1 Topic 24: Investment Vehicles CDs Money market funds Money market mutual funds temporarily insured T bills Commercial paper Bankers acceptances Bank guaranteed notes to assure payment for exports Eurodollars Dollar denominated deposits Municipal bonds No federal income tax on interest; cap gains taxed General obligation versus revenue bonds Treasury STRIPS Separates interest payments and principal payment
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Money market mutual funds temporarily insured T bills Commercial paper Bankers acceptances
Bank guaranteed notes to assure payment for exports Eurodollars
Dollar denominated deposits Municipal bonds
No federal income tax on interest; cap gains taxed General obligation versus revenue bonds
Treasury STRIPS Separates interest payments and principal payment
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Topic 24: Investment Vehicles TIPS
Principal increased twice a year to reflect CPI All income is ordinary income
Series EE bonds Issued at a discount (half maturity face amount) Rate fixed Income not taxed until redeemed Income never taxed if used for college tuition
Subject to rules to qualify Ginnie Maes
Pool of mortgages guaranteed by U.S. government Freddie Mac/Fannie Mae
Not guaranteed until 09/08; higher rate than Ginnie Mae Risk of falling interest rates will cause mortgage loans to be
repaid early
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Topic 24: Investment Vehicles CMOs
Investors can select tranches of various maturity, risk levels Zero coupon bonds
Pricing Use in retirement accounts
ADRs Foreign stocks trading on U.S. exchange Still have currency risk
Privately/separately managed accounts High minimum to start Actually own stocks, bonds (not mutual funds) More control over tax consequences
Internal Rate of Return Present value of -0- If IRR>required return, present value positive Assumes cash flows reinvested at IRR Favors projects generating cash flows early
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Topic 27: Investment Returns Total return:(capital gain + dividend)/investment YTM: return on bonds
Compute using semi-annual periods for zero coupon bonds Yield to call: assumes bond is called in YTM calculation Current yield: annual income/current price
After-tax: dividends currently taxed at 15% Taxable equivalent yield (munis):
tax-free yield/(1- tax rate) After-tax rate of return:
Taxable return x (1 – tax rate)
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Topic 28: Asset Allocation Strategic asset allocation: asset class is most
important decision. Stocks vs. bonds; not Google vs. Intel Life cycle: older investors should take less risk? Risk tolerance: loss felt more than gain?
Rebalancing: sell winners and buy more losers How often?
Tactical asset allocation: search for undervalued assets
Concentrated portfolios: Recipe for success; collars
Topic 31: Investment Strategies Strategic asset allocation: return determined by asset class
selected Tactical asset allocation: buy undervalued assets and sell
overvalued Market Timing: active; typically technical Passive: index. Efficient markets.
Core and satellite. Indexes:
Stock: S&P 500; Russell 5000; MS EAFE
Buy/hold: markets are efficient. Contrarian: run up the stairs in World Trade Center Bond swaps: take advantage of “mispriced bonds”
GMAC: junk bond status Collars: sell call and buy put
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Topic 31: Investment Strategies Dollar cost averaging: same amount every month. Makes sense.
Academics: it doesn’t. DRIPs: reinvest dividends.
Compounding Taxable
Bond ladders: bonds have different maturities Less interest rate risk over time longer than investment
horizon Bond bullets: noncallable; will have lower coupon Bond barbells: buy short-term and long-term bonds. Active
management required. Immunization: match weighted average duration of portfolio with
cash needs
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Topic 31: Investment Strategies Margin trading
Initial margin: can only borrow 50% of initial purchase Maintenance margin: (FMV – Debt)/FMV
Must be at least 25% 100 shares at $40 = $4,000. Borrow $2,000. Maintenance 25%.
What price margin call? Price= (1-Initial Margin %)/(1-Maint Margin %) x
Initial Price P = (1-50%)/1-25%) x $40
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Topic 31: Investment Strategies Margin trading
Amount of margin call if price falls to $22? Current Value of Stock x Maint Margin % = Equity Needed $2,200 x 25% = $550 Present Equity = $2,200 Current Value - $2,000 Debt = $200 Margin Call = $550 - $200 =$350
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Topic 31: Investment Strategies Short selling: sell borrowed stock; buy back at lower price
Uptick rule eliminated June 2007 Reinstated for financial stocks during 2008
Stock owner gets dividends Must have margin account; broker determines
maintenance margin
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Topic 31: Investment Strategies
Hedging: protect against price moves in assets own. Buy a $3.50 put on December corn.
Options Puts: buy and sell
Naked Calls: buy and sell
Covered Topic 41, Problems 25 and 32
LEAPS: as long as three years
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Topic 31: Investment Strategies
Straddle: buy put/call on same stock at same strike price Anticipate big move either way
Collar: sell call, buy put Concentrated positions
Spread: Buy and sell a call at different prices or expirations
Taxation of options Buy call, exercise: add to basis Buy call, expires: short-term capital loss Sell call, exercised: add to proceeds Sell call, expires: short-term capital gain
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Topic 31: Investment Strategies
Taxation of options Buy put, exercise: add to basis Buy put, expires: short-term capital loss Sell put, exercised: reduce basis Sell put, expires: short-term capital gain