LM 1: Rates & Returns

Question 1

What are three different ways to consider interest rates? RDO

Answer 1

1. required rates of return
2. discount rate
3. opportunity cost

Question 2

What are the 5 factors that determine interest rates? RIDLM

Answer 2

1. real risk-free rate
2. inflation premium
3. default risk premium
4. liquidity risk premium
5. maturity premium

Question 3

What is the nominal risk-free rate vs the real rate?

Answer 3

nominal risk-free rate: risk-free rate and a premium for expected inflation

real return: return accounting for inflation and other premiums

Question 4

What is the multiplicative for compounding and the additive formula for the nominal risk-free rate?

Answer 4

multiplicative formula:
(1+ nominal risk-free rate) = (1+ real risk free rate) * (1+inflation premium)

additive formula:
nominal risk free rate = real risk free rate + inflation premium

Question 5

What is the holding period return?

Answer 5

rate of return for the single period spanning when investment is made to when position is sold

Question 6

How do you calculate the holding period return for periods less than a year and periods longer than a year?

Answer 6

period less than 1 year:
(price ending- price beginning + income) / price beginning

period more than 1 year:
((1+ return1) * (1+return2) * (1+ return3)) -1

Question 7

What is arithmetic or mean return and formula?

Answer 7

average return of total investments instead of individual investments

(sum of returns) / # of periods

Question 8

What is geometric return?

Answer 8

return method for compounding returns

Question 9

What is the geometric return formula?

Answer 9

return = [(1+return1)(1+return2)(1+return3)] ^(1/T) -1

Question 10

What is harmonic mean and formula?

Answer 10

used for extreme outliers and cost averaging

{1 / [1/N] * ((1/1+ return) + (1/1+return) + (1/1+ return ) + (1/1+ return)…) } -1

Question 11

What is cost averaging?

Answer 11

the periodic investment of a fixed amount of money

Question 12

What is the relationship formula between the arithmetic mean, harmonic mean, and geometric mean?

Answer 12

arithmetic mean * harmonic mean = geometric mean^2

Question 13

What is the trimmed mean?

Answer 13

mean computed after excluding a stated small percentage of the lowest and highest observations

Question 14

What is the winsorized mean?

Answer 14

mean computed after assigning a stated percentage of lowest values a specific low value and a stated percentage of high values a specific high value

Question 15

Which return method would you use for including all values including outliers?

Answer 15

arithmetic mean

Question 16

Which return method would you use for compounding returns?

Answer 16

geometric mean

Question 17

Which return methods would you use for extreme outliers?

Answer 17

1. harmonic mean
2. trimmed mean
3. winsorized mean

Question 18

What is the money-weighted return and how do you calculate it?

Answer 18

internal rate of return (IRR) from the timing of cash inflows and outflows

calculate using CF on financial calculator

put in the in cash flows as negative, and then at the end put total gain from all cash inflows and sale price at end.

Question 19

What is the time-weighted rate of return and how do you calculate it?

Answer 19

return that is unaffected by the timing of cash flows

Calculate it just like geometric return

Question 20

What is the formula for FV and PV with interest rates compounded more than annually?

Answer 20

FVn = PV *(1 + Rs/M) ^mn

PV = FVn *(1+Rs/M) ^mn

rs = stated interest rate
m = compounding periods per year
n = periods

Question 21

What is the annualized return formula?

Answer 21

r annual = ((1 + rate) ^c) -1

c = monthly, weekly, or daily

Question 22

What is the continuous compounding formula?

Answer 22

FVn = PVe ^(rs*n)

rs = interest rate
n = period

Question 23

What is the difference between gross return and net return?

Answer 23

gross return is return before fees

net return is return after paying all applicable fees

Question 24

What is the real return formula?

Answer 24

real = (1 + nominal / 1 + inflation) -1