Investment Foundations cheat sheet

The investment industry's core function is intermediation: pooling savings from surplus units and allocating them to deficit units (issuers) through primary markets, while secondary trading provides liquidity and price discovery.

Buy-side firms (asset managers, pension funds, insurers, hedge funds, sovereign wealth funds) manage money and demand securities; sell-side firms (broker-dealers, investment banks) create, underwrite, trade, and research them.

Asset management revenue is typically a percentage of assets under management (AUM); a 50 bp fee on $2bn AUM yields $10m of annual management fee revenue before performance fees.

Open-end funds issue and redeem at net asset value (NAV) and must hold liquid assets; closed-end funds and ETFs trade on exchange, so their price can diverge from NAV at a premium or discount.

Custodians safekeep assets and settle trades; transfer agents maintain shareholder records; depositories (e.g., CSDs) hold securities in book-entry form; prime brokers lend cash and securities to hedge funds.

Regulation separates advice from sales: suitability or best-interest standards, fiduciary duty, and disclosure regimes differ by jurisdiction and by whether the client is retail, professional, or institutional.

Conflicts of interest are structural, not incidental: soft-dollar research, underwriter research, performance-fee asymmetry, and principal trading all create incentives that disclosure and inducement rules target.

Industry consolidation is driven by economies of scale in technology, compliance, and distribution; fee compression in passive products pushes active managers toward differentiated strategies and alternative assets.

Career and firm roles map to the value chain: research and portfolio management (investment), trading and execution, risk and compliance, operations and technology, distribution and client service.

Primary markets raise new capital via IPOs, follow-on equity offerings, and bond issuance; secondary markets transfer existing securities between investors and do not raise capital for the issuer.

Order types: market orders prioritize execution certainty, limit orders prioritize price certainty; a stop order becomes a market order once the stop price trades, so slippage is possible.

Bid-ask spread is the immediate cost of a round trip; quoted spread plus market impact plus commissions and taxes form total transaction cost, which erodes returns over time.

Market structures differ: quote-driven (dealer) markets rely on committed market makers, order-driven markets match a central limit order book, and hybrid markets combine both with designated liquidity providers.

Exchanges are centralized, regulated, and transparent; OTC markets are bilateral and decentralized, dominant in bonds, FX, and swaps, with trade reporting rather than a central tape.

Short selling borrows securities to sell, betting on a price decline; it is constrained by locate and borrow availability, margin requirements, and in some jurisdictions uptick or ban rules.

Margin trading uses borrowed funds with initial and maintenance margin requirements; a margin call occurs when equity falls below maintenance margin, forcing deposit or liquidation.

Market efficiency in the semi-strong sense means public information is already in prices; anomalies such as momentum and post-earnings drift are cited as evidence against strict efficiency.

Indices are weighted by market capitalization, price, equal weight, or fundamentals; weighting choice determines sector concentration and the return an index-tracking product delivers.

Money market instruments (T-bills, commercial paper, CDs, repos) have maturities of one year or less, low credit risk, and prices quoted on a discount-yield basis.

Bond price and yield move inversely; for a given yield change, longer maturity and lower coupon mean higher duration and larger price sensitivity, approximated by modified duration times yield change.

Equity holders are residual claimants: they receive dividends only after debt service and rank last in liquidation, but they capture unlimited upside and typically hold voting rights.

Preferred stock sits between debt and common equity: fixed or floating dividends, priority over common in liquidation, often callable, and frequently without voting rights.

Derivatives (forwards, futures, options, swaps) derive value from an underlying; futures are standardized and cleared, forwards are bespoke and carry counterparty risk, options convey a right not an obligation.

Collective investment vehicles include open-end mutual funds, ETFs, closed-end funds, unit trusts, and hedge funds; differences center on liquidity, pricing, leverage limits, and fee structure.

Real assets (real estate, infrastructure, commodities) offer inflation sensitivity and diversification; direct property is illiquid with high transaction costs, while REITs provide listed, liquid exposure.

Alternative investments (private equity, private credit, hedge funds) typically use lockups, capital calls, and performance fees, and report smoothed valuations that can understate true volatility.

Suitability of an instrument depends on time horizon, liquidity needs, tax status, currency exposure, and the investor's capacity and willingness to bear loss, not on past return alone.

Total return = (ending value - beginning value + income) / beginning value; annualizing a multi-year holding-period return uses the geometric mean, (1 + HPR)^(1/n) - 1.

Arithmetic mean overstates long-run compounded growth; the geometric mean is the correct measure of realized compound return, and the gap widens with volatility.

Standard deviation measures total risk (systematic plus unsystematic); beta measures sensitivity to the market, and CAPM states required return = risk-free rate + beta x (market return - risk-free rate).

Sharpe ratio = (portfolio return - risk-free rate) / standard deviation; it penalizes all volatility, so it is inappropriate for portfolios with illiquid or smoothed valuations.

Correlation ranges from -1 to +1; portfolio risk falls with lower correlation, and diversification benefit depends on correlation, not on the number of holdings alone.

Time value of money: PV = FV / (1 + r)^n; the net present value of an investment is the sum of discounted cash flows minus initial outlay, and IRR is the discount rate that sets NPV to zero.

The yield curve plots yield against maturity; an inverted curve has short rates above long rates, and duration plus convexity together approximate bond price change for larger yield moves.

Real return approximates nominal return minus inflation (Fisher: (1 + nominal) = (1 + real)(1 + inflation)); compounding at high inflation makes the approximation materially wrong.

Risk tolerance is a blend of ability (horizon, wealth, income stability) and willingness (attitude, past behavior); where the two conflict, ability constrains the plan.

The investment policy statement (IPS) records objectives, return requirement, risk tolerance, constraints (liquidity, time horizon, tax, legal, unique), and review procedures; it anchors every later decision.

Risk must be assessed twice: ability to take risk (objective capacity) and willingness (subjective attitude); when they conflict, the lower of the two sets the portfolio's risk level and the conflict is documented.

Know-your-client data includes financial situation, investment experience, time horizon, liquidity needs, tax position, and any ethical or religious restrictions on holdings.

Asset allocation explains most of the variability of portfolio returns over time; strategic allocation sets long-term weights and tactical allocation makes temporary deviations within policy limits.

Rebalancing to target weights enforces a sell-high/buy-low discipline; calendar (time-based) and threshold (band) rules are the two common triggers, and bands widen as transaction costs rise.

Fees compound against the client: a 1% annual fee reduces a 6% gross return to about 5% net, and over 20 years the cumulative shortfall materially exceeds the annual figure suggests.

Suitability versus fiduciary standard: a fiduciary must place the client's interest first and manage conflicts, while a suitability standard requires only that a recommendation be appropriate.

Behavioral biases affect clients and advisers: loss aversion, recency, anchoring, overconfidence, and herd behavior; written policy and pre-commitment rules are the standard countermeasures.

Performance reporting must use time-weighted returns for manager skill (removes cash-flow effects) and money-weighted returns (IRR) for the client's actual experience of their money.

A pension fund with $500m AUM paying a 40 bp fee generates $2m in annual fees; institutional mandates typically price below retail share classes for the same strategy.

Front office (research, portfolio management, sales and trading), middle office (risk, compliance, valuation), and back office (settlement, custody, accounting) define operational boundaries and control ownership.

A fund's NAV per share = (total assets - total liabilities) / shares outstanding; it is struck at a defined valuation point, so dealing prices depend on when an order is received.

Investment banks intermediate capital raising (underwriting, syndication) and advisory (M&A); underwriting risk is the exposure of the bank if it cannot place the issue at the agreed price.

Index providers license benchmarks; the provider's methodology (eligibility, weighting, rebalancing) determines what an index fund must hold and therefore the fund's tracking error.

Outsourcing and delegation are common (sub-advisers, administrators), but the delegating manager retains accountability to clients and regulators for the delegated activity.

Fee models vary: AUM-based, performance-based (often with high-water marks), subscription and redemption fees, and transaction-based commissions; each creates different incentive alignment.

Market conduct rules typically prohibit insider dealing, market manipulation, and misleading marketing, and require best execution and client-order priority in handling.

A limit buy order above the current price is marketable and executes immediately; a limit order away from the market rests in the book and adds liquidity rather than taking it.

Price improvement occurs when an order executes better than the best quoted price; best execution assesses price, cost, speed, and likelihood of execution together, not price alone.

Short selling profit = sale proceeds - repurchase cost - borrowing fees - dividends owed to the lender; a short position has theoretically unlimited loss.

Circuit breakers and trading halts pause trading after large moves; they aim to restore order flow but create gap risk for stop orders placed near the trigger.

Settlement cycles (T+1 or T+2) determine when cash and securities exchange; failure to settle creates counterparty and operational risk even when the trade price was agreed.

Bid-ask spread widens with volatility, lower trading volume, and wider credit or information asymmetry; it narrows when competing market makers quote the same instrument.

A market index's return differs from an investor's return because of fees, tracking error, timing of cash flows, and taxes; index level alone is not an achievable return.

Dark pools and internalizers execute off the lit order book, reducing pre-trade transparency; trade reporting requirements partially restore post-trade transparency.

Foreign exchange is the largest OTC market by turnover, trades nearly continuously across time zones, and is quoted in currency pairs with a base and a quote currency.

Bond price = sum of coupon / (1 + y)^t plus face / (1 + y)^n; a bond trades at a premium when coupon exceeds yield and at a discount when yield exceeds coupon.

Credit spread is the yield difference over a comparable government bond; it compensates for default risk, recovery uncertainty, and liquidity, and widens in risk-off markets.

Callable bonds cap upside for the holder (issuer refinances when rates fall); putable bonds give the holder the right to sell back, supporting price when rates rise.

Common equity valuation approaches: discounted cash flow, relative multiples (P/E, EV/EBITDA), and asset-based; each relies on assumptions that must be stated and tested.

An option's premium has intrinsic value (in-the-money amount) plus time value; time value decays toward zero at expiry, and implied volatility drives the premium level.

A swap exchanges cash flows: in a plain vanilla interest rate swap, one party pays fixed and receives floating on a notional principal that is not exchanged.

ETFs trade intraday at market prices and may trade at a premium or discount to NAV; creation and redemption by authorized participants arbitrages large deviations.

Bond funds differ from individual bonds: a fund has no maturity date and no guaranteed return of principal, though it offers diversification and daily liquidity.

Structured products combine a bond with a derivative payoff; capital protection depends on the issuer's creditworthiness, not on the underlying alone.

Holding-period return for a single period with income: HPR = (P1 - P0 + D1) / P0; for multiple periods, chain the periodic returns: (1 + r1)(1 + r2)... - 1.

Portfolio expected return is the weighted average of asset expected returns; portfolio variance is w1^2 s1^2 + w2^2 s2^2 + 2 w1 w2 s1 s2 rho, so risk is not a weighted average of risks.

Realized volatility is often annualized by multiplying periodic standard deviation by the square root of periods per year (e.g., 12 for monthly, 252 for daily).

Modified duration = Macaulay duration / (1 + y/m); approximate price change = -modified duration x yield change, with convexity adding a positive correction for large moves.

Nominal (coupon) yield ignores reinvestment; yield to maturity assumes coupons reinvested at the YTM; yield to call uses the call date and call price; current yield = coupon / price.

Alpha is return not explained by benchmark exposure; a positive alpha with high tracking error may reflect luck rather than skill, so significance and consistency matter.

Required return inputs: risk-free rate (government curve), equity risk premium, beta, size and value premia, and a country risk premium for emerging exposures.

Fundamental analysis builds from revenue drivers, margins, reinvestment, and cost of capital; a DCF value is only as reliable as its terminal-growth and discount-rate assumptions.

Scenario and stress testing revalue a portfolio under defined shocks (rate +200 bp, equity -30%); they test resilience and liquidity, not probability of the scenario.

Return requirement should be stated in real terms when the goal is purchasing power; a 5% nominal return with 3% inflation delivers about 2% real growth before fees and taxes.

Liquidity constraint covers expected withdrawals (pension payments, tuition) and an emergency reserve; assets needed within a year belong in low-volatility, liquid holdings.

Tax constraints shape location decisions: hold income-producing assets in tax-deferred accounts and low-turnover growth assets in taxable accounts where tax rates differ.

Rebalancing example: a 60/40 target drifts to 70/30 after an equity rally; selling equity to restore 60/40 realizes the gain and returns the portfolio to its stated risk level.

Client communication should separate outcome from process: report performance against the benchmark and the IPS objectives, and explain deviations in terms of the agreed policy.

Risk-profiling questionnaires can be gamed by clients seeking higher expected returns; corroborate stated willingness with actual past behavior and capacity data.

A wrap or fee-based account charges one asset-based fee covering advice and dealing; a commission account charges per transaction, which can incentivize trading.

An adviser must document the basis for a recommendation, disclose conflicts and remuneration, and keep records sufficient for later review by the client, firm, and regulator.

Changing client circumstances (job loss, inheritance, retirement, divorce) trigger an IPS review; the policy is a living document, not a one-time form.