Chapter 3 Flashcards
Compound interest
This is the process of interest earning interest.
Future value
FV = PV (1+r)x year
Compounding factor
(1+(r/j))x number of years
Interest frequency
The more or less frequent interest is paid will effect the FV and the the more of it means the better return.
Present value
PV is used to determine how much to invest today using the rate of interest and frequency of payments.
PV of future sum cash flow
This is the amount needed to be invested to achieve a certain goal
PV = FV/ (1+r)x number of years
PV of an annuity
This refers to a series of equal cash payments that will be received over a specified time. You must discount the value of the cash flow to find out the true value. The discount factor is calculated by dividing the cash flow by the interest rate. Meaning you get the present value.
PV of an annuity calculation
CF x (1/r)-1/r(1+r)^n
Cf amount of annuity each year
R rate of interest
N number of periods
Present value perpetuities
A perpetuity is a series of regular cash flows that are due to be paid or received indefinitely.
PV of this = A/r
A is the amount of payments
r is interest rate.
Perpetual bonds
Don’t have a maturity so the coupon is indefiantly.
FV
= PVx (1+r)x number of years
Applying compound interest to regular payments
This is how the FV can be effected by regular payments being invested.
The time value of money
How does holding an investment over time effect it’s blue also including what is inflation doing.
Inflation and investment returns
Nominal rate is the rate before inflation is considered once it is then we have the real return.
Risk premium
High risk - genially have a high reward potential, plus greater possibility of loss
Low risk - genially have lower reward but also with lower possibility of loss.
Types of risk
Interest risk
Inflation risk
Systemic risk
This is the connection with the risk of collapse of an entire financial system and is more prevalent now economies are highly linked.
Systematic (market) risk
This is risk associated with a system as a whole or known are marked risk. Examples
Interest rates
Exchange rates
Inflation
Tax
Other risks of international assets
Political risk
Regulation risk
Overseas tax
Emerging markets concern
Volatility
This is the speed in which price/ value can change for an asset.
Unsystematic risk
This relates to specific business, investments or share so usually reduced through diversification. They are no market wide. Ie
business risk based on there industry.
Industry risk
Management risk
Financial risk.
Counterparty risk
This is a risk that a counterparty cannot uphold their commitment to a transaction.
Concentration and diversification
Concentrated portfolios focus to much on one asset type where diversification means investments cover multiple asset types usually 15-20 types.
Geography
Being totally reliant on investments that have similar geography can also be a risk.
Company size
Having a mixture of company sizes can be a good idea as it means whatever the economic cycle your investments could be benefiting
Credit quality
Ensuring that you have a good variety of bonds and that their quality is strong enough to cover risk
Risk and return management
Variance and standard deviation this measures the amount an investment can fluctuate from its standard return.
Standard deviation
Is the square root of variance of the dispersion
Correlation
This is a keystone feature of portfolio construction, this is the study of how the return of investments move in relation to other vents and assets.
Measuring correlation
Measured from -1 to 1
0.66 to 1 = strong relationships
0.33 to 0.66 = moderate relationships
0 to 0.33 = zero relationships
Total return
This is the measure of investments performance that includes the change in price of the asset plans any income. This uses
Holding period yield
Money weighted rate of return
Time weighted rate of return
Holding period return (HPR) when comparing to investments
When comparing returns on an investment with another you need to include the total holding period returns which is made up of
Income earned
Current yield
Capital appreciation
It is calculated by
Sum of income + value at end of holding - price at beginning / price at beginning
Money weighted rate of return
This is used to measure the performance of an investment that has had deposits and withdrawals during the period of investment.
Time weighted rate of return
The term weighted refers to the fact that returns are averaged over time. This means that this removes the impact of cash flow on the rate of return calculations. This is then the reason it is the preferred method for investment performance.
Risk adjusted performance measures
This is how to compare a fund to its peer groups across the market their are multiple ways for doing this.
Sharpe ratio
Sortino ratio
Treynor ration
Jensen ration
Information ratio
Sharpe ratio
Sharpe ratio measures the return over and above the risk free interest. Calculated by
Return of portfolio- the risk free return/ the standard deviation
Sortino ratio
This is a variant Sharpe ratio in terms of the risk measure is used to adjust the excess returns.
Treyno ratio
Similar to the Sharpe ratio but it divides the excess return by beta as a measure of risk.
Beta is a measure of volatility of. A portfolio in relation to the overall market. Beta can also be looked at as a measure of correlation.
Treynor = return of portfolio - risk free return/ beta
Measures of beta
1 = similar volatility
Less than 1 = more volatile than market as a whole
Between 0 & 1 = less volatile than market
<0 = moves in opposite than market
0= no clear relationship.
Jensen alpha
This is used to evaluate a well diversified portfolio against a benchmark as predicted by the capital asset pricing model (CAPM)
= return on portfolio - return predicted by capm
The information ratio
The information ratio assess the degree to which a portfolio manager uses skill and knowledge to enhance returns.
= mean of excess/ standard deviation
R-Squared
This measures diversification it denotes the extent of diversification within a portfolio relative to a benchmark
Benchmarking
Three main ways
Comparison with relevant bond market
Comparison to similar fund
Custom benchmark
Alternative benchmarking
Another method used a peer group average. Or against the CAPS which is an investment service for the uk
Holding period return of a two security portfolio
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Relative return
This is the return in context to other options
= absoulte performance - benchmark performance
Synthetic Risk and Reward indicators
Regulators make funds provide this as it is the overall risk of a fund. And work from a 1-7 risk model. It is based on the volatility over a 16 week period. 1-3 are very small and then = over 25%
Models of investment theory
This looks at how sentiment effect mark and investor physiology
The efficient market hypothesis EMH
This is the theory that posits all public information and avaible information about a security is reflected in the price and this is the securities fair value providing that
The security is freely traded
The markets themselves are operating efficiently
Versions of the EWH
There are three of them
Weak form = this assumes that the price reflect all the information based on historic information also.
Semi-strong form = all the information from weak from but also including publically available information
Strong form = the price reflect private and public information on the security and that no one can do better than an average without luck.
Assumptions and shortcomings of EMH
It assumes that because information is there it is sited which is not true.
It assumes new information is fairly distributed and received randomly
Capital asset pricing +CAPM
This says the return on a portfolio should the rate of return on a Rick free plus the risk premium and if it does not meet this then it should not be undertaken. It’s assumptions though are as followed
All market participant borrow and lend at the same rate
Everyone is a well diversified investor
No tax or transaction cost
All investors want to achieve max returns
Everyone has the same expectations
Expected return
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Arbitrage pricing theory APT
Developed in 1970 in response to CAPM. APT doesn’t rely on a single single market beta but a multi factor response. It does this by
Capturing exactly what factors determine security price
Applying separate risk premium to each indervidula factor
Applying a separate beta to each of these Rick premiums.
Assumptions of APT
Securities market is price sensitive
Investors always want max returns
Investors can sell short
Identified factors are uncorrelated
Multi factor models, assumptions and limitations
This is a financial model that may be used in the analysis of securities when constructing an investment portfolio. For the client. Categories included.
Macroeconomic models
Fundamental models
Statistical models
These models are compared in the following equation:
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Fama -French three factor model
This is multi factor model that expands on CAPM and aims to describe stock return through three factors
Company size
Book to book market values
Excess returns on the market
Can be represented in
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Behaviour finance
Fin ace works when investors make rational decisions this can be effected by congenital and emotional biases
Cognitive bias
This is because of heuristics which are mental rules of thumb which are used by investors and other ps to make desisions.
Key cognitive bias
Confirmation bias - investors are morse lickley to look for information that supports their initial idea
Hindsight bias - if an investor believes an event was very predicable meaning they create reasons they may not be true.
Other congestive bias
Anchoring
Avaibility
Bandwagon
Framing
Information
Optimism
Overreaction
Representative bias
Emotional bias
Emotional bias involves an investor being their desk on on their indervidual feelings rather than on facts. Some types of this are
Loss aversion
Regret aversion
Overconfidence
Studs quo bias
Theories of behavioural finance
Prospect theory - people will react differently to situations depending if it presented a a gain or a loss
Regret theory - this is the theory related to people’s action when they have made an error. They may not sell stocks that have loss to avoid the loss even thought they run the risk of further loss.
Alpha beta and r-squared
Alpha = measures the difference between funds actual returns and the expected performance given the level of risk
Beta = an expression of a funds sensitivity to movements in the benchmark index. Thus a measure of volatility.
R-squared = reflects the percentage of a funds movements that are explained by movements in its benchmark.
Asset allocation
This is the process of deciding where to invest you money and into what assets. Diversifying is the process of not putting all your money into one asset class.
Hedging
This is the process of positioning an investment purely to cover off the risk of another investment. Ie if one goes down it means the other will go up.
Immunisation
This is the risk migration strategy that can be viewed as a special case of interest rate hedging. Ie matching the duration of assets and liabilities.
Active and passive strategies
These are the two main stratergies you can follow.
Active stratergies
This is about returning returns greater than the benchmark by exploiting believed pricing anomalies, it is done in two main ways
Top-down = this is the big picture strategy
Bottom up = focuses on solely unique attractions of indervidual securities.
Fundermental and technical analysis
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Active equity and bond stratergies
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Passive stratergies
These investors do not take any long term views on economic volatility they seek to max returns by minimising buying and selling.
