Revision (CH1)

Question 1

Definition: Required Rate of Return (RRR)

Answer 1

it is the minimum return an investor should accept from an investment to compensate for deferring consumption.

Question 2

Components of RRR

Answer 2

1. The time value of money during the period of the investment
2. The expected rate of inflation during the period
3. The risk involved

Question 3

Definition: Time Value of Money (TVM) {with regards to RRR}

Answer 3

it is the starting point in determining the required rate of return.

It is the real risk-free rate of return (RRFR), which is the price charged for the exchange between current goods and future goods.

Question 4

What are the two factors influencing the normal risk-free rate (NRFR)?

Answer 4

1. The expected rate of inflation
2. The conditions in the capital market

Question 5

What is the relationship between expected inflation and nominal interest rates?

Answer 5

An increase in expected interest rates leads to an increase in nominal interest rates.

Question 6

Definition: Time Value of Money (TVOM)

Answer 6

• An amount of money can
  increase in value because of
  interest earned from an
  investment over time.
• Is used to perform
  valuations.

Question 7

Definition: Risk

Answer 7

The uncertainty about whether an investment will earn its expected rate of
return.

Question 8

List the two parts that risk can be divided into

Answer 8

Non-financial risk/pure risk
Financial risk

Question 9

Definition: Return

Answer 9

The sum of cash dividends, interest and any capital appreciation or loss
resulting from an investment.

Question 10

What is HPR and what does it measure?

Answer 10

HPR - holding period rate.
measures the change in wealth resulting from an investment.

Question 11

HPR value > 1

Answer 11

indicates an increase in wealth or a positive rate of return.

Question 12

HPR value < 1

Answer 12

indicates a decline in wealth.

Question 13

HPR value = 0

Answer 13

indicates the loss of all one’s money.

Question 14

What is the relationship between risk and investors RRR?

Answer 14

the greater the risk, the greater the investors required rate of return.

Question 15

What can be used to measure risk of a single asset?

Answer 15

1. Standard deviation
2. Coefficient of variance (CV)

Question 16

Definition: Expected Return

Answer 16

is the weighted average of the possible outcomes (ki
values), with the weights being determined by the probability of occurrence (Pi values)

Question 17

Definition: Standard deviation

Answer 17

• Is a measure of total risk.
• Measures how ‘tightly’ the probability distribution is centred around the expected value.

Question 18

What is the relationship between standard deviation and risk?

Answer 18

The greater the standard deviation, the greater the risk (uncertainty) - because of a broader distribution.

Question 19

Definition: Coefficient of Variation (CV)

Answer 19

• Is a measure of relative dispersion.
• Useful in comparing the risk of assets with differing expected
  returns:

Question 20

What is the relationship between risk and CV?

Answer 20

The higher the CV, the greater the risk.

Question 21

What does the risk-adjusted return measure?

Answer 21

measures how much return your investment has made per unit of risk.