Reading 31 - Return Concepts Flashcards
How do you caluclate a Holding per Return (HPR))?
If a daily return is 0.80%, how would you calculate an annualized return?
= (1.0008) ^365
Define the required rate of return…
The minimum level of expected return that an investor requires in order to invest.
How do you calculate Expected Alpha?
= Expected Return - Required Return
If an asset’s price equals the intrinsic value price, what is the expected alpha?
0
How do you calculate an expected return?
= Required return + a return from the convergence of price to value
What does Market Informational Efficiency mean?
Price is equal to current intrinsic value
Define the Equity Risk Premium….
The incremental return that investors require for holding equtiies rather than the risk free asset
Equity Risk Premium = required return on equity index - risk free rate
What are the steps to create a historical Equity Risk Premium estimate?
- Determine which equity index to represent market returns
- Chose the time period for computing the estimate
- Calculate the mean return on the index
- Select a proxy for the risk free rate
When estimating an Equity Risk Premium, explain when Arthimetic Mean and Geometric Mean are most appropriately used
- Arithmetic - when looking at a single period
- Geometric - the preferred method for use in historical estimates
Explain Survivorship Bias….
tends to inflate historical estimates of ERP because poorly performing or defunct companies have been removed from the index
How do you calculate the Gordon Growth Model (GGM) equity risk premium?
= (1 yr forecasted dividend yield on market index) + (consensus long term earnings growth rate) - (long term government bond yield)
What are two weakness of the GGM ?
- That forward looking estimates will change through time and need to be updated
- The assumption of a stable growth rate, which is often not appropriate in rapidly growing economies
What is the formula of the Macroeconomic Model created by Ibotson & Chan?
How do you calculate expected inflation (EINFL)?
= (1+YTM on 20 yr t-bonds) / (1+ YTM on 20 yr TIPS) - 1
How do you calculate the Expted Growth in Real EPS?
- Should approximately track the real GDP growth rate
- Real GDP = Σ Labor Productivity Growth + Labor Supply Growth rate
How do you calculate the expected growth in the P/E ratio?
- Base value is 0 to reflect the efficient markets view
- 1.05 would represent a view that the P/E would rise by 5%
What are the 2 key assumptions within CAPM?
- Investors are risk averse
- Make investments based on the mean return & variance of returns in their portfolios
What is the main insight of the CAPM model?
That investors evaluate the risk of an asset in terms of the asset’s contribution to the systematic risk of their portfolio
What is Beta ?
The measure of the level of systematic risk assumed from holding the security
What are 2 influences on Beta estimates?
- Choice of index for market portfolio
- length of data period and the frequency of observations
What is beta drift?
the observed tendency of an estimated beta to revert to a value of 1.0 over time
What is the formula for Adjusted Beta?
= (2/3 * regression beta ) + (1/3 * 1)
What time period is the industry standard for calculating betas?
5 Years
