Intro returns & compounding

Question 1

What is the definition of the financial system?

Answer 1

A set of institutions that allows for the exchange of contracts and provision of services that allows income and consumption streams to be desynchronized

Question 2

What does the time dimension of returns allow for?

Answer 2

The time dimension allows for the smoothing of consumption over time

Question 3

Define an Individual’s wealth

Answer 3

An individual’s wealth is the present value of all future income, including investment earned and endowed income

Question 4

What is utility maximisation

Answer 4

Utility maximisation is the process of doing the best you can for yourself, subject to the resources at your disposal

Question 5

What are the 3 ways a financial system allows the smoothing of income?

Answer 5

• Insurance > protect against significant costs in the event of losses
• Hedging > reduce volatility and risk in portfolio and investment decisions
• Diversification > The spread of investment allocation within a portfolio, reducing the effect of individual risk

Question 6

What do financial assets give someone claim to?

Answer 6

Financial assets give someone claim to all future wealth generated by those assets

Question 7

What are examples of future cash flows?

Answer 7

Examples of future cash flows include: Dividends, coupon payments, the sale of an asset, insurance payments

Question 8

Decisions that affect a firm’s future cash flows have … … implications

Answer 8

Decisions that affect a firm’s future cash flows have asset pricing implications

Question 9

The market expects us to diversify against…

Answer 9

Risk

Question 10

What will the market compensate us for?

Answer 10

The market will compensate us for taking on more risk by increasing expected return

Question 11

Risk is measured by the s…d… of …

Answer 11

Risk is measured by the standard deviation of yearly returns

Question 12

Why is a dollar today and a dollar in future not the same?

Answer 12

A dollar today and a dollar in the future are not the same because we must account for both risk and time

Question 13

To move a cash flow forward in time, what must we do to it?

Answer 13

To move a cash flow forward in time, we must compound it

Question 14

What is the definition of compounding?

Answer 14

The definition of compounding is the ‘interest on interest’ principle

Question 15

To move a cash flow backwards in time, what must we do to it?

Answer 15

To move a cash flow backwards in time, we must discount it using the discount rate

Question 16

What is the definition of discounting?

Answer 16

Discounting is finding the equivalent value today of some future cash flow

Question 17

What is an individual’s wealth?

Answer 17

Present value of all future income, including investment earned and endowed income

Question 18

What is utility maximisation?

Answer 18

“Do the best you can for yourself, subject to the resources at your disposal”