L2 - Risk and Return Flashcards
How would you derive the perpetuity formula?
PV of an annuity?
Why do we use the EAR?
Dont use APR, use EAR for all discounting (taking into account you reinvesting all extra payments where over that period)
Annual Percentage rate?
EAR > than APR except for when n = 1 then they are the same
- monthly interest would be APR/12 and not account for any gains from reinvested interest
How do we covert from APR to EAR?
How do you compound continuously?
- (1+EAR) = eAPR
- To get the PV formula just sub into the bottom of the fraction the above formula and rearrange algebraically
How do you convert between real and nominal interest rates?
What is the Fisher Equation for nominal interest rate?
What does a probability distribution of returns look like?
Why do we use standard deviation over variance as a measure of risk?
- of the same units as expected return
- While variances and Covariances could be used,
- But we are making the assumption that returns are normally distributed over time, and scattered around the mean, so s.d. is a good measure to go with e.g. 68% of results should be within 1 s.d. of the mean
- 2 s.d. –> 95%
- 3 s.d. –> 99.7%
- What is the distribution is skewed or not normal
- lots happening at extremes or attendance to be positive/negatively skewed
- using s.d. in this case you could be under/overestimating the risk involved in the investment
- in this case, we need other moments to measure risk
- skewness and kurtosis of the distribution
- usually in the distribution isn’t normal you can log the distribution then treat it as if it was noraml
how do calculate holding period returns?
When do we use expected returns and variance using probability over arithmetic mean and variances?
- use the later on historical returns
- remember to adjust for 1 degree of freedom in the variance calculation
the historical trade-off between risk and return of different asset classes
How do you calculate correlation and covariance between two stocks?
