The economy hits the second phase of the business cycle when the GDP is at its highest growth point, or at PEAK. During the peak, the growth rate of the expansion slows, and the economy is in a prosperity stage. During this phase, industries and employment are at full capacity and inflation is higher. Economic policies and the hiring freeze drive down the consumer spending, government spending, and business investments. The Stocks and bonds performance reaches plateau and the value of existing bonds decreases.

The third phase of the business cycle is reduction or CONTRACTION in GDP. During the contraction phase, the economy shrinks or declines. The Consumer spending, home construction, business investments, and inflation decrease and the unemployment rates, inventories, and deflation increase. This has a negative impact on the securities markets and causes a rise in debt default and bankruptcies. A recession is defined as a fall in GDP for two consecutive quarters (6 months). A depression is defined as a GDP decline for six consecutive quarters (18 months).

The fourth phase of economy is , TROUGH, it is when the contraction reaches it's lowest point. During trough, working hours and overtime, purchase of durable goods, and building permits increase. The GDP and securities markets head in a positive direction.

In regards to the business cycle of the economy, the RECOVERY is not a phase itself, but a return to the expansion phase.

The different phases of the economic cycle generate opportunities for some industries and difficulties for other industries. Sector Rotation is an investment style which exploits economic cycles by moving investments across business sectors at opportune times. Sector rotation leads to overweighting and underweighting of industries during an economic cycle.

ECONOMIC INDICATORS

Economic indicators help locate investment opportunities. Leading indicators (plant and equipment orders, money supply, stock prices, consumer expectations, average work week for production workers, average weekly unemployment claims) predict the future economic pattern. Lagging indicators (unemployment rate, business spending, labor costs, bank loans outstanding, and bank interest rates) confirm a pattern is occurring or is about to occur. Coincident indicators (nonfarm employment industrial production, manufacturing and trade sales, personal income (excluding Social Security, disability benefits, and unemployment compensation)) indicate where the economy pattern is at that current time.

Inflation refers to rising prices and reduced purchasing power of the U.S. dollar. The result is more money chasing fewer goods, and therefore, prices increase. The rate of inflation tends to increase during expansions and decrease during contractions or recessions. When inflation becomes too high, businesses and consumers cannot afford to purchase goods or borrow money, and the GDP begins to decline. High inflation speeds the shift from the peak phase to the contraction phase. One of the underlying goals of purchasing securities is to outpace inflation. Deflation is opposite of inflation and causes prices to decline. When prices are too low, companies have trouble making profits and lay off employees; causing unemployment, and in turn economy shrinks. Deflation is rare and only occurs during recessions.

The most important measure of inflation is the Consumer Price Index (CPI). The CPI surveys and tracks the price change of common things like groceries, gasoline, clothing, and movie tickets. It is a percentage increase or decrease in prices. The stock and bond markets are very sensitive to changes in the CPI as changes to consumer spending have a direct effect on stock and bond prices.

Producer Price Index (PPI) is a measure of the price of commercial items, such as farm products and industrial commodities. PPI indicates the cost to produce items and is the leading indicator of inflation.

Gross domestic product (GDP) is a monetary measure of the market value of all final goods and services produced in a period. GDP components help in learning different economic policies. GDP can be expressed as a percentage of growth or decline from year to year or from quarter to quarter. 6% GDP growth for the year means the economy grew by 6% from the prior year.

GDP = C (Consumer spending) + I (Business investment) + G (Government expenditures) + NX (Net Exports)

Real GDP is a variant that takes out the impact of inflation, so that the GDP can be compared over time. The Real GDP is the basic measure of business activity and tracks the business cycle. Real GDP is calculated by subtracting the amount of increase in GDP due to inflation (or decrease in GDP due to deflation). If an investor had a return of 8% on an investment, but the CPI rises 4%, then the “real” rate of return is the amount above inflation or 4%.

REAL GDP = GDP - CPI

The Employment and unemployment statistics are released each month by The Department of Labor. The number of employed and unemployed as well as the unemployment rate is a good measure of the overall economy. When people work, they purchase goods, services, and securities which help grow the economy.

Unemployment Rate = Unemployed workers DIVIDED BY Total Workforce

Trade balance or net exports, is the difference between the value of goods a country has exported or imported with other countries. A positive trade balance is called a trade surplus. A negative trade balance is a trade deficit.

BALANCE OF TRADE = $ OF GOODS EXPORTED - $ OF GOODS IMPORTED

Balance of payments (BOP) is the amount of foreign currency taken in minus the amount of domestic currency paid out. The current account measures the amount of money into and out of the country. Positive payments of money include exports and income received from owning foreign assets. Negative payments of money include imports, payments made to foreigners owning assets in the country, and net transfers (giving away money to the rest of the world). The capital account focuses on the change in U.S. assets and investments (stocks, bonds, and real estate) owned by foreigners, and the change in U.S. ownership of foreign assets and investments. Positive inflows occur when foreigners purchase U.S. assets. Negative outflows occur when the U.S. purchase foreign assets. The current account and capital account balance or net out. This is due to the fact that the U.S has a trade deficit with the rest of the world and pays the world in U.S. dollars. The rest of the world then purchases U.S. assets sending enough money back into the U.S. to balance the cash outflows from imports with foreign investment inflows.

ECONOMIC GROWTH FACTORS

Monetary policy refers to actions taken by the Federal Reserve (Fed) to increase or decrease the money supply in the economy. This affects inflation, interest rates, the value of the U.S. Dollar, and the economic growth. The Fed attempts to decrease the money supply during the economic expansion and increases money supply during the economic contraction.

Open-market operations is when the Fed buys or sells government securities in the open market. The Federal Open Market Committee (FOMC) Buys to Ease and Sells to Tighten (BEST). Buying government securities increases the money supply by injecting cash into the economy and helps lead to lower interest rates; selling securities decreases the money supply by removing cash from the economy and helps to raise interest rates.

The Discount rate is the interest rate charged to commercial banks and other depository institutions for loans received from the Federal Reserve Bank’s discount window. The Fed offers three discount window rates. The primary rate is for a short-term loans, usually overnight. The secondary rate is for a bank who needs short term liquidity to overcome financial difficulties (lender of last resort) and who does not have the credit worthiness to qualify for the primary rate. The seasonal credit is for seasonal demand loans, such as banks in agricultural or resort communities. When lowering the discount rate, the Fed prints new money to lend which in turn loosens the money supply. When the Fed raises the discount rate they tighten the money supply and do not print new money.

The Fed establishes the reserve requirement, the amount of funds that a depository institution must hold in reserve against specific deposit liabilities, and cannot be used for lending activities. Any changes in the reserve requirement will domino through the economy. Higher reserve requirements tighten the money supply; lower reserve requirements loosen the money supply. The reserve requirement is a percentage of deposit liabilities. A reserve requirement of 5%, requires that $5 of a $100 deposit be held as cash in the vault or at the Federal Reserve Bank, and only $95 be loaned.

The Federal Reserve Board governs the margin requirements with Regulation T. Changing the percentage of credit required to buy securities on margin can also increase or decrease the money supply in the economy.

Fiscal policy refers to the government actions (approved by Congress) that may influence economic activity. Fiscal Policy influences the economy by adjusting expenditures (spending) and revenue collection (taxation). To stimulate the economy, the government may lower taxes, increase spending, or increase benefits like Social Security payments. However, while this increases consumer spending and investments, there are no government savings to pay for any of the stimulation; therefore, the federal deficits rise.

Global and Geopolitical Factors

When the American dollar is strong, it is worth more than other currencies. This leads to increased purchasing power making imported goods less expensive and the U.S. export of goods more expensive in other currencies. A weak American dollar is good for exporting, because the goods are less expensive for foreign purchasers, but the price of imported goods rise because of the reduced purchasing power of the dollar. Increases to the money supply drive the value of the dollar down. Individuals investing in foreign securities have currency or exchange rate risk, of one currency losing its value in relation to another. Currency risk can impact the return on an investment, including mutual funds that invest overseas. When the demand for a country's currency declines; so, will the currency's value.

Interest Rates, Yield Curves, Credit Spreads

When the supply of money increases, interest rates fall, and when the supply of money tightens, interest rates increase. When monetary policy expands credit, lower interest rates make bonds less attractive as investments compared to stocks. Company earnings may rise because of lower interest expense, which may cause the market price of the stock to rise. When monetary policy tightens credit, interest rates will rise, earnings will decrease, and the market price of the stock is likely to decrease as well. As interest rates rise, bonds become more appealing.

There are five interest rates to be familiar with. The discount Rate is what banks pay when borrowing from the Federal Reserve. The Fed Funds Rate is what banks charge each other for overnight loans. The Broker Call Loan Rate is what brokers pay when borrowing on behalf of margin customers. The Prime Rate is what most creditworthy corporations pay when borrowing. The Margin loan rate is the rate a broker-dealer charges a customer.

Interest rates may also be referred to as the yield. The yield is the amount of interest received for the amount of money paid by the investor and is always quoted as an annual rate of return despite the length of maturity. A yield curve is simply a graph that plots yields against maturity. The curve will show whether interest rates are higher, lower, or flat through maturity.

A normal yield curve is typically seen during the times of expansion. Most of the time, the yield curve will be positively sloped, which means lower interest rates are correlated with the shorter maturities. As maturity lengthens, interest rates increase. Below is an example of a normal yield curve

An inverted yield curve may be a sign of economic decline. The yield curve will be inverted, which means short-term interest rates are higher than long-term rates. As maturity lengthens, interest rates decrease. This could also occur if interest rates were high but expected to fall. Below is an example of an inverted yield curve.

A flat yield curve is rare and occurs when yields are the same regardless of the length of maturity. In these situations, the market typically readjusts naturally as holders of long-term debt divest to purchase shorter-term securities for the same yield. Below is an example of a flat yield curve.

A credit rating agency is a company that assigns credit ratings, which rate a debtor's ability to pay back debt on time and the likelihood of default. The three largest credit rating agencies are Standard & Poor's (S&P), Moody's, and Fitch Group. The difference in yield paid between high-risk debt securities and low-rated debt securities is the yield spread. This difference also includes the risk premium, or an additional amount required by investors for the additional risk of default. The economy lacks confidence if the spread between the yields on low quality debt and high quality debt widens whereas a narrow spread displaces confidence in the economy.

INCOME STATEMENT TERMS and RATIOS

When a company has securities publicly traded in the markets, it must provide financial reporting to regulators (sometimes federal and state), as well as to existing shareholders. This reporting contains documents and records reflecting the company's operations and financial strength. Financial statements are formal records of a company’s financial activities which provide a historical measurement of the company’s operations, and finances.

The Income Statement or Statement of Profits and Losses (P&L) gives you the ability to compare revenues to expenses to determine if a company is profiting. Revenues are the company’s total sales. Expenses are the company’s costs. A company profits when its revenues are higher than its expenses. If the expenses exceedes the revenues, the company undergoes a loss.

The two methods to determine the cost of materials or inventory of goods sold: The first in, first out (FIFO) method shows costs in a chronological order with older, cheaper materials being expensed first. The last in, first out (LIFO) method shows cost on more recent and expensive materials first.

Cost of Goods Sold (COGS) reflects the labor, material, and production costs associated with creating the goods to be sold.

Selling, General, & Administrative (SG&A) Expenses are the company’s expenses on advertising and marketing, depreciation and amortization, and corporate and administrative costs, and salaries for key functions like management, accounting, finance, and human resources.

Operating Expenses are how much it costs the company to produce the goods or services it sold.
Operating Expenses = COGS(Cost of Goods Sold) + SG&A (Selling, General, & Administrative) Expenses.

Operating income represents income received from core operations, minus the cost of day-to-day functions and the loss accumulated on tangible assets. It does not include things such as investments in other firms, taxes, interest expenses or nonrecurring items, such as cash paid in a lawsuit settlement.
Operating income = Gross income - (operating expenses + depreciation)

The Operating/Gross Profit, also known as Earnings Before Interest and Tax (EBIT), is the money made by the company on the sale of its goods or services less production cost of goods or services.
Operating/Gross Profit = Total Revenues - Operating Expenses(COGS+SG&A)

The Earnings Before Interest, Tax, Depreciation, and Amortization (EBITDA) is one way companies and investors like to report earnings. This shows the operations’ efficiency in a company and can be used to analyze the profitability between companies and industries because it eliminates the effects of financing and accounting decisions. EBITDA is a good metric to evaluate profitability, but not cash flow.
EBITDA = GROSS PROFIT + DEPRECIATION + AMORTIZATION EXPENSE

Net Income is a company's total earnings, or profit. The measure is also used to calculate earnings per share.
Net income = Total income - (depreciation + interest + tax liabilities + other expenses)

Cash flow is essentially the amount of cash a company generates and uses during a period.
Cash flow = Net income + depreciation +/- other charges to income

The Operating Margin is the % of total revenues that equals the operating/gross profit. It is measurement of what proportion of a company's revenue is left over after paying for variable costs of production, such as wages, raw materials, etc. and allows you to compare a company's efficiency, or quality of operations, to that of other companies.
Operating Margin = Operating/Gross Profit / Total revenues

Profit Margin measures how much out of every dollar in sales a company actually keeps in earnings. Profit margin makes it easier to compare companies in similar industries. A higher profit margin, compared to other industry competitors, indicates a more profitable company that and better cost control.
Profit Margin = Net income / Total revenues

The Earnings Per Share (EPS) ratio is the amount of net income earned by the company for every share that is outstanding. It helps investors determine how much money the company is making for each share of stock. Earnings Per Share (EPS) = Net Income / Number of Outstanding Shares

Diluted EPS is the earnings per share if all convertible securities (preferred stock or debt securities that are convertible, as well as rights, warrant, and options that can be converted into common stock) were exercised.

The Dividend Payout Ratio is used to measure the amount of dividend paid out in relation to the company’s earnings. The dividend payout ratio can be calculated two ways with both yielding the same result.
Dividend Payout Ratio = annual dividend per share / earnings per share
or
Dividend Payout Ratio = total dividends paid / company's net income

Balance Sheet Terms

A Balance sheet shows the difference between assets and liabilities, or the company's equity (net worth) at a specific point of time. The key calculation derived from a company's balance sheet is working capital, which is obtained by subtracting current liabilities from current assets. Working capital shows how much money the company has on hand to meet current obligations, or its operating liquidity.
Working Capital = Current Assets - Current Liabilities

An asset is any tangible or intangible thing that is capable of being owned and produces value or is held for positive economic value. Assets on the balance sheet are classified by how soon they can be converted into cash, known as liquidity. Current assets (cash and equivalents, marketable securities, accounts receivable, inventories, and prepaid expenses) can be converted into cash immediately or within one year. Fixed assets are owned and used by the company (real estate, equipment, long-term notes, receivables, bonds, and furniture) and typically take more than a year to convert to cash. The value used on the balance sheet for fixed assets is the original cost minus depreciation taken in previous years. Intangible assets (patents, copyrights, trademarks, franchises and goodwill) are non-physical assets of the business's value and are usually listed separately on the balance sheet.

A liability is recorded on the balance sheet and can include accounts payable, taxes, wages, accrued expenses, and deferred revenues. Current liabilities are debts payable within one year, while long-term liabilities are debts payable over a longer period. Current liabilities also include any portion of a long-term liability that is being paid within that year.

Stockholder’s equity (the company's book value) is the capital received for shares issued plus retained earnings and is a final piece of the balance sheet. It is the difference between the company’s assets and liabilities. On the balance sheet only the par value of common and preferred stock is used. Par (face) value is the dollar amount assigned to a security when it is first issued. This value has no relationship to the market price. Any amount received above the par value is know as capital surplus or additional paid in capital (APIC).
Shareholder's Equity = Total Assets - Total Liabilities
or
Shareholder's Equity = Capital Stock - Treasury Stock + Retained Earnings

Capital stock refers to par plus the capital surplus or APIC.
Capital Stock = Par + Capital Surplus (APIC)

Treasury stock refers to the amount of repurchased stock hold by the company. It is included in the stockholder’s equity section on the balance sheet and is subtracted from the capital stock.

Retained earnings are the net profits the company retains for future use rather than pay out as dividends. The retained earnings account contains all prior years’ profits and losses. It is impacted each year by net income, net losses, and any dividends paid.
Retained Earnings = Prior Retained Earnings + Net Income - Dividends

The Current Ratio is a measure of a company's operating liquidity and is used to determine if a company's short-term assets are readily available to pay off its short-term liabilities. The higher the number the better, a ratio under 1 suggests that the company would not be able to pay off its obligations if they became due at that point.
Current Ratio = Current Assets / Current liabilities

The Quick Ratio (Acid test) measures the amount of the most liquid current assets there are to cover current liabilities. The quick ratio excludes inventory and other current assets more difficult to turn into cash. The higher the number the better, a ratio under 1 suggests that the company would not be able to pay off its obligations if they became due at that point and the company could not quickly convert all of its assets to cash.
Quick Ratio (Acid Test) = (Current Assets - Inventory) / Current liabilities

The Cash Ratio is another measurement of a company's liquidity that only takes in to account the amount of cash, cash equivalents or invested funds there are in current assets to cover current liabilities. Said differently, it removes any inventory and accounts receivable from current assets.
Cash Ratio = (Cash + Cash equivalents + Invested funds) / Current liabilities
or
Cash Ratio = (Current Assets - Inventory - Accounts receivable) / Current liabilities

The Debt Ratio is the amount of a company’s total debt compared to its assets. A debt ratio greater than 1 indicates that a company has more debt than assets, a ratio less than 1 indicates that a company has more assets than debt.
Debt Ratio = Total Debt / Total Assets

The Debt-to-Equity Ratio is a measurement of how much suppliers, lenders, and creditors have committed to the company versus what the shareholders have committed. It compares a company's total liabilities to its total shareholders' equity. A lower percentage means that a company is using less leverage and has a stronger equity position.
Debt-to-Equity Ratio = Total Liabilities / Shareholders' Equity

Statement of Cash Flows

A cash flow statement is one of the public financial reports publicly traded companies are required to disclose to the U.S. Securities and Exchange Commission (SEC). It shows the money coming in and out of the company and is based on the accrual system. This means revenues and expenses are recognized when they are realized not necessarily when those revenues and expenses are actually received or paid. Meaning it will exclude accounts receivable (customer purchases on credit) and accounts payable (company purchases on credit).

Cash flow from operating activities cash coming in to the company from sales and cash going out to pay operating expenses, interest, and income taxes. It represents the net amount of cash the company made from regular business activities.
Cash Flow from Operating Activities = Net Income + Depreciation/Amortization + Changes in Working Capital.
Cash flows from investing activities is the amount of cash the company earned or invested in buying and selling capital equipment (capital expenditures), investing in stocks and bonds of other companies, or acquiring other companies. These are are generally fixed assets (land, buildings, machinery, and equipment). Net cash flows from investing activities is a negative number, unless the company is selling off its assets or making gains on its investments in other companies.

Cash flows from financing activities is cash the company received for issuing securities and from borrowing, less any payments to shareholders and creditors. Cash flows from financing activities is a negative number, unless the company has issued new securities or borrowed additional money.

The Price-to-Cash Flow Ratio measures the company’s market value in relation to its cash flow. A high price-to-cash-flow ratio indicates that the company is trading at a high price and not supported by the cash flows it generates.
Price to Cash Flow = Stock Price per Share / Cash Flow per Share

Corporate SEC Filings

Public companies, companies with stocks or bonds traded on the public exchanges, are required to file financial statements with the SEC and make those financial statements available to their investors and the public.

Registration statements provide investors with an understanding of the securities offered and the profitability of the company. All companies, foreign and domestic, must file these statements or qualify for an exemption. The registration must include the prospectus which is a legal document that charges the issuer of the securities to provide details of the investment offered, how the business operates, its history, management, financial condition and insight into any risk. The financial forms included in the prospectus, such as an income statement, must be audited by an independent certified public accountant. The registration must also include any relevant additional information, such as recent sales of unregistered securities.

Once a company has issued it securities its required to file annual and quarterly reports, which include the financial statements. The annual report is called a 10-K and is filed on SEC Form 10-K. It includes the business summary, management discussion and analysis, financial statements, and other sections discussing the management team and legal proceedings. It details the company's latest developments and provides a preview of the direction it plans to take. The quarterly report, called 10-Q and is filed on SEC Form 10-Q. Major differences from the 10-K include unaudited financial statements and less detailed reports. The SEC also requires that an 8-K be filed for significant events include a bankruptcy or receivership, material impairments, completion of acquisition or disposition of assets, departures or appointments of executives and other events of importance to the investor. If an issuer has an investor who accumulates 5% or more ownership in the company, or if the issuer changes their name a 10-C must be filed.

Analytical Methods

The Time Value of Money is the difference between the present value (today’s value) of money compared to the future value. One of the main goals of investing is that the money invested will be worth more in the future to allow for growth and inflation protection.

Future value is the value of an asset at a specific date. It measures the nominal future sum of money that an initial sum of money is worth at a specified time in the future assuming a certain rate of return.
Future Value = Principal X (1 + r)ⁿ

r is the rate of interest.
n is the number of compounding periods (years, months, etc.)

Present Value is the amount of money that must be invested today to achieve the desired number in the future taking in to account an expected rate of return. For example, determining how much money needs to be invested today, if your want to have $1 million in the future.
Present Value = Future Value / (1 + r)ⁿ

r is the rate of interest.
n is the number of compounding periods (years, months, etc.)

The net present value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows. It determines if the project will not only cover expenses, but also make a profit. Positive NPV means the investment will add value. Zero NPV means the investment will not lose or make value. Negative NPV means the investment will lose value.

The Internal Rate of Return (IRR) is essentially the interest rate that makes the net present value of all cash flow equal zero. It represents the return a company would earn if it expanded or invested in itself rather than elsewhere. The IRR is always displayed as a percentage. The IRR to a bond is its yield to maturity.

The Price-to-Earnings (P/E) Ratio is used to determine if a company is over or undervalued. It values a company by measuring its current share price relative to its per-share earnings.
P/E Ratio = Market Value or Stock Price per Share / Earnings per Share

The Price-to-Book Ratio is used to compare a stock's market value to its book value. A low price-to-book ratio could mean the company is undervalued. A high price-to-book ratio could mean that the stock is overpriced.
Price-to Book Ratio = Stock Price Per Share / (Total Assets - Intangible Assets and Liabilities)

DESCRIPTIVE STATISTICS

Mean is the average value of a data set.

Median is the middle value of a data set.

Mode is the most common number in a data set.

Outlier is any value far outside of the norm or central tendency in a data set.

Range is the difference between the lowest and higest values in a data set.

Standard deviation is the variation or dispersion of the values from the average in a data set. Higher standard deviations (where the values drastically differ from the average) indicate volatility within the data set. Standard deviation measures the volatility of a stock’s return based on its mean or average performance.

Beta measures the volatility of an individual stock in relation to the overall market. A beta of 1 means that the stock moves in tandem with the market. A beta greater than one means the stocks is more sensitive to market conditions than the market as a whole. A beta less than one means the stock is less sensitive to market conditions than the market as a whole. A negative beta means the stock moves the opposite direction as the market.

Alpha represents the performance of a portfolio relative to a benchmark. Alpha is the return on an investment that is not a result of general movement in the greater market. As such, an alpha of 0 would indicate that the portfolio or fund is tracking perfectly with the benchmark index.

R-Squared measures the percentage of a fund or security's movements that can be explained by movements in a benchmark index like the S&P 500. R-squared can be used to validate the Beta of a stock or portfolio. A high number would validate the Beta as useful, and a low number would mean the Beta is not useful. R-squared ranges from 0 to 100. If R-squared is 100, that means the stocks rises and falls in line with the index. If R-squared is low (50 or lower), that means the stock does not move with the market.

Sharpe Ratio is the average return earned in excess of the risk-free rate per unit of volatility or total risk. The Sharpe ratio calculates the excess return per unit of risk (risk-adjusted return) by comparing the risk premium to the standard deviation. The risk premium is the difference between the actual return and the riskless rate of return (the yield on 90-day Treasury bills). The the greater the value of the Sharpe ratio, the more attractive the risk-adjusted return. If the Sharpe ratio is one, the investor received a return equal to the risk taken.
Sharpe Ratio = Risk Premium / Standard Deviation

Risk Premium = Actual Return – Riskless Rate of Return

Capital Asset Pricing Model (CAPM) is used to determine if an asset should be added to a portfolio, based upon its expected rate of return, non-diversifiable risk (Beta), the expected return of the market, and the expected return of a risk free investment. It is trying to find the most efficient correlation between risk and return. It evaluates if risk can be reduced while maintaining the same return, or fi the return can increase while keeping the risk the same. The CAPM uses beta as the measure for volatility rather than standard deviation and, the risk premium is the expected rate of return for the market as whole less the riskless rate of return.
Risk Premium = Expected return for the market – Riskless rate of return

Expected Return = Riskless Rate of Return + (Beta x Risk Premium)

TYPES OF RISK

Systemic risk is the risk of loss because the entire financial system (industry or economy) collapses. Companies considered a systemic risk are called “too big to fail.”

Systematic (market) risk is the potential for the entire market to decline. Meaning all individual securities of that market are impacted despite their individual circumstances. Investors can protect against systematic risk by using option and future contracts on related market indexes. Portfolio allocation among negative correlated assets plays an important role in reducing systematic risk, but it also reduces overall returns. Diversification does not reduce Systematic Risk. Beta can be used to determine an assets exposure to systematic risk.

Interest rate risk is a systematic risk affecting bonds and other securities that trade based on their yield. Bonds have an inverse relationship with interest rates. When interest rates rise, bond values decline. When interest rates decline, the value of bonds rise. A bond's sensitivity to interest rates depends on the coupon rate and the time remaining to maturity, this is known as the bond's duration. Longer term debt is always more volatile than shorter term debt. Lower coupon bonds offer less protection against rising interest rates than higher coupon bonds. Long term zero coupon bonds are the most volatile. A 10-year zero-coupon bond has higher duration than a 10-year bond that pays semiannual interest payments because it has a lower coupon rate.

Inflationary risk (constant dollar risk/purchasing power risk) is a type of systematic risk caused over a period of time by the constant increase in the cost of goods and services, as measured by the consumer price index. When prices rise, each dollar buys fewer and fewer goods and services in turn reducing the purchasing power of a dollar. Fixed income securities are most subject to inflationary risk while equity investments tend to outpace inflation over a period of time. Investors typically purchase stocks to try to beat inflation.

Unsystematic risk (specific risk or idiosyncratic risk) is the risk that any one stock may go down in value, independent of the stock market as a whole. It is a specific risk to that security or industry and is uncorrelated to broad market returns (i.e. the security declines despite the broad market advancing). This risk may be minimized through diversification (own securities of many issuers and or in many different industries or different regions).

Unsystematic risk falls in to many different categories. Business risk refers to the possibility of a company having lower than anticipated profits or even losses due to either internal events within the organization (bad management, corporate restructuring) or external events (competition) or both. Credit Risk refers to the possibility that the issuer of a bond, note, etc. will default on a debt security or have their credit rating reduced. Liquidity risk is the risk that a security cannot be sold fast enough to prevent a loss or to lock in a profit. Hedge funds, private placements, direct participation programs (DPP), and penny stocks have liquidity risk. Social and political risk is the risk a business may face as result of political changes in policies (fiscal/monetary) or political instability (terrorism/corruption) that alters the probability of success. Legislative or regulatory risk is the risk a government may harm the business through regulatory or tax changes. Currency exchange risk is the risk that the value of one country's dollar compared to another country’s currency will negatively impact businesses and investors. This risk affects funds invested in foreign securities or multi-national companies with operations overseas. Call risk is the risk of a callable bond being called in when interest rates fall. This causes the investor to lose the higher rate of the bond and be forced to invest at lower rates. Reinvestment risk can refer to reinvestment of principal after a bond is called, as well as reinvestment of the dividends from a high-coupon bond into a lower-rate investment. Event risk refers to any events that can impact the creditworthiness of the issuer. This includes things like leveraged buyouts, corporate restructurings, mergers and acquisitions, and bankruptcies.

Opportunity Cost or Opportunity Risk refers to the potentially higher rate of return an investor could earn if the money used to purchase a bond were placed in an alternate investment. It measures the potential gains of investment alternatives passed over for an investment choice. If an investment was made in a security that delivered a loss of 5% and an investment could have been made in a security with a guaranteed 5% return, then the opportunity cost was 10%.

Capital Structure

Companies that utilize debt financing to raise capital are considered to be a “leveraged capital structure.” Leverage meaning the use of debt. Debt financing occurs when corporations raise money by issuing bonds to investors in return for a promise to repay the amount and pay interest on that amount. Bondholders have no ownership or voting rights in the company and are limited to the returns of the interest payments made by the corporation regardless of its profitability. Bondholders and other creditors have the first right of claim against the company’s remaining assets if a company were to fail.

Equity financing occurs when corporations raise money by issuing stock in the corporation. Investors who purchase stock obtain a percentage or share of ownership relative to the number of shares they own. Stockholders receive the benefits of a profitable company in the form of dividends and increased share price. Investors may lose their entire investment if the company fails.

Liquidation preference or priority determines who gets how much when a company is liquidated, sold, or goes bankrupt. In the event of a company’s bankruptcy or failure, the order of liquidation priority is; Secured Bonds, Unsecured Bonds (Debentures), Subordinate Debentures, Preferred Stock, then Common Stock. Common stockholders do not have liquidation rights until all other creditors and equity investors have been paid.

Secured bonds (mortgage bonds, equipment trust certificates and collateral trust bonds) are insured by collateral and allow corporations to borrow at a lower interest rate. A trustee will take possession of the collateral and sell it on behalf of bondholders if the corporation defaults and is unable to pay the debt. This allows the bondholders to recover at least part of their investment.

Unsecured bonds or debentures are only insured by a company’s good faith (promise to pay) and credit (ability to pay). They are riskier and have higher interest rates because there are no assets securing the debt. If the company defaults, debenture holders have liquidation rights to claim assets after secured bondholders.

Subordinated debentures, like unsecured bonds, have no assets securing the debt and are even more risky and expensive than other unsecured bonds. They have a lower priority liquidation rights than the other debentures and will be paid only after all other bondholders, in the event a corporation declares bankruptcy.

Preferred Stock combines features of debt, in that it pays fixed dividends, and equity, in that it has the potential to appreciate in price. Preferred shares usually do not carry voting rights. Preferred stockholders have liquidation rights before common stockholders but only after bondholders.

Common stock holders can exercise control by electing a board of directors and voting on corporate policy. However, they are on the bottom of the priority for ownership structure and in the event of liquidation, common shareholders have rights to a company's assets only after bondholders, preferred shareholders and other debt holders are paid in full.