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Financial Exam

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Ok, after meditating on how I would feel if I failed this test, and just sat around and let life come at me instead of acting, I decided I'm ready to own this test so hard. I decided being lazy, and being weak, and making excuses, just isn't an option for me. I'm gonna smash up these exam questions so epicly in a few weeks and blow myself away. I'm gonna put aside everything this month and just do this. I'm ready to get angry, and slam this up so hard and fast. I have found that the best way to learn anything and everything is attempting to explain what you're learning to someone else. So I'm gonna write some random stuff here. Obviously if someone has a question (mostly directed toward Americans reading this), then ask. I'm already a tax preparer, so you can at least trust me on tax questions. But it would be nice if someone could ask me a practical question. I already know nobody is going to ask anything, but whatever...

About this exam:

This is 1 of 4 tests I must take in order to become an investment advisor. This one is really broad. The other 3 tests are somewhat more specific. Usually a company just trains you for the tests, but I'm doing at least 1 of these on my own so I have a better chance of actually getting hired.

There are 4 major parts to this test:

1. economics and analysis

2. investment vehicles

3. investment strategies

4. law and ethics

So we'll divide up our thinking into these 4 categories.

A realistic figure for me is probably 85%+. I only need a 68.5% to pass, but that isn't going to look very good in my resume, and frankly mediocrity is unacceptable if you're going to be responsible for other people's money.

Will update this occasionally until test day.

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INTRODUCTION

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Before we approach a new subject, we have to think about how we're going to acquire what is essentially a new language. In this case, the language of finance. First, we'll define this word, "Finance". Then we'll answer why we are going to learn about this in order to better structure our attention so that the most relevant things are looked at.

What is finance? Why are we learning this new language? Communication has 2 components: a system of signs for representing concepts and objects in this world, and a very practical component, such as bartering with a salesman or something, or telling someone to go do something. Finance is no different. The word "finance" represents a system of signs and concepts that we are going to be learning. And for our purposes, the implications of finance are very practical, such as advising clients in money management. The reader might want to learn finance for other reasons, maybe just out of curiosity, or learning more about the financial system to be a more informed citizen. Whatever.

So let's define this word first. That brings us to our first definition, and I think wikipedia has a pretty good definition lol:

Finance

Finance is the science of funds management.[1] The general areas of finance are business finance, personal finance, and public finance.[2] Finance includes saving money and often includes lending money. The field of finance deals with the concepts of time, money and risk and how they are interrelated. It also deals with how money is spent and budgeted.

What's most important to us (or at least me, I keep using "we" and "us" because it sounds pretentious to address yourself in your writing lol) is personal finance, and dealing in the securities market. It is funds management. Clients will come to me with X amount of money, and some sort of goal. Are we trying to rapidly grow your money? Are we building a nest egg? Are we just trying to set aside some savings in a money market fund? Not sure what to do with a windfall? Do we need to shift our asset allocation in our portfolio due to recent massive shifts in the markets?

Finance is also just a subset of economics, and thinking about it a little more philosophically (I guess), it is a subset of probability. Modern finance is characterized by one extremely fundamental aspect of this universe: Risk. We could get very philosophical about "risk", and I wouldn't be surprised if someone has written a whole book concerning the ontology of "risk" or "probability", but we won't get into that... But we should briefly think about what risk means, because risk is virtually going to be apart of everything we are about to look at.

When we say that something is risky, we're saying that there is a probability of various events happening, and prior to rolling the dice, we have no certainty of events in the future. When we buy Google stock, its stock price could rise 10% in the next few weeks, or something catastrophic may happen, like all of Google's 1 million servers crash at the same thing so they go bankrupt and the internet breaks or something lol. Unlikely, but it could happen. If you read what I said closely, you'll notice we put 2 things 'at risk':

1. Time - Future events are uncertain. The longer we stay in Google stock, the greater our chances of both bad and good events happening.

2. Money - If we put $5000 in Google stock, we are giving up other options. In other words, I could have put $5000 in government bonds or whatever, but I didn't, I put it in Google stock. I sacrificed that opportunity. This is one of the 5 basic principles of economics, opportunity cost, the cost of something is what you sacrifice to get it. I don't want to get into it, but I think opportunity cost is really the only fundamental principle of economics. I'll leave that for another time...

A financial/investment advisor's job is to communicate within the language of finance, with clients, in order to achieve some sort of goal. We assess the client and their needs, and we must work within our limitations, and hopefully, meet financial needs. Since we are practically applying finance to real world needs, this will shape the way we think about the subject.

Basic questions we are going to ask ourselves take the form of If____then____ and comparing outcomes in order to make decisions. Also, economic systems are, well, systems. If interest rates in the U.S. rise 2%, there is going to be a domino effect that ends up affecting pretty much everything. I just emphasized that because when people ask "If then" questions, they tend to stop after 1 step, but there may be 10 steps to this domino train.

We're going to be using a lot of highfalutin' wall street speak because it's nearly impossible to communicate finance without it. We'll define terms, assess the implications, and possible techniques for analysis.

http://www.investopedia.com <<< Helpful site. It has an amazing financial dictionary, in case you ever want to know what the heck the parity of a convertible bond is, or anything else.

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BASIC ECONOMIC CONCEPTS

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A logical place to begin is looking at some basic economic concepts. I'm sure nearly everyone reading this already understands supply and demand, and that concept can actually get pretty complex if we get into volatility and 'sticky' prices, but that's not important to this test (I'm just trying to pass this test here). We're going to particularly interested in how supply and demand in the securities market affects interest rates and vice versa. This isn't so apparent if you have not learned about it before, but we'll look at that when we get there.

I. Supply and Demand

What is supply and demand?

Definition. Demand

If I'm hungry, I am going to search for food, that is demand.

Definition. Supply

The concept of supply is somewhat less obvious than demand. Supply is really what someone is
willing
to sell. That 'willing' word is very important. It is not just how much goods a supplier has, it is how much they are willing and capable of selling.

We normally express our demand as consumers through the usage of money. If I want food, I'm willing to pay for food up to a certain amount of money.

Suppliers express their willingness to supply goods depending on the demand in the marketplace, and the operating cost of their business. If the benefit for increasing output exceeds the costs, a business will logically increase output. Assuming they want profits, and we're all capitalist pigs here, so we always want to increase output if it makes us a profit.

The amount of demand in the market, and the amount of supply in the market, determines the price of goods and services. We can graph this relationship.

From wikipedia:

240px-Supply-and-demand.svg.png

The point at which demand and supply meet is the equilibrium price. Price (in theory) is constantly tending toward equilibrium. If demand or supply or price shifts, everything else will shift with it to meet the equilibrium. Modern economics are extremely chaotic, so there are inefficiencies, price dislocations, supply and demand dislocations... everywhere. A modern economy is never at equilibrium, but (in theory) it is always tending toward equilibrium.

So what does this have to do with finance? Well the financial markets are, well, a market. In the financial markets, we have demanders, and we have suppliers. What is the product of a financial market? Money.

"But we pay for goods at the grocery store with money. How the heck do you buy and sell money?" I'll just give you the answer without getting into it: interest rates are the price of money.

Definition. Interest Rate

The price of money. Normally expressed as a percentage of principal that is obligated to be paid over a period of time in regular payments between a lender and a borrower.

When you go to Wal-Mart, you demand goods, and Wal-Mart supplies you with 75 lb bags of Chips Ahoy cookies right? You give Wal-Mart 1.99 USD, they give you a 75 lb of Chip Ahoy cookies. Pretty simple. But the demanders and suppliers aren't so apparent in the financial market. It is a normally a lender-debtor relationship, and we have to think about who is really doing the demanding, and who is doing the supplying.

Example.

You wish to purchase a corporate bond from say, Microsoft. By purchasing a corporate bond for $100 with an annual interest rate of 5%, you are lending Microsoft $100 and charging them 5% annual interest.

Read that carefully. The financial markets are a place where people buy and sell money. Who did the buying (the demanding) and who did the selling (the supplying)? That's right. You sold money to Microsoft and charged them 5%. Microsoft demanded $100, you, the the investor supplied them $100.

It is important to understand this relationship because when we start looking closely at debt instruments, you will be very confused if you start mixing up who is supplying and who is demanding (and thus what and who determines interest rates, the prices, on debt instruments).

II. The Business Cycle

We hear a lot in the news about economies growing and shrinking. How do we know if an economy is growing or shrinking? A basic measure of economic growth is GDP (gross domestic product).

Definition. GDP

The sum of all goods and services in an economy.

There are some other (somewhat better) measures, like gross national product and national income, but we won't get into that.

If we track the GDP of a nation over time, we'll see that most nations tend to follow somewhat regular periods of expansion and recession, with expansionary periods being somewhat longer than recessionary periods. There are many competing theories as to why nations grow in this way, but we can at least point out 3 major theories that describe why growth occurs at all.

1. Keynesian Theory

In short, Keynes asserted that growth is affected by income and spending. If a nation wants to alleviate a recession, the government should fund projects and increase their spending to stimulate consumption. In other words, he placed emphasis on fiscal policy.

Definition. Fiscal Policy

Congressional actions that affect government spending and taxation, such as social security, tax rates, trade deficit policy, miscellaneous government programs.

2. Monetary Theory

Milton Friedman, the most famous monetarist, argues that the central bank is the primary mover of the market. We'll look at the central bank closely later on (called The Federal Reserve Bank in the U.S. or just The Fed). Monetary policy is essentially actions by the central bank to influence money supply in the economy.

Definition. Monetary Policy

Actions taken by the central bank of an economy to influence the rate of money supply in the economy. Its primary strategy is shifting interest rates. It has a number of tactics, such as holding auctions to the general public for government bonds on behalf of the government.

3. Supply-Side Theory

AKA Reaganomics. It is essentially the opposite of Keynesian theory. Supply-siders argue that government programs stifle individual initiative. 9 out of 10 economists believe this is bullshit, so you can just ignore this. When we analyze it, we have to assume that the supply curve is nearly vertical, which is unrealistic. Under such an assumption, the only thing that would increase economic output is increasing goods and services.

The only reason this theory is still around is for speculative analysis, and political sophistry.

III. The Economic Environment and Prices

The basic environment of an economy is inflationary or deflationary. Inflation/deflation is highly controversial, and for our purposes, we will not explore the topic, but only clear up the definition, and use the definition to derive the difference between nominal and real interest rates.

Definition. Inflation

Typically defined as a price increase for the same output. $1 dollars today might get me a Snicker's bar. If I wait several years, and assume the economy is inflating, it may cost me $1.50 to buy the same Snicker's bar. Deflation is just the opposite.

I'm going to carefully approach this, but I think there's actually 2 kinds of inflation. There's domestic inflation and currency inflation. Domestic inflation are price changes within an economy, not taking into account fluctuations in purchasing power parity for a currency. Currency inflation is specifically when PPP between currencies fluctuate. I'm mentioning this because I think this lack of clarification causes a lot of controversy when it comes to debates about monetary policy. From now on, when I use the word "inflation", I'm talking about domestic inflation unless I state otherwise.

The most common measure of inflation is CPI (consumer price index). Basically the government takes a basket of goods that it thinks accurately reflects the average of all consumer spending, and it tracks the price over time. The year-over-year change is the inflation rate. The CPI is controversial because it affects things like COLA (cost of living adjustments) for government programs such as social security.

Inflation rates tend to increase during prosperous times. This is because consumers are more confident in things such as job security, so they are willing to spend more (demand rises). Inflation rates tend to decrease during recessionary periods because consumers simply spend less.

A. Real versus Nominal Interest

It is important to remember the difference between real and nominal interest in order to properly gauge how fast your money is really growing.

Definition. Nominal

What you get when you don't take into account the inflation rate.

Example.

Go back to the Microsoft bonds. Assume an inflation rate in the economy of 3% per annum. The bond has a stated rate of 5%, assuming you just get paid once per year, the real interest rate of the bond is only 2%, because the value of your initial investment is eroding at 3% per year. The nominal rate is just the stated rate, which is 5%.

We'll look at why interest rates in the economy change later on, and what I mean when I say, "interest rates in the economy".

IV. The Relationship Between Risk and Return

All financial transactions will involve some form of risk. When you buy that Microsoft bond (when you lend Microsoft $100), there is a possibility that Microsoft will be unable to pay back that bond. This is extremely unlikely considering the kind of company that Microsoft is.

But if we lend Joe Schmoe's Risky Business Inc. $100, we, the investors, will demand a higher price in the form of higher interest payments. Instead of 5%, we may demand 12% since Joe Schmoe don't know jack about running a profitable corporation.

rcbEF.png

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BASIC PORTFOLIO CONSTRUCTION

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In this section, we'll look at various components and considerations of a portfolio. Much later on, we'll look at some actual basic techniques for choosing what to put in a portfolio. In other words, we're really just going to look at some definitions in this section so that we can build a big picture before getting down to business and investing.

A portfolio just means the sum of all your investments. If you're an average middle class citizen, your portfolio probably includes something like a house, a savings account, a retirement plan through your employer, the money in your checking account, the income stream generated by working, maybe an educational savings account etc.

Clearly, many things can go into a portfolio, but I'm just going to choose stocks as an example to get started so that we can look at big picture concepts in portfolio construction.

I. Miscellaneous Equity Securities

We're going to have a whole section just about stocks (AKA equities) later on, this is a taste.

A. Blue Chip - High quality companies with proven earnings and dividends over a long period of time.

B. Growth - Start up companies that aren't paying out dividends. Typically considered risky. High potential for growth and profits (or loss).

C. Income - Companies with unusually high and regular dividend payouts but little to not growth. For example utilities.

D. Cyclical - A company whose growth tends to follow the business cycle. Almost all companies are cyclical.

E. Counter Cyclical - Companies whose growth is the opposite of the business cycle. If you think about it, you'll understand why this is so rare. A classic example is gold mining company. During economic downturns, gold often becomes a hot commodity, so gold stocks do relatively well.

F. Defensive - Companies whose growth doesn't react strongly to market fluctuations. Public utilities are an example.

G. Speculative - Companies that react wildly to market fluctuations. An airplane manufacturing company is an example.

H. Special Situation - Companies going through bankruptcy, massive restructuring, legal proceedings, a big shift in management etc. offer the potential for extreme profits or losses.

2 approaches to stock picking:

1. Top down - An investor looks at the economy as a whole, then moves to greater and greater detail (from the economy to the sectors, to the industries etc.) to decide which company to pick.

2. Bottom up - An investor analyzes companies individually, and doesn't pay much attention to the overall economic conditions. The belief is that a solid company will do well no matter the economic environment.

II. Measuring Portfolio Return

A simple way to measure portfolio return is to simply look at the ROI formula (return on investment).

ROI

= (sum of all cash flows/# of years) / investment amt

Example.

You invest $1000 in an investment that pays $100 for 4 years, and you receive your principal back on the 5th year.

ROI = [ (100+100+100+100+1000)/5 ] / 1000

= (1500/5) / 1000

= (300) / 1000

= 30% return on investment

When applying ROI to equities, make sure you take into account dividends and capital gains.

Definition. Capital Gains

In the context of equities, a capital gain is simply the difference between your investment and your proceeds after selling. You don't realize a capital gain until you actually sell something.

ROI for equities = Dividends + Growth

Investments do not always produce the exact expected return, we live in an imperfect universe. Therefore, various assets have a measure of standard deviation. Standard deviation is relatively complex, so I won't explain it or show how to derive it.

(Wrong, highly simplified) Definition. Standard Deviation

The standard deviation of an investment is essentially the likeliness and unlikeliness of that investment to produce a range of returns through time.

Example.

- 1 year treasuries yield approximately 5%. STDEV is approximately 3%.

- Large capitalization stocks yield approximately 12%. STDEV is approximately 20%.

- For 1 year treasuries, rate of return is very unlikely to be outside of +-3% of 5%. We can expect with near certainty that we will get 4.85% to 5.15% rate of return.

- For large capitalization stocks, we can expect with near certainty our investment will yield +-20% of 12%, or 9.6% to 14.4%.

A. Risk Free Rate of Return, Risk Premium, and Risk-Adjusted Rate of Return

What is the safest security you can think of? U.S. Government treasuries of course. These are considered risk-free investments. How likely is it that the U.S. government is going to default on all its debt in the near future?

The U.S. Gov issues various type of bonds (t-bills, t-notes, and t-bonds), the 3 month t-bills are often used as a benchmark. In other words, investors assume U.S. government treasury bills with a 3 month maturity are risk free. From that, we assume that the yield from 3 mo t-bills are a risk free rate of return.

http://www.ustreas.gov/offices/domestic-finance/debt-management/interest-rate/yield.shtml

According to that, about 0.14% is the current risk-free rate of return.

Definition. Risk Free Rate of Return

The rate of return on an investment considered risk free.

When an investor invests in anything more risky, they will demand some sort of risk premium to make up for the fact that they may not get their money back, or they're forced to deal with more volatility.

The risk adjusted rate of return is simply total return - risk free rate.

A portfolio theorist by the name of William Sharpe came up with the Sharpe Ratio. The ratio measures reward versus volatility (standard deviation).

Sharpe Ratio

(Return - Risk Free Rate of Return) / Portfolio Standard Deviation

By using the Sharpe Ratio, we can determine whether incurring greater amounts of risk will be beneficial to our portfolio. The larger the ratio, the greater the reward.

Interesting bit from the wikipedia article:

Sharpe Ratio

However like any mathematical model it relies on the data being correct. Pyramid schemes with a long duration of operation would typically provide a high Sharpe ratio when derived from reported returns but the inputs are false. When examining the investment performance of assets with smoothing of returns (such as With profits funds) the Sharpe ratio should be derived from the performance of the underlying assets rather than the fund returns.

B. Holding Period and Volatility

The longer we hold an asset, the greater the volatility. The reason lies in the mathematics of compounding interest. Fluctuations in an investment compound over time because investments are based on interest rates of return which are exponential.

But there's a flip side to this. The longer we hold an investment, the more stable our actual return will be. I know that was probably confusing.

Think about those "buy-and-hold" people. When you invest in the long-term, typically investments in the same investment class will achieve very similar rates of return.

Summary: The longer we hold an asset, the greater the volatility, but the smaller the variability. The shorter we hold an asset, the lesser the volatility, but the larger the variability.

C. Compound Interest

When you buy a 5 year bond that pays 5% annual on $100 principal, you aren't going to get back, $125 in 5 years, it will be somewhat more due to the nature of compounding interest.

$100 x .05 = $105

$105 x .05 = $110.25

$110.25 x .05 = $115.76

$115.76 x .05 = $121.55

$121.55 x .05 = $127.63

Compound Interest

Future Value = Principal*(1 + interest rate)^number of years compounding

FV = P(1 + r)^n

III. Portfolio Risks

There are always a risk of loss in your portfolio. The classic way to reduce risk of loss in a portfolio is diversification of assets.

Definition. Diversification

Placing uncorrelated assets into a portfolio in order to minimize general loss. Modern portfolio theory says that if we add stocks to a portfolio consisting entirely of bonds, the risk for the whole portfolio will actually be lesser even though stocks are riskier than bonds.

Systematic risk is general market risk that can degrade your portfolio. This risk cannot be diversified away.

Non-Systematic risk is the risk of individual investments. We can reduce these by diversifying our portfolio.

Capital risk. We may not recover our initial investment.

Timing risk. We may buy and sell at disadvantageous times.

When choosing stocks, modern portfolio theory says that we should choose stocks that are closest to the efficiency frontier which gives us the greatest return based on a certain amount of risk.

250px-Capital_Market_Line.png

The appropriate investments are determined by the Capital Asset Pricing Model. It's pretty complex, but we just need to know that the efficiency frontier is manifested by the CAPM.

http://en.wikipedia.org/wiki/Capital_Asset_Pricing_Model

Modern behavioral economics is starting to challenge modern portfolio theory.

A common way to measure risk is the Beta of a stock.

Definition. Beta

A measure of stock price volatility. The higher the beta, the more volatile the stock relative to the market.

A beta of +1 means a stock will move parallel to the market. A beta of +1.5 means the stock will move 50% faster than the market (if the market rises 10%, the stock will rise 15%, if the market falls 10%, the stock will fall 15%).

Some stocks have negative beta, such as gold mining companies.

If a portfolio has a beta of +1, that means the only risk in the portfolio is systematic risk.

Delta is a measure of price volatility for options. We'll talk about stock options later.

Edited by Michio

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Thanks Oneiromancy! I might learn something. :D

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