Challenge Pathway -Prep Book

This sum is returned over a pre-determined tenure at pre-determined instalments. In case of default, the property so mortgaged is sold and dues are recovered. Home loans and loan against property are primary examples of mortgage loans. Fixed rate mortgage loans where the installment repayable every month is pre- determined is the most popular method of mortgage, the instalment payable monthly is called EMI (equated monthly instalment). Over the tenure of the loan, if the interest rate reduces and the EMI remains the same, the borrower ends up paying less interest and more principal as part of his EMI. The interest rate on mortgage loans generally goes from 8.5% to 13.5% p.a. and about 50-60% of the value of the property is provided as the loan Fixed Rate and Variable Rate Loans The rate of interest set by the government in terms of the borrowing rate announced by the RBI- called the repo, sets the tone for the interest rate on all banking products across the country.Fixed rate loans are ones where the rate of interest on the loan if fixed along the tenure of the loan. Variable interest rate loans set themselves up to a benchmark – most the base lending rate of the bank. As and when it keeps changing, the variable interest rate for that year will change. The fixed rate loan if often more expensive than the variable interest but it ensures higher predictability to the borrower of his repayment schedule. MIBOR – Mumbai Interbank Offered Rate The rate at which banks lend in India to each other on the wholesale debt market is called the MIBOR. It is similar to the LIBOR (London Interbank offered Rate). International College of Financial Planning – Challenge Pathway Prep Book Page 47

Banks may need funds for various purposes – such as meeting short term liquidity requirements, meeting statutory balances, reserves as prescribed by the RBI – and they can borrow on the interbank market using the MIBOR as the reference rate. The NSE (National Stock exchange) calculates this rate everyday based on inputs received from the panel of 30 banks and primary dealers (PDs) and uses this to determine rates of forward contracts, derivatives and floating rate debentures on the exchange. MCLR- Marginal Cost of Funds Based Lending Rate MCLR is used by the banks to determine an average rate at which it has borrowed all of its obligations. For a bank or a lending institution, the capital which is used to lend to its borrowers can come from deposits from customers, owner’s capital, preference share issues, perpetual bond issues and so on. Since there is a fixed liability to the bank for the interest payment due on these loans, there is an average cost of funds that the bank calculates to determine the minimum opportunity cost of its funds. Add to the cost of raising the actual funds, there are other factors such as loan Tenor, the operating costs of the bank and the Negative interest rate carried on the Cash reserve Ratio that it has to maintain with the RBI. Since the bank cannot utilize the CRR-oriented funds to lend, the interest foregone on this sum is also recovered from the rest of the corpus. All loans, barring a few, are priced over and above this base lending rate. RBI implemented the MCLR from 1st April 2016 replacing the base rate, to ensure better and quicker transmission of its repo rate changes in the banking system. It improves the transparency of the lending structure and makes the system more agile to changes. International College of Financial Planning – Challenge Pathway Prep Book Page 48

Loan against Property (LAP) or Loan against Securities (LAS) A borrower who wishes to pledge his existing assets in the form or real estate or financial assets can approach a lender to take a loan against these at a certain interest rate. A lending institution often uses a certain margin of safety called the haircut or the loan limit before it determines the loan eligibility. The value of the asset is often considered to be 50%-80% of its market value and this is the Loan to Value (LTV) for the borrower. The interest rate charged to the borrower is fairly decent at 10-11% p.a. and the loan tenure can be for 3-5 years. The payments can be made in lump sums periodically or via EMIs. In case of a default, the lender has a right to auction/sell the assets and recover his dues. The remainder is given to the borrower. Loan against securities – primarily listed shares and mutual funds have certain lending limits predetermined by the Stock Exchanges and RBI. The listed shares are classified as Class A, B & C and have haircuts ranging from 50% to 70% of the security’s value depending on which class the share belongs to. Any broker or lending institution has to strictly follow these rules for listed securities while lending to the borrower. Gold Loan Loan taken against a pledge of one’s gold jewellery or Bullion are called Gold Loans. In times of need, a borrower can pledge his gold to the financial institution and can get a loan sanctioned within a few minutes at an interest rate of around 10.5%-12% p.a. and a tenure of 1-5 years………….. These loans can then be utilised by the borrower for any purpose – personal or business. It is a major help to individuals who have gold but do not have easy access to credit or need a loan within a very short period of time. International College of Financial Planning – Challenge Pathway Prep Book Page 49

In case of a default, the lender can auction the collateral kept with itself and recover the loan amount. Gold Monetization Scheme Gold monetization scheme was a method adopted by the Indian Government in 2015-16 to aid the outlet of gold Jewelry and bullion stock maintained by crores of Indian Households into the main markets. It was also aimed at reducing gold imports by decreasing the metal’s demand. Keeping one’s gold in Monetization scheme could earn the individual interest on his idle metal. One has to give up one’s gold jewelry/bullion and accept GM bonds in return which earn him interest at the rate of up to 2.5% p.a. these bonds also appreciate in value moving in line with the gold prices. At the end when the depositor wishes to encash, he can take either physical gold or money in return for his bonds. The tenure of these bonds can vary from 1 – 15 years. The tax on appreciation of the gold bonds is NIL. Reverse Mortgage A reverse mortgage is a concept meant for senior/retired homeowners whose property where they are living is a major asset for them and they wish to utilize the entire value of this property till they are alive. In this type of mortgage, the property is pledged with the financial institution and the homeowner gets a set sum of money every month till the end of his life. After his life, the reverse mortgage often also covers the lifetime of the surviving spouse. Post both homeowners are no more, the loan amount becomes due for payment within 6 months of the death of the last surviving spouse. International College of Financial Planning – Challenge Pathway Prep Book Page 50

The inheritors if any, in such an event may choose to repay the loan and keep the property or the bank sells the property and the dues are recovered. The bank enjoys capital appreciation of the property while paying for the value of the property in gradual installments over the lifetime of the borrower. It provides an additional source of income to the retired couple. In the event the homeowner wishes to sell or move out of the property, the entire loan balance becomes due for payment during the loan tenure. Using the Right Credit to Finance Goals One can avail various kinds of loans which could vary in many ways for the borrower as well as the lender. One has to choose between the various types available to suit one’s own needs and debt servicing capabilities. Some criteria one should put some thought to before finalizing a loan – 1) Tenor required – long term or short term 2) Reason for the loan – consumption or creation of asset 3) Security available to be placed as collateral- if one has enough security to provide the lender for a pledge on a secured loan 4) Margin available to be placed for the difference between amount required and loan sanctioned 5) Credit scores maintained in the past 6) Rate of interest that one can comfortably service without compromising one’s dear-t-life expenses. 7) Recourse available to the lender in case of a default and the suitability of this recourse to oneself and one’s family. International College of Financial Planning – Challenge Pathway Prep Book Page 51

8) Loan eligibility in terms of one’s earnings and tax slabs 9) Fixed or floating rate depending upon the need for predictability of future outflows and also the current trend of the interest rates in the economy. 10) Foreclosure or prepayment charges and penalties to repay the loan earlier. Delayed payment charges in case of default or delay in repaying one’s obligations. International College of Financial Planning – Challenge Pathway Prep Book Page 52

INVESTMENT PLANNING AND ASSET MANAGEMENT International College of Financial Planning – Challenge Pathway Prep Book Page 53

International College of Financial Planning – Challenge Pathway Prep Book Page 54

Asset Classes and Securities An asset class is a group of similar investment vehicles. Different classes, or types, of investment assets – such as fixed-income investments – are grouped together based on having a similar financial structure. They are typically traded in the same financial markets and subject to the same rules and regulations. Understanding Different Asset Classes There’s some argument about exactly how many different classes of assets there are. However, many market analysts and financial advisors divide assets into the following five categories:  Stocks or equities – Equities are shares of ownership issued by publicly-traded companies. They are traded on stock exchanges such as the NYSE or NASDAQ. You can potentially profit from equities either through a rise in the share price or by receiving dividends. The asset class of equities is often subdivided by market capitalization into small-cap, mid-cap, and large-cap stocks.  Bonds or other fixed-income investments – Fixed-income investments are investments in debt securities that pay a rate of return in the form of interest. Such investments are generally considered less risky than investing in equities or other asset classes.  Cash or cash equivalents, such as money market funds – The primary advantage of cash or cash equivalent investments is their liquidity. Money held in the form of cash or cash equivalents can be easily accessed at any time.  Real estate or other tangible assets – Real estate and other physical assets are considered an asset class that offers protection against inflation. The tangible nature of such assets also leads to them being considered as more of a “real” asset. In that respect, they differ from assets that exist only in the form of financial instruments, such as derivatives.  Forex, futures and other derivatives – This category includes futures contracts, spot and forward foreign exchange, options, and an expanding array of financial derivatives. Derivatives International College of Financial Planning – Challenge Pathway Prep Book Page 55

are financial instruments that are based on, or derived from, an underlying asset. For example, stock options are a derivative of stocks. Additional Factors in Classifying Assets It’s difficult to classify some assets. For example, suppose you’re investing in stock market futures. Should those be classified with equities, since they’re essentially an investment in the stock market? Or should they be classified with futures, since they’re futures? Gold and silver are tangible assets, but are frequently traded in the form of futures or options, which are financial derivatives. If you invest in a real estate investment trust (REIT), should that be considered an investment in tangible assets, or as an equity investment since REITs are exchange-traded securities? The diversity of available investments also creates complications. Exchange-traded funds (ETFs), for example, trade on exchanges, just like stocks. However, ETFs may be composed of investments from one or more of the five basic asset classes. An ETF that offers exposure to the energy market may be composed of investments in oil futures and in stocks of oil companies. Assets may also be categorized by location. Market analysts often view investments in domestic securities, foreign investments, and investments in emerging markets as different categories of assets. Other asset classes include collectibles, hedge funds or private equity investments, and cryptocurrencies such as Bitcoin. These asset classes are a bit more off the beaten path. For that reason, they are sometimes classified together under the heading of “alternative investments”. Generally speaking, the more “alternative” an investment is, the more illiquid and the riskier it tends to be. Asset Classes and Diversification Good news! – You don’t really have to know for certain which asset class a specific investment falls into. You just need to understand the basic concept that there are broad, general categories of International College of Financial Planning – Challenge Pathway Prep Book Page 56

investments. That fact is important because of the concept of diversification. Diversification is the practice of reducing your overall risk by spreading your investments across different asset classes. There is typically little correlation, or an inverse or negative correlation, between different asset classes. During periods of time when equities are performing well, bonds, real estate, and commodities may not be performing well. However, during a bear market in stocks, other assets, such as real estate or bonds, may be showing investors above-average returns. You can hedge your investments in one asset class, reducing your risk exposure, by simultaneously holding investments in other asset classes. The practice of reducing investment portfolio risk by diversifying your investments across different asset classes is referred to as asset allocation. Asset Allocation and Risk Tolerance The other reason to have a basic understanding of asset classes is just to help you recognize the nature of various investments that you may choose to trade. For example, you might choose to devote all, or nearly all, of your investment capital to trading futures or other financial derivatives such as foreign currency exchange. But if you do, you must at least be aware that you have chosen to trade a class of assets that is usually considered to carry significantly more risk than bonds or equities. The extent to which you choose to employ asset allocation as a means of diversification is going to be an individual decision that is guided by your personal investment goals and your risk tolerance. If you’re very risk-averse, then you may want to invest only in relatively safe asset classes. You may aim to diversify within an asset class. Stock investors commonly diversify by holding a selection of large- cap, mid-cap, and small-cap stocks. Alternately, they may seek diversification through investing in unrelated market sectors. On the other hand, if you’re blessed with a high-risk tolerance and/or with having money to burn, you may care very little about diversification, and just be focused on trying to identify the asset class that currently offers the highest potential profits. International College of Financial Planning – Challenge Pathway Prep Book Page 57

Primary Market IPOs  Stock ownership is usually categorized as either public or private.  When small businesses choose to issue additional shares of stock, they often become publicly held corporations through an initial public offering (IPO).  When a company is ready to raise capital through a security offering (e.g., IPO), it will approach an investment bank to underwrite the offering.  When the investment bank is simply facilitating the sale to the public, it’s called a best efforts commitment.  When the investment bank buys all shares to resell them, it’s called firm commitment underwriting.  In addition to investment banks, an IPO uses the services of other entities, such as accounting and law firms, collectively referred to as the selling syndicate. Secondary Market Securities that investors already own are bought and sold in the secondary market. Although stocks are also sold on the primary market when they are first issued, it is what most people think of as “the stock market.” These exchanges, such as the NASDAQ and the New York Stock Exchange (NYSE), are secondary markets. All types of investors can benefit from secondary market transactions. Their costs are significantly reduced because of high volume transactions. The following are a few examples of secondary market transactions involving securities. Securities are traded on a secondary market between investors, not with the issuer. Investors who wish to purchase Larsen & Toubro stock will have to do so from another investor who owns such shares, not directly from L&T. Therefore, the company will not be involved in the transaction. In a secondary market, individual and corporate investors, as well as investment banks, buy and sell bonds and mutual funds. International College of Financial Planning – Challenge Pathway Prep Book Page 58

Types of Secondary Market There are two types of secondary markets – stock exchanges and over-the-counter markets. Exchanges are centralised platforms where securities are traded without any contact between buyers and sellers. Examples of such platforms include the National Stock Exchange (NSE) and Bombay Stock Exchange (BSE). Stock Exchanges One will not find direct contact between the seller and the buyer of securities in this type of secondary market. Regulations are in place to ensure the safety of trading. In this case, the exchange is a guarantor, so there is almost no counterparty risk. Exchanges have a relatively high transaction cost because of exchange fees and commissions. Over the Counter Markets Investors trade among themselves on these decentralised markets. In such markets, there is fierce competition to get higher volumes, which leads to price differences between sellers. Due to the one- to-one nature of the transaction, the risk is higher than with exchanges. Examples of OTC markets include a foreign exchange. Stock Stocks are a type of security that gives stockholders a share of ownership in a company. Stocks also are called “equities.” Why do people buy stocks? Investors buy stocks for various reasons. Here are some of them:  Capital appreciation, which occurs when a stock rises in price  Dividend payments, which come when the company distributes some of its earnings to stockholders  Ability to vote shares and influence the company International College of Financial Planning – Challenge Pathway Prep Book Page 59

Why do companies issue stock? Companies issue stock to get money for various things, which may include:  Paying off debt  Launching new products  Expanding into new markets or regions  Enlarging facilities or building new ones What kinds of stocks are there? There are two main kinds of stocks, common stock and preferred stock. Common stock entitles owners to vote at shareholder meetings and receive dividends. Preferred stockholders usually don’t have voting rights but they receive dividend payments before common stockholders do, and have priority over common stockholders if the company goes bankrupt and its assets are liquidated. Common and preferred stocks may fall into one or more of the following categories:  Growth stocks have earnings growing at a faster rate than the market average. They rarely pay dividends and investors buy them in the hope of capital appreciation. A start-up technology company is likely to be a growth stock.  Income stocks pay dividends consistently. Investors buy them for the income they generate. An established utility company is likely to be an income stock.  Value stocks have a low price-to-earnings (PE) ratio, meaning they are cheaper to buy than stocks with a higher PE. Value stocks may be growth or income stocks, and their low PE ratio may reflect the fact that they have fallen out of favor with investors for some reason. People buy value stocks in the hope that the market has overreacted and that the stock’s price will rebound. International College of Financial Planning – Challenge Pathway Prep Book Page 60

 Blue-chip stocks are shares in large, well-known companies with a solid history of growth. They generally pay dividends. Another way to categorize stocks is by the size of the company, as shown in its market capitalization. There are large-cap, mid-cap, and small-cap stocks. Shares in very small companies are sometimes called “microcap” stocks. The very lowest priced stocks are known as “penny stocks.” These companies may have little or no earnings. Penny stocks do not pay dividends and are highly speculative. What are the benefits and risks of stocks? Stocks offer investors the greatest potential for growth (capital appreciation) over the long haul. Investors willing to stick with stocks over long periods of time, say 15 years, generally have been rewarded with strong, positive returns. But stock prices move down as well as up. There’s no guarantee that the company whose stock you hold will grow and do well, so you can lose money you invest in stocks. If a company goes bankrupt and its assets are liquidated, common stockholders are the last in line to share in the proceeds. The company’s bondholders will be paid first, then holders of preferred stock. If you are a common stockholder, you get whatever is left, which may be nothing. Even when companies aren’t in danger of failing, their stock price may fluctuate up or down. Large company stocks as a group, for example, have lost money on average about one out of every three years. If you have to sell shares on a day when the stock price is below the price you paid for the shares, you will lose money on the sale. Market fluctuations can be unnerving to some investors. A stock’s price can be affected by factors inside the company, such as a faulty product, or by events the company has no control over, such as political or market events. International College of Financial Planning – Challenge Pathway Prep Book Page 61

Stocks usually are one part of an investor’s holdings. If you are young and saving for a long-term goal such as retirement, you may want to hold more stocks than bonds. Investors nearing or in retirement may want to hold more bonds than stocks. The risks of stock holdings can be offset in part by investing in a number of different stocks. Investing in other kinds of assets that are not stocks, such as bonds, is another way to offset some of the risks of owning stocks. Common Stock Shareholders A shareholder is a person, company, or institution that owns at least one share of a company's stock . Shareholders essentially own the company, which comes with certain rights and responsibilities. This type of ownership allows them to reap the benefits of a business's success. These rewards come in the form of increased stock valuations or financial profits distributed as dividends. Conversely, when a company loses money, the share price invariably drops, which can cause shareholders to lose money or suffer declines in their portfolios. Dividends A dividend is a share of profits and retained earnings that a company pays out to its shareholders. When a company generates a profit and accumulates retained earnings, those earnings can be either International College of Financial Planning – Challenge Pathway Prep Book Page 62

reinvested in the business or paid out to shareholders as a dividend. The annual dividend per share divided by the share price is the dividend yield. A dividend’s value is determined on a per-share basis and is to be paid equally to all shareholders of the same class (common, preferred, etc.). The payment must be approved by the Board of Directors. When a dividend is declared, it will then be paid on a certain date, known as the payable date. Steps of how it works: 1. The company generates profits and retained earnings 2. The management team decides some excess profits should be paid out to shareholders (instead of being reinvested) 3. The board approves the planned dividend 4. The company announces the dividend (the value per share, the date when it will be paid, the record date, etc.) 5. The dividend is paid to shareholdersa Dividend Payout Ratio The dividend payout ratio is the amount of dividends paid to stockholders relative to the amount of the company’s net income. ������������������������������������������������ ������������������������������������ ������������������������������ Dividend Dates Dividends can provide a big part of a stock’s value and return. As such, it is important to know the four key dates related to dividend payments. International College of Financial Planning – Challenge Pathway Prep Book Page 63

Dividend Declaration Date : when the board of directors declares a dividend Dividend Distribution Date : when the dividend is paid Dividend Record Date : when the corporation closes its books and identifies shareholders of record (i.e., those who own shares of the stock and will receive the dividend) Ex-Dividend Date : a few days prior to, or after, the record date (e.g., four days before in Australia, two days in the U.S., and the day after in New Zealand). Investors who purchase shares on or after the ex- dividend date do not receive the scheduled dividend. Rights of Shareholders Stock Split When a company wants to increase its number of shareholders, but its stock price has grown too high to be appealing, its board of directors may authorize a stock split. Approval : A stock split (which must be approved by shareholders) reduces the price of each share of stock, thereby making it easier and more appealing for investors to buy shares. But because the split increases the number of shares outstanding, it does not change the total value nor does it impact the ownership interest of current shareholders. A= L+E When a company wants to increase its number of shareholders, but its stock price has grown too high to be appealing, its board of directors may authorize a stock split. A stock split (which must be approved by shareholders) reduces the price of each share of stock, thereby making it easier and more appealing for investors to buy shares. When a company wants to reduce the number of outstanding shares and/or increase its stock price. In this case, a company might do a reverse split. The primary purpose of increasing the market price per International College of Financial Planning – Challenge Pathway Prep Book Page 64

share is to raise it high enough to prevent it from being delisted on an exchange or on the over-the- counter market. After a reverse split, an existing stockholder will own fewer shares, at a greater price. Reverse splits are not all that common, and usually are associated with lower-quality companies that are in some difficulty. Dividend Discount Model Stocks are valued in many ways, using several metrics. Dividends can play an important part in the valuation of a stock, and perhaps the simplest valuation method using dividends is to calculate the Dividend Discount Model (DDM). If we assume dividends grow at the same estimated rate as earnings, we can determine the intrinsic value of the stock by: Example : Using the dividend discount model, what is the intrinsic value of a dividend paying stock where the current dividend is $1.75, it is assumed to grow at 4% annually, and the required return is 10%? V = 1.75 (1.04)/.10 - .04 = 1.82/.06 = $30.33. Page 65 International College of Financial Planning – Challenge Pathway Prep Book

Additional Valuation Ratios Example : DEF corporation shares are valued at $100 per share. Being a relatively new company, DEF does not yet pay dividends. Revenue last year was $50 million and the company has one million shares outstanding (sales per share = $50). DEF had earnings per share last year of $10. The company currently has a book value per share of $75. What valuation ratios would you use to determine the value of DEF stock, and what is the value based on your choices and does the current price represent a good value? Bonds  bullet Bonds allow the issuer to borrow money. They represent loans made to the issuer with a promise of repayment along with interest. Once the bond is issued, the issuer has a legal obligation to repay the principal, along with interest, when due.  bullet A bond’s par value (also called its face value or maturity value) is the amount of principal paid at maturity. Most bonds are issued with a minimum par value of $1,000.  Bullet The amount of interest paid annually is based on the bond’s coupon rate (sometimes called simply the “coupon”). The coupon rate is the annual interest rate paid by the bond issuer. So, a 6% coupon would pay $60 each year, normally paid semi-annually, on a $1,000 par value bond. International College of Financial Planning – Challenge Pathway Prep Book Page 66

Types of Bonds and Issuers Notes or Bills: Bonds issued for periods ranging from less than a year to 30 years or more. Treasury or Sovereign Bonds : Bonds issued by a national government (e.g., U.S. Treasuries, U.K. Gilts, German Bunds, French OATs, Japanese JGBs). As with all bonds, credit quality varies with the issuer, and interest paid varies by territory, monetary policy and economic environment. Agency: Bonds issued by agencies created by, and related to, the government. These are not technically sovereign bonds, and do not carry the same credit rating and guarantees as sovereign debt. Municipal: Bonds issued by territory, state, province, or city (municipal) governments. Asset Backed Securities: Bonds or notes backed, or secured, by financial assets. The asset is typically a nonmortgage loan (e.g., credit card, auto, home equity). The lending institution bundles the loans into a marketable security (i.e., securitization). Zero Coupon Bond: A zero-coupon bond, also known as an accrual bond, is a debt security that does not pay interest but instead trades at a deep discount, rendering a profit at maturity, when the bond is redeemed for its full face value. Floating Rate Bond: The coupon rate of a floating-rate bond can change over time hence the name “Floating-rate”. The Floating-rate equals a Reference rate plus a Spread. The size of the Spread will depend on the borrower’s credit rating. Inflation Linked Bond : An Inflation-lined bond is a special type of Floating-rate bond and it is important to understand the key differences between a Floating-rate bond and an Inflation-protected bond. -With an Inflation-linked bond, it is the par value that changes, so a constant coupon rate multiplied by a changing par value is what drives the changes in the coupon payment amounts. If inflation is going up, the bond-holder is protected from inflation, because on maturity, the par value of the bond has increased which has protected the investors purchasing power from inflation. International College of Financial Planning – Challenge Pathway Prep Book Page 67

Example : Calculate a bond’s current price/value A three-year fixed-rate bond has a par value of €1,000 and a coupon rate of 5%, with coupon payments made semi-annually. The bond will make six coupon payments of €25 (one coupon payment every six months over the life of the bond) and the final principal payment of €1,000 on the maturity date. Solution : The value of the bond is calculated by discounting the bond’s promised payments using a discount rate that is appropriate to the riskiness of the bond’s cash flows. 1) When the discount rate equals the coupon rate, then the bond price will equal the par value. When the discount rate is higher than the coupon rate, then the bond price will be below the par value. The algebra shows that we are increasing the numerator. Increasing the numerator decreases the present value or price. If interest rates have increased or if the company risk has increased and similarly risky investments are now paying 6% then why would someone buy a bond that is only paying 5%? If the price is reduced, or the bond is “discounted” then the bond’s yield to maturity will equal the market rate. International College of Financial Planning – Challenge Pathway Prep Book Page 68

Solution: Preferred Stock  Preferred stock is a class of stock that pays dividends at a specified rate.  Typically, preferred stock dividends are paid quarterly. To many people, this makes preferred stock seem more like a bond.  It is senior to common stock, meaning that it has a higher priority when it comes to paying dividends and liquidating corporate assets.  Companies may issue multiple classes of preferred stock with various stated rates of return.  Preferred stock is unlike common stock in that it usually does not come with voting rights, and people generally are not investing for growth. Preferred Stock- The zero-growth model. The formula for this is Where: Page 69 V = the preferred stock value D = the annual dividend r = the required rate of return International College of Financial Planning – Challenge Pathway Prep Book

Example: Maria wants to know the value of her preferred stock. It has an annual dividend of $5 per share and her required rate of return is 10%. Using the zero-growth model, what is the current value of her stock? The current value is $100 (V = $5/.05) Advantages and Disadvantages of Real Estate Advantages  Real estate has a low correlation to equity and bond markets, and provides diversification when added to an investment portfolio.  Real estate can also serve as a hedge against inflation. As prices and the cost of living increase with inflation, typically so do real estate values (capital appreciation), as well as the amount of rent that is charged in investment properties (income).  Rental properties can provide a consistent cash flow.  Depending on the territory in which real estate is owned, there may be tax advantages and deductions associated with owning real estate.  Individuals who purchase real estate may do so with a mortgage loan rather than paying for a property in full. While borrowing can also be used to finance the purchase of other kinds of assets, greater levels of borrowing are typically available against real estate assets. This provides leverage to investors, as they only have to put up a fraction of the purchase price, but still enjoy ownership and appreciation of the whole property. International College of Financial Planning – Challenge Pathway Prep Book Page 70

 Investors have some control over the measures taken to improve properties and, thus, increase values. Disadvantages  Where directly owned, real estate is much less liquid than financial assets like stocks or bonds.  Investment properties must be managed and maintained.  The initial investment in real estate is significantly higher than most financial assets.  The acquisition and sale costs of real estate are also significantly higher than financial assets.  Once a piece of real estate is developed for a certain purpose, it is rare that it can be used for another purpose.  Changes in the overall economy and/or interest rates are not predictable, and have a direct and sometimes significant impact on the value of real estate.  Where a property investment has used debt to provide some or all of the purchase price (i.e., is geared or leveraged), the risks are magnified. International College of Financial Planning – Challenge Pathway Prep Book Page 71

Derivatives: Futures and Forward Contracts  A futures contract gives you the obligation to buy a certain commodity, a foreign currency, or a financial instrument at a certain price on an agreed later date.  Futures contracts specify the quality and quantity of the underlying asset, and are standardized to facilitate trading on a futures exchange, such as the Chicago Mercantile Exchange.  Some futures contracts may call for physical delivery of the asset, while others are settled in cash.  “Hedgers” are those individuals who either produce or consume commodities, and are seeking to lock in a future purchase or sales price.  For example, a wheat farmer may be several months away from harvesting his crop, and is concerned about a decline in the price of wheat between now and then.  To hedge against a decrease in the price of wheat over the coming months, the farmer could enter into a short futures contract.  The contract would obligate them to sell the wheat at a set price at a predetermined date in the future.  The counterparty to the contract (the buyer) is obligated to purchase (and take possession of) the wheat at that price and on that date.  If the price of wheat does decline, the farmer will have locked in the higher sales price.  The trade-off for this price protection is that the farmer has set a ceiling for the future sales price.  If wheat is trading at a price higher than in the contract at the delivery date, the farmer will forgo the additional increase in price. Options An option is a contract between a buyer and a seller (also known as a writer). Rather than own the actual stock (or other security), the buyer uses an option to buy or sell an underlying investment at a given price for a specified period. International College of Financial Planning – Challenge Pathway Prep Book Page 72

Buying options is less risky than selling or writing options. Option writers have the obligation to fulfil the terms of the contract they’ve sold. Buying a call option gives the buyer the right to purchase X shares of the underlying stock at the stated strike price, until the option expires. The seller (writer) must deliver the X shares upon receiving notice that the buyer is exercising the option. (Notice the significant difference—the buyer may exercise the option, but the seller must deliver if the option is exercised.) People buy calls if they think the underlying security will rise in price. Buying a put option gives the buyer the right to sell X shares of underlying stock at a strike price, until expiration. As with a call, a put writer has the obligation to buy the shares if the holder exercises the option. People buy puts if they think the underlying security will drop in price. Investors who want to short sell (or short) a stock borrow the stock and then sell it. If the market rises rather than falls, shorting results in a loss—sometimes substantial. Covered Calls  Bull Strategy / Covered Call / Buy Write  Example: Buy stock; sell calls on a share for share basis  Market Outlook: Neutral to slightly bullish  Risk is from a fall in stock price and giving up potential upside  Break Even Price = Starting Stock Price minus Premium Received  Selling a call is an obligation to sell at the strike price  Assumes – you own equities and want to own equities  Note – Options Premiums are taxed as Capital Gains. Structured Products/Market-Linked Securities In general terms, structured products are investment vehicles whose value is derived from, or based on, a reference asset, market measure or investment strategy. Reference assets and market measures may include single equity or debt securities, indexes, commodities, interest rates and/or foreign currencies, as well as baskets of these reference assets or market measures. International College of Financial Planning – Challenge Pathway Prep Book Page 73

Market-Linked Notes Market-linked notes offer a return of principal if held to maturity, subject to the issuer’s ability to repay. In other words, the promise to return principal at maturity is only as good as the financial strength of the company that makes the promise. In the event the issuer goes bankrupt, investors who hold these notes are generally considered unsecured creditors and might recover little, if anything, of their original investment. Alternate Investments Alternative investments are those assets and asset classes that fall outside of the scope of traditional stocks, bonds, and cash. Some territories also include real estate in their definition of alternative investments, although others do not. Private Equity -Many individuals use the terms “venture capital” and “private equity” interchangeably, which is incorrect. -Venture capital is a type of private equity transaction that targets new, smaller start-up companies. International College of Financial Planning – Challenge Pathway Prep Book Page 74

-When people say “private equity,” they are usually referring to the other primary type of private equity transaction, which is called a private equity buyout. -Private equity buyouts typically involve larger, more established companies that are not performing well for a variety of reasons. -The primary objective of many private equity buyouts is to acquire a struggling company, get it back on its feet and performing well, and then sell the company. Venture Capital -Typically used by start-up companies that do not have the capacity to raise capital through a public stock offering, venture capital involves the exchange of a percentage ownership in the new company in exchange for the start-up capital from a venture capital firm. -Companies receiving venture capital money tend to be innovative in nature, and are expected to produce new breakthrough products or services, and as a result experience very rapid growth. Hedge Funds -Hedge funds are a form of pooled investment structure, but are subject to much less regulation and oversight, and can employ many different strategies. -Unlike traditional pooled funds like mutual funds or exchange-traded funds that only take a buy-and- hold approach, hedge funds can establish long and short positions within their holdings, as well as employing the use of options, margin, or other derivative securities. -Many diverse hedge fund strategies: Page 75 -Long-short equity -Event driven -Relative value International College of Financial Planning – Challenge Pathway Prep Book

-Global Macro -Managed futures Pooled Investment Products Mutual Funds -Mutual funds are one of the most popular global investment vehicles. -The technical term for a mutual fund is an open-end investment company. They are so named because new shares are constantly being created (and existing shares redeemed) as investors purchase into, and sell out of, the fund. -Otherwise known as a collective investment scheme, a mutual fund is a form of security through which investors’ funds are pooled together and a professional investment adviser is hired to invest that money into several different securities to achieve one or more investment objectives. While mutual funds have several different investment objectives, they can generally be said to fall into one of three categories: 1. Capital Appreciation/Growth: Seeking an increase in the value of the investment. 2. Income: Seeking regular, ongoing income from the investment. 3. Capital Preservation: Seeking maintenance of the investment’s value regardless of market conditions. Advantages of Mutual Funds Professional Management: Many individuals do not have the time, ability, or interest to research, purchase, and manage a portfolio of various securities. International College of Financial Planning – Challenge Pathway Prep Book Page 76

Diversification: The number of different securities or issues that a given mutual fund holds will vary based on factors like the size of the fund, the investment objective, etc. By purchasing shares of the mutual fund, an investor receives instant diversification across all the fund’s holdings. Low Minimum Investment: By pooling money from a large group of investors, mutual funds enjoy economies of scale and can provide much lower initial investment entry points. Disadvantages of Mutual Funds Tax Inefficiency: The mutual fund owns the individual investments in its portfolio, while the individual investor owns shares in the mutual fund. Due to this structure, mutual funds are not tax efficient (in some territories). Mutual funds pass all gains, losses and—usually—taxes through to shareholders, who have no control over the timing of purchases and sales of holdings within the fund. Herd Effect: Another disadvantage to the ownership structure in mutual funds is that it subjects individual investors to the herd effect. Pricing: Unlike stock prices that change with every trade and fluctuate throughout the day, mutual funds are priced only after the market is closed, and the closing price of each holding has been determined and aggregated. The effect is that shareholders do not know what price they are paying to buy shares, or what price they will receive when selling shares, until after that day’s market is closed. Costs: Investors incur various costs when purchasing and owning a fund. These costs can be divided into two categories: (1) transaction costs, which are the costs incurred in buying or redeeming shares of the fund, which can include commissions paid to advisors (depending on applicable laws); and (2) operating expenses, which are the shareholder’s portion of the costs of operating the fund throughout the year. Mutual Funds--Open-End Funds -Shares issued and redeemed as necessary. International College of Financial Planning – Challenge Pathway Prep Book Page 77

-May be load or no-load. -No load: no deposit or redemption fees. -Sales load: may have to pay sales load at the time of purchase, at the time of redemption, or over time. -Price equals net asset value (NAV) at close of trading. -NAV = Total net value of fund / Number of shares outstanding. Closed-End Funds A closed-end investment company, more commonly known as a closed-end fund, and known in some territories as a listed investment company (LIC), issues a fixed number of shares (hence the term closed-end) that can be bought and sold on a stock exchange or in an over-the-counter market. Because they are traded like shares of stock, a commission is charged when shares are bought or sold, and, depending on the supply and demand for the shares, the price paid per share can be more or less than the net asset value per share. Closed-End Funds-The major types of closed-end funds include the following: Stock Funds -General equity funds, containing a broad portfolio of stocks -Specialty equity funds, concentrating in one sector or theme -International equity funds, which invest primarily in a single country (like Germany, Spain, Japan, or Australia) or a region (like Europe, Asia, or the Middle East) International College of Financial Planning – Challenge Pathway Prep Book Page 78

Bond Funds -Domestic taxable funds, containing a variety of corporate bonds -Sovereign debt (government) funds -Local government (municipal) debt funds -International bond funds, which invest in bonds from various foreign countries Advantages of Close Ended Funds  They provide diversification and professional management.  Because they are traded like stocks, closed-end funds have an additional source of profit if the market price of the shares increases relative to the net asset value per share at time of the initial purchase.  Closed-end funds are easier to manage than open-end funds, thanks to one important aspect: They are not subject to ongoing cash inflows and outflows. If investors want their money, they sell their closed-end fund shares in the market rather than redeeming the shares, as is the case with open-end (mutual) funds. Disadvantages of Close Ended Funds  One disadvantage is the cost of trading. Depending on the brokerage firm and type of account, trading commissions, related fees, and account-related minimums can all impact closed-end fund holdings.  If the basket of securities does not perform well, the only option is to sell the shares and select a different fund. With a mutual fund—especially one that is experiencing steady inflows of new funds—the fund managers can use these to vary their holdings within the fund. International College of Financial Planning – Challenge Pathway Prep Book Page 79

Exchange Traded Funds (ETFs) -Exchange-traded funds are similar to index mutual funds, but trade like stocks throughout the course of a trading day. Like mutual funds, many ETFs are registered as open-end investment companies, but are structured differently than mutual funds. -Each ETF is designed to track an index and replicate its returns. -ETFs are broadly diversified and highly transparent, with very low management and trading costs. -Funds may invest in every security in the index, a strategy known as full replication. -Funds may invest in only a representative sample of the index securities, a strategy called sampling replication. Advantages of Exchange Traded Funds (ETFs) Cost Efficiency Passively managed index mutual funds normally have lower expenses than their actively managed counterparts. ETFs have significantly lower expenses than even passive mutual funds that track the same indexes. Tax Efficiency ETF owners control the timing of their purchases and sales. Availability of Option Contracts Several ETFs have call and put options available on them. This gives the investor the ability to employ strategies not available with mutual funds, such as writing covered calls for income and using protective puts to hedge positions. International College of Financial Planning – Challenge Pathway Prep Book Page 80

Disadvantages of Exchange Traded Funds (ETFs) NAV and Tracking Error ETFs are designed to track the performance of various market indexes, but they do not always trade exactly at their net asset value, leading to performance that differs from the index. The primary cause of tracking error in an ETF relates to how it is constructed. A security market index is a group of securities representing a given security market, market segment, or asset class. The following are some well-known indices, by country: -United States: S&P 500 Index -United Kingdom: FTSE 100 (practitioners commonly pronounce FTSE as “footsie”) -France: CAC 40 -South Korea: Korea Stock Price Index (KOSPI)Ø International College of Financial Planning – Challenge Pathway Prep Book Page 81

Exchange-Traded Notes (ETNs)  Exchange-traded notes (ETNs) are senior unsecured debt securities that, similar to ETFs, track the performance of various market indexes and trade like a stock.  ETNs are usually issued by large banking institutions and do not actually own any underlying securities. As debt issues, ETNs do not possess any voting rights, nor do they pay a fixed rate of interest.  ETNs are most commonly used to track commodity and currency exchange markets, where mutual funds and ETFs aren’t typically available. Advantages of ETNs  Benchmarking: ETNs track, exactly, the performance of their underlying market  Liquidity: ETNs are open-ended securities, and therefore are not limited to on-exchange volumes  Accessibility: ETNs are traded and settled on a stock exchange, the same as any equity, and can be purchased and held in ordinary brokerage or custodial accounts  Ease of Ownership: ETNs do not involve any of the difficulties with buying and then managing a futures position (e.g., worrying about margin calls, contracts expiring and rolling positions) or in buying and storing physical assets.  Transparency: ETN pricing is based on a transparent formula with the pricing updated daily by the issuer. ETNs are priced using published settlement prices  Flexibility: Investors can long or short ETNs Disadvantages of ETNs  ETNs are not rated, but are tied instead to the creditworthiness of the issuer. Thus, the issuer’s credit rating is an important consideration for ETN investors.  Typically, ETNs have a repurchase feature, providing qualified investors, known as authorized participants, the election to redeem notes of at least a specified minimum denomination or value with the issuer on a daily or weekly basis at a predetermined price. International College of Financial Planning – Challenge Pathway Prep Book Page 82

 Individual investors not qualified for redemption election can purchase or sell their ETNs in the secondary market, sell at a specified issuer call event, or allow them to mature. Unit Investment Trusts (UITs)  Like mutual funds and closed-end funds, unit investment trusts (UITs) are registered investment companies that pool investor money, but unlike the other two funds, UIT holdings do not change.  Like mutual funds and closed-end funds, unit investment trusts (UITs) are registered investment companies that pool investor money, but unlike the other two funds, UIT holdings do not change.  Like mutual funds, UITs are priced daily, after markets close. Advantages of UITs  A UIT typically issues redeemable securities (or “units”), like a mutual fund, which means that the UIT will buy back an investor’s “units,” at the investor’s request, at their approximate net asset value (NAV). Some ETFs are structured as UITs.  Two of the appealing aspects to UITs are a fixed portfolio that may be subject to tax on income distributions but not subject to capital gains until the termination of the trust, and a known portfolio of holdings (depending on the territory). Disadvantages of UITs  A UIT does not actively trade its investment portfolio; a UIT buys a relatively fixed portfolio of securities (e.g., five, 10, or 20 specific stocks or bonds), and holds them with little or no change for the life of the UIT.  A UIT will have a termination date (a date when the UIT will terminate and dissolve) that is established when the UIT is created (although some may terminate more than fifty years after they are created). International College of Financial Planning – Challenge Pathway Prep Book Page 83

 In the case of a UIT investing in bonds, for example, the termination date may be determined by the maturity date of the bond investments. When a UIT terminates, any remaining investment portfolio securities are sold and the proceeds are paid to the investors. Managed Accounts Another approach to investing that has traditionally only been available to high net worth clients are managed accounts. Sometimes referred to as separately managed accounts (SMAs) or privately managed accounts (PMAs), these are individual (or joint) accounts that are managed by a professional investment manager (typically on a feebased platform), directly for the account owner. Unlike a mutual fund where the fund owns the securities in the portfolio and individuals then own shares of the mutual fund, investors in managed accounts own the individual securities directly. Advantages of Managed Accounts  Advantages of Managed Accounts Tax efficiency/Tax loss harvesting: Because each security is owned individually, the owner (and manager) controls what securities are sold, and when. This allows for much more strategic tax and investment planning, as shares with a loss can be sold before those with a gain, which helps minimize the impact of capital gains.  Customized portfolios: Investors can specify individual securities or types of asset classes they do or do not want in their portfolios. Disadvantages of Managed Accounts  Generally, investors must have at least $100,000 or Rs 25lakhs to invest to participate in a separately managed account. Considerations in Investment Product Analysis/Selection Fund Comparison Before comparing multiple funds, it is important that a like-for-like basis is found for the comparison, meaning the funds being compared should be of a similar type/have similar investment objectives. International College of Financial Planning – Challenge Pathway Prep Book Page 84

Manager Discretion While investment objectives guide which securities are included in a fund’s portfolio, managers may have some flexibility in what they invest in. It is important to know just how much flexibility a manager is allowed, as they may be permitted to purchase assets that may not match the stated investment objective, a client’s objectives, or the purpose for investing in the fund in the first place. Total Costs In addition to a fund’s expense ratio, there are several other costs that can add as much or more, including: -Brokerage commissions -Bid-ask spread -Taxes (as applicable) Fund Size: As with the style of management (active/passive), there is some debate as to whether the total assets of a fund can make it too big or too small. Turnover -The frequency that holdings are bought and sold impacts both the cost of a fund (transaction costs) and its tax efficiency (or inefficiency). -The more frequent the portfolio is turned over (all holdings sold, and new holdings purchased) the greater the chance for short-term capital gains (or losses) to be generated. -High turnover can also be an indicator of more active or short-term trading by a manager, which should be a red flag warranting further research. International College of Financial Planning – Challenge Pathway Prep Book Page 85

Principles of Investment Risk Total Risk There are two broad categories of investment-related risk: Systematic and Non-systematic. Systematic risk Systematic risk is also sometimes called market risk, and it refers to factors that affect the overall economy or securities markets. Non systematic risk Non systematic risk (or specific risk) is associated with a specific company, industry or investment product (FINRA, 2013 Exogenous: opposite of endogenous risk is exogenous risk International College of Financial Planning – Challenge Pathway Prep Book Page 86

Standard Deviation Standard deviation (σ) is a measure of the degree to which an individual value in a probability distribution tends to vary from the distribution’s mean. More specifically for investments, it is the degree to which an investment’s return is expected to vary from its mean return. Standard deviation is a frequently used measure of an investment’s risk, and is calculated by taking the square root of the variance. Steps to Calculate Standard Deviation of a Portfolio Page 87 Calculate the average return Subtract the average return from each period return Add the sum of the squares Divide by the number of periods minus one (sample); this gives us the variance Take the square root of the variance and you have the standard deviation International College of Financial Planning – Challenge Pathway Prep Book

Standard Deviation of Two Asset Portfolio Example : International College of Financial Planning – Challenge Pathway Prep Book Page 88

In a normal distribution, 68% of the time the return will fall within one standard deviation, and within two standard deviations 95% of the time. So, an investment with a mean return of 10% and a standard deviation of 5% would likely have a range of returns between 5% and 15% (one standard deviation) and 0 and 20% (two standard deviations). Covariance -Covariance identifies the likelihood of two variables—investment returns, in our context—moving together (in the same direction at the same time), over time. -If we think about how diversification can reduce overall portfolio risk, covariance is the primary measurement of which assets when combined should give the best risk-reduction results, without necessarily having a negative impact on performance. -Positive covariance means the assets being evaluated have moved “in sync.” -Negative covariance shows that the assets have tended to move in opposite directions. Generally, the higher the number, the more the assets move either together (positive number) or apart (negative number). International College of Financial Planning – Challenge Pathway Prep Book Page 89

Correlation Coefficient -For portfolio construction, it is important to know covariance as well as the degree of correlation. Like the idea that standard deviation is a more useful number than variance, correlation is a bit easier to internalize than covariance. -Covariance can give us a number like 3.6. We know that there is a positive relationship, but we don’t know how strong it is. The correlation coefficient between two variables identifies their degree of correlation (i.e., relationship), using a scale of +1 (perfectly positive) and -1 (perfectly negative). With correlation falling between –1 to +1 we understand the strength of the relationship much quicker. Coefficient of Determination (R2) -Earlier, we identified two major divisions of risk: systematic (market-related) and non-systematic (non- market-related). Systematic risk is undiversifiable, while non-systematic risk can be mitigated through diversification. International College of Financial Planning – Challenge Pathway Prep Book Page 90

-It is valuable to be able to determine how much of a portfolio’s (or asset’s) risk is diversifiable and how much is undiversifiable -To put it another way, how can an advisor determine the amount of a portfolio’s price movement that is attributable to the market (i.e., an appropriate benchmark)? -The calculation to measure this is called the coefficient of determination, R2, or R-squared. As the name implies, something is squared. That “something” is the correlation coefficient. As an example, let’s say the correlation coefficient between Portfolio A and the FTSE 100 is 0.30. Squaring the correlation coefficient, the result is 0.090. -This means that 9.00% of Portfolio A’s price movement is directly associated to the movement of the FTSE 100 (i.e., systematic risk). -The remainder can be attributed to other factors (i.e., non-systematic risk). -As is the case with calculating a correlation coefficient against a market benchmark, you must use the proper market index/benchmark when calculating R-squared. Beta -However, when the correlation is not perfect, we could expect the asset to have more or less movement than the benchmark as it moves. -As an example, a beta of 1.50 means the asset will be 50% more volatile than the market, while a beta of 0.70 means the asset will be just 70% as volatile as the market. -When the market moves up 10%, a beta of 1.5 will cause the asset to rise 15% (0.10 x 1.50), and when it moves down 10%, a beta of 0.70 will cause the asset to fall 7.0% (0.10 x 0.70). -As a rule, clients who identify themselves as being conservative will want to focus on assets that have a beta below 1.0, or at least very close to 1.0 on the upside. International College of Financial Planning – Challenge Pathway Prep Book Page 91

International College of Financial Planning – Challenge Pathway Prep Book Page 92

Investment Performance Management Weighted Average Return A weighted average return is the average of the returns of each holding in the portfolio, adjusted by the percentage weighting of each holding in the portfolio. The weights are proportional to the value of each holding within the portfolio, to take into account what portion of the portfolio each individual return represents in calculating the contribution of that holding to the return on the portfolio. Weighted Average Return The geometric, or time-weighted, return is most appropriately used for evaluating the performance of investment managers. An investor’s transactions in a portfolio and the portfolio’s returns over a four- year period are below: An investor’s transactions in a portfolio and the portfolio’s returns over a four-year period are below: International College of Financial Planning – Challenge Pathway Prep Book Page 93

Time Weighted Return International College of Financial Planning – Challenge Pathway Prep Book Page 94

Dollar-Weighted Return -This return is also known as a money-weighted return or internal rate of return (IRR). -Unlike the time-weighted approach to measuring investment returns, the money-weighted return also allows for the size and timing of cash flows into and out of an investment. -This makes dollar-weighted returns or internal rate of return (IRR) the most appropriate measure of return to use with individual portfolios. Sharpe Ratio Three of the most widely used performance measures are the 1. Sharpe ratio, 2. Treynor ratio and 3. Jensen index (often referred to as “Alpha”). -The Sharpe and Treynor ratios are used to compare the risk-adjusted return of an investment to the risk-adjusted return of a similar investment or market index. International College of Financial Planning – Challenge Pathway Prep Book Page 95

-The formulas for calculating Sharpe and Treynor differ only in the type of risk represented in each. -Both are relative measures of performance, meaning the information produced by either formula is useful only in comparison to another investment or index. -The Jensen index, or Alpha, is used to compare actual returns to expected returns. The formula for Sharpe ratio is: Examples : If an investment’s return is 10% with a standard deviation of 11, with an available risk-free rate of 3%, the Sharpe Index (ratio) is .6364. When comparing investments based on this ratio, the higher the number the better the return/risk relationship for the investor. Comparing 2 Funds : All other factors being equal, Fund 1 would be the better choice based on the Sharpe ratio, because it produced more return per unit of risk that was taken. When comparing investments based on this ratio, the higher the number the better the return/risk relationship for the investor International College of Financial Planning – Challenge Pathway Prep Book Page 96