Chapter 4 Terms Flashcards
Why is return important?
Allows us to “keep score” on how our investments are doing compared to our expectations
Satisfactory Investment
one for which the present value of benefits equals or exceeds the present value of its costs
Required Return
The rate of return an investor must earn on an investment to be fully compensated for its risk
Real Rate of Return
Measures the change in purchasing power provided by an investment
Expected Inflation Premium
The average rate of inflation expected in the future
Risk Premium
Additional return an investor requires on a risky investment to compensate for risks based upon issue and issuer characteristics
Holding Period
the period of time over which an investor wishes to measure the return on an investment vehicle
Realized Return
current return actually received by an investor during the given return period
Paper Return
return that has been achieved but not yet realized (no sale has taken place)
Advantages of holding period return
- Easy to calculate
- Easy to understand
- Considers income and growth
Disadvantages of Holding Period Return
- Does not consider time value of money
- Rate may be inaccurate if time period is longer than one year
Internal Rate of Return
determines the compound annual rate of return earned on an investment held for longer than one year
Advantages of Internal Rate of Return
- Uses the time value of money
- Allows investments of different investment periods to be compared with each other
- If the yield is equal to or greater than the required return, the investment is acceptable
Disadvantages of Internal Rate of Return
Calculation is complex
Reinvestment Rate
the rate of return earned on interest or other income received from an investment over its investment horizon.
Fully compounded rate of return
the rate of return that includes interest earned on interest
Risk-Return Tradeoff
The relationship between risk and return, in which investments with more risk should provide higher returns, and vice versa
Business Risk
is the degree of uncertainty associated with an investment’s earnings and the investment’s ability to pay the returns owed to investors.
Financial Risk
the degree of uncertainty of payment resulting from a firm’s mix of debt and equity; the larger the proportion of debt financing, the greater this risk
Purchasing Power Risk
the chance that changing price levels (inflation or deflation) will adversely affect investment returns
Interest Rate Risk
the chance that changes in interest rates will adversely affect a security’s value
Tax Risk
the chance that Congress will make unfavourable changes in tax laws, driving down the after-tax returns and market values of certain investments.
Liquidity Risk
the risk of not being able to liquidate an investment conveniently and at a reasonable price
Market Risk
the risk of decline in investment returns because of market factors independent of the given investment
Event Risk
comes from an unexpected event that has a significant and unusually immediate effect on the underlying value of an investment.
