Revision (CH1) Flashcards
Definition: Required Rate of Return (RRR)
it is the minimum return an investor should accept from an investment to compensate for deferring consumption.
Components of RRR
- The time value of money during the period of the investment
- The expected rate of inflation during the period
- The risk involved
Definition: Time Value of Money (TVM) {with regards to RRR}
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.
What are the two factors influencing the normal risk-free rate (NRFR)?
- The expected rate of inflation
- The conditions in the capital market
What is the relationship between expected inflation and nominal interest rates?
An increase in expected interest rates leads to an increase in nominal interest rates.
Definition: Time Value of Money (TVOM)
- An amount of money can
increase in value because of
interest earned from an
investment over time. - Is used to perform
valuations.
Definition: Risk
The uncertainty about whether an investment will earn its expected rate of
return.
List the two parts that risk can be divided into
Non-financial risk/pure risk
Financial risk
Definition: Return
The sum of cash dividends, interest and any capital appreciation or loss
resulting from an investment.
What is HPR and what does it measure?
HPR - holding period rate.
measures the change in wealth resulting from an investment.
HPR value > 1
indicates an increase in wealth or a positive rate of return.
HPR value < 1
indicates a decline in wealth.
HPR value = 0
indicates the loss of all one’s money.
What is the relationship between risk and investors RRR?
the greater the risk, the greater the investors required rate of return.
What can be used to measure risk of a single asset?
- Standard deviation
- Coefficient of variance (CV)
Definition: Expected Return
is the weighted average of the possible outcomes (ki
values), with the weights being determined by the probability of occurrence (Pi values)
Definition: Standard deviation
- Is a measure of total risk.
- Measures how ‘tightly’ the probability distribution is centred around the expected value.
What is the relationship between standard deviation and risk?
The greater the standard deviation, the greater the risk (uncertainty) - because of a broader distribution.
Definition: Coefficient of Variation (CV)
- Is a measure of relative dispersion.
- Useful in comparing the risk of assets with differing expected
returns:
What is the relationship between risk and CV?
The higher the CV, the greater the risk.
What does the risk-adjusted return measure?
measures how much return your investment has made per unit of risk.
