Chapter 5 - Risk, return, and the historical record

Question 1

holding period return

Answer 1

• Rate of return over a given investment period
• Dollars earned (price appreciation + dividend) per dollar invested

Question 2

HPR =

Answer 2

= (endP - begP + div) / begP
or
= div yield + capital gains yield

Question 3

dividend yield

Answer 3

• dividend / share price
• the percentage return from dividends

Question 4

div yield =

Answer 4

= (cash dividends / beginning price)

Question 5

capital gains yield

Answer 5

the percentage price increase

Question 6

arithmetic average

Answer 6

The sum of returns in each period divided by the number of periods

Question 7

geometric average

Answer 7

• The single per-period return that gives the same cumulative performance as the sequence of actual returns
• e.x. r = [(1 +.10) x (1 + .25) x (1 - .20) x (1 + .20)]^¼ - 1 = 7.19%

Question 8

Dollar-weighted average return

Answer 8

The internal rate of return on an investment

Question 9

IRR

Answer 9

the interest rate that sets the present value of the cash flows equal to the initial cost of establishing the portfolio

Question 10

APR =

Answer 10

= per-period rate x periods per year

Question 11

EAR =

Answer 11

= ((1 + rate per period)^n) - 1
= ((1 + APR / n)^n) - 1

Question 12

nominal interest rate

Answer 12

The interest rate in terms of nominal (not adjusted for purchasing power) dollars

Question 13

real interest rate

Answer 13

The growth rate of purchasing power derived from an investment

Question 14

Rreal =

Answer 14

= (Rnom - i) / (1 + i)

Question 15

fisher equation

Answer 15

Rreal ≈ Rnom - E(i)

Question 16

consumer price index

Answer 16

measures purchasing power by averaging the prices of goods and services in the consumption basket of an average urban family of four

Question 17

inflation rate

Answer 17

The rate at which prices are rising, measured as the rate of increase of the CPI

Question 18

equilibrium nominal rate of interest

Answer 18

Rnom = Rreal + E(i)

Question 19

scenario analysis

Answer 19

A list of possible economic scenarios, the likelihood of each, and the HPR that will be realized in each case

Question 20

probability distribution

Answer 20

List of possible outcomes with associated probabilities

Question 21

expected return of scenario analysis

Answer 21

The mean value of the distribution of HPR

Question 22

Variance(Var)

Answer 22

The expected value of the squared deviation from the mean

Question 23

standard deviation

Answer 23

The square root of the variance

Question 24

Value at risk(VaR)

Answer 24

• Measure of downside risk
• The worst loss that will be suffered with a given probability, often 1% or 5%
• =NORMSINV(.05) in excel

Question 25

kurtosis

Answer 25

• Measure of the fatness of the tails of a probability distribution relative to that of a normal distribution
• Indicates likelihood of extreme outcomes

Question 26

skew

Answer 26

Measure of the asymmetry of a probability distribution

Question 27

risk free rate

Answer 27

The rate of return that can be earned with certainty, often measured by the rate on Treasury bills

Question 28

risk premium

Answer 28

An expected return in excess of that on risk-free securities

Question 29

excess returns

Answer 29

Rate of return in excess of the risk-free rate

Question 30

risk aversion

Answer 30

Reluctance to accept the risk

Question 31

individual risk =

Answer 31

risk premium of portfolio (E(rC) - rf) / variance of portfolio return(σ^2C)

Question 32

price of risk

Answer 32

The ratio of portfolio risk premium to variance

Question 33

sharpe ratio

Answer 33

• Ratio of portfolio risk premium to standard deviation
• Quantifies the incremental reward(increase in risk premium) for each 1% increase in the portfolio stdev
• Only for ranking portfolios, not individual assets

Question 34

sharpe ratio =

Answer 34

= portfolio risk premium / stdev of portfolio excess return

Question 35

mean-variance analysis

Answer 35

Evaluating portfolios according to their expected returns and standard deviations (or variances)

Question 36

A high book-to-market (B/M) ratio is interpreted as…

Answer 36

• value stock
• an indication that the value of the firm is driven primarily by assets already in place, rather than the prospect of high future growth

Question 37

asset allocation

Answer 37

Portfolio choice among broad investment classes

Question 38

Capital allocation to risky assets

Answer 38

The choice between risky and risk-free assets

Question 39

complete portfolio

Answer 39

The entire portfolio including risky and risk-free assets

Question 40

Risk premium of the complete portfolio =

Answer 40

= risk premium of the risky asset x the fraction of the portfolio invested in the risky asset

Question 41

The stdev of the complete portfolio =

Answer 41

stdev of the risky asset times the fraction of the portfolio invested in the risky asset

Question 42

capital allocation line (CAL)

Answer 42

• Plot of risk-return combinations available by varying portfolio allocation between a risk-free asset and a risky portfolio
• The slope, S, equals the increase in expected return that an investor can obtain per unit of additional stdev

Question 43

Investors preferred capital allocation =

Answer 43

= available risk premium to variance ratio / required risk premium to variance ratio

Question 44

passive strategy

Answer 44

Investment policy that avoids security analysis, often entails indexing

Question 45

capital market line (CML)

Answer 45

The capital allocation line using the market index portfolio as the risky asset