Module 1 Rates & Returns Flashcards
What are three ways to think of interest rates?
Required rate of return
Discount rate
Opportunity cost
What is an interest rate?
A rate of return that reflects the relationship between differently dated cash flows.
What is the required rate of return?
The minimum rate of return an investor must receive to accept an investment.
What are discount rates?
A rate of return that reflects the relationship between differently dated cash flows.
What are opportunity costs?
The value that investors forgo by choosing a course of action. If a party decide to spend money today, he forfeits potential interest he could have received on that money.
What are the components of an interest rate?
Real Risk-Free Interest Rate + Inflation Premium + Default Risk Premium + Liquidity Premium + Maturity Premium
What is the real risk-free interest rate?
The single-period interest rate for a completely risk-free security if no inflation were expected.
What is the inflation premium?
A premium that compensates investors for the expected inflation and reflects the average inflation rate expected over the maturity of the debt.
What is the default risk premium?
A premium that compensates investors for the possibility that the borrower will fail to make a promised payment at the contracted time and in the contracted amount.
What is the liquidity premium?
A premium that compensates investors for the risk of loss relative to an investment’s fair value if the investment needs to be converted to cash quickly. Illiquid assets often contain a liquidity premium.
What is the maturity premium?
A premium that compensates investors for the increased sensitivity of the market value of debt to a change in market interest rates as maturity is extended. Often a positive maturity premium on longer-term debt.
What is the nominal risk-free interest rate?
Real risk-free rate + inflation premium
How is the nominal risk-free rate represented in real life?
By short-term government debt
How are interest rates typically quoted?
Annually, that means that a 3% T-Bill over 90 days means an annual 3% interest.
What are the two components of a financial asset’s total return?
Income yield such as dividend or interest + Capital gain or loss reflecting the underlying price of the asset.
What is a Holding Period Return?
The return earned from holding an asset for a single specified period of time.
How to calculate a Holding Period Return?
( (Price at T1 - Price at T0) + Income Yield ) / Price at T0
How to compound Holding Period Returns?
Multiplying
What is Arithmetic Return or Mean Return?
Normal average return, denoted by R with a bar above.
What is Geometric Mean Return?
The compound rate of return. An average return that includes the previous year’s earnings into the base amount. A way to calculate compound returns.
What is an advantage of Geometric Mean over Arithmetic Mean?
Geometric mean includes gains or losses from the previous period into the calculation which makes it more appropriate for portfolio performance measurement.
What is a disadvantage of the Arithmetic Mean?
It is biased upwards unless each of the underlying holding period returns is equal. The bias is particularly severe if the returns are both positive and negative.
What is the Harmonic Mean?
The Harmonic Mean is appropriate in cases in which the variable is a rate or a ratio. Think of Cost Averaging Example.
What is an advantage of Harmonic Mean?
It is not influenced much by outliers.
How are Arithmetic, Harmonic and Geometric Mean mathematically related to each other?
Arithmetic Mean * Harmonic Mean = Geometric Mean Squared
How to calculate the Geometric Mean?
Multiply all numbers between brackets and square it with 1/n
How to calculate Harmonic Mean?
Divide n by the sum of 1/X between brackets.
What is Trimmed Mean?
The trimmed mean removes a small defined percentage of the largest and smallest values from a dataset before calculating the normal mean.
What is Winsorized Mean?
Calculate normal mean after replacing extreme values at both ends with the values of their nearest observations.
When to use Arithmetic Mean, Geometric Mean, or Harmonic / Trimmed / Winsorized Mean?
When you want to include all values = Arithmetic Mean
When there is compounding = Geometric Mean
When there are extreme outliers = Harmonic / Trimmed / Winsorized
What is the money-weighted return?
A return that accounts for the money invested and places more emphasis on periods with more money invested. Gives investors more information on the actual return on her investment.
How to calculate the money-weighted return?
Discount all cash flows back to the present value and set present value equal to zero.
What is the internal rate of return?
Equal to money-weighted rate of return. The discount rate at which the sum of present values is equal to zero.
What is the time-weighted rate of return?
The return that compounds returns over sub-periods together, with each period weighted according to its duration.
How to calculate the time-weighted rate of return?
Multiply the returns of each period + 1 and finally subtract one again.
What is the continuously compounded return?
The natural logarithm of one plus the ending price over the beginning price (actual return).
What is the gross return of asset managers?
The return earned by the asset manager before any deductions like fees or taxes. However, trading commissions are deducted.
What is the net return of an asset manager?
The return after all deductions, net return for investors.
How to calculate the Leveraged Return?
Leveraged Return = Portfolio Return + ( Borrowed Value / Equity Value ) * (Portfolio Return - Interest)
