7. Risk and Return Flashcards
assumptions when calculating risk & required rate of return
- future will be like past & today’s investors expect to receive the same normal rates of return
- expected future market risk premium can be measured by the average past market risk premium
critique of 1st assumption when calculating risk & required rate of return
assumption that future will be like past & today’s investors expect to receive the same normal rates of return is weak since risk free rate (rf) varies, can only assume that the market premium stays the same
do expected market risk premiums stay constant over time?
NO.
expected market risk premium
= market rate of return- risk free rate of return
BABs
short term debt securities (guaranteed by bank)
–> risk of bab depends on risk of bank not borrower,
LOW RISK = LOW YIELD.
–> approx 180 days to maturity
why would an investor buy BABs?
if they think interest rates will fall in the future (since what they pay is the FV discounted back to today, with the ‘interest’ earned essentially being the dif btw price paid & future value)
zero coupon security
no interim interest payments, BABs only return the lump sum on maturity
what is the primary risk with BABs even though they’re pretty much considered risk free?
INFLATION risk. BABs are calculated by taking the face value and discounting back by the days to maturity at a rate of return (ri).
ri will include some compensation for inflationary returns, BUT, if i fails to do this then the buyer faces inflation risk (bc if inflation is higher than i, the final lump sum of the face value is actually lower)
treasury bonds
10 year gov bonds, long term security debts, risker than BABs as they’re exposed to greater risk of inflation & interest rate risk.
a rate of return is only guaranteed to investors who hold them to maturity
shares in listed companies
the most risky. uncertain CFs & claims are residual, with no redemption due life being indefinite.
we look at average return of an equity security by looking at the market index for that particular market.
what equation do we use to measure TOTAL returns?
AOAIt=
AOAIt-1) x (market capitalisationt + dividendst)/market capitalisation t
when we’re calculating indices, what are we measuring & what formula?
measuring price of movements of as a whole
It= (It-1) x ((market capitalisationt) /market capitalisationt)
What is the advantage of an accumulation index, such as the S&P/ASX 200 Accumulation Index or the All Ordinaries Accumulation Index, over the better-known S&P/ASX 200 or All Ordinaries Indices? Why are the accumulation indices not more commonly used?
–> S&P/ASX 200 Accumulation Index and All Ordinaries Accumulation index include both capital gains and dividend income in the calculation of change in aggregate market value.
They therefore give a better measure of the change in shareholder wealth.
The S&P/ASX 200 and All Ordinaries indices are calculated every 15 seconds, whilst the Accumulation indices are calculated once a day with a one day lag, because of the additional complexities in calculating their value.
what is market capitalisation?
total market value of a company’s outstanding shares
= company’s shares outstanding x current market price/share
what is a problem with changes in shareholder wealth and S&P/ASX200?
it isn’t fully reflected because the index ignores the dividends paid to shareholders, but issues arise when measuring returns over long periods/when dividends are paid.
