READING 1 RATES AND RETURNS

Question 1

Interest rates can be thought of in three ways:

Answer 1

1. Required rates of return
2. Discount rates
3. Opportunity costs

Question 2

That is, the minimum rate of return an investor must receive to accept an investment.

1. Required rates of return
2. Discount rates
3. Opportunity costs

Answer 2

1. Required rates of return

Question 3

Rate that must be applied to a future cash flow to determine its present value (PV).

1. Required rates of return
2. Discount rates
3. Opportunity costs

Answer 3

2. Discount rates

Question 4

Is the value that investors forgo by choosing a course of action.

1. Required rates of return
2. Discount rates
3. Opportunity costs

Answer 4

3. Opportunity costs

Question 5

True or false

Economics tells us that interest rates are set by the forces of supply and demand, where investors supply funds and borrowers demand their use.

Answer 5

True

Question 6

We can view an interest rate r as being composed of a real risk-free interest rate plus a set of premiums that are required returns or compensation for bearing distinct types of risk:

Answer 6

r = Real risk-free interest rate + Inflation premium + Default risk premium + Liquidity premium + Maturity premium.

Question 7

Is the single-period interest rate for a completely risk-free security if no inflation were expected. In economic theory, it reflects the time preferences of individuals for current versus future real consumption.

1. Real risk-free interest rate
2. Nominal risk-free interest
3. Risk-free interest rate

Answer 7

1. Real risk-free interest rate

Question 8

Compensates investors for expected inflation and reflects the average inflation rate expected over the maturity of the debt.

1. Inflation premium
2. Liquidity risk premium
3. Maturity premium
4. Default risk premium

Answer 8

1. Inflation premium

Question 9

Compensates investors for the possibility that the
borrower will fail to make a promised payment at the contracted time and in the contracted amount.

1. Inflation premium
2. Liquidity risk premium
3. Maturity premium
4. Default risk premium

Answer 9

4. Default risk premium

Question 10

Compensates investors for the risk of loss relative to an investment’s fair value if the investment needs to be converted to cash quickly.

1. Inflation premium
2. Liquidity risk premium
3. Maturity premium
4. Default risk premium

Answer 10

2. Liquidity risk premium

Question 11

Compensates investors for the increased sensitivity of the market value of debt to a change in market interest rates as maturity is extended, in general (holding all else equal).

1. Inflation premium
2. Liquidity risk premium
3. Maturity premium
4. Default risk premium

Answer 11

3. Maturity premium

Question 12

The sum of the real risk-free interest rate and the inflation premium is?

Answer 12

Nominal risk-free interest rate

The nominal risk-free interest rate reflects the combination of a real risk-free rate plus an inflation premium:

(1 + nominal risk-free rate) = (1 + real risk-free rate) (1 + inflation premium).

Question 13

Typically, interest rates are quoted in.

Answer 13

Annual terms

So the interest rate on a 90-day government debt security quoted at 3 percent is the annualized rate and not the actual interest rate earned over the 90-day period.

Question 14

Simply the percentage increase in the value of an investment over a given period.

1. Holding period return (HPR)
2. Time-weighted rate of return
3. Money-weighted rate of return

Answer 14

2. Time-weighted rate of return

Question 15

The simple average of a series of periodic returns. It has the statistical property of being an unbiased estimator of the true mean of the underlying distribution of returns.

1. Arithmetic mean
2. Harmonic mean
3. Geometric mean

Answer 15

1. Arithmetic mean

Question 16

A compound rate.

1. Arithmetic mean
2. Harmonic mean
3. Geometric mean

Answer 16

3. Geometric mean

Question 17

True or false

When periodic rates of return vary from period to period, the geometric mean return will have a value more than the arithmetic mean return.

Answer 17

False

When periodic rates of return vary from period to period, the geometric mean return will have a value less than the arithmetic mean return

Question 18

Used for certain computations, such as the average cost of shares purchased over time.

1. Arithmetic mean
2. Harmonic mean
3. Geometric mean

Answer 18

2. Harmonic mean

Question 19

The relationship among arithmetic, geometric, and harmonic means can be stated as follows:

Answer 19

Arithmetic mean multiplied by Harmonic mean equals Geometric mean squared

Question 20

For values that are not all equal.

1. Geometric mean < harmonic mean < arithmetic mean
2. Harmonic mean < geometric mean < arithmetic mean
3. Arithmetic mean < harmonic mean < geometric mean

Answer 20

2. Harmonic mean < geometric mean < arithmetic mean

This mathematical fact is the basis for the claimed benefit of purchasing the same money amount of mutual fund shares each month or each week. Some refer to this practice as cost averaging.

Question 21

Measures of average return can be affected by outliers, which are unusual observations in a dataset. Two of the methods for dealing with outliers are?

Answer 21

Winsorized and trimmed mean.

Question 22

Appropriate uses for the various return measures are as follows. Include all values, including outliers.

1. Harmonic mean
2. Arithmetic mean
3. Geometric mean
4. Winsorized mean and trimmed mean

Answer 22

2. Arithmetic mean

Question 23

Appropriate uses for the various return measures are as follows. Compound the rate of returns over multiple periods.

1. Harmonic mean
2. Arithmetic mean
3. Geometric mean
4. Winsorized mean and trimmed mean

Answer 23

3. Geometric mean

Question 24

Appropriate uses for the various return measures are as follows. Calculate the average share cost from periodic purchases in a fixed money amount.

1. Harmonic mean
2. Arithmetic mean
3. Geometric mean
4. Winsorized mean and trimmed mean

Answer 24

1. Harmonic mean

Question 25

Appropriate uses for the various return measures are as follows. Decrease the effect of outliers. 1. Harmonic mean 2. Arithmetic mean 3. Geometric mean 4. Winsorized mean and trimmed mean

Answer 25

4. Winsorized mean and trimmed mean

Question 26

Applies the concept of the internal rate of return (IRR) to investment portfolios. 1. Holding period return (HPR) 2. Time-weighted rate of return 3. Money-weighted rate of return

Answer 26

3. Money-weighted rate of return

Question 27

The interest rate at which a series of cash inflows and out flows sum to zero when discounted to their present value. 1. Real risk-free interest 2. Nominal risk-free rate 3. Internal rate of return 4. Risk-free rate

Answer 27

3. Internal rate of return The money-weighted rate of return is defined as the IRR on a portfolio, taking into account all cash inflows and out lows.

Question 28

Measures compound growth and is the rate at which $1 compounds over a specified performance horizon. It is the process of averaging a set of values over time. 1. Holding period return (HPR) 2. Time-weighted rate of return 3. Money-weighted rate of return

Answer 28

2. Time-weighted rate of return

Question 29

The ... rate of return is not affected by the timing of cash inflows and out lows. 1. Time-weighted rate of return 2. Money-weighted rate of return

Answer 29

1. Time-weighted rate of return

Question 30

In the investment management industry, ... is the preferred method of performance measurement because portfolio managers typically do not control the timing of deposits to and withdrawals from the accounts they manage 1. Time-weighted rate of return 2. Money-weighted rate of return

Answer 30

1. Time-weighted rate of return

Question 31

If funds are contributed to an investment portfolio just before a period of relatively poor portfolio performance, the ... will tend to be lower than the ...

Answer 31

The money weighted rate of return will tend to be lower than the time-weighted rate of return

Question 32

if funds are contributed to a portfolio at a favorable time (just before a period of relatively high returns), the ... will be higher than the ...

Answer 32

the money weighted rate of return will be higher than the time-weighted rate of return.

Question 33

If the manager has complete control over money flows into and out of an account, the ... would be the more appropriate performance measure. 1. Time-weighted rate of return 2. Money-weighted rate of return

Answer 33

2. Money-weighted rate of return

Question 34

Interest rates and market returns are typically stated as ..., regardless of the actual length of the time period over which they occur. 1. Annualized 2. Semi-annual 3. Quarterly

Answer 34

1. Annualized

Question 35

In time value of money calculations (which we will address in more detail in our reading on The Time Value of Money in Finance), more frequent compounding has an impact on future value and present value computations. Specifically, because an increase in the frequency of compounding increases. 1. Internal rate of return 2. Holding period return 3. Effective interest rate 4. Time-weighted rate of return

Answer 35

3. Effective interest rate

Question 36

True or false The effective interest rate, increases the present value of a given cash flow and decreases the future value of a given cash flow

Answer 36

False The effective interest rate, increases the future value of a given cash flow and decreases the present value of a given cash flow

Question 37

The mathematical limit of shortening the compounding period is known as.

Answer 37

Continuous compounding.

Question 38

Refers to the total return on a security portfolio before deducting fees for the management and administration of the investment account. 1. Net return 2. Gross return 3- Real return

Answer 38

2. Gross return Net return refers to the return after these fees have been deducted. Commissions on trades and other costs that are necessary to generate the investment returns are deducted in both gross and net return measures.

Question 39

Nominal return adjusted for inflation. 1. Real risk-free rate 2. Real return 3. Leveraged return

Answer 39

2. Real return Consider an investor who earns a nominal return of 7% over a year when inflation is 2%. The investor’s approximate real return is simply 7 − 2 = 5%

Question 40

Refers to a return to an investor that is a multiple of the return on the underlying asset. It is calculated as the gain or loss on the investment as a percentage of an investor’s cash investment. 1. Real risk-free rate 2. Real return 3. Leveraged return

Answer 40

3. Leveraged return An investment in a derivative security, such as a futures contract, produces a leveraged return because the cash deposited is only a fraction of the value of the assets underlying the futures contract.