Portfolio Management Techniques (PMT) Practice Questions And Answers

ERISA
The Employee Retirement Income Security Act, or ERISA, regulates the creation and administration of retirement plans and corporate pensions and sets standards that must be maintained for both types of plans. ERISA was enacted to protect the rights of individual investors. Per ERISA, all profit-sharing plans and corporate pensions must be established through the use of a trust. Trustees are then appointed and assume fiduciary duty in the administration of the plan. ERISA provides tax incentives for employees to save money for retirement. These incentives come in the form of income reduction (thus tax reduction) and deferral of taxation on investment earnings in the ERISA plans.

Market order, limit order, and stop order
There are many tools at an investor’s disposal when trading securities. If an investor desires to trade immediately at the current level of the market, he or she will place a market order and accept the next price for which they can buy or sell the desired security. No restrictions are placed on market orders. Limit orders help investors time their transactions according to market movements without having to constantly watch the security for the right price. A limit order will execute a buy or sell if the price reaches the desired level but will not execute if the price fluctuates past the desired levels. Stop orders, similar to limit orders, help the investor with timing. The stop level is essentially a trigger point in the securities price. Unlike a limit, however, once desired level is reached, the very next price will be accepted regardless of the next price.

Trade as a principal and trade as an agent
A trader selling securities from his or her own inventory and acting on his or her own behalf is acting as a dealer in the role of a principal. A principal or dealer’s profit motive is satisfied by the capital gains and trading fees he or she may acquire due to the transactions between the principal and the principal’s clients. A trader acting on behalf of a client or dealer is known as a broker, acting in the role of an agent. The broker may be an agent either for a dealer or for a client. A broker’s profit motive is satisfied by the commission he or she earns as a result of the sale and through fees charged. Principals act on their own behalf; agents act on the behalf of others.

Internal rate of return
Internal rates of return are discount rates by which investors determine the viability of taking on new investments. Internal rates of return take many factors into consideration, especially the time value of money. If the internal rate of return is calculated to be positive and higher than the rate that the investor requires from an investment, the investor accepts the investment. The internal rate of return calculation is most applicable to the bond market as there are regular cash flows to measure and compare with a set maturity. Investors find these measurements helpful in determining the proper course when presented with two seemingly identical investments.

Fundamental analysis
Fundamental analysis is the method by which investors determine the value of equity securities using data gathered from the company’s financial statements. Information from the income statement, the balance sheet, and the statement of cash flows are analyzed to provide a clear picture of the company’s profitability, liquidity, and debt management. These fundamental numbers are assessed, and if they are found to be favorable, an investor will place a high valuation on the security, perhaps higher than the current market value. This indicates to the investor that it is a good time to buy the stock.

Hedge funds
Hedge funds are alternative investments that seek high returns through the use of sophisticated investment management strategies. They tend to be very aggressively managed and use some combination of leverage, long/short strategies, and derivative contracts to generate the highest returns possible. This strategy also leads to higher-than- normal risk, and limits their investor pool to high-net-worth individuals and institutional investors. Since those who invest in hedge funds are typically sophisticated and experienced investors, there is little regulation of hedge funds. High minimum investments also limit their investors to higher-net-worth individuals as well. Contrary to their moniker, hedge funds are generally not used to hedge risk, but to maximize returns. Hedge funds are not generally open to retail investors and lack liquidity due to minimum time commitments of the investors’ capital.

Derivative securities
Derivative securities are those securities that derive their existence based on other securities. Without the existence of the underlying security, derivatives would not exist. Derivatives are created when an investor or group of investors make securities based on other securities available to other investors. These derivatives range from the ultra-risky and speculative to the ultrasafe, income-producing derivatives. Examples of derivatives include options, futures, and forward contracts, among others. Speculative derivatives are complex securities that investors purchase in hopes of capital appreciation but at great risk.

Limited partnerships
Limited partnerships are a form of alternative investment in which an investor may take part in the business venture on a limited basis. To this end, he or she is only liable for the business to the extent of the investment, but he or she participates in the partnership’s profits. If he or she loses the full investment, he or she is no longer liable for the company’s debts. Investors find limited partnerships attractive because the partnerships provide them with access to nontraditional investments, such as business ventures, without exposing them to personal risk of liability if a company becomes insolvent.

Sole proprietorship
Sole proprietorships are business structures that investors may use to their advantage concerning simplicity for purposes of taxation. A business that is formed by the owner and not structured as a limited liability corporation, but a sole proprietorship, may report its income and losses on the individual owner’s income tax returns. This may lead to some tax advantages, such as reduced reportable income for the individual, but it also makes the owner (sole proprietor) liable for all of the businesses debts. In this case, a failed venture on the part of the investor would not limit the investor’s loss to the investment in the venture but gives creditors access to the client’s personal assets as well.

Client’s investment profile
A client’s investment profile is a multifaceted look at the client’s current situation and goals. It consists of many factors to be considered. The advisor must be aware of the client’s current income, their goals regarding retirement, their plans regarding their eventual death and possible disability, and their time horizon and risk tolerance. It is also important to consider their current financial status including their cash flows, their balance sheet of assets, any existing investments, and their tax situation. Lastly, and just as important, are the nonfinancial investment considerations including their values, attitude, experience and level of sophistication, and their demographics. Each of the preceding factors plays an important part in determining the client’s investment profile.

Implications associated with investing in foreign governmental debt
Investors in the governmental debt of foreign countries should be cautious. Foreign countries are often characterized by cultures with which investors from the United States are not familiar. This can result in political and legislative risk to which the investor is unaccustomed. An unstable foreign government debt issue offers additional risk. If the government experiences revolution, the new government may refuse to honor the debts of the previous leadership.

Buying and selling bonds at a discount
Buying bonds at a discount is the practice of investors paying less than par value for a bond. The reason a bond might be valued at less than par is in rising interest rate environments where bonds paying the old, lower rate of interest are not in demand. Because an investor will not pay par value to receive a lower rate of interest for a similar bond, bond sellers discount the prices of the bonds they hold to make them more attractive to investors. The lower outlay of capital in conjunction with the lower coupon helps investors to receive similar yield to the new bonds with higher rates of interest. This is a contributing factor in the valuation of a bond.

Maturity terms are the effective length of debt instruments, particularly bonds. When a debt instrument is issued at par value with a fixed interest rate, it is also assigned a maturity date. For the length of time until maturity, the issuing entity promises to pay the fixed rate. Bonds may then trade on the secondary market at a discount or premium to par until maturity. At maturity, the issuing entity redeems the bond at par value and is no longer obligated to pay the fixed rate. Duration is a function of maturity that uses the bond’s maturity as part of the calculation.

Implications of valuing convertible bonds
Convertible bonds differ from conventional bonds in that they may be converted from debt instruments to equity securities by the investor. Convertible bonds are attractive to investors because they provide investments in the more stable bond market while providing the investor with the opportunity to participate in the equity gains of a company should it begin to perform well. While this is an attractive option for the investor, it comes with a price. Because of this advantage, lower coupons are offered on convertible bonds. Lower coupons result in lower valuations of the bonds because they don’t provide as much current income as may be available in other debt instruments.

Common stock
Common stock is an equity security representative of shares of ownership in a company. They are tradable securities that are fairly liquid if there is enough demand for the stock of the company. Common stockholders benefit from ownership by having input on the operation of the company, such as voting rights on membership on the board. Board voting rights are only afforded to common stockholders, not preferred stockholders. Common stock tends to be the most volatile of all securities, with high gains or losses possible intraday.

Resale restrictions on equity securities
Equity securities can have different restrictions on their resale or transference which then classify the securities as restricted stock (also called Section 1244 stock or letter stock). These restrictions especially apply to executives or other insider employees of a company who would receive stock as compensation but who would not be able to sell the stock given the harms such early selling could bring to the company’s stock value. Accordingly, restricted stock can often be on a vesting schedule, such that an employee would fail to retain the stock if he departed from the company before it was fully vested. Resale restrictions on stocks are regulated by the SEC and not merely by private agreements between publicly-traded companies and their insider employees.

Range
Range is the difference in the highest return of the portfolio and the lowest return of the portfolio. It covers all numbers in between. This look at a portfolio’s performance allows the investor or adviser to statistically evaluate the range of the included securities. If there is a large range, there may or may not be a problem with the portfolio that needs to be addressed, depending on the investors’ time horizon and risk appetite. A large range may also be a sign of negative correlation in the portfolio, whereas a smaller range tends to indicate positive correlation. Both of the scenarios can be problematic or show that an investor’s strategy is working, again dependent upon time horizon and risk appetite.

Opportunity cost
Opportunity cost is the potential benefits ceded from one opportunity in order to pursue another opportunity. While this may seem ambiguous, investors may think of it in concrete terms. To investors, opportunity cost may be the return given up on other investments when they choose a specific investment. If their chosen investment returns less than another investment, then they suffered a measurable opportunity cost measured by the differences in the returns.

Demand deposits
Demand deposit accounts are most closely associated with checking and savings accounts. The name demand deposit refers to the liquidity of the instrument. The deposit may be “demanded” at any time without advanced notice from the depositor. While an investor may receive a small amount of interest on a deposit in a demand deposit account, it is not suitable for any long period as the rate of interest paid usually does not exceed inflation, thereby losing purchasing power in the long run. They are useful, however, due to their totally liquid nature.

Commercial paper
Commercial paper is a money market instrument characterized by a short duration and an unsecured nature. They are loans that large corporations use to finance accounts receivable and inventory. Commercial paper maturities typically go no longer than nine months, with the average maturity being one to two months. Commercial paper is considered a very safe investment due to the fact that a company’s financial situation is easy to forecast in such a short time period.