RPA2 Module 2 Flashcards
Describe the two components of return on a typical investment.
The two components of return are yield and capital gain or loss. The yield
component is the periodic cash flows from the investment in the form of interest,
dividends or other such cash income. The change in value of the asset, either
appreciation or depreciation, is called capital gain or loss.
An investor purchased a security for $1,000 and sold it six months later for $1,800.
During the six-month period, the investor received $200 in cash dividends. What is
the investor’s total return?
The total return is any cash received plus price changes, divided by the purchase
price. In this case, $200 plus $800 is $1,000, and $1,000 divided by the purchase price
of $1,000 is 100%
What is the relationship between total return and return relative?
Return relative adds 1.0 to the total return in order that all returns can be stated on
the basis of 1.0 (which represents no gain or loss), thereby avoiding negative
numbers so that the cumulative wealth index or the geometric mean can be
calculated.
A stock was purchased for $30 per share. A dividend of $2 per share was received
by the investor. What is the return relative if the stock is sold for (a) $34 or (b) $25?
(a) $2 1 $4 5 $6, and $6 divided by $30 is 20%.
Therefore, the return relative is 1.20.
(b) $2 1 (-$5) 5 -3, and -3 divided by $30 is -10%.
Therefore, the return relative is 0.90
Distinguish between the concepts of total return, return relative and the cumulative
wealth index.
While total return and return relative measure changes in the level of wealth, the
cumulative wealth index measures the aggregate effect of returns over time given
some stated beginning amount.
Use the following figures to calculate the cumulative wealth index for the period 2014-2018 for $1 invested at the end of 2013. (Retirement Plan Investing Essentials, pp. 41-42) Year Total Return (%) 2014 10 2015 8 2016 5 2017 -12 2018 20
The calculation would be as follows:
1.00 (1.10) (1.08) (1.05) (.88) (1.20) 5 1.317
What is the rate of return over the entire period (2014-2018) in the previous
question?
The rate of return is the cumulative wealth index minus 1, or
1.317 2 1.0 5 .317 or 31.7%
A U.S. investor bought some Canadian stock for C$250 when the value of the
Canadian dollar stated in U.S. dollars was $0.80. One year later, the stock is selling
for C$300, and Canadian dollars are now at $0.70. No dividends were received.
What was the return relative?
The increase from 250 to 300 is 50, and 50 divided by 250 is an increase of 20%. In
other words, the stock went up 20%, and the return relative is 1.20.
An investment was worth $100 at the end of 2010. At the end of 2011, it was worth
$180. At the end of 2012, it was worth $100. During the entire period, no dividends
or other income were received from the investment. What is this investment’s (a)
arithmetic mean rate of return and (b) geometric mean rate of return?
(a) The arithmetic mean rate of return would be calculated as follows:
First year: $100 increasing to $180 is an 80% increase.
Second year: $180 decreasing to $100 is a decrease of 44.44%
(i.e., 180 2 100 5 80, and 80 divided by 180 is 44.44%).
The arithmetic average of 80% and -44% is 18%.
(b) The geometric mean rate of return is the return that will make the beginning
value equal the ending value. It measures the compound rate of growth over
time. In this case, the g
Explain when an investor should use an arithmetic mean rate of return and when a
geometric mean rate of return should be used
The arithmetic mean rate of return should be used when the investor wants to
refer to the typical performance for a single period. That is the return that is
“representative” of the periodic returns. The geometric mean rate of return is a better
measure of the change in value (or wealth) over time (involving multiple periods).
The geometric mean is preferable when the true average compound rate of growth is
desired.
Over multiple periods, such as years, the geometric mean shows the true average
compound rate of growth that actually occurred—that is, the annual average rate at
which an invested dollar grew, taking into account the gains and losses over time
The total return for an investment over a period of time was 24.65%. During the
same time, the inflation rate was 4.33%. What was the inflation-adjusted return?
1.2465/1.0433 5 1.1948, and 1.1948 minus 1 5 .1948 or 19.48%
How does an investment decision involve the dual concepts of risk and expected
return?
The investment decision can be described as a trade-off between risk and expected
return. It is not sensible to talk about investment returns without talking about risk,
because investment decisions involve a trade-off between the two. Investors must
constantly be aware of the risk they are assuming, understand how their investment
decisions can be impacted, and be prepared for the consequences.
On what sort of time horizon is it realistic to expect adequate expected return
for having assumed the risk associated with various securities?
Although investors may receive their expected returns on risky securities on a longrun average basis, they often fail to do so on a short-run basis. It is a fact of investing
life that realized returns often differ from expected returns.
Interest rate risk
Interest rate risk is the variability in a security’s returns caused by changes in the
level of interest rates. Other things being equal, security prices (especially bonds)
move inversely to interest rates. Interest rate risk affects bonds more directly
than common stocks, but it affects both types of securities and is a very
important consideration for most investors.
Market risk
Market risk
Market risk is the variability in returns caused by fluctuations in the overall
market. All securities are exposed to market risk, although it affects primarily
common stocks. Market risk includes a wide range of factors including
recessions, wars, structural changes in the economy and changes in consumer
preferences.
