Lecture 7-Introducing and measuring returns Flashcards
What are fixed-income (debt) securities?
They pay a specified cash flow over a specific period.
What is equity?
An ownership share in a corporation.
What are derivative securities?
Securities providing payoffs that depend on the values of other assets.
Explain the information role of financial markets.
Investors will decide whether a company lives or dies.
Explain consumption timing
Some earn greater than they consume therefore will (buy shares)
However,
others consume greater than they earn therefore (sell shares)
Describe allocation of risk
Where both risk tolerant and risk averse investors are happy.
Examples of assets in an investment portfolio.
Stocks
Bonds
Real estate
Commodities
Derivatives
How to calculate Holding period return for a stock.
Capital gain yield + dividend yield (cash dividend/ share price).
What is arithmetic average?
A way of measuring average returns over longer periods of time.
How is arithmetic average calculated?
The sum of returns in each period / the number of periods.
What is geometric average?
The single-period return that gives the same cumulative performance as the sequence of actual returns (Time-weighted returns).
How is geometric average calculated?
Compounding the actual period by period returns and then finding the equivalent single-per period return.
When should you use GAR vs ARR?
Use ARR if you are not reinvesting any cash flows received before the end of the period.
Use GAR if you are reinvesting any cash flows received before the ed of the period.
Examples of Annual percentage rate (APR) assets.
Assets with regular cash flows e.g. mortgages or bonds.
How do you calculate APR?
APR=(periods in year) X (rate for period)
example: monthly return of 1.01%
APR= 1.01% X 12= 12.12%
How can APR be translated into n effective annual rate (EAR) ?
APR is calculated as EAR = (1+ rate for period) ^n periods per year -1
Example: monthly return of 1.01%
EAR= (1.01)^12 -1= 12.68%
Now expressed relation:
1+EAR=(1+ Rate per period)^n = (1+ APR/n)^n
What is scenario analysis?
Quantifying risk, through devising a list of possible economic outcomes, or scenarios, and specifying both the likelihood of each scenario and the HPR the asset will realise in that scenario.
What is probability distribution?
The list of possible HPRs with associated probabilities.
What is expected return in scenario analysis?
The mean value of the distribution of HPR.
Explain the importance of probability distribution.
Allows us to derive measurements for both the reward and risk of the investment.
To implement scenario analysis and probability distribution, what measures are required?
Mean- The mean of the distribution.
Variance- The expected value of the squared deviation from the mean/ the expected value of the squared ‘surprise’ across scenarios.
Standard deviation- The square root of the variance.
what is deviation in measuring risk?
Uncertainty surrounding the investment is a function of the magnitudes of the possible suprise.
Describe normal distribution
The probabilities are higher for outcomes near the mean and significantly lower for outcomes far from the mean.
What are the two critical theoretical and practical rationalisations of investment management?
The return of a portfolio of two or more assets whose returns are normally distributed will also be normally distributed.
The normal distribution is fully described by its mean and standard deviation.
What do the 2 rationalisations of theoretical and practical of investment management imply?
The standard deviation is the appropriate measure of risk for a portfolio comprised of assets with normally distributed returns.
What is the formula for HPR?
HPR = (Ending price - Beginning Price + Dividend) / Beginning Price
What are the features of Equity Securities?
Ownership:
-Represents ownership shares in a corporation
Claim priority:
-Lower priority (after creditors)
Payment:
-Dividends not guaranteed, depends on profits and reinvestment
Life span:
-Indefinite
Risk and returns:
- Higher risk, results on company performance and market conditions.
What are the features of fixed-income securities?
Ownership:
-Does not confer ownership interest
Claim priority:
- Higher priority (before equity holders)
Payments:
_fixed cash flows paid at contracted intervals until maturity.
Life span:
- Fixed term, priciple repaid at maturity
Risk and returns:
- Lower risk, more stable returns based on on interest rates and issuers credit status
Differences between real and financial assets.
Real assets are assets used to produce goods and services.
Financial assets are claims on real assets or the income generates by them.
