Lesson 3

Question 1

3.1.1 Differentiate between interest rate, nominal interest rate, and real interest rate.

Answer 1

An interest rate is a promise rate of return denominated in some unit of account over sometime. $/Month

Nominal interest rate is the growth rate of your money. It is the interest rate that is quoted it on bonds and loans

Real interest-rate is the growth rate of your purchasing power. It is approximated as the nominal rate reduced by inflation

Question 2

3.1.2 List 4 fundamental factors that determine the levels of nominal in real interest rates

Answer 2

1. The supply of funds from savers
2. Business demand for funds to finance physical investments in real assets or capital formation
3. The governments net supply or demand for funds as modified by actions of monetary authority such as the government and the central bank
4. The rate of inflation

Question 3

3.1.3
Assume one year ago you deposited $500 in a one year time deposit guaranteeing a 10% rate of return.

You collect $550 in cash. Explain how a 3% rate of inflation impacts your purchasing power

Answer 3

Part of your $50 interest earnings are offset by the reduction in purchasing power by the dollars you’ll receive at the end of the year. Using the real interest rate approximation rule, you were left with a net increase in purchasing power of about 7%

Question 4

3.1.7.a If businesses increases their capital spending in order to acquire or upgrade buildings machinery and equipment how will this impact the demand curve for funds and the real rate of interest

Answer 4

The demand curve will shift to the right and increase the real rate of interest

Question 5

3.1.7.b If households are induced to save more because of increased uncertainty about their future how will this impact the supply of funds curve and real interest rate

Answer 5

This will shift the supply of funds curve to the right and real interest rates will fall

Question 6

3.1.7.c If the bank of Canada sells treasury bonds to reduce the supply of money, the public pays for these bonds with currency and bank deposits reducing the money in circulation, how will this impact the supply of funds curve and the real rate of interest

Answer 6

This will shift the supply curve to the left. The real rate of interest will rise.

It can also cause an increase in the demand for funds. This will shift the demand curve to the right

Question 7

3.1.8 Describe the significance of the Fisher hypothesis

Answer 7

The fisher equation for nominal interest rates implies that if real interest rates are reasonably stable, then changes in the nominal interest rates predict changes in inflation rates. That is the nominal interest rate equals the real interest rate plus expected inflation

Question 8

3.2.1 Explain a limitation of total return when comparing returns

Answer 8

Total return is the amount of value an investor earns from the security over it’s investment time horizon or holding period.

Investments generate returns in various ways which are expressed as a percentage of the amount it originally invested. Because total returns are cumulative over the investment time horizon, typically, the longer the time horizon of the investment, the greater the total returns. Therefore, I limitation of total return is that total returns on investment with differing time horizons are not comparable

Question 9

3.2.2 Describe annual percentage rate [APR]

Answer 9

Rates on short term investments are often reported using simple rather than compound interest these are called APRs.

APR= number or periods x per period rate

Question 10

3.2.3 Describe effective annual rate [EAR]

Answer 10

The annual effective rate is an annual rate of interest actually earned on investment as a result of compounding the interest over and given period of time.

It is used to compare different financial products that calculate interest with different compounding periods

Question 11

3.2.4 Explain how the frequency of compounding impacts the difference between the APR and EAR

Answer 11

An investment whose interest is compounded annually will have an effective annual rate that is equal to the annual percentage rate.

When interest is compounded more frequently than annually the effective annual rate is higher than the corresponding annual percentage rate

Question 12

3.2.5 Assume you’re choosing between investing $50,000 in a conventional one year uppercase GIC offering an interest rate of 5% any one year inflation plus GIC offering an interest rate of 1.5% plus the rate of inflation. Identify the investment offering the higher expected return

Answer 12

If the expected Inflation rate is less than 3 1/2% then the GIC offering the 5% guarantee you will have a higher expected return

Question 13

3.3.1 Identify three factors impacting and investments holding period return (HPR)

Answer 13

Holding. Return is the total return from holding an investment over a period of time. It is affected by:

1. The difference between the asset price when it was purchased and the price at the end of the holding period
2. Any income in the form of dividends over the holding period
3. Any income in the form of interest over the holding period

Question 14

3.3.3 Explain I have semi annual dividends what affects the holding period return As opposed to quarterly dividends given that the total dividends paid are equal

Answer 14

The holding period return for both investments will be equal since the holding period return ignores reinvestment income earned on dividends paid

Question 15

3.3.9 Defined the terms standard deviation of the rate of return and variance

Answer 15

The standard deviation of the rate of return is a measure of risk. Standard and deviation is used to “define the amount of variation or dispersion of a set of data points. A low standard deviation indicates they are close together well the high standard deviation indicates that data points are spread out over a wide range of values

Variation is calculated by taking the expected value of the square deviations of each value in the set from the expected return.

Question 16

3.3.11.a Defined the term risk-free rate

Answer 16

The risk-free rate is the interest rate that can be earned with certainty on the investment it is the rate you can earn by investing in risk-free assets such as treasury bills money market funds or bank deposits

Question 17

3.3.11.b Defined the term risk premium

Answer 17

The risk premium is the expected return on investment in excess of that provided on risk-free securities.

The risk premium compensates for the risk of an investment. For example with the risk-free rate is 5% per year and they expect a return on investment is 8.75% per year when it’s risk premium is 3.75%

Question 18

3.3.11.c Defined the term excess return

Answer 18

The difference between the actual rate of return on a risky asset and the risk-free rate is the excess return.

Therefore the risk premium is the expected access return, and a standard deviation of the excess return is a measure of the investments risk

Question 19

3.3.12 Explain the significance of the level of risk aversion for investment decision making

Answer 19

The less risk averse a investor is the more willing they are to commit funds to risky investments in exchange for a higher rate of return.

Financial analyst generally assume and just it was our risk-averse in the sense that if risk premiums were zero, people would not be willing to invest any money in stocks.

Question 20

3.3.13 Explain the difference between a arithmetic average and a geometric average as they relate to a portfolios return

Answer 20

The arithmetic average is simply a sum of the returns divided by the number of years this calculation considers the returns as independent events.

Geometric averages take into account reinvestment and accurately reflect the impact of capital losses as such geometric averages are more accurate reflections of returns

Question 21

3.3.14 Explain how observation frequency and the duration of a sample time series impact the accuracy of mean estimates of return on investment

Answer 21

Observation frequency has no impact on the accuracy of mean estimates.

A longer sample will improve accuracy.

Use the longest sample that you believe comes from the same return distribution. The underlying assumption is that the majority of investment and price activity follows a normal distribution

Question 22

3.4.1.a Give the formula for the Sharpe ratio

Answer 22

Sharpe Ratio =

Risk Premium /
Standard Deviation of excess return

Question 23

3.4.1.b Explain the significance of the sharp ratio for evaluating the attractiveness of an investment portfolio

Answer 23

The sharper ratio is a measure for calculating risk-adjusted return. It can be used to evaluate the total performance of an investment portfolio or the performance of an individual stock.

The shop ratio tells an investor what portion of a portfolio performance is associated with risk-taking using one measure of risk, the standard deviation or variance in returns.

It isolates the expected access return that the portfolio could be expected to generate per unit of portfolio return variability

Question 24

3.4.1.c In general what does a higher sharpe ratio indicate

Answer 24

The higher the sharpe ratio the more return the investor is shouldering per unit of risk carried, the more tractive the risk-adjusted return.

Question 25

3.4.1.d In general what does a lower sharpe ratio indicate

Answer 25

The lower the sharpe ratio the more risk the investors shouldering to earn additional returns

Question 26

3.4.1.d For a sharpe ratio what is considered to be a good an excellent ratio and what ratio with a portfolio of risk-free assets have

Answer 26

A ratio of 0 would be for a risk free portfolio

A ratio of 1 or better is considered good, 2 or better is very good, 3 or better is excellent

Question 27

3.4.1.e What distribution of expected returns will the Sharpe ratio work best for

Answer 27

The sharpe ratio is designed to be applied to investment strategies that have normal expected return distributions.

It is not suitable for measuring investments that are expected to have asymmetric returns