Measuring Return

Question 1

what is the holding period return formula (using price, not return percentages)?

Answer 1

HPR = (selling price - purchase price +/- cashflows) / purchase price

Question 2

when there are dividends received, how is the holding period return formula impacted?

Answer 2

dividends received are added to the numerator

Question 3

when there is margin interest paid, how is the holding period return formula impacted?

Answer 3

margin interest paid is subtracted from the numerator

Question 4

what is the effective annual rate?

Answer 4

the real return on an investment when the effects of compounding over time are taken into account

Question 5

what is the arithmetic average?

Answer 5

the simple average

aka the mean

the sum of all numbers divided by the number of observations

Question 6

what is the main problem of using the arithmetic average?

Answer 6

it does not take compounding into consideration

Question 7

what is the geometric average?

Answer 7

time-weighted compounded rate of return

aka geometric mean

Question 8

what is the weighted average?

Answer 8

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.

Question 9

what does NPV stand for?

Answer 9

Net Present Value

Question 10

what is net present value used for?

Answer 10

used to evaluate capital expenditures that will result in differing cash flows over the useful life or investment period

Question 11

when should an investor make an investment, according to NPV?

Answer 11

when the NPV is positive or zero

Question 12

when should an investor NOT make an investment, according to NPV?

Answer 12

when the NPV is negative

Question 13

when comparing two projects and their NPVs, which should an investor take?

Answer 13

the investor should choose the project with the higher NPV

Question 14

NPV = … ?

Answer 14

NPV = PV of cash flows - initial cost

Question 15

what does IRR stand for?

Answer 15

Internal Rate of Return

Question 16

what is the internal rate of return?

Answer 16

the discount rate that sets the NPV formula equal to zero

it is the compounded rate of return

Question 17

when should IRR be used?

Answer 17

when you have uneven cash flows and you are asked to calculate a compounded rate of return

Question 18

if NPV is positive, how does the IRR compare to the discount rate?

Answer 18

if NPV is positive, then IRR > discount rate

Question 19

if NPV is zero, how does the IRR compare to the discount rate?

Answer 19

if NPV = 0, then IRR = discount rate

Question 20

if NPV is negative, how does the IRR compare to the discount rate?

Answer 20

if NPV is negative, then IRR < discount rate

Question 21

what is the dollar-weighted return?

Answer 21

calculates IRR using the investor’s cash flows

Question 22

what is the time-weighted return?

Answer 22

calculates IRR using the security’s cash flows

Question 23

do mutual funds report on a dollar-weighted return or a time-weighted return?

Answer 23

time-weighted return

Question 24

what is the difference between dollar-weighted and time-weighted return?

Answer 24

dollar-weighted uses the investor’s cash flow

time-weighted uses the security’s cash flow

Question 25

what does APT stand for?

Answer 25

Arbitrage Pricing Theory

Question 26

what is Arbitrage Pricing Theory?

Answer 26

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

Question 27

what are the steps to calculate a problem when there is foreign currency translation?

Answer 27

1. convert US dollars to foreign currency to determine the cost
2. compute the return, typically using the HPR calculation
3. convert the foreign currency back to US dollars