Investments Flashcards
Investment Policy Statement
written document provides general guidelines for investment manager
Includes:
- Objectives (risk & return)
- Constraints (time horizon, taxes, liquidity, legal considerations, unique needs/special circumstances)
does NOT identify specific investments
Holding Period Return HPR
return measure
HPR = (SP - PP +- CFs) / PP = made / paid
Arithmetic Mean
return measure
sum the returns & divide by n
more misleading w/ larger variations in return
Geometric Mean
return measure
compound ROR
will ALWAYS be less than or equal to arithmetic mean
use PV, FV, n, then solve for i
IRR, YTM, YTC, time-weighted return (use the security cash flows), & dollar-weighted return (use the investor’s cash flows) are ALL geometric mean calculations
Weighted Average
return measure
portfolio expected return, portfolio beta, & portfolio duration are all calculated as weighted averages
portfolio standard deviation is NOT a weighted average
Real Rate (inflation adjusted return)
return measure
use w/ education funding & retirement needs questions
Real Rate = [(1+nominal)/(1+inflation) - 1] x 100
Tax Adjusted
return measure
used to determine the after-tax ROR from an investment
After-Tax Return = Pre-Tax Return x (1 - Marginal Rate)
= corporate rate x (1 - tax rate)
Required Return
use CAPM to determine the required ROR on an investment given its systematic risk
Expected Return
use current price & expected future cash flows to calculate the expected return on an investment
RR < expected return = invest (asset undervalued)
RR = expected return = invest
RR < expected return = do NOT invest (asset overvalued)
Actual Return
use w/ Sharpe/Treynor/Jensen to determine risk-adjusted performance
Which measure should you use to evaluate a manager’s performance?
High r^2 = all three measures are reliable
Low r^2 = use Sharpe (bad beta!)
Sharpe Ratio
relative risk measure
excess return divided by total risk (SD)
Treynor Ratio
relative risk measure
excess return divided by systematic risk (beta)
Jensen’s Alpha
absolute risk measure
portfolio return minus CAPM (uses beta)
Information Ratio
ratio of a portfolio’s return in excess of the returns of a benchmark (such as an index) to the standard deviation of those excess returns (tracking error)
the ratio indicates the portfolio manager’s ability to consistently beat the index
the higher the IR the more consistent the manager is in generating excess returns
P/E Ratio
market price of the common stock divided by EPS
= expected price per share / EPS
how much investors are willing to pay for each dollar of earnings
growth stocks = high P/E ratios
value stocks = low P/E ratios
earnings are accounting based & thus do NOT reflect cash flow which is central to equity valuation
P/E ratios also tend to be lower during times of higher inflation
Earnings Per Share (EPS)
= (Net Income - Preferred Dividends) / # common shares outstanding
P/CF Ratio
market price of the common stock divided by cash flow
useful ratio for evaluating non-dividend paying firms
P/S Ratio
market price of the common stock divided by sales
useful ratio for evaluating non-dividend paying firms or firms w/ low or negative profits
PEG Ratio
stock’s P/E ratio divided by 3-5 year growth rate in earnings
PEG < 1.0 = stock may be undervalued; P/E ratio less than average growth in earnings
PEG > 1.0 = stock may be overvalued; P/E ratio greater than average growth in earnings
Yield Curve Theories - 3
attempt to explain the shape of the yield curve
- Expectations Theory
- Liquidity Preference Theory
- Market Segmentation Theory
Expectations Theory
expectations of inflation & the effect on future ST interest rates determine shape
could explain normal & inverted curves
Liquidity Preference Theory
investors accept lower yields for ST investments (price for liquidity) & require premiums for longer term maturities
explains only a normal curve
Market Segmentation Theory
the supply/demand for funds in ST & LT markets determine the shape of yield curve
could explain normal & inverted curves