MODULE 1.1: Interest Rates and Return Measurement

Question 1

What are Interest rates and required return

Answer 1

time value of money and change based on the risk of the asset - we can then have a required return to calculate what the required return for a certain asset is based on a specific risk.

Question 2

risk-free rate

Answer 2

• no inflation expection and no probability of default. This represents the time preference of things.
• T bills are essentially risk free but have AN INFLATION PREMIUM

Question 3

nominally risk free and formula

Answer 3

refers to investments that have virtually no risk of default or loss of principal, but are still subject to inflation risk. Treasury bills (T-bills) are a prime example - while they guarantee return of principal and interest, their purchasing power can be eroded by inflation over time.

1+ nominal risk free rate = (1 + real risk free rate) (1 + expected inflation rate)

Question 4

Real rate

Answer 4

rate of return adjusted for inflation, showing true purchasing power increase

Question 5

risk free rate

Answer 5

rate with no default risk (gov securities), but includes inflation

Question 6

real risk free rates

Answer 6

pure time value of money - no inflation and no default risk (very theoretical )

Question 7

Time preference

Answer 7

refers to how people value immediate consumption over future consumption.This preference helps explain why interest rates exist - people need to be compensated with additional future value to delay consumption.

Question 8

premium

Answer 8

kind of like an added fee to a return (adding inflation premium to a risk free rate to calculate the nominal risk free rate like for a T bill)(inflation - like when we calculate the rate on a t-bill, we need to add inflation to adjust for it

Question 9

default risk premium

Answer 9

if the borrower of the money cannnot make their payments, then they have to default on thier loan which is risky

Question 10

liquidity risk premium

Answer 10

if you need the money asap so you need to sell the security to get it and you don’t reap the long term reward of keeping it

Question 11

maturity premium for long term bonds

Answer 11

• long term bonds can be a bit risky for example so we need to add a premium to help mitigate this risk and increase the time value of money

Question 12

HPR (holding period return) formula

Answer 12

HPR = (end of period value / beginning of period value ) - 1

Question 13

Arithmatic mean formula

Answer 13

sum / n

usually the largest of the means if there is variation in the dataset. This is very much effected by extreme values in the data

Question 14

geometric mean

Answer 14

nth root of the returns multiplied - 1

nthROOT((1+R1)(1+R2)(1+R3)) - 1

Question 15

Annual return formula

Answer 15

• similar to geometric mean in formula where you take the nth root of the returns -1, but n= the number of annnual periods (could be semi annual etc )(like 4 semi annual means 2 years)

Question 16

harmonic mean formula

Answer 16

= N / (1/x + 1/x + 1/x)

Question 17

arithmetic harmonic geometric mean relationship

Answer 17

arithmetic x harmonic = geometric ^ 2

arithmatic mean > geometric mean > harmonic mean when variation is present