Measuring Return Flashcards
what is the holding period return formula (using price, not return percentages)?
HPR = (selling price - purchase price +/- cashflows) / purchase price
when there are dividends received, how is the holding period return formula impacted?
dividends received are added to the numerator
when there is margin interest paid, how is the holding period return formula impacted?
margin interest paid is subtracted from the numerator
what is the effective annual rate?
the real return on an investment when the effects of compounding over time are taken into account
what is the arithmetic average?
the simple average
aka the mean
the sum of all numbers divided by the number of observations
what is the main problem of using the arithmetic average?
it does not take compounding into consideration
what is the geometric average?
time-weighted compounded rate of return
aka geometric mean
what is the weighted average?
can be used to calculate a weighted average share price, expected return, beta, or duration
takes into account the number of shares of each of the various priced securities that are owned, or the total value of each security owned, or the individual betas of each security owned, etc.
what does NPV stand for?
Net Present Value
what is net present value used for?
used to evaluate capital expenditures that will result in differing cash flows over the useful life or investment period
when should an investor make an investment, according to NPV?
when the NPV is positive or zero
when should an investor NOT make an investment, according to NPV?
when the NPV is negative
when comparing two projects and their NPVs, which should an investor take?
the investor should choose the project with the higher NPV
NPV = … ?
NPV = PV of cash flows - initial cost
what does IRR stand for?
Internal Rate of Return
what is the internal rate of return?
the discount rate that sets the NPV formula equal to zero
it is the compounded rate of return
when should IRR be used?
when you have uneven cash flows and you are asked to calculate a compounded rate of return
if NPV is positive, how does the IRR compare to the discount rate?
if NPV is positive, then IRR > discount rate
if NPV is zero, how does the IRR compare to the discount rate?
if NPV = 0, then IRR = discount rate
if NPV is negative, how does the IRR compare to the discount rate?
if NPV is negative, then IRR < discount rate
what is the dollar-weighted return?
calculates IRR using the investor’s cash flows
what is the time-weighted return?
calculates IRR using the security’s cash flows
do mutual funds report on a dollar-weighted return or a time-weighted return?
time-weighted return
what is the difference between dollar-weighted and time-weighted return?
dollar-weighted uses the investor’s cash flow
time-weighted uses the security’s cash flow
what does APT stand for?
Arbitrage Pricing Theory
what is Arbitrage Pricing Theory?
asserts that pricing imbalances cannot exist for any significant period of time, otherwise the investors will exploit the price imbalance until the market prices are back to equilibrium
what are the steps to calculate a problem when there is foreign currency translation?
- convert US dollars to foreign currency to determine the cost
- compute the return, typically using the HPR calculation
- convert the foreign currency back to US dollars
