Chapter 1

Investment

The commitment of current resources (time, money, etc.) with the expectation of enhanced future benefits. In FIL 242, an investment is typically financial in nature requiring the purchase of a security in exchange for claims on the assets of the issuing company.

Direct vs. indirect investments

In a direct investment, the supplier of funds and the user of funds interact directly. Excess funds from households funnel directly to the user of funds while the security created exchanges hands from the issuing company directly to the investor.

With indirect investments, a direct exchange between suppliers and users of funds is compromised. A financial intermediary, such as a bank or mutual fund, is placed between the originator of the security and the ultimate supplier of the funds. During intermediation, the security held by individual households, who are supplying funds, is different from the security held by the intermediary.

Example: Mutual funds buy shares directly in companies like IBM, Microsoft, and Caterpillar, but individuals buy shares of the mutual fund.  

Debt

Debtholders have a fixed claim on the income and the assets of the borrower. A contract establishes the size of the claim held by the lender.  Debtholders get paid before equityholders do.

Equity

Equity represents partial ownership in a corporation. Equityholders have claim to the residual value of income and assets of a company.

Investment policy statement (IPS)

IPS is the written document that guides investors in decision making. It is frequently used by professional money managers to describe the requirements of the investor (client) and the strategies which manager is going to use to fulfill those requirements. Important components of the investment policy statement include asset allocation and security selection decisions, as well as recognizing any specific constraints.

Asset allocation

Asset allocation is the broad proportions of asset classes that comprise the portfolio of an investor.   Typical asset categories include stock, bonds, real estate, international investments, and cash.

Example: 50% of the portfolio invested in stock, 30% invested in bonds, 10% in real estate, 5% international investments, and 5% in cash.

Security selection

Security selection is the choice of the specific assets within a particular asset class, such as stocks. Whereas asset allocation describes the total percentage invested in stocks, security selection next answers which individual stocks to purchase.

Capital gains

When the price of an asset increases over and above the initial purchase price, the difference between those two prices is called capital gain. If the price of the asset falls over the investment horizon the investor is said to experience a capital loss.

Example: If you buy a stock for $10 and sell it for $25, you had a capital gain.

Realized vs. unrealized capital gains/losses

Capital gains are realized if the investor actually sells the asset and gets cash. Realizing capital gains and losses means the investor has experienced changes in their cash position as a result of the investment.

Unrealized capital gains/losses (a.k.a. “paper gains/losses”)

When the value of the investments changes but the investor has not sold the asset, the capital gain or loss is said to be unrealized.

Chapter 2 - Security overview

Coupon

The contractual interest obligation a bond issuer agrees to pay to its debtholders.

Face value

The underlying principal of a bond contract. It is the amount that an issuer agrees to repay at the maturity date of the bond.

Maturity

Maturity is the time period after which debt is due and the issuer will repay the underlying principal or face value back to the bondholder.

Sinking fund

Sinking fund is reserve fund used by the company to repay the principal amount of bonds when they mature. Companies basically reserve some money annually in the sinking fund so at the time of the maturity there will not be scarcity of funds. Investors see the accumulating funds and feel better about the company’s ability to meet their debt obligations as they come due.

Term vs. serial bonds

Term bonds pay off all bonds on a single maturity date. Serial bonds are arranged so that specified principal amounts become due on staggered dates to reduce the financial stress associated with paying off a large principal amount on one particular date.

Secured vs. unsecured bonds

Secured bonds are back by different types of collateral. In the case of default the borrower recovers losses to bondholders by liquidating the pledged collateral. Unsecured bonds have no explicit collateral but are just backed by faith and good image of the issuer. Unsecured bonds typically have higher interest rates to reflect the additional risk associated with the bonds. Unsecured bonds are called debentures.

Senior vs. junior (subordinated) bonds

In case of default, the senior bondholders will be paid before junior or subordinated bondholders.

Notes vs. bonds

Notes are debt instruments that have initial maturities (when issued) of up to 10 years. Bonds have initial maturities longer than 10 years.

Municipal bonds

State or local governments offer muni bonds or municipals, as they are called, to pay for government projects. The interest that investors receive is exempt from some income taxes.

Treasury securities

Debt instruments that are issued by the U.S. government. These securities are assumed to be free from default risk – that is, 100% of the time it is assumed that the U.S. government will meet all of their obligations that are due under the debt contracts.

Agency bonds

A bond, issued by a U.S. government-sponsored agency. The offerings of these agencies are backed by the U.S. government, but not guaranteed by the government since the agencies are usually private companies (except Ginnie Mae). Such agencies have been set up in order to allow certain groups of people to access low cost financing, especially students and first-time home buyers. Some prominent issuers of agency bonds are Student Loan Marketing Association (Sallie Mae), Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac).

Price weighted index

An index that is computed by adding together all of the stock prices included in the index and dividing by a divisor. Upon establishing the index, the divisor is chosen to be the number of shares in the index. As stocks split over time, the divisor needs to be adjusted periodically. The Dow Jones industrial average is the most well known price-weighted index.

Market-value weighted index

An index that is computed by comparing the market capitalization of the stocks included in the index at two different times: the index date and some initial base period.

Chapter 3 - Economy

Business cycle

Business cycle represents repetitive up and down movements in the economy over a period of time. Historically, economies experience natural periods of growth and contraction. Swings in the business cycle are commonly measured by the real growth in gross domestic product (GDP).

Top-down approach to investment analysis

Top-down investment analysis is a sequential process for selecting investments which begins looking at general economic issues and then works down to understand individual security issues. First, macroeconomic issues are studied. Next, the focus turns toward specific industries which are expected to thrive in different stages of the economy. Finally, individual companies are selected from those top industries.

Fed funds rate

The rate that banks charge to borrow and lend excess reserves, typically on an overnight basis. The fed funds rate is the interest rate that is targeted by the Federal Reserve.

Fiscal policy

Government policy related to spending and taxation. Increased spending and tax cuts are frequently used to increase economic activity.

Monetary policy

Actions taken by the Federal Reserve to influence interest rates and/or the money supply. Increasing interest rates is an attempt to slow down a rapidly growing economy which has inflationary pressures. Decreasing interest rates is an attempt to spur economic activity.

Budget deficit

In the U.S., the Federal government has historically spent more money than it collects in tax revenue. To make up the difference, the Federal government borrows heavily in the financial markets.

Trade deficit

When a country imports more than it exports.

Cyclical vs. defensive stocks

The performance of cyclical stocks is closely aligned with movements in the business cycle and performance of economy. If economy is growing, cyclical companies sell significantly more products which often increase profits. Subsequently, cyclical stocks perform well in growth stage of the economy. Defensive stocks are less susceptible to swings in the business cycle. An underlying demand exists for these products regardless of the stage of the economy.

Examples of cyclical stocks include big

ticket items such as housing, automobiles, luxury and leisure products (air travel). Defensive companies include health care, groceries,

tobacco, and diapers.

Sector rotation

A portfolio strategy which attempts to move money into different industries based on economic conditions. For example, investing in cyclical stocks during times of economic growth and switching to defensive industries as the economy shrinks.

Chapter 4 - Individual security risk and return

Dollar return

Investing in securities brings two potential sources of returns: income and capital gains. The total dollar return includes both of these sources.

Total percentage return (a.k.a. holding period return or HPR)

The total dollar return per dollar invested. You can also break the total percentage return into its components, called capital gains yield and income yield.

Capital gains yield

The percentage return earned from capital gains.

Income yield

The percentage return earned from income. The income yield is a generic term that is used for any investment. More commonly, the return from income goes by alternate names depending on the specific asset. For stocks, it is called dividend yield and for bonds, it is called current yield.

Dividend yield

The percentage return earned from a dividend paying stock. In the financial press, dividend yield is the annual return from income (dividends) if a stock is purchased today at the current market price.

Current yield

The percentage return earned from a coupon-paying bond. It is calculated as the total annual interest income from the bond divided by its current price. Current yield indicates the returns that investor will receive strictly from income over the coming year if they purchase the bond today.

APR (annualized percentage rate or return)

HPR is the return over a period which is typically less than one year in length. APR is the HPR on an annual basis and is calculated by multiplying HPR by the number of periods in a year. APR does not account for compounding.

EAR (effective or equivalent annual rate or return)

HPR is the return over a period which is typically less than one year in length. EAR assumes the original amount invested is compounded each period throughout the year.

Internal rate of return

The Internal rate of return (IRR) is the discount rate that equates the present value of inflows with the present value of outflows. IRR determines the return from an investment by explicitly accounting for the timing of the cash flows involved during the investment horizon.

Variance

The variance measures the average squared deviation from expected. It is a measure of uncertainty, or surprise, that may be experienced when investing in a security. To calculate the variance, first one needs to calculate the arithmetic average return. Then, compute the squared difference between each observation and the arithmetic average return.

Standard deviation

The square root of the variance.

Arithmetic average return

The simple average return, computed by adding up all of the periods’ returns and divided by the number of periods. Arithmetic return does not account for compounding and is therefore used as a one-period prediction of returns.

Geometric average return

A measure of the average compound rate of growth of an initial investment in a portfolio over an entire investment horizon. Geometric average return assumes that the portfolio is reinvested fully each period. To calculate geometric average return, the returns of each period should be compounded. Then take the nth root of the compounded return.

Market risk

Market risk refers to uncertainty that is common to all securities in a particular market (such as the stock market). All securities in the market are similarly affected by changes in interest rates, unemployment, and other general economic phenomena.

Firm specific risk

Uncertainty that is unique to a company such as a strike, the outcome of unfavorable litigation, or a natural catastrophe. This type of risk does not affect other companies.

Liquidity risk

The uncertainty that a security can be sold quickly at close to its fair market value.

Default risk

Credit risk is the risk that a company or individual will be unable to pay the contractual interest or principal on its debt obligations. This type of risk is of particular concern to investors who hold bonds in their portfolios.

Risk aversion

Wanting to avoid risk unless adequately compensated for it which is the attitude of most investors. As an example, if two investments have the same expected return, the one with lower risk would be preferred by risk averse investors. A riskier investment has to have a higher expected return in order to provide an incentive for a risk-averse investor to select it.

Risk premium

The excess compensation (return), over and above the risk free rate, or .

Margin

The margin relates to an investor’s equity position when investing. When buying on margin, it is the proportion that is contributed by the investor. When selling stock, it is the additional collateral required by the lender of the shares. Margin is defined as:

Maintenance margin and margin call

When buying a stock on margin, the broker lends money to the investor. When short selling stock, an investor lends shares to the short seller. In these transactions, the lenders require some security to protect them against the risk of default of the investor. Equity represents the available cushion to the lender. In order to be sure that this cushion remains sufficient, the lender puts a lower bound on the margin of investment positions. If the margin falls below the maintenance margin, the investor receives a margin call which is a request for additional equity. If the investor fails to either pay off part of the loan or contribute more equity to their account, the lender will close out the position immediately.