additional return of the market over the risk-free rate of return (the part in parentheses), will be adjusted by the systematic risk associated with that asset (the beta coefficient).
Expected Rate of Return, after-Tax Return, and Holding-Period Return
In which is the expected return expressed as a percentage, is the expected dividend, P is the price of the asset, and is the expected growth. After-tax return is calculated by multiplying the pretax rate by the quantity one minus the marginal tax bracket of the investor.
Holding-period return is the total return and is calculated: Where is the sale price, is the purchase price, and D is the dividend paid.
Internal Rate of Return, Yield to Maturity, and Yield to Call
The internal rate of return is the discounted rate that allows the present value of the cash outflows to equal the initial cash outflows, such that the net present value equals zero. The yield to maturity is the internal rate of return of a bond if the bond is held until maturity. This measure will consider the current interest return and all price appreciation or depreciation. This is also a measure of risk and is the discount rate that equals the present value of all cash flows. The yield to call can be used to determine the internal rate of return earned by a bond until it is called or retired by the firm. Yield to call is calculated in a manner consistent with the calculation of yield to maturity, except that the expected call date is used instead of the known maturity date, and principal plus call penalty is used instead of principal only.
Current Yield and after-Tax Yield
The measure of current yield only considers the coupon component of a bond. In other words, it does not include any reinvestment income, price appreciation, or price depreciation. The current yield is calculated as annual coupon payment divided by the price of the bond. The after-tax yield on a bond issue after paying taxes is calculated as pretax yield on an equivalent but fully taxable bond multiplied by one minus the marginal tax rate. Taxable equivalent yield is calculated to determine the yield that must be earned on a taxable bond in order to equal the same yield for a tax-exempt municipal bond. It is computed as the tax-exempt yield divided by one minus the marginal tax rate.
Realized Compound Rate and Geometric Return The realized compound rate of an asset is its actual return based on the present value of future cash flows.
The realized compound rate is commonly known as the time value of money, and it is calculated as:
Where is is the purchase price of the security, r is the rate of return for the period, is the price at which the security is sold. Another common way to determine the rate of return over a period of years is to find the geometric average return. The equation for finding the geometric average return is:
Bond Duration The duration of a bond is the average amount of time that it takes to capture interest and principal repayments. Bond durations are compared between bonds with different coupons and maturities by assessing the sensitivity of these bonds to changes in the interest rate. Bonds will tend to exhibit more price volatility the longer it takes them to reach maturity. Bonds with a low coupon will tend to be more volatile than those with high coupons.
When two bonds have the same maturity, it is typical for the bond with the lower coupon to have a longer duration. Bonds with a longer duration will tend to decline more in price when interest rates go up and will increase more with a decrease in interest rates. The duration of a bond is calculated as the sum of the present value of cash flows weighted by a time period in which payment is received.
Bond Convexity
Bond duration and approximate change in price bear an interesting relation to one another. Actual price change will be greater than estimated price change when yields decrease, and actual price change will be less than estimated price change when yields increase. The greater the change in yields, the less exact will be the measure of duration. This is because actual price as charted on a price-yield graph is a curved line, and the closer it gets to any extreme, the more it departs from the straight line of estimated price. When financial planners are able to measure the degree of bond convexity, they can better predict the price of a bond. Typically, duration is used to calculate the first percentage change in price, and convexity is used to calculate the second, and is added to duration.
Capitalized Earnings
Capitalization treats both earnings and dividends as perpetuities. Preferred stock is an instrument of perpetual debt, and its dividends will continue indefinitely because it has no maturity date. The value of a preferred stock is the present value of its dividends counted at the appropriate interest rate over an infinite period of time.
The value of a preferred stock can be calculated as: The value of a bond can also be found through capitalization as the present value of future cash flows discounted at the appropriate interest rate.
Dividend Growth Models When valuing stock with no dividend growth, one can use the same equation as when valuing preferred stock. The only real difference will be the required rate of return on common stock, which will usually be riskier than that of a preferred stock. When valuing stock with a one-year holding period, one can calculate it as the present value of any dividend received during the year plus the present value of the price of the stock at the end of the year. The model used for considering stocks with a constant dividend growth suggests that dividends will increase at a fixed rate on an annual basis in the future.
In order to calculate the value of a common stock with a constant rate of growth, you can use this equation: Where D0 is the current annual dividend, g is the constant growth rate, and k is the required rate of return.
Price/Earnings Ratio
The price/earnings (P/E) ratio is used to determine the value of stock. The dividend of the firm is compared to the earnings and to the proportion distributed. Unlike the dividend discount model, the P/E ratio can be applied to stocks that are not paying cash dividends. On the other hand, the P/E ratio cannot tell an investor whether a stock is overvalued or undervalued in relation to its market price, a calculation that is relatively easy to perform with the dividend discount model. Instead, investors will have to take a look at the historical P/E ratios in order to make this determination. To determine the estimated value of a stock, take the P/E ratio and apply it to estimated earnings for the next year.
Price/Free Cash Flows Ratio, Price/Sales Ratio, and Price/Earnings/Growth Ratio
The price/cash flow ratio can be defined as the market value divided by the per-share cash flow. The price/free cash flow ratio is frequently used in tandem with the P/E ratio, because it places emphasis on growth in cash flow rather than earnings. The price/sales ratio is the firm’s stock price divided by its per-share sales. This ratio is good for assessing distressed firms, which will have a hard time hiding poor sales figures. The price/sales ratio may distort valuation in situations where earnings drop, however. The price/earnings/growth (PEG) ratio is found by dividing the P/E ratio by the estimated earnings growth rate. When the dividends are significant, the dividend yield should be added to the growth rate when calculating PEG ratio. This ratio indicates the price that the market placed on earning expectations.
Intrinsic Value and Book Value
The intrinsic value of a stock is the underlying value that a careful evaluation would produce. Efficient markets tend to value stocks at their intrinsic value. According to the dividend discount model, the intrinsic value of a stock is the present value of the stock’s expected future dividends discounted at the stock’s required rate of return. When a stock trades above its intrinsic value, it should be sold. Book value is the equity of a stockholder divided by his or her outstanding shares. Value investors try to select stocks that are trading below book value. The price/book value is the firm’s stock price divided by its per-share book value. A low ratio indicates that a stock is undervalued, though what is considered high or low is basically left up to the discretion of the analyst.
Portfolio Theory Portfolio theory strives to understand the relationship between portfolio risk and correlation. Markowitz portfolio theory assumes that a portfolio is efficient if no other portfolio offers a higher expected return with the same or lower risk. The standard deviation of a portfolio will be less than the weighted average standard deviation of the individual stocks in the portfolio. In order to determine the standard deviation of a portfolio, we must find the covariance of returns among stocks. Correlation only affects the risk of a portfolio. Modern portfolio theory has taught us that the correlation coefficient drives the theory of portfolio diversification.
The lower the correlation coefficient, the greater will be the diversification. Markowitz’ efficient frontier is the set of portfolios that will give the investor the highest return at each level of risk.
Capital Market Theory Capital market theory builds on the work done by Markowitz portfolio theory. This theory assumes that investors are efficient and have the same expectations and freedom in the market. In graphical form, the combination of a risk-free asset and a risky asset will produce a linear risk/return line.
A linear efficient frontier line is called the capital market line. Any two assets that fall on this line will be perfectly correlated with one another. In capital market theory, there is a set of all stocks, bonds, and risky assets in existence that is known as the market portfolio. Any securities that are below the capital market line are considered inefficient and will not be bought. The proper relationship between risk and return is systematic risk and return; beta is the measure of systematic risk.
Performance Measures Sharpe Ratio and Treynor Ratio The Sharpe ratio is the measure of the risk-adjusted performance of a portfolio based on total risk.
The measure for total risk is the standard deviation. This measure implies that a portfolio is not widely diversified. It is calculated as: Where rp is the portfolio rate of return, rf is the risk-free rate of return, and σ is the standard deviation of the portfolio.
The Treynor ratio, meanwhile, is the relative measure of the risk-adjusted performance of a portfolio based on market risk, and is more appropriate for using on diversified portfolios. It is calculated as: Where beta is the risk of the portfolio. Jensen Ratio and Investment Policy Statement
In the Jensen ratio, alpha (α) is used as an absolute measure of performance; specifically, it compares the performance of a managed portfolio with that of an unmanaged portfolio of equal risk. The Jensen ratio measures how much the realized return differs from the required return, and more generally it measures the performance of portfolio managers. An investment policy statement does four things in order to create a structure for making sound investment decisions: it establishes risk and return objectives; it determines constraints; it establishes a set of agreed-upon goals and other criteria for measuring performance; and it reduces professional liability by illustrating how appropriate steps were taken at all points of the portfolio management.
Portfolio Management Appropriate Benchmarks and Dollar-Weighted vs. Time-Weighted Rate of Return The evaluation of a portfolio should be done from the perspective of the entire portfolio’s composition or from the perspective of certain classes of assets in the portfolio; it is not appropriate to compare unlike securities. The dollar-weighted rate of return applies the concept of internal rate of return to investment portfolios, taking into account all of the cash inflows and outflows. The time-weighted rate of return, on the other hand, doesn’t weigh all of the dollar flows in each time period. Instead, it computes the return for each period and averages the results; then, it averages the holding periods. When the investment is for more than one year, it takes the geometric mean of the annual returns to find the time-weighted rate of return for the measurement period. The time-weighted approach is more commonly used in the investment management profession, since it is not affected by the timing of cash flows. Probability Analysis
Portfolio managers use a number of simulations to try to predict the behavior of securities. One of the most common methods for solving differential equations is the Monte Carlo simulation, which is usually performed on a computer. If we were to assume that the value of an option depends on two underlying factors, the stock index and the exchange rate for instance, we could use a Monte Carlo simulation to price the option. The computer would create a large number of scenarios for the value, allow all of them to be affected by the two variables, and then create a probability distribution to indicate what the likely prices for the option are. The sum probability of all the probabilities in the probability distribution will have to equal one. Dollar Cost Averaging, Dividend Reinvestment Plans, Bond Ladders, and Bond Barbells
Dollar cost averaging is the process wherein securities are purchased over a period of time through periodic investments at a predetermined amount. This is done to reduce risks caused by changes in the market. Dividend reinvestment plans (DRIP) are those in which, for little or no cost, dividends are used to purchase more shares of a firm’s common stock. For tax purposes, these reinvested dividends are treated the same as cash. A bond ladder is a series of bonds that have their maturity dates spread out over a period of time. This reduces interest rate risk and makes cash available more often. Bond barbells are portfolios consisting of some long-term bonds and some short-term bonds. If an investor can correctly predict rate change, barbells can offset fluctuating interest rates.
Market Timing and Passive Investing
In the investment strategy known as market timing (or active investing), investors adjust their portfolios based on the changes they predict in the market. This strategy directly conflicts with the efficient market hypothesis, and so is used more often by investors who feel the market is inefficient. Passive investing, on the other hand, is when investors seek to protect their portfolios from market change. They try to stick with a good rate of return and thereby keep transaction costs down. In the strategy known as fundamental analysis, investments are based on an evaluation of the financial strength of the firm in question. Investors making use of fundamental analysis will try to pick the best firms in the most promising industries.
Portfolio Immunization and Buy and Hold
In the investment strategy known as buy and hold, investors buy stocks and keep them because they believe that active management only drives up transaction costs without really contributing to a portfolio. Unlike a passive investing strategy, in which asset allocation percentages are maintained by rebalancing the portfolio, the buy and hold strategy does not include periodically rebalancing the portfolio. Another common strategy is portfolio immunization, in which an investor seeks to balance his or her portfolio so as to avoid suffering from any changes in the direction of interest rates. This can be done either by purchasing a series of zero-coupon bonds that have maturities corresponding with the planning horizon or by assembling a bond portfolio in which the duration is equal to the planning horizon.
Swaps
A swap is an investment technique in which bonds are sold and different bonds are purchased with the proceeds. A swap is conducted for the purposes of deriving advantageous tax treatment, yields, maturity structure, or trading profits. In a substitution swap, bonds with virtually identical characteristics but different yields are swapped. When the difference in yields between the bonds is huge, it is called an intermarket spread swap. When a low-yield bond is sold and a high-yield bond is purchased (typically because it has a longer maturity), it is known as a pure-yield pickup swap. A swap that is designed to handle an expected interest rate change is called a rate anticipation swap. When an investor seeks to lock into a loss, he or she may execute a tax swap, selling a bond only to then buy a similar bond.
Technical Analysis
When investors perform a technical analysis, they are assuming that prices are determined by supply and demand, which are driven by rational and irrational behavior. They believe that shifts in supply and demand can be observed in the behavior of market price. The major challenge to this belief is the efficient frontier hypothesis, which states that new information in the market will cause instantaneous adjustments in price that cannot be predicted. Whereas technicians believe that new information affects price slowly, fundamentalists assert that it does so quickly, and efficient market theorists assert that it does so almost instantly. Efficient market theorists believe that technical analysis takes too much time for it to be effective.
There are a couple of different views that bear on the technical analysis of investment. Contrarians are those that assert that investors should do the opposite of the general investor, as the general investor is wrong most of the time.
Smart money traders are those who simply follow the money movement of individuals who they consider to be sophisticated investors.
Contrarians will make use of mutual fund cash positions, the investor credit balances in brokerage accounts, investment advisory opinion, and OTC vs. NYSE volume, whereas smart money traders will make use of the Confidence Index, T-bill yields, Eurodollar rates, short sales by specialists, and the margin debit balances in brokerage accounts.
The Confidence Index, which is used by smart money traders, is the ratio of Barron’s average yield on 10 top-grade corporate bonds to the yield on a Dow-Jones average of 40 bonds. Basically, the Confidence Index measures the difference between high-quality bonds and a large cross-section of bonds.
Another market indicator used in technical analysis is the Dow Theory, which tries to identify trends in the security markets. Analysts will also consider volume, as a price change on high volume is much more telling than a price change on low volume. They may also examine the breadth of the market, which is the ratio of advancing stocks to decreasing stocks. Other indicators include the short interest ratio (the cumulative number of shares sold short divided by the daily volume of trading), support and resistance levels, relative strength ratio, and moving average lines.
Strategic Asset Allocation
Strategic asset allocation is when an investor selects a suitable mix of assets based on his or her own portfolio. A client’s risk tolerance, for instance, can be deduced from his or her age, and an investment portfolio should match the client’s risk tolerance while meeting his or her return objectives. Asset allocation programs are usually marketed in one of five ways: aggressive growth, growth, growth and income, balanced, and fixed income; these are listed above in descending order of return and risk level.
Investments will be divided up among stocks, bonds, and cash and money market instruments. Typically, the driving force of strategic asset allocation is the correlation coefficient.
Tactical Asset Allocation, Passive and Active Portfolio Management, and Dealing with Concentrated Positions
When an investor engages in tactical asset allocation, he or she is using security selection as the main determinant in developing a portfolio. Regular asset allocation tends to use an investment policy. A passive portfolio management strategy begins by establishing specific percentages for each asset class and then rebalancing occasionally to maintain these percentages. In an active strategy, on the other hand, the most important factor is market timing. When dealing with a tax-deferred retirement account, it is most appropriate to rebalance a portfolio to maintain asset allocation percentages, since the gains on these securities will not be taxed. This is also appropriate for regular accounts, although constant rebalancing can make tax reporting overly complicated.
Efficient Market Hypothesis Strong Form and Semi-Strong Form
The efficient market hypothesis (EMH) asserts that individuals cannot outperform the market on a risk-adjusted basis over an extended period of time because security prices will be very consistent with the amount of risk involved with a certain security. A strong form of the EMH asserts that security process will fully reflect all information. This includes public, private, and nonmarket public information. This form of the theory indicates that an investor should not expect success. The semi-strong form of EMH states that stock prices fully reflect all of the information, and so an investor should not expect to achieve success using a fundamental analysis. In this form of the theory, security prices only include market and nonmarket public information, so insider trading is possible. Weak Form EMH and Tests The weak form of the efficient market hypothesis asserts that stock prices fully reflect all of the available information. The weak form also states that security prices are not correlated to another and that returns are likewise independent. The random walk theory is often used to explain the weak form of the EMH: historical indicators, price behavior, and any other indicators are incapable of providing useful information for investment. There are a few different tests of the EMH. To test the weak form, analysts will frequently conduct statistical tests of the independence of security returns. To test the semi-strong form, they will try to predict future rates of return based on public information. In order to test the strong form, they will use academic tests to isolate the legal use of public information and its effects. Anomalies from Cross-Sectional Tests
Many studies have shown that the dividend yield, default spread, and term structure spread can all be used to determine the rate of return on stocks and bonds. Moreover, quarterly earnings reports show that the market may not have adjusted stock prices as quickly as expected in order to reflect earning surprises. One should also keep in mind the January effect, which shows that stocks tend to perform well in January. There also is a similar day of the week effect: the days of the weekend tend to generate a lower rate of return. This suggests that investors should try to buy a stock on Monday rather than Friday, as the stock will be more likely to generate returns during the week. Conclusions and Anomalies from Strong-Form Academic Tests Strong-form academic tests indicate that stock exchange analysts have access to information that is essentially monopolistic; for this reason, they derive better-than-average returns. Also, corporate insiders have exclusive information, and they therefore tend to have greater returns than others. In conclusion, market results seem to support the weak-form efficient market hypothesis, while results are spottier for the semi-strong form EMH.
Specifically, time-series and cross-sectional tests indicate that markets are not always semi-strong form efficient. For the most part, results support the strong form EMH; the exceptions to this are corporate insiders and specialists.
Capital Asset Pricing Model (CAPM)
The capital asset pricing model (CAPM) calculates the required rate of return for risky investments. This figure is derived from the risk-free rate an investor can earn by investing in risk-free security (like a Treasury bill) and the risk premium. The risk premium is both the additional return an investor will earn and the volatility of the security to the market. If the difference between the market rate and the risk-free rate grows, so does the risk premium. The CAPM is often used to identify overvalued and undervalued assets: if the expected return is greater than the required return, the asset is undervalued; if the expected return is lower than the required return, the asset is overvalued. Similarly, if a stock’s expected return falls below the security market line, the stock is overpriced (i.e., the expected return is too low).
Multifactor Asset Pricing Model The multifactor asset pricing model (also known as the arbitrage pricing theory) was developed because of the variety of factors that influence stock performance. This model assumes that capital markets are competitive, investors will prefer more wealth to less, and that the K-factor model represents the process that generates asset returns. This model, unlike CAPM, does not assume that security returns are normally distributed, that investors have quadratic utility functions, or that the market portfolio contains all securities and is mean variance efficient. This model assumes an unspecified number of risk factors and represents an attempt to calculate the rate of return by evaluating the responsiveness of the stock to all of these risk factors.
Describe the Option Pricing Model
The goal of the asset pricing model known as the option pricing model is to determine the value of a call option. This model assumes that the call option is in the European rather than the American style, meaning it can be exercised only on its expiration date. In the option pricing model, there are four variables: time to maturity, interest rates, the price of the underlying stock, and volatility. The value of a call will typically decrease with an increase in strike price. Put-call parity determines the value of a put option. This indicates that there is a close relation between the prices of puts and calls and the value of stock. Put-call parity ensures that the prices of a call and a put will change with one another and the underlying stock.
Margins If an investor purchases a stock on the margin, then he or she must make an initial payment (much like the down payment on a house) and pay for the rest with borrowed money. The Federal Reserve has at present set the initial margin requirement at 50%. Stock exchanges and brokerage houses will set a maintenance margin requirement, with maintenance margin being the minimum equity an investor must have for a margin position. A maintenance margin protects the brokerage house from having to shoulder too much risk.
Margins provide a great deal of leverage to an investor: when the price of stock rises, for instance, the customer’s profits will rise much faster. Of course, losses can be much greater as well.
Margin Calls When a stock or portfolio declines a great deal in price, the result will be a margin call. Margin calls indicate that the equity in the account has dropped beneath the margin requirement. Investors will have to increase their equity by either selling assets or depositing cash or securities.
In order to find the price that will trigger a margin call for a certain stock, analysts use the following formula: Where is the original price of the stock, is the initial margin required, and is the maintenance margin required. The rate of return on a margin transaction can be figured by finding the net profit and total investment in the transaction, and then dividing net profit by investment to find the percentage gained or lost.
Strategy of Buying Calls and Puts
Investors will seek to buy calls when they anticipate that the underlying stock or index is going to rise. Long call positions may be used either speculatively through the use of leverage or conservatively as insurance policies. The absolute gain or loss on a transaction will tend to be smaller than it would be if the stock were owned, since options are less expensive. An investor may seek to buy puts in a situation where he or she anticipates a decline in price in the underlying stock. The maximum gain will increase as stock price decreases, with the maximum loss being the premium paid for the options. Time decay will accelerate as options approach expiration. Often, puts are used as an alternative to selling short.
Strategy of Selling Naked Calls and Naked Puts
The strategy of selling options is frequently referred to as naked call writing. Typically, naked call writing will expose an investor to a substantial amount of risk, because if the call is exercised after a rise in the price of stick, the option writer will be forced to buy the stock back and then sell it to the buyer. The maximum gain in this strategy is the price of the premium, while the maximum loss is unlimited. This strategy is usually used to take advantage of volatility and time decay. Investors may also write naked puts. In this scenario, the option trader assumes the risk of the underlying security in exchange for the premium. Maximum gain is the premium that is received, and maximum loss is the cost of buying the stock at the strike price.
Strategy of Covered Call Writing and Covered Put Writing When investors write a covered call (also called covered call writing), they are taking short calls with a long stock position in the underlying stock. When the option is exercised, the seller will supply the stock at the strike price. The call seller will limit the gain on the stock by the premium received plus the strike price, less the price paid for the underlying stock. Maximum gain is made when the stock trades above the strike price at expiration. In the strategy of covered put writing, the investor sells the stock short and sells the put in order to create the covered put. When the put is exercised, the investor buys the shares and uses them to cover the short position. This strategy is only effective when the investor expects a stable stock price.
Short Sales A short sell is when an investor sells borrowed securities because he or she anticipates a drop in price. The investor will profit by selling the securities and then buying them back at the reduced price. The maximum loss of a poor short sell can be unlimited if the value of the stock continues to rise. Typically, the investor does not own the securities that are being sold short; they are sold with a promise of future delivery. There are two technical points that bear on short selling: short sellers have to pay all dividends owed to the lender of the security; and short sellers must deposit margin money to cover the repurchase of the security.
Tax-Efficient Investing Mutual Funds In mutual funds, those with a greater portfolio turnover ratio will create more tax consequences for investors. A mutual fund turnover ratio assesses the amount of buying and selling in a certain mutual fund. Even though the returns of a mutual fund are stated before tax, the investor only gets to keep the after-tax returns. A mutual fund is said to be tax-efficient when it can generate returns without creating large amounts of tax obligations. There will be no tax obligations if the fund doesn’t generate income or realize any capital gains. Investors should always be aware of the date on which capital gains and income are distributed (either mid-year or year-end). Hidden capital gains can result in unexpected taxes, while hidden capital losses can indicate tax-free gains. Stocks, Bonds With stocks, the returns of a portfolio will be measured by after-tax returns. According to the wash-sale rule, the practice of selling shares at a loss and then buying them back within 30 days makes it impossible to deduct such losses on one’s tax return. The disallowed loss amount can then be added to the cost basis of any additional shares purchased, and any taxable gain or loss on the sale of these shares will include the loss incurred on the original shares. This rule also applies to mutual funds and bonds. For bonds, the taxable equivalent yield is calculated as the tax-exempt municipal yield divided by one minus the marginal tax rate. If bonds were purchased at a premium, the investor may want to amortize a part of the premium and reduce the basis by the amount deductible. The SEC yield is a good measure of performance for various bond funds.
Investment Strategies in Tax-Advantaged Accounts
For investors, every gain or loss can be classified as either ordinary or capital. A capital gain or loss will be the result of the sale of a stock or bond; every other gain or loss (for example dividends) will be classified as ordinary. Individuals do not have to pay interest on capital gains and income on tax-deferred accounts as long as the proceeds and payments are left in the account. The net unrealized appreciation is also nontaxable. It is a good idea to fill tax-advantaged accounts with high-income-producing assets, zero coupon bonds, stocks that are held for short-term appreciation, and TIPS. It is a good idea to fill taxable accounts with municipal bonds, treasury bills, notes, bonds, and growth stocks with a long term of appreciation.
Taxation Mutual Funds In order to determine the basis of a mutual fund, add the cash investments, reinvested dividends, and capital gains, and then subtract returns of capital received. Front-end and other sales charges will adjust the share purchase price and increase the basis, while back-end loads and redemption charges will reduce the proceeds acquired through the sale of securities. When the cost basis of a mutual fund is assessed, an investor must identify the specific shares that have been sold, receive written confirmation from the broker, and then calculate the shares on a first-in, first-out arrangement. In order to figure the average basis, investors calculate the total cost of the shares owned divided by the total number of shares owned. Stocks Stock dividends are reported on Form 1099-DIV, while interest is reported on Form 1099-INT. Any dividend reinvestments are considered constructive receipt and are taxed as ordinary income. In order to calculate the basis, capital gains are recognized not on the settlement date, but on the trade date. Those securities that are purchased have a basis that is calculated by adding the price and any commission charges. Selling expenses are figured against the gross sales price in the calculation of the amount realized on sale. The realized capital gain from the sale of a security is the amount that is realized over the cost basis in the security; realized capital loss is the excess of the basis over the amount realized. When investors choose to have their dividends reinvested, these become the cost basis of new shares. Capital gains on stocks are reported on Form 1099-B. Taxes will be due the year that a sale occurred in a taxable account. Taxes on tax-deferred accounts will not occur until the liquidation of the account, and they will be subject to ordinary income only. The receipts for stock splits, stock dividends, and rights are considered nontaxable events, since these are just rearrangements of already-owned stocks. Taxable distributions are reported as income, with the taxable dividend being equal to the fair market value of the stock on the date of distribution. Nontaxable distributions will affect the basis of the old shares: the cost basis of old stock is divided by the total number of shares held after distribution. The exercise of a warrant is not a taxable event. Federal Government Bonds, Agency Bonds, and Municipal Bonds The interest on instruments of federal debt is subject to federal income tax but is exempt from state and local taxes. For treasury bills, interest earned is equal to purchase price less the amount paid at maturity. For Treasury notes and bonds, interest is to be paid semiannually and is reported in the year that it is earned. Agency bonds can be taxed at both the federal and the state/local level; interest will be taxed as ordinary income, while treatment of capital gains and losses will be applicable only if the bonds have appreciated or depreciated in value. As for municipal bonds, the interest income they create is excluded from federal taxes. Any state and local bond interest may be taxed by the state or locality in which the investor lives. The treatment of capital gains or losses will apply when the bonds are sold. Zero Coupon Bonds and TIPS Interest on zero coupon bonds is taxed as if it were received. Original issue discount occurs when a long-term debt instrument is issued at a price lower than par value. Investors are not allowed to defer recognition of the interest income created by original issue discount. In the case of Treasury inflation protected securities (TIPS), the principal will have to be adjusted up or down for inflation or deflation, and the fixed interest rate must also be considered. Interest on TIPS is paid semi-annually, though inflation-adjusted principal is not paid until the bond matures. Investors will have to pay federal income tax on the increasing principal amount as well as on any coupon interest. Convertible Bonds, Accrued Interest, and US Savings Bonds Changing convertible bonds into common stock is not a taxable event. The cost basis for the new common stock is the same as the original cost of the convertible bond. The holding period for shares will begin at the time the convertible was originally purchased. As for accrued interest on investments, the seller is required to report accrued interest in his or her gross income. The purchaser, on the other hand, will deduct the accrued interest from the next interest payment as if it were a return of capital. The interest on US savings bonds is only subject to federal taxation; it is exempt from state and local taxes. The taxpayer has the option of either reporting interest annually or upon redemption of the bond. Annuities Although investors are not taxed on the annual buildup in the value of an investment, they are taxed on the gain in an annuity when it is distributed. This gain is treated as ordinary income. Any interest earning will be assumed to be withdrawn first, and then principal; only a portion of the annuity payable will be taxable as ordinary income. Annuities may be subject to full taxation if the taxpayer has not contributed to the cost, or if the taxpayer’s entire cost has been recovered. For partially taxable distributions, the percentage of each annuity payment excluded from gross income is the total after-tax contribution of the employee divided by the annual payment multiplied by life expectancy.
Goals of Fundamental Investment Analysis
The term fundamental analysis describes the process of analyzing data and applying the data to ratios to determine the relative financial health of what is being analyzed. The three areas of fundamental investment analysis occur at the economic, industry, and individual company levels. Empirical data for each level is analyzed to determine whether the time for investment may be right. If a fundamental investor determines that an entire country at the economic level may not be suitable for investment, he may eschew drilling down further and avoid all investment in the country. Fundamental analysts use ratios to determine the soundness of investing in economies and industries, and if they determine that the time is right for both, they’ll move to individual companies where they’ll use fundamental analysis to estimate a reasonable fair market value for the stock of the company to determine if there is an opportunity for investment.
Top-down and Bottom-up Fundamental Investment Analysis
There are two basic types of fundamental analysis: top down and bottom up.
Top-down fundamental analysis describes the analysts beginning with the overall economy of the country in which they choose to invest. After they determine the health of the economy, they’ll determine the fundamental financial health of individual industries, and once they’ve selected an industry, they’ll begin evaluating individual companies. Bottom-up analysts, colloquially known as stock pickers, begin at the company level, then move to the industry level, and finally to the economy level. There are proponents for both types of analysis. Top-down analysts may save themselves time and effort by eliminating economies and industries that are not suitable for investment before they drill down to the company level. Alternatively, bottom-up analysts may save themselves time and effort by choosing relatively stable economies and industries and skipping their analysis altogether.
Fundamental Evaluation
Fundamental investment analysis occurs at three levels: the economic level, the industry level, and the individual company level. At the economic level, analysts are studying the health of a given country’s finances. Data considered at the economic level includes (but is not limited to) interest rates, fiscal and monetary policy, and legislative environments. At the industry level, the fundamental analyst is endeavoring to determine the health of individual sectors of the economy. Such things as supply, demand, and business cycles are considered at the industry level. Finally, at the individual company level, fundamental analysts are trying to determine the fair market value, or FMV, of individual companies. Ratios such as liquidity and activity ratios using raw data from the companies’ financial statements are used to assist in determining their FMV.
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