chap 4

Question 1

Nominal Rate of Return:

Answer 1

the return that the investment earns expressed in current dollars. It does not take into account the effects of inflation

Question 2

Real Rate of Return

Answer 2

measures the increase in purchasing power that the investment provides.

–Approximately equals the nominal rate of return minus the inflation rate:

Real Return= Nominal Return - Inflation Rate

Question 3

Risk premium:

Answer 3

Additional return an investor requires on a risky investment to compensate for risks based upon issue and issuer characteristics

Question 4

Holding period:

Answer 4

the period of time over which one wishes to measure the return on an investment

Question 5

Internal Rate of Return:

Answer 5

The discount rate that equates an investment’s cost to the present value of the benefits that it provides for the investor

Question 6

Business Risk:

Answer 6

the degree of uncertainty associated with an investment’s earnings and the investment’s ability to pay the returns (interest, principal, dividends) that investors expect.

Tied to a firm’s industry

Generally, investments from similar kinds of firms have similar business risk

Differences in management, costs, and location can cause variation

Question 7

Financial Risk:

Answer 7

the increased uncertainty that results when a firm borrows money.

The more debt used to finance a firm, the greater its financial risk

Question 8

Purchasing Power Risk:

Answer 8

the chance that unanticipated changes in price levels (inflation or deflation) will adversely affect investment returns

Question 9

Interest Rate Risk:

Answer 9

the chance that changes in interest rates will adversely affect a security’s value.

Question 10

Liquidity Risk:

Answer 10

the risk of not being able to sell (liquidate) an investment quickly without reducing its price

Question 11

Tax Risk

Answer 11

The chance that Congress will make unfavorable changes in tax laws, driving down the after−tax returns and market values of certain investments.

Question 12

Event Risk

Answer 12

occurs when an unexpected event has a significant and unusually immediate effect on the underlying value of an investment.

Question 13

Market Risk

Answer 13

the risk that investment returns will decline because of factors that affect the broader market, not just one company or one investment.

Examples: political, economic, and social events as well as changes in investor tastes and preferences

Actually embodies a number of risks including purchasing power risk, interest rate risk, and tax risk.