Lecture 7-Introducing and measuring returns

Question 1

What are fixed-income (debt) securities?

Answer 1

They pay a specified cash flow over a specific period.

Question 2

What is equity?

Answer 2

An ownership share in a corporation.

Question 3

What are derivative securities?

Answer 3

Securities providing payoffs that depend on the values of other assets.

Question 4

Explain the information role of financial markets.

Answer 4

Investors will decide whether a company lives or dies.

Question 5

Explain consumption timing

Answer 5

Some earn greater than they consume therefore will (buy shares)

However,
others consume greater than they earn therefore (sell shares)

Question 6

Describe allocation of risk

Answer 6

Where both risk tolerant and risk averse investors are happy.

Question 7

Examples of assets in an investment portfolio.

Answer 7

Stocks
Bonds
Real estate
Commodities
Derivatives

Question 8

How to calculate Holding period return for a stock.

Answer 8

Capital gain yield + dividend yield (cash dividend/ share price).

Question 9

What is arithmetic average?

Answer 9

A way of measuring average returns over longer periods of time.

Question 10

How is arithmetic average calculated?

Answer 10

The sum of returns in each period / the number of periods.

Question 11

What is geometric average?

Answer 11

The single-period return that gives the same cumulative performance as the sequence of actual returns (Time-weighted returns).

Question 12

How is geometric average calculated?

Answer 12

Compounding the actual period by period returns and then finding the equivalent single-per period return.

Question 13

When should you use GAR vs ARR?

Answer 13

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.

Question 14

Examples of Annual percentage rate (APR) assets.

Answer 14

Assets with regular cash flows e.g. mortgages or bonds.

Question 15

How do you calculate APR?

Answer 15

APR=(periods in year) X (rate for period)

example: monthly return of 1.01%

APR= 1.01% X 12= 12.12%

Question 16

How can APR be translated into n effective annual rate (EAR) ?

Answer 16

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

Question 17

What is scenario analysis?

Answer 17

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.

Question 18

What is probability distribution?

Answer 18

The list of possible HPRs with associated probabilities.

Question 19

What is expected return in scenario analysis?

Answer 19

The mean value of the distribution of HPR.

Question 20

Explain the importance of probability distribution.

Answer 20

Allows us to derive measurements for both the reward and risk of the investment.

Question 21

To implement scenario analysis and probability distribution, what measures are required?

Answer 21

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.

Question 22

what is deviation in measuring risk?

Answer 22

Uncertainty surrounding the investment is a function of the magnitudes of the possible suprise.

Question 23

Describe normal distribution

Answer 23

The probabilities are higher for outcomes near the mean and significantly lower for outcomes far from the mean.

Question 24

What are the two critical theoretical and practical rationalisations of investment management?

Answer 24

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.

Question 25

What do the 2 rationalisations of theoretical and practical of investment management imply?

Answer 25

The standard deviation is the appropriate measure of risk for a portfolio comprised of assets with normally distributed returns.

Question 26

What is the formula for HPR?

Answer 26

HPR = (Ending price - Beginning Price + Dividend) / Beginning Price

Question 27

What are the features of Equity Securities?

Answer 27

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.

Question 28

What are the features of fixed-income securities?

Answer 28

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

Question 29

Differences between real and financial assets.

Answer 29

Real assets are assets used to produce goods and services.

Financial assets are claims on real assets or the income generates by them.