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Financial Stuff (More Complete)
Financial Stuff (More Complete)
Summary
A mutual fund brings together a group of people and invests their money in stocks, bonds, and other securities. The advantages of mutuals are professional management, diversification, economies of scale, simplicity and liquidity. The disadvantages of mutuals are high costs, over-diversification, possible tax consequences, and the inability of management to guarantee a superior return. There are many, many types of mutual funds. You can classify funds based on asset class, investing strategy, region, etc. Mutual funds have lots of costs. Costs can be broken down into ongoing fees (represented by the expense ratio) and transaction fees (loads). The biggest problems with mutual funds are their costs and fees. Mutual funds are easy to buy and sell. You can either buy them directly from the fund company or through a third party.
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the fundamental level, there are three varieties of mutual funds: Equity funds (stocks) Fixed-income funds (bonds) Money market funds
All mutual funds are variations of these three asset classes. Money Market Funds The money market consists of short-term debt instruments, mostly Treasury bills. This is a safe place to park your money. You won't get great returns, but you won't have to worry about losing your principal. A typical return is twice the amount you would earn in a regular checking/savings account and a little less than the average certificate of deposit (CD). Bond/Income Funds Income funds are named appropriately: their purpose is to provide current income on a steady basis. When referring to mutual funds, the terms "fixed-income," "bond," and "income" are synonymous. The primary objective of these funds is to provide a steady cashflow to investors. Bond funds are likely to pay higher returns than certificates of deposit and money market investments, but bond funds aren't without risk. Because there are many different types of bonds, bond funds can vary dramatically depending on where they invest. For example, a fund specializing in high-yield junk bonds is much more risky than a fund that invests in government securities. Furthermore, nearly all bond funds are subject to interest rate risk, which means that if rates go up the value of the fund goes down. Balanced Funds The objective of these funds is to provide a balanced mixture of safety, income and capital appreciation. The strategy of balanced funds is to invest in a combination of fixed income and equities. A typical balanced fund might have a weighting of 60% equity and 40% fixed income. The weighting might also be restricted to a specified maximum or minimum for each asset class. Equity Funds Funds that invest in stocks represent the largest category of mutual funds. Generally, the investment objective of this class of funds is long-term capital growth with some income. There are, however, many different types of equity funds because there are many different types of equities.
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Hedge Funds
Hedge funds pool investors money to make a positive return. Typically more flexible investment strategies than mutual funds. Uses leverage to profit in all markets. (Leverage = borrowing to increase investment exposure thereby increasing risk as well.) Also uses short selling and other speculative methods that arent often used by mutual funds. Not subjected to some regulations designed to protect investors unlike mutual funds. Investors do not receive law protections that commonly apply to mutual funds. Eg. Level of disclosure of hedge funds is lower than mutual funds, making it difficult to evaluate investment terms and verify representations.
Return enhancement Able to enhance overall returns of a portfolio by 2 ways: 1. Maintain low-risk portfolio by using low-volatility hedge fund to squeeze some additional returns. Return on portfolio increases while maintaining low volatility. 2. Add a hedge fund with a high-return strategy to boost overall returns. These funds generally take directional positions based on forecasts of future prices on derivatives instruments such as stocks, bonds currencies etc. They often exhibit high levels of volatility but when properly allocated, can give a nice boost in returns without proportional increase in portfolio volatility.
Hedge fund investors do not receive all of the federal and state law protections that commonly apply to most mutual funds. For example, hedge funds are not required to provide the same level of disclosure as you would receive from mutual funds. Without the disclosure that the securities laws require for most mutual funds, it can be more difficult to fully evaluate the terms of an investment in a hedge fund. It may also be difficult to verify representations you receive from a hedge fund.
Term Structure
Terms of each hedge fund is unique and can completely differ from another. They are usually based on: Subscriptions and Redemptions Hedge funds do not have daily liquidity like mutual funds do. Some hedge funds can have subscriptions and redemptions monthly, while others accept them only quarterly. The terms of each hedge fund should be consistent with the underlying strategy being used by the manager. The more liquid the underlying investments, the more frequent the subscription/redemption terms should be. Lock-Ups Some funds require up to a two-year "lock-up" commitment, but the most common lockup is limited to one year.
Equity Hedge
It is commonly referred to as long/ short equity and one of the easiest strategies to understand. However, a variety of sub-strategies are present. Long/Short Hedge fund managers can either purchase stocks that they feel are undervalued or sell short stocks they deem to be overvalued. In most cases, the fund will have positive exposure to the equity. Market Neutral In this strategy, a hedge fund manager applies the same basic concepts mentioned in the previous paragraph, but seeks to minimize the exposure to the broad market. This can be done in two ways. 1. If there are equal amounts of investment in both long and short positions, the net exposure of the fund would be zero. 2. To have zero beta exposure. In this case, the fund manager would seek to make investments in both long and short positions so that the beta measure of the overall fund is as low as possible. In either of the marketneutral strategies, the fund manager's intention is to remove any impact of market movements and rely solely on his or her ability to pick stocks.
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STOCK OPTIONS
Summary
An option is a contract giving the buyer the right but not the obligation to buy or sell an underlying asset at a specific price on or before a certain date. Options are derivatives because they derive their value from an underlying asset. A call gives the holder the right to buy an asset at a certain price within a specific period of time. A put gives the holder the right to sell an asset at a certain price within a specific period of time. There are four types of participants in options markets: buyers of calls, sellers of calls, buyers of puts, and sellers of puts. Buyers are often referred to as holders and sellers are also referred to as writers. The price at which an underlying stock can be purchased or sold is called the strike price. The total cost of an option is called the premium, which is determined by factors including the stock price, strike price and time remaining until expiration. A stock option contract represents 100 shares of the underlying stock. Investors use options both to speculate and hedge risk. Employee stock options are different from listed options because they are a contract between the company and the holder. (Employee stock options do not involve any third parties.) The two main classifications of options are American and European.
of time. Puts are very similar to having a short position on a stock. Buyers of puts hope that the price of the stock will fall before the option expires. The Lingo The price at which an underlying stock can be purchased or sold is called the strike price. This is the price a stock price must go above (for calls) or go below (for puts) before a position can be exercised for a profit. All of this must occur before the expiration date. For call options, the option is said to be in-the-money if the share price is above the strike price. A put option is in-the-money when the share price is below the strike price. The amount by which an option is in-the-money is referred to as intrinsic value. The total cost (the price) of an option is called the premium. This price is determined by factors including the stock price, strike price, time remaining until expiration (time value) and volatility. There are two main reasons why an investor would use options: to speculate and to hedge. Speculation The advantage of options is that you aren't limited to making a profit only when the market goes up. Because of the versatility of options, you can also make money when the market goes down or even sideways. Hedging The other function of options is hedging. Think of this as an insurance policy. Just as you insure your house or car, options can be used to insure your investments against a downturn. There are two main types of options: American options can be exercised at any time between the date of purchase and the expiration date. European options are different from American options in that they can only be exercised at the end of their lives.
Long-Term Options These options are called long-term equity anticipation securities (LEAPS). By providing opportunities to control and manage risk or even to speculate, LEAPS are virtually identical to regular options. LEAPS, however, provide these opportunities for much longer periods of time. Although they are not available on all stocks, LEAPS are available on most widely held issues. Exotic Options (Non- standard) The simple calls and puts we've discussed are sometimes referred to as plain vanilla ( Standard) options.
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Short Selling
Many investors make money on a decline in an individual stock or during a bear market, thanks to an investing technique called short selling. Short selling is not complex, but it's a concept that many investors have trouble understanding. In general, people think of investing as buying an asset, holding it while it appreciates in value, and then eventually selling to make a profit. Shorting is the opposite: an investor makes money only when a shorted security falls in value.
Summary
In a short sale, an investor borrows shares, sells them and must eventually return the same shares (cover). Profit (or loss) is made on the difference between the prices at which the shares are borrowed compared to when they are returned. An investor makes money only when a shorted security falls in value. Short selling is done on margin, and so is subject to the rules of margin trading. The shorter must pay the lender any dividends or rights declared during the course of the loan. The two reasons for shorting are to speculate and to hedge. There are restrictions as to what stocks can be shorted and when a short can be carried out (uptick rule). Short interest tells us the number of shares that have already been sold short in a security. Short selling is very risky. You can lose more money than you invest but are limited to 100% profit on the upside. A short squeeze is when a large number of short sellers try to cover their positions at the same time, driving up the price of a stock. Even though a company is overvalued, it may take a long time for it to come back down. Fighting the trend almost always leads to trouble. Critics of short selling see it as unethical and bad for the market. Short selling contributes to the market by providing liquidity, efficiency and acting as a voice of reason in bull markets. Some unethical traders spread false information in an attempt to drive the price of a stock down and make a profit by selling short.
Bond Basics
Bonds during raging bull markets, seem to offer an insignificant return compared to stocks. However, all it takes is a bear market to remind investors of the virtues of a bond's safety and stability. In fact, for many investors it makes sense to have at least part of their portfolio invested in bonds.
Summary
Bonds are just like IOUs. Buying a bond means you are lending out your money. Bonds are also called fixed-income securities because the cash flow from them is fixed. Stocks are equity; bonds are debt. The key reason to purchase bonds is to diversify your portfolio. The issuers of bonds are governments and corporations. A bond is characterized by its face value, coupon rate, maturity and issuer. Yield is the rate of return you get on a bond. When price goes up, yield goes down, and vice versa. When interest rates rise, the price of bonds in the market falls, and vice versa. Bills, notes and bonds are all fixed-income securities classified by maturity. Government bonds are the safest bonds, followed by municipal bonds, and then corporate bonds. Bonds are not risk free. It's always possible - especially in the case of corporate bonds - for the borrower to default on the debt payments. High-risk/high-yield bonds are known as junk bonds. You can purchase most bonds through a brokerage or bank. If you are a U.S. citizen, you can buy government bonds through Treasury Direct. Often, brokers will not charge a commission to buy bonds but will mark up the price instead. Debt Versus Equity Bonds are debt, whereas stocks are equity. This is the important distinction between the two securities. By purchasing equity (stock) an investor becomes an owner in a corporation. Ownership comes with voting rights and the right to share in any future profits. By purchasing debt (bonds) an investor becomes a creditor to the corporation (or government). The primary advantage of being a creditor is that you have a higher claim on assets than shareholders do: that is, in the case of bankruptcy, a bondholder will get paid before a shareholder. However, the bondholder does not share in the profits if a company does well - he or she is entitled only to the principal plus interest. To sum up, there is generally less risk in owning bonds than in owning stocks, but this comes at the cost of a lower return.
Zero-Coupon Bonds This is a type of bond that makes no coupon payments but instead is issued at a considerable discount to par value.
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Stocks
The Definition of a Stock Plain and simple, stock is a share in the ownership of a company. Stock represents a claim on the company's assets and earnings. As you acquire more stock, your ownership stake in the company becomes greater. Whether you say shares, equity, or stock, it all means the same thing.
gray in color or simply absent. Often, the ticker symbol and the net price change appear color-coded: green if the price is higher than the previous session, red if price is lower. Risk No guarantees when it comes to individual stocks. Companies often do not pay out dividends. No obligation to pay out dividends even for those firms that have traditionally given them. Without dividends, money can be profited only through appreciation of stock in open market On the downside, any stock may go bankrupt, in which case your investment is worth nothing. Although risk might sound all negative, there is also a bright side. Greater risk demands a greater return on your investment. This is the reason why stocks have historically outperformed other investments such as bonds or savings accounts.
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Hedging and Speculation CDS have the following two uses. A CDS contract can be used as a hedge or insurance policy against the default of a bond or loan. An individual or company that is exposed to a lot of credit risk can shift some of that risk by buying protection in a CDS contract. This may be preferable to selling the security outright if the investor wants to reduce exposure and not eliminate it, avoid taking a tax hit, or just eliminate exposure for a certain period of time. The second use is for speculators to "place their bets" about the credit quality of a particular reference entity. With the value of the CDS market, larger than the bonds and loans that the contracts reference, it is obvious that speculation has grown to be the most common function for a CDS contract. CDS provide a very efficient way to take a view on the credit of a reference entity. An investor with a positive view on the credit quality of a company can sell protection and collect the payments that go along with it rather than spend a lot of money to load up on the company's bonds. An investor with a negative view of the company's credit can buy protection for a relatively small periodic fee and receive a big payoff if the company defaults on its bonds or has some other credit event. A CDS can also serve as a way to access maturity exposures that would otherwise be unavailable, access credit risk when the supply of bonds is limited, or invest in foreign credits without currency risk.
An investor can actually replicate the exposure of a bond or portfolio of bonds using CDS. This can be very helpful in a situation where one or several bonds are difficult to obtain in the open market. Using a portfolio of CDS contracts, an investor can create a synthetic portfolio of bonds that has the same credit exposure and payoffs. Trading CDS contracts are regularly traded with the value of it fluctuating based on the increasing/ decreasing probability that a reference entity will have a credit event. Increased probability of such an event would make the contract worth more for the buyer of protection, and worth less for the seller. The opposite occurs if the probability of a credit event decreases. A trader in the market might speculate that the credit quality of a reference entity will deteriorate some time in the future and will buy protection for the very short term in the hope of profiting from the transaction. An investor can exit a contract by selling his or her interest to another party, offsetting the contract by entering another contract on the other side with another party, or offsetting the terms with the original counterparty. Are better suited for institutional rather than retail investors as CDS are traded over the counter (OTC), involving intricate knowledge of the market and underlying assets and valued using industry computer programs. Market Risks The market for CDSs is OTC and unregulated, and the contracts often get traded so much that it is hard to know who stands at each end of a transaction. There is the possibility that the risk buyer may not have the financial strength to abide by the contract's provisions, making it difficult to value the contracts. The leverage involved in many CDS transactions and the possibility that a widespread downturn in the market could cause massive defaults and challenges the ability of risk buyers to pay their obligations, adds to the uncertainty.
Swaps
A swap is an agreement between two parties to exchange sequences of cash flows for a set period of time. Usually, at the time the contract is initiated, at least one of these series of cash flows is determined by a random or uncertain variable, such as an interest rate, foreign exchange rate, equity price or commodity price. Conceptually, one may view a swap as either a portfolio of forward contracts, or as a long position in one bond coupled with a short position in another bond.
For example On Dec. 31, 2006, Company A and Company B enter into a five-year swap with the following terms: Company A pays Company B an amount equal to 6% per annum on a notional principal of $20 million. Company B pays Company A an amount equal to one-year LIBOR + 1% per annum on a notional principal of $20 million.
LIBOR, or London Interbank Offer Rate, is the interest rate offered by London banks on deposits made by other banks in the eurodollar markets. The market for interest rate swaps frequently (but not always) uses LIBOR as the base for the floating rate. For simplicity, let's assume the two parties exchange payments annually on December 31, beginning in 2007 and concluding in 2011. At the end of 2007, Company A will pay Company B $20,000,000 * 6% = $1,200,000. On Dec. 31, 2006, one-year LIBOR was 5.33%; therefore, Company B will pay Company A $20,000,000 * (5.33% + 1%) = $1,266,000. In a plain vanilla interest rate swap, the floating rate is usually determined at the beginning of the settlement period. Normally, swap contracts allow for payments to be netted against each other to avoid unnecessary payments. Here, Company B pays $66,000, and Company A pays nothing. At no point does the principal change hands, which is why it is referred to as a "notional" amount. Figure 1 shows the cash flows between the parties, which occur annually (in this example).
Figure 2: Cash flows for a plain vanilla currency swap, Step 1. Then, at intervals specified in the swap agreement, the parties will exchange interest payments on their respective principal amounts. To keep things simple, let's say they make these payments annually, beginning one year from the exchange of principal. Because Company C has borrowed euros, it must pay interest in euros based on a euro interest rate. Likewise, Company D, which borrowed dollars, will pay interest in dollars, based on a dollar interest rate. For this example, let's say the agreed-upon dollar-denominated interest rate is 8.25%, and the euro-denominated interest rate is 3.5%. Thus, each year, Company C pays 40,000,000 euros * 3.50% = 1,400,000 euros to Company D. Company D will pay Company C $50,000,000 * 8.25% = $4,125,000. As with interest rate swaps, the parties will actually net the payments against each other at the then-prevailing exchange rate. If, at the one-year mark, the exchange rate is $1.40 per euro, then Company C's payment equals $1,960,000, and Company D's payment would be $4,125,000. In practice, Company D would pay the net difference of
Figure 3: Cash flows for a plain vanilla currency swap, Step 2 Finally, at the end of the swap (usually also the date of the final interest payment), the parties re-exchange the original principal amounts. These principal payments are unaffected by exchange rates at the time.
In general, both interest rate and currency swaps have the same benefits for a company. These derivatives help to limit or manage exposure to fluctuations in interest rates or to acquire a lower interest rate than a company would otherwise be able to obtain. Swaps are often used because a domestic firm can usually receive better rates than a foreign firm. For example, suppose company A is located in the U.S. and company B is located in England. Company A needs to take out a loan denominated in British pounds and company B needs to take out a loan denominated in U.S. dollars. These two companies can engage in a swap in order to take advantage of the fact that each
company has better rates in its respective country. These two companies could receive interest rate savings by combining the privileged access they have in their own markets.
Help companies hedge against interest rate exposure by reducing the uncertainty of future cash flows. Allows revision of debt conditions to take advantage of current or expected future market conditions, allowing a lower amount needed to service a debt. Allow companies to take advantage of the global markets more efficiently by bringing together two parties that have an advantage in different markets. Although there is some risk associated with the possibility that the other party will fail to meet its obligations, the benefits that a company receives from participating in a swap far outweigh the costs.
Example: Currency Forward Contracts Corporation A has a foreign sub in Italy that will be sending it 10 million euros in six months. Corp. A will need to swap the euro for the euros it will be receiving from the sub. In other words, Corp. A is long euros and short dollars. It is short dollars because it will need to purchase them in the near future. Corp. A can wait six months and see what happens in the currency markets or enter into a currency forward contract. To accomplish this, Corp. A can short the forward contract, or euro, and go long the dollar.
Corp. A goes to Citigroup and receives a quote of .935 in six months. This allows Corp. A to buy dollars and sell euros. Now Corp. A will be able to turn its 10 million euros into 10 million * .935 = 935,000 dollars in six months. Six months from now if rates are at .91, Corp. A will be ecstatic because it will have realized a higher exchange rate. If the rate has increased to .95, Corp. A would still receive the .935 it originally contracts to receive from Citigroup, but in this case, Corp. A will not have received the benefit of a more favorable exchange rate.