·
Rate of Return or Return on Investment (ROI) is the ratio
of money gained or lost on an investment relative to the amount of money
invested
o
ROI = Net Income/Investment
·
Yield is a rate of return that is based on compounding,
reinvestment, and/or the changing market value of a security
·
The internal rate of return
(IRR) is a capital budgeting method used by firms to decide whether they should
make long-term investments
·
The main factors that are used by
investors to determine the rate of return at which they are willing to invest
money include:
o
estimates of future inflation rates
o
estimates regarding the risk of the
investment
o
whether or not the investor wants the
money available (“liquid”) for other uses.
Risk
·
Market Risk: risk of the market as a
whole (i.e. the stock market)
·
Company Risk
·
Sector Risk
·
Stocks
·
Stock is the capital
raised by a corporation through the issuance and distribution of shares. A stock certificate (or share in the
·
Shareholders are granted special
privileges depending on the class of stock, including the right to vote on
matters such as elections to the board of directors, the right to share in
distributions of the company's income, the right to purchase new shares issued
by the company, and the right to a company's assets during a liquidation of the
company.
·
Shareholder's rights to a company's
assets are subordinate to the rights of the company's creditors. This means
that shareholders typically receive nothing if a company is liquidated after
bankruptcy, although a stock may have value after a bankruptcy if there is the
possibility that the debts of the company will be restructured.
·
Dividends are payments
made by a company to its shareholders.
o
The "ex dividend" date is set by the exchange where the stock is
traded, several days (usually two) before the date of record, so that all
trades made on previous dates can be properly settled and the shareholder list
on the date of record will accurately reflect the current owners. Purchasers
buying before the ex-dividend date will receive the dividend, even if they sell
their stock after the ex-dividend date The stock is said to trade "cum
dividend" ("with dividend") on these dates. Purchasers buying on
or after the ex-dividend date will not receive the dividend.
o
Some companies have dividend
reinvestment plans, or DRIPs. These
plans allow shareholders to use dividends to systematically buy small amounts
of stock, usually with no commission and sometimes at a slight discount. In
some cases the shareholder might not need to pay taxes on these re-invested
dividends, but in most cases they do.
·
The aggregate value of a corporation's
issued shares is its market
capitalization.
·
Types of Stocks
·
Growth Stocks: returns primarily come through stock
price appreciation
·
Income Stocks: returns come through dividends (cash paid to shareholders)
·
Cyclical Stocks: strength varies with the overall
economy
·
IPO: Initial Public Offering
·
Stock Market Indexes:
o
Dow
Jones Industrials
o
Standard
& Poor’s 500
o
Wiltshire
5000
·
See
Economics: Stocks
Stock Mutual Funds and ETFs
·
Both
hold baskets of securities – stocks, bonds, etc.
·
Mutual Funds: are generally actively-managed by a
manager
- Are purchased or sold only
after the market close
·
Load funds: charge sales fees when being bought
or sold
o
Class A shares = front-end load
o
Class B shares = 1% annual charge
o
Class C shares = Back-end load
·
Other
fees: management, 12b-1 (marketing).
o
Totaled
in the expense ratio – preferably
less than 1%
·
Closed-end funds: Do not sell new shares. Some are
traded like stocks on the NYSE
·
Index Funds
o
Track
stock market indexes (i.e. S&P 500)
·
Bond funds and ETFs: ETFs generally track muni-bond indexes
to replicate the price and yield performance of a designated benchmark. Some
mutual funds also track indexes, but most are run by managers who pick and
choose securities individually.
- Muni-bond
ETF’s use of representative sampling (i.e. holding 35 out of 22,000
muni-bonds) can result in greater tracking error
Exchange-Traded Funds (ETFs)
·
Exchange-Traded
Funds:
- Trade like stocks – may be traded
intraday
- Are generally not actively
managed, but are stable like indexes.
As such, expenses are generally lower than mutual funds.
- No end-of-year capital gains
distributions, lower initial deposits than index funds
·
The
industry is seeing more ETFs that provide leveraged or inverse exposure to
market indexes
·
Barclays
has a reputation for being first to market with its ETFs, which it calls
iShares.
·
Exchange-traded notes or ETNs, have a similar structure to
ETFs. Barclays PLC, which introduced the first ETNs in June 2006, said the
eight products it manages have attracted more than $3 billion in total assets.
Its money-management arm, Barclays Global Investors, is the largest provider of
traditional ETFs.
o
With
ETNs, investors are essentially getting a promise from Barclays to pay the
return of an index plus any accrued interest. This is a different setup than
ETFs, where investors buy a piece of a portfolio. The structure of the ETN
shifts the risk of index-tracking error to Barclays, but investors are taking
on credit risk that Barclays will be solvent when they want to sell shares.
However, Barclays says ETNs can provide better tax efficiency. Bear Stearns and Goldman Sachs have
also launched ETNs.
Options
·
An option contract is an
agreement in which the buyer (holder) has the right (but not the
obligation) to exercise by buying or selling an asset at a set price (strike price) on (European style
option) or before (American style option) a future date (the exercise date or expiration); and the
seller (writer) has the obligation to honor the terms of the contract.
·
Put
options give the holder the right to sell the asset at the strike price. Call options give the holder the right to buy the asset at the strike price.
·
Since the option gives the buyer a
right and the writer an obligation, the buyer pays the option premium to
the writer.
·
Options will be in-the-money when the strike price is above/below (put/call) the
security's current price. They will be at-the-money when the strike price
equals the security's current price. They will be out-of-the-money when the
strike price is below/above (put/call) the security's current price. Options
at-the-money or out-of-the-money have an intrinsic value of zero.
·
Generally the contract will either be
o
American style - which allows
exercise up to the expiration date - or
o
European style - where
exercise is only allowed on the expiration date - or
o
Bermudan style - where
exercise is allowed on several, specific dates up to the expiration date.
·
Pricing models include the
binomial options model for American options and the Black-Scholes model for
European options.
·
Stock option names are written in the
following format: SYMBOL+MONTH+STRIKE. SYMBOL = Option
Root Symbol MONTH = Month the option expires STRIKE = Strike
price
·
Long
Call: A trader who believes that a stock's price will increase
might buy the right to purchase the stock (a call option).
o
If the stock price increases over the
exercise price by more than the premium paid, he will profit. If the stock
price decreases, he will let the call contract expire worthless, and only lose
the amount of the premium. This is an example of the principle of leverage.
·
Short
Call (Naked short call): A trader who believes that a stock's
price will decrease can sell a call.
o
If the stock price decreases, the short
call position will make a profit in the amount of the premium. If the stock
price increases over the exercise price by more than the amount of the premium,
the short will lose money.
o
Unless a trader already owns the shares
which he may be required to provide, the potential loss is unlimited. However,
such a trader who sells a call option for those shares he already owns has sold
a covered call.
·
Long
Put: trader who
believes that a stock's price will decrease can buy the right to sell the stock
at a fixed price (put option).
o
If the stock price decreases below the
exercise price by more than the premium paid, he will profit. If the stock
price increases, he will just let the put contract expire worthless and only
lose his premium paid.
·
Short
Put (Naked put): A trader who believes that a stock's price will
increase can sell the right to sell the stock at a fixed price (put option).
o
The trader now has the obligation to
purchase the stock at a fixed price. The trader has sold insurance to the buyer
of the put requiring the trader to insure the stockholder below the fixed
price. This trade is generally considered inappropriate for a small investor.
If the stock price increases, the short put position will make a profit in the
amount of the premium. If the stock price decreases below the exercise price by
more than the premium, the short position will lose money.
·
Covered
call — Long the stock, short a call. This has essentially the
same payoff as a short put.
·
Straddle — Long
a call and long a put with the same exercise prices (a long straddle), or short
a call and short a put with the same exercise prices (a short straddle).
·
Strangle — Long a call
and long a put with different exercise prices (a long strangle), or short a
call and short a put with different exercise prices (a short strangle).
·
Bull spread — Long a call
with a low exercise price and short a call with a higher exercise price, or
long a put with a low exercise price and short a put with a higher exercise
price.
·
Bear spread — Short a call
with a low exercise price and long a call with a higher exercise price, or
short a put with a low exercise price and long a put with a higher exercise
price.
·
Butterfly
— Butterflies require trading options with 3 different exercise prices.
Assume exercise prices X1 < X2 < X3 and that (X1 + X3) /2 = X2
o
Long butterfly — long 1 call with
exercise price X1, short 2 calls with exercise price X2, and long 1 call with
exercise price X3. Alternatively, long 1 put with exercise price X1, short 2
puts with exercise price X2, and long 1 put with exercise price X3.
o
Short butterfly — short 1 call with
exercise price X1, long 2 calls with exercise price X2, and short 1 call with
exercise price X3. Alternatively, short 1 put with exercise price X1, long 2
puts with exercise price X2, and short 1 put with exercise price X3.
·
Box
spreads — Any combination of options that has a constant payoff
at expiration. For example combining a long butterfly made with calls, with a
short butterfly made with puts will have a constant payoff of zero, and in
equilibrium will cost zero. In practice any profit from these spreads will be
eaten up by commissions (hence the name "alligator spreads").
·
Interest
rates and bond prices move in opposite directions
·
As a rule, bond markets rise (while
yields fall) when stock markets fall.
·
May
be bought as bond mutual funds or individual bonds
·
With
new issues the seller pays the commission
·
Investors generally do not pay
brokerage commissions to dealers with whom they buy or sell bonds. Rather,
dealers earn revenue for trading with their investor customers by means of the
spread, or difference, between the price at which the dealer buys a bond from
one investor--the "bid" price--and the price at which he or she sells
the same bond to another investor--the "ask" or "offer"
price - the bid/offer spread.
·
Bondholders enjoy a measure of legal protection:
under the law of most countries, if a company goes bankrupt, its bondholders
will often receive some money back, whereas the company's stock often ends up
valueless.
- As
an example, Worldcom bonds pain 35 cents on the dollar after bankruptcy.
·
Bonds do suffer from less day-to-day
volatility than stocks, and bonds' interest payments are higher than dividend
payments that the same company would generally choose to pay to its
stockholders.
·
Bonds carry two types of risk: credit
risk and interest rate risk.
- Credit
risk is the risk that the issuer will default on (not
pay) the bond
- All bonds are rated for credit
risk by Standard & Poor’s or
Moody’s
- Interest
rate risk is the risk that the bond will be worth
relatively less if global/national interest rates rise, so that new bonds
with higher interest rates will be available to investors.
·
A number of bond indices exist: Lehman
Aggregate, Citigroup BIG and Merrill Lynch Domestic Master.
The most important features of a bond are:
·
Nominal, principal,
par or face value—the amount over which the issuer pays interest,
and which has to be repaid at the end.
o
In
the secondary market bonds are usually sold at a premium (more than) or discount
to (less than) their par value, depending on whether current interest rates are
lower or higher (respectively) than the bonds coupon (interest rate)
·
Issue price—the price at
which investors buy the bonds when they are first issued.
o
The net proceeds that the issuer
receives are calculated as the issue price, less issuance fees, times the
nominal amount.
·
Current Market Value—the current price of the bond
·
Current yield = Market Value / Annual Interest
Payment * 100
·
Yield to Maturity (YTM)
·
Maturity date—the date on
which the issuer has to repay the nominal amount.
o
The length of time until the maturity
date is often referred to as the term or maturity of a bond.
o
The maturity can be any length of time,
although debt securities with a term of less than one year are generally
designated money market instruments rather than bonds. Most bonds have a term
of up to thirty years.
o
Some bonds have been issued with
maturities of up to one hundred years, and some even do not mature at all.