Lecture 2

Question 1

To establish the level of risk we should find in the marketplace

Answer 1

Use historical experience to forecast, there is no theory about the level of risk

Question 2

Are expected returns/ risk directly observable?

Answer 2

No

Question 3

Can we observe realised rates of return?

Answer 3

Yes

Question 4

Total risk-free return formula =

Answer 4

(Par value) / P(T) ) - 1

Question 5

Investment returns are expressed as

Answer 5

Effective annual rate (EAR)

Question 6

Effective annual rate (EAR) shows

Answer 6

% increase in funds invested over a 1 year horizon

Question 7

Gross return =

Answer 7

Terminal value of a $1 investment

Question 8

EAR formula =

Answer 8

EAR = rf(1)

Question 9

Gross return formula =

Answer 9

(1 + EAR)

Question 10

Annual percentage rate (APR) shows

Answer 10

Annual rate charged for borrowing or earned through an investment

Question 11

As T (years) approaches zero

Answer 11

Effectively approach continuous compounding. The relationship between EAR and APR given by the exponential function.

Question 12

Holding period =

Answer 12

How long an individual holds an investment for

Question 13

Realised rate of return depends on (2)

Answer 13

• Price per share at period’s end

- Cash dividends collected over the year

Question 14

Holding period return assumes

Answer 14

All dividends are received at the end of the period

Question 15

Holding period return formula =

Answer 15

[ (Ending price of share - starting price) + Cash dividend ] / Starting price

Question 16

Holding period return ignores

Answer 16

Reinvestment income earned between receipt payment and end holding period if dividends are received during the period

Question 17

Dividend yield =

Answer 17

% return from dividends

Question 18

Holding period return simple formula =

Answer 18

Dividend yield + Rate capital gains

Question 19

Standard deviation of the rate of return is

Answer 19

A measure of risk

Question 20

Standard deviation =

Answer 20

Square root of variance

Question 21

Variance =

Answer 21

Expected value of squared deviations from expected returns. Provides measure of uncertainty of outcomes.

Question 22

Higher the volatility

Answer 22

Higher the variance

Question 23

Standard variance is a reasonable measure of risk as long as

Answer 23

The probability distribution is symmetric about the mean

Question 24

Risk premium =

Answer 24

Expected return - risk free rate

Question 25

Excess return =

Answer 25

Actual rate of return - actual risk free rate

Question 26

Risk premium is an estimate for

Answer 26

The value of excess return

Question 27

Risk aversion =

Answer 27

Degree to which investors willing to commit funds to stock

Question 28

If the risk premium = 0

Answer 28

Investors wouldn’t invest > risk averse

Question 29

Geometric average return =

Answer 29

Measure of performance (fixed annual HPR) which compounds over a period to a terminal value

Question 30

Arithmetic average return =

Answer 30

Arithmetic average of a sample of rates of return

Question 31

Larger the swings in rates of return

Answer 31

Greater the discrepancy between arithmetic and geometric averages

Question 32

3 types of means

Answer 32

• Expected
• Arithmetic
• Geometric

Question 33

Sharpe ratio

Answer 33

The importance of the trade off between reward (risk premium) and risk (measured by s.d) suggests that we measure the attraction of a portfolio by a ratio of risk premiums to s.d. of excess returns

Question 34

Sharpe ratio formula =

Answer 34

Risk premium / SD of excess returns

Question 35

Sharpe ratio widely used

Answer 35

To evaluate performance of investment managers

Question 36

When the distribution is positively skewed

Answer 36

Standard deviation overestimates risk due to extreme positive surprises (which don’t concern investors) but increase the estimate of volatility

Question 37

Kurtosis measures

Answer 37

The degree of fat tails

Question 38

Any kurtosis above 0 (excess)

Answer 38

Sign of fatter tails

Question 39

Value at risk (VaR) =

Answer 39

Measure of the risk of loss for investments

Question 40

Value at risk is (2)

Answer 40

• The most optimistic measure of risk > as it takes the highest return (smallest loss)
• More realistic > expected loss of downside exposure
  This is called expected shortfall (ES) or conditional tail expectation (CTE)