chapter 5 3fb3

Question 1

Q: How is the rate of return on a zero-coupon bond measured over a holding period?

Answer 1

A: It is measured as the effective annual rate (EAR), which represents the percentage increase in funds per year.

Question 2

Q: What does the effective annual rate (EAR) represent?
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Answer 2

A: EAR is the percentage increase in funds per year, accounting for compounding.

Question 3

Q: What are the key fundamental factors influencing the supply of funds in determining interest rates?

Answer 3

A: The supply of funds primarily comes from savers, particularly households.

Question 4

Q: How does business activity affect the level of interest rates?

Answer 4

A: Businesses demand funds to finance investments in plant, equipment, and inventories, influencing interest rates.

Question 5

Q: How do government actions and inflation expectations impact interest rates?

Answer 5

Government net demand for funds, modified by central bank actions (e.g., Bank of Canada, Federal Reserve), affects interest rates.
The expected rate of inflation also plays a crucial role in determining interest rate levels.

Question 6

: What is the nominal interest rate?

Answer 6

A: The nominal interest rate is the growth rate of your money.

Question 7

: What is the real interest rate?

Answer 7

A: The real interest rate is the growth rate of your purchasing power.

Question 8

Q: How does inflation affect nominal interest rates?

Answer 8

A: As inflation increases, investors demand higher nominal rates of return.

Question 9

Q: What does the Fisher equation predict about nominal interest rates?

Answer 9

A: The Fisher equation predicts that nominal interest rates should track the inflation rate, keeping the real interest rate relatively stable.

Question 10

Q: When does the Fisher equation work more effectively?

Answer 10

A: It works better when inflation is predictable, allowing investors to accurately gauge the nominal rate required to achieve an acceptable real return.

Question 11

Q: What are the main sources of investment risk?

Answer 11

Macroeconomic fluctuations: Changes in the economy like recessions or interest rate shifts.
Industry changes: Risks tied to the performance of specific sectors.
Firm-specific risks: Unexpected events within a company, like management changes or product failures.

Question 12

Q: How do macroeconomic factors affect investments?

Answer 12

A: Macroeconomic risks include inflation, interest rates, and economic cycles, which can impact overall market performance and investor returns.

Question 13

Q: What is holding period return (HPR)?

Answer 13

A: HPR measures the total return on an investment during a period, including price changes and dividends.

Question 14

Q: What is risk aversion and how does it affect investment decisions?

Answer 14

Risk aversion refers to the degree to which investors are unwilling to take on risk. It influences the pricing of risky assets, ensuring that the risk premium (excess return over the risk-free rate) is appropriate for the risk level of the asset.

Question 15

Q: How is risk best measured in investing?

Answer 15

A: Risk is best measured by the standard deviation of excess returns (the return over the risk-free rate), not by total returns, as it isolates the variability of returns from the risk-free benchmark.

Question 16

Q: What is the Sharpe ratio and how is it calculated?

Answer 16

A: The Sharpe ratio evaluates an investment’s performance by comparing the risk premium (excess return) to the standard deviation of excess returns.

Question 17

Q: Why is investment management easier when returns are normally distributed?

Answer 17

A: When returns are normally distributed, the standard deviation effectively measures risk. This allows for more straightforward estimation of future returns and risk, simplifying investment management.

Question 18

Q: What happens if excess returns are not normally distributed?

Answer 18

A: If excess returns are not normally distributed, the standard deviation is no longer a complete measure of risk, and the Sharpe ratio is not a complete measure of portfolio performance.

Question 19

Q: When are portfolio returns symmetric, and what is needed to estimate future scenarios?

Answer 19

A: If individual security returns are symmetric, portfolio returns will also be symmetric. In this case, only the mean and standard deviation are needed to estimate future scenarios.

Question 20

Q: How can the statistical relationship between returns be summarized?.

Answer 20

A: The statistical relationship between returns can be summarized using a single correlation coefficient, which measures the degree to which returns move together

Question 21

Q: What is a lognormal distribution?

Answer 21

A: A lognormal distribution is a probability distribution that characterizes a variable whose log has a normal (bell-shaped) distribution.

Question 22

Q: Why are continuously compounded returns used instead of effective annual returns?

Answer 22

A: Continuously compounded returns are used because they align better with the lognormal distribution, which is often assumed for asset prices over time.

Question 23

Q: What is the difference between short-run and long-run risk?

Answer 23

A: Short-run risk is typically more volatile and subject to market fluctuations, while long-run risk tends to be more stable and can be more accurately estimated due to the time horizon.