Investment Foundations flashcards

32 cards. Read the term and the definition here. The deck at the top of this page is optional.

Buy-side versus sell-side

Buy-side firms (asset managers, pension funds, insurers) manage and demand securities; sell-side firms (broker-dealers, investment banks) underwrite, trade, research, and distribute them. The two sides are counterparties in the market.

Net asset value per share

Total fund assets minus liabilities, divided by shares outstanding. Open-end funds deal at this price at a set valuation point; listed funds may trade away from it.

Primary versus secondary market

The primary market raises new capital for issuers through IPOs and bond issues. The secondary market transfers existing securities between investors, providing liquidity and price discovery without funding the issuer.

Custodian and depository roles

A custodian safekeeps client assets and settles trades on the client's behalf. A central securities depository holds securities in book-entry form, enabling transfer without physical certificates.

Fiduciary versus suitability standard

A fiduciary must put the client's interest first and manage conflicts. A suitability standard requires only that a recommendation be appropriate for the client's profile. The duties differ materially.

Economies of scale in asset management

Fixed costs of technology, compliance, and distribution are spread over a larger asset base, lowering unit cost. This drives consolidation and fee compression, especially in passive strategies.

Market versus limit order

A market order executes immediately at the best available price, prioritizing certainty. A limit order sets a maximum buy or minimum sell price, prioritizing price over execution certainty.

Bid-ask spread

The difference between the highest price a buyer will pay and the lowest a seller will accept. It is an immediate transaction cost, widening with volatility and thin trading volume.

Order-driven versus quote-driven market

Order-driven markets match buy and sell orders in a central limit order book. Quote-driven markets rely on dealers posting firm bid and ask prices. Many venues are hybrids.

Short selling mechanics

An investor borrows securities, sells them, and later repurchases them to return to the lender. Profit equals sale proceeds minus repurchase cost and fees; losses are theoretically unlimited.

Margin call

A demand for additional cash or collateral when account equity falls below the maintenance margin requirement. Failure to meet it typically results in forced liquidation of positions.

Semi-strong market efficiency

The view that prices already reflect all publicly available information, so fundamental analysis cannot earn consistent excess returns. Only private information would be useful.

Index weighting methods

Indices may weight constituents by market capitalization, price, equal weight, or fundamentals. The weighting method determines concentration and the return an index-tracking fund must deliver.

Inverse price-yield relationship

Bond prices fall when yields rise and rise when yields fall. Sensitivity is greater for longer maturities and lower coupons, and is measured by modified duration.

Modified duration

Macaulay duration divided by one plus the periodic yield. It approximates the percentage price change for a one percentage point yield change, with sign reversed.

Credit spread

The yield premium of a corporate or other non-government bond over a comparable government bond. It compensates for default risk, recovery uncertainty, and illiquidity.

Preferred stock characteristics

A hybrid security paying fixed or floating dividends with priority over common stock in liquidation, usually without voting rights. It ranks below debt and is often callable.

Futures versus forwards

Futures are standardized, exchange-traded, and centrally cleared with daily settlement. Forwards are bespoke OTC contracts with counterparty risk and no interim cash flows.

Option premium components

The price of an option equals intrinsic value plus time value. Intrinsic value is the in-the-money amount; time value decays toward zero as expiry approaches.

ETF creation and redemption

Authorized participants exchange baskets of underlying securities for new ETF shares, or redeem shares for securities. This arbitrage mechanism keeps market price close to net asset value.

Interest rate swap

An agreement to exchange cash flows, typically fixed for floating, on a notional principal over a set term. The notional is not exchanged; only the net interest difference is paid.

Geometric versus arithmetic mean

The geometric mean is the correct compound growth rate over multiple periods. The arithmetic mean is higher and overstates long-run growth; the gap widens with return volatility.

Sharpe ratio

Excess return over the risk-free rate divided by standard deviation. It measures return per unit of total volatility and penalizes upside and downside variability equally.

CAPM required return

Required return equals the risk-free rate plus beta times the market risk premium. Beta measures sensitivity to market movements, not total volatility.

Portfolio variance formula

For two assets: w1 squared times variance1, plus w2 squared times variance2, plus twice the product of weights, standard deviations, and correlation. Lower correlation reduces portfolio risk.

Net present value

The sum of expected future cash flows discounted at the required rate, minus the initial outlay. A positive NPV indicates the investment adds value at that discount rate.

Real versus nominal return

The Fisher relationship: one plus nominal equals one plus real multiplied by one plus inflation. Real return measures change in purchasing power and drives long-term goal adequacy.

Investment policy statement

A written document recording client objectives, return requirement, risk tolerance, constraints (liquidity, horizon, tax, legal, unique), and review procedures. It governs all later portfolio decisions.

Ability versus willingness to bear risk

Ability is objective capacity from horizon, wealth, and income stability; willingness is subjective attitude. When they conflict, the lower sets portfolio risk and the conflict is documented.

Strategic versus tactical allocation

Strategic allocation sets long-term target weights consistent with the policy statement. Tactical allocation makes temporary deviations to exploit short-term views, within permitted limits.

Rebalancing bands

Pre-set thresholds that trigger a return to target weights when an asset drifts beyond them. Bands widen with higher transaction costs and taxes to avoid excessive trading.

Time-weighted versus money-weighted return

Time-weighted return removes the effect of external cash flows and measures manager skill. Money-weighted return, the internal rate of return, reflects the client's actual experience of their money.