Claritas investment certicate study guide summary by resumenesfinancieros

Claritas Investment Certicate Study Guide Summary

Chapter I: General Information

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Important Acronyms:    

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APR: annual percentage rate. CAPM: capital asset pricing model. DCF: discounted cash flow. EAR: effective annual rate.

Money Markets: securities with maturities shorter than a year. Capital Markets: securities with maturities longer than a year. Direct Finance: funds movement between investors and recipients. Indirect Finance: when there is an intermediary between savers and borrowers. Benefits Investment Industry: facilitates lending and borrowing, contributes to efficient resource allocation and brings liquidity to the markets (ease of buying and selling assets). Laws vs. Regulations: laws are passed by congress and regulations by agencies. Auditors: evaluate a company’s accounting and internal controls. Investor Categories: retail, high-net-worth and institutional investors. Duty of Care: legal obligations that investor professionals have with their clients. Key forces of the Industry: competition, computerization, globalization and regulation. Levels of Care for Investment Professionals: high level (fiduciary standard) and lower level (suitability standard).

Chapter II: Ethics and Regulations

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Ethical behavior, professional standards and regulation create trust in the investment industry. Professional Standards: established by representative industry to guide the conduct of participants in the industry. Regulations: standards of conduct that carry the force of law. Corporate Policies: put in place by individual companies to promote desired behaviors. Ethical Standards: based on principles that support and promote desired values. Ethics: set of moral principles. High Ethical Standards: investors’ confidence, public trust, clients’ trust, integrity of markets, etc. Always have the best interest of clients in mind. Churning = Excessive Trading. Loyalty: employees will work diligently, employer’s interest above their own. Fair Dealing: treat different clients the same way. Ethical Standards: guide behavior when laws and regulations are ambiguous. Characteristic of a profession is adherence to a code of ethics and standards. Unethical behavior may affect the industry, clients, employers and individuals. CFA Code of Ethics: act with integrity and respect, independence in judgement and use diligence and reasonable care.

Chapter III: Regulation and Supervision

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Regulations are rules that carry the force of law. Systemic Failure: failure of the entire financial market. Non-Public Information = Information not yet known by the market. Objectives of Regulation: consumer protection, capital formation, economic growth, economic stability, fairness, efficiency and social objectives. Common Regulatory Process (10 steps): perceived need, legal authority, analysis, public consultation, adoption, implementation monitoring, enforcement, dispute resolutions and reviews. Corporate policies and procedures respond to a perceived need. Principle-Based Regulation: regulators set up broad principles within the industry. Rules-Based Regulation: regulators provide explicit rules which participants must comply with. Merit-Based Regulation: regulators attempt to protect investors by limiting the products sold to them. Investing in hedge-funds is only for investor with certain level of expertise. Disclosure-Based Regulation: seeks to have available all the information possible for investors. US regulation is often described as rules-based. US Examinations: FINRA Series 7 and 63. Gate Keeping Regulations: personnel and financial products; background check and regulations compliance. Operational Rulemaking: the way industry participants must operate:  Net Capital Rules: maximum level of leverage of a firm.  Handling of customer assets.

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Disclosure Rules:  Corporate Issuers: disclose information to potential buyers,  Market Transparency: pre-trade and post-trade.

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Sales Practice Rules are to behave with integrity when offering financial products:  Advertising: Global Investment Performance Standards (GIPS); guidance to calculate post performance.  Fee: price controls.  Information Barriers: barriers between departments that may have conflict of interests.  Suitability Standards: suitable advice given to clients.  Self-Dealing Restrictions: conflict of interest between institution and client. 3

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Basel Committee on banking supervision establishes standards for bank capital requirements and supervision. Wash Trades: conspirator puts big stakes of sell and buy orders to push price higher and then exits. Trading Rules (prohibited operations):     

Market Standards: common and accepted behaviors. Abusive Practices: market manipulation. Insider Trading. Front Running: trading before executing a client’s order. Brokerage Practices: commissions used to pay for external research instead of clients interest.  Proxy Voting.

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Regulations affect all aspects of the industry. Supervision within a Firm: hiring and training, continuing education, supervisory systems and documentation of politics. Anti-Money Laundering and continuity plans exist under regulation.

Chapter IV: Microeconomics

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Economics is the study of choices in the presence of scarce resources. Microeconomics: studies the economic behavior of companies and individuals. The concepts of microeconomics help investors allocate their savings. Complementary Products: products that are frequently consumed together. Normal Goods: +Income +Demand. Inferior Goods: +Income –Demand. Elasticity: change in demand given a change in price. Income Elasticity Demand: how changes in income affect the quantity demanded. Accounting Profit = Revenue – Costs. Economic Profit: difference between salary and entrepreneurship income; implicit and explicit costs are taken into account. Categories of Factors of Production:    

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Natural Resources. Physical Capital. Labor Force. Entrepreneurship.

Operating Leverage: extent to which fixed operating costs are used in production. Marginal Costs = Marginal Revenue; Maximize Profit. Mark-Up of a product is determined by uniqueness and by substitutability. Opportunity Cost: cost of any activity measured in terms of the value of the best alternative not chosen. Price Elasticity of Demand: ΔDemand/ΔPrice; if >1 Elastic, <1 Inelastic. Own Price Elasticity: Δ1% price how affects demand. Cross-Price Elasticity: %Δ ProductA/%Δ ProductB; if – complementary goods, + substitute goods.

Chapter V: Macroeconomics

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Gross Domestic Product (GDP): total value of goods and services produced within a country (calculated by expenditure or income approach). Expenditure Approach = C + I + G + (X – M). Economic Growth: percentage change in real output (GDP) for a country; determined by growth of labor force and productivity gain (output per unit of labor). Potential Output (aggregate supply): capital equipment, skill of labor force, land and raw materials. Business Cycle:  Expansion: production and inflation tend to rise along with interest rates.  Peak: economic growth reaches maximum level and begins slower growth.  Contraction: is there is negative growth a recession may occur.  Trough: end of contraction and beginning of recovery back to expansion; lower interest rates.

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Multiplier Effect: increasing spending creates snowball effect. Economic Key Indicators:      

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Industrial Production: monthly. Average Weekly Hours Productions Workers. Initial Claims Unemployment Insurance. Durable goods Orders. Retail Sales. Sentiment Surveys.

Lagging Indicators: signal a change in economic activity after output has already changed. Coincident Indicators: reveal current economic condition but do not have predicting value. Leading Indicators: signal changes in the economy in the future. Inflation, explained by two schools:  Monetarist: if the supply of money is large more funds choose the same amount of goods.  Resource Slack View: inflation is driven by the costs of production – inflation is associated with shortage in key elements of production.

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Measures of Inflation:  Consumer Price Index (CPI): weight of each factor in a basket of goods YoY.  Core Inflation: excludes the effects of temporary volatility.  Producer Price Index (PPI): measures the average selling price of goods in the economy received by producers.

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Implicit GDP Deflator = Current GDP/Constant Dollar GDP: Broadest-Based Measure of Inflation. Deflation: persistent and pronounced decrease in prices across most goods of an economy. Stagflation: little or no economic growth paired with inflation. Hyperinflation: violent increase in prices. Monetary Policy: directed toward influencing the money supply and credit in an economy (employment, inflation and output). Tools used for Monetary Policies:  Open Market Operations: purchase and sale of government notes and bonds,  Official Interest Rates: increase or decrease in borrowing rates to commercial banks.  Reserve Requirements: proportion of deposits that must be held by a bank.

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Fiscal Policy: use of government expenditure and tax policies to influence the economic activity. Automatic Stabilizers (government benefits) reduce the impact of economic shocks. Time Lag: time that takes to realize the problem and policies to take effect.

Chapter VI: International Trade and Foreign Change

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International trade creates additional demand for domestic products and services; it also provides consumers with a greater choice of products. Tariffs: taxes on imported duties and services. Quotas: limits quantity of goods that can be imported. Non-Tariff Barriers: certifications, licensing, sanctions, etc. Comparative Advantage: production of goods and services that a country can produce more efficiently. Balance of Payments: transactions of one country with the rest of the world over a period of time:  Current Account: goods and services (flow of money in goods and services transactions), income (salaries and investment income) and current transfer (unilateral transfers).  Capital and Financial Account: capital (transfers between domestic and foreign entities) and financial (types of investments: direct, portfolio and other investments).

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Current Account + Capital and Financial Account = 0 Reserve Currency: is held in significant quantities by governments. Limits to Free Trade: import/export restrictions, transportation costs and perishable goods.

CHAPTERS VII AND VIII REFER TO SIMPLE ACCOUNTING RULES AND INFORMATION (INCOME STATEMENTS, BALANCE SHEET AND CASH FLOWS). VERY GENERAL AND SIMPLE, THERE IS NO NEED IN ADDRESSING THOSE TOPICS IN THIS SUMMARY.

Chapter IX: Equity Securities

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Capital Structure: company’s composition of debt and equity capital. Types of Securities: common stocks, preferred stocks (no voting rights) and debt security (legal rights to promised cash flows, no voting rights). Priority of Claims:  Debt.  Preferred Stock.  Common Stock.

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Shareholders have limited liability. Global Depository Receipt (GDR): security representing an economic interest in a foreign company that trades like a common stock. Warrant = Call Option given to company employees. Systematic risk = Market Risk. Unsystematic Risk = risk associated with investing in a particular company or security. Valuation of Common Shares:  Discounted Cash Flow (DCF): present value of future cash flows.  Relative Valuation.  Asset-Based Valuation.

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Secondary Equity Offering: sell of additional shares after IPO. Dilutes ownership. Stock Splits divide amount of shares outstanding; no new stocks are issued. Exercise of warrants can decrease shareholders equity. Spinoffs: creation of a new company from an existing subsidiary.

Chapter X: Debt Securities

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Debt securities with maturity of a year or less = Bills. Debt securities with maturity from 1 to 10 years = Notes. Debt securities with maturity of more than 10 years = Bonds. Covenants: actions the issuer must perform or is prohibited of performing in order to protect bondholders’ equity. Secured Debt Securities: backed by collateral. Priority of Debt Securities:     

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Secured Debt. Senior Unsecured Debt. Senior Subordinated Debt. Subordinated Debt. Junior Subordinated Debt.

Bond Categorization by Coupon Rates:  Fixed-Rate = Straight Bonds.  Floating-Rate = Variable-Rate Bonds.  Zero-Coupon.

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Embedded Provisions of Bonds: callable (issuer can buy at any moment), putable (holder can sell at any moment) and convertible bonds (right to convert bond into securities). Inflation Linked Bonds: the par value is adjusted. Structured Debt Securities: securitization refers to the creation of new debt securities, backed by a pool of other debt securities. Example: mortgage-backed securities. Risks Involved in Debt Securities: credit, interest rate, inflation. Structure of Interest Rates: variation of interest rates vary with maturity: yield curve. Difference in yield of risky bonds and governments bonds = Credit Spread.

Chapter XI: Derivatives

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Most important derivative contracts are: forwards, futures, options and swaps. Characteristics of Derivatives: underlying, maturity, size, price and settlement. 80% of derivatives are traded OTC. Futures vs. Forwards: futures are standardized and trade on exchanges while forwards trade OTC. Forwards and future contracts help manage risk. Factors that affect and option price: underlying price, strike price, time to maturity, underlying volatility and risk-free interest rate. American vs. European Option: American option can be exercised at any time (as long as option contract in in the money) and European can only be exercised at maturity. Swap: exchange of cash flows or other financial instruments. Credit Default Swap (CDS): unilateral contract; an insurance for counterparty default. Currency Swap: payment in local currency, interest payment in foreign currency and principal payback in local currency. Avoids currency exchange costs. Swap contracts have an initial net value of 0.

Chapter XII: Alternative Investments

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Private Real Estate: investments in private partnerships or funds. Public Real Estate: investments in publicly traded companies that invest in real estate. Private Equity and real estate offer historical higher returns. This type of investments are illiquid and difficult to value. Private Equity Strategies:  Venture Capital: investment in the early stage of a company; highest risk.  Growth Equity: existing business model with possibility of expansion.  Buyouts.  Distressed Investments.

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Real Estate Segments: land, offices, family, retail and hotels. Private Equity Funds are generally funded by limited partners.

Chapter XIII: Structure of the Investment Industry

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Types of Investors: individual, retail, high-net-worth and ultra-high-net-worth. Institutional Investors: pension funds, endowments and foundations, governments and sovereign wealth funds, non-financial companies, investments companies, finance and insurance companies. Endowment Funds are long term funds for non-profit organizations. Passive investment managers seek to match the return and risk of a benchmark. Active investment managers seek to outperform a benchmark. Fundamental Management: present value of all future cash flows. Investment Information Services:  Investment Research Providers.  Credit Rating Agencies.  Data Vendors.

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Brokers: agents who arrange trades for their clients. Dealers: trade directly with their clients whatever they want. Clearing and Settlement Agents are responsible of settling trades after they have been arranged through a process called confirmation. Clearinghouses guarantee contracts performance in future contracts. Exchanges: organize auction markets to which buyers and sellers submit orders for matching. Depositary Institutions = S&L’s. Securitization: creation of new financial products by repackaging securities or other assets; improves liquidity in the underlying assets. Sell-Side Firms: investment banks, brokers and dealers (provide transaction services and financial products). Buy-Side Firms: investment managers. Firm Organization:  Front Office: client facing activities.  Middle Office: core activities of the firm.  Back Office: administrative and support functions to run the firm.

Chapter XIV: Investment Vehicles and Structure

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Security Market Index is a group of securities representing a given security market. Assigning weights to the securities of an index:  Price Weighted.  Capitalization Weighted.  Equal Weighted.

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Index Funds follow a passive investment strategy. Index Universe: broad market (entire asset class within a country or region), industry indices, etc. Direct Investment: investor buy securities and real assets. Indirect Investment: investor buys assets of companies that make direct investments. Equity-Linked Securities: bonds related to an index; buyer receives at least invested money, plus gains depending on index performance. Exchange Traded Notes: debt securities issued by investment banks; the notes closely replicate the returns of an index. Structured Investment Products may be very illiquid, hard to value and have credit risk. Close-End Funds: shares are sold at IPO, shares outstanding rarely change and are traded through exchanges and dealers. Open-End Mutual Funds: can issue and redeem shares as necessary. Sales Load: fee to enter or exit a fund. Money Market Fund: uninsured interest paying bank account (invested in short term good rating bills). Unit Investment Trust: fixed portfolio of securities until the fund expires. Hedge Funds: limited number of select investors; agreement that locks up the investor capital and has a managers performance-based compensation. Private investment pools. High-Water Mark: maximum level if the fund on which performance fees were paid in the past. Managed Accounts:  Wrap Account: all fees are wrapped in a single flat fee.  Commingled Accounts: the capital of two or more investors are pooled together and jointly managed.

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Pension Plans:  Pay-As-You-Go: sponsors pay pension benefits out of current revenues.  Funded Plans: sponsors make contribution before the benefits are paid.  Benefit Plans: promises certain pension benefits to its beneficiaries; sponsors must pay those benefits.  Contribution Plans: sponsors make contributions on behalf of their beneficiaries for future payments.

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Managers of hedge funds generally impose capital lock-ups. Unit investment trusts are exchange traded.

Chapter XV: Investment Market Characteristics

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Most Common IPO: underwritten offering occurs when an investment bank guarantees the sale of the securities; remnant is bought by the bank (when this happens it is said that the IPO was undersubscribed). Issuer: investment bank or syndicate (group of investment banks). Best Effort Offering: investment bank acts like a broker (does not buy securities). Shelf Registration: sale of new securities when the issuer needs additional capital. Private Placements: issue of securities to select investors. Right Offerings = Call Options. Trading Services Providers:  Brokers: agents who fill orders for their clients.  Dealers: agents who trade with their clients  Exchanges: provide places where traders can meet to arrange operations (stock exchanges).

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Alternative Trading Systems: trading venues that function like exchanges without regulatory authority. Trading Sessions:  Call Market: participants can arrange trades only when the market is called at a particular time and place.  Continuous Market: participants can trade at any time the market is open.

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Execution Mechanisms:  Quote-Driven Markets: OTC; bond, currencies and spot commodities.  Order-Driven Markets: options, futures and shares; arrange trades using rules to match buy orders with sell orders.

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Trade Pricing Rules:  Uniform Pricing Rule: all trades execute at the same price.  Discriminatory Pricing Rule: limit orders.  Derivative Pricing Rule: trades execute at the mid-point of bid and ask. 17

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Brokered Markets: arranged by brokers for assets that are unique and of interest to a limited number of potential investors. Order Exposure: how and to whom an order is exposed to. Settlement: clearinghouses arrange final settlement trades. Trade Settlement:  Clearing: activities that occur previous to the settlement.  Settlement: final exchange of cash for securities.

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Dual-Listed Securities: trade in two exchanges. Market Efficiency:  Operational Efficiency: trades are easy to arrange with low financial costs.  Price Efficiency: prices reflect all available information about fundamental value.

Chapter XVI: Risk Management

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Risk: the effect of uncertain future events of an organization. Risks are classified according to the source of uncertainty, Operational Risk: losses from human, systems and process failure. Compliance Risk: failure to comply with laws and regulation. Investment Risk: fluctuation in the value of investments. Risk Management Process:     

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Financial firms set internal risk limits. Risk Response Strategies are classified in four T’s categories: tolerate, treat, transfer and terminate. Enterprise Risk Management: helps a company manage its risk in an integrated manner. Value at Risk (VaR): risk measure; estimate of the minimum loss of value that can be expected for a given period with a given probability. Weakness of VaR: gives estimate of minimum loss, not maximum. Relies on historical data and future returns are modelled with normal distribution. Organizations lose on average 5% of their revenues on fraud. Other risks: political, legal, settlement. Financial companies must have business continuity and disaster recovery planning. Banks are subject to the Basel Accords. Compliance Risk and their Management:     

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Set Objectives. Detect and Identify Events. Asses and Prioritize Risks. Select a Risk Response. Control and Monitor.

Framework of Operations. Anti-Corruption Laws. Financial Accounting and Reporting. Tax Reporting. Market Disclosures.

Investment Risks:  Market Risk: caused by changes in market conditions.  Credit Risk: failure of borrower to pay an obligation.  Liquidity Risk: ability to buy and sell quickly.

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Risk Management does not try to eliminate all risks. 19

Chapter XVII: Performance Evaluation

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Holding-Period Return: capital gain or loss, plus income, over a period of time. Time-Weighted Rate of Return: return calculated taking into account the period of cash inflows. GIPS: Global Investment Performance Standards. Adjusting Returns for Risk: standard deviation, downside deviation (standard deviation but only calculates those that are negative). Measure of return variability that focuses only on outcomes that are less than the mean. Reward-To-Risk Ratio: compares portfolio excess return with its standard deviation (Sharpe Ratio)  (Return on Portfolio – Risk free Return)/SD Portfolio Returns. Risk Free Investments = Short term Government Bonds. Relative Returns: portfolio return compared to benchmark or index. Financial Market Benchmark Characteristics: investability, compatibility, clarity and prespecifications. Tracking Error: difference between the performance of a portfolio and its benchmark, measured with standard deviations of returns of portfolio vs. benchmark. Information Ratio = Difference in average Return between Portfolio vs. Benchmark/Fund Tracking Error. Alpha: return of the fund due to manager’s skill. Beta: market risk or non-diversifiable risk; broad market movements. Attribution Analysis: used to identify the sources of a fund manager performance. Capital Asset Pricing Model (CAPM): separates funds return into that portion that could have been achieved passively.

Chapter XVIII: Investment Industry Documentation

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Objectives of Documentation: educates, communicates, authorizes, formalizes, organizes, measures, records and protects. Documents Classified by Source: original, derived and associated. There are standardized and ad-hoc documents. Internal Documentation: policies, procedures and processes. Policy documents state an organization’s position on various laws and regulations. Procedure and Process Documentation: providing a bridge between the activities that are allowed on a policy level and what needs to happen at a process level. Policy  Procedure  Process. Process: input, activity, output. External documentation exists between a firm and external parties. Marketing Documentation: presentation materials, offering documentation and facts sheets. Client On-Boarding: acceptance of a client and input of his details into records. Know Your Client process (KYC). Straight-Through Processing (STP): online information inputs (digital). Version Control: number and date on a given standardized document.

Chapter XIX: Investor Needs and Investment Policy

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Individual Investors: differentiated on their resources. Difference between Defined Contribution Plan vs. Defined Benefit Plan: in Contribution Plan the risk is taken by the employee. Institutional Investors: pension funds, endowments, insurance mutual funds, among others. Investor Needs: time horizon, return requirements and risk tolerance. Factors that Influence Investment Policy: regulatory issues, taxes, unique circumstances, among others. Investment Policy Statements (IPS): guide for investor and investment manager regarding requirements:  Objectives: return requirements and risk tolerance.  Constraints: time horizon, liquidity, taxes, etc.

Chapter XX: Asset Allocation & Chapter XXI: Active/Passive Investment Management

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Diversification reduces risk. Strategic Asset Allocation is the long term mix of assets that is expected to meet investor’s objectives. Mean-Variance Model is used to build a strategic asset allocation. Tactical Asset Allocation: short-term adjustment among asset classes (active portfolio management). Idiosyncratic Risk = Specific Risk. Active Management may be preferred in less efficient markets. Active Managers try to identify market inefficiencies through fundamental research. Managers using statistical studies and information are called “quants”.

Practice Test Review

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Financial Intermediaries do not deal with physical capital. The obligations of all the employees in the investment industry, no matter their area of work, are similar. The objective of public consultation before implementing a new regulation is for affected parties to be aware. Sales Practice Rules address possible conflicts of interest. At economic peak, there is most likely a drop in consumers’ confidence. The value of a put option decreases when interest rates increase. Structured Products can try to replicate the price of a commodity. Real Estate Investment Trust (REIT) are publicly traded. Real Estate Equity funds are privately traded. Carried Interest is the share of profits that the general partner retains. Dark Pools: alternative trading systems with lack of transparency. Market Impact = Price Concessions. Records help preserve corporate learning. Classification of documents: origin, direction and level of standardization. Basis Interest Rate Swap: exchange of floating rate for another floating rate.