Unit 10 Flashcards
Define future value.
what an amount invested today at a given rate will be worth at some period in the future
Define present value.
value today of the future cash flows of an investment discounted at a specific interest rate to determine the present worth of those future cash flows
If actual return is less than expected:
If actual return is higher than expected:
PV will be higher
PV will be less
If the actual return is less than expected:
If the actual return is higher than expected:
FV will be lower
FV will be higher
Rule of 72
to find the number of years for an investment to double, divide the number 72 by the interest rate the investment pays
What is NPV?
It is the difference between an investment’s PV and its cost
- NPV is expressed in dollar amounts
PV - market price = NPV
What is the internal rate of return?
IRR is the discount rate (r) that makes the NPV of an investment equal to 0
It’s difficult to calculate, must be determined by a trial-and-error princess called iteration
Practical use for common stock is limited to those companies paying stable dividends
IRR is the method of computing long-term returns that takes into consideration:
The time value of money
The yield to maturity of a bond reflects its:
IRR
The investment is a good one if it has:
a positive NPV; stay away if the NPV is negative.
When an investment’s IRR is equal to the discount rate,
the NPV = 0. In an efficient market, bonds should be priced so that their NPV is 0.
IRR is always expressed as ___ whereas NPV is expressed as as ____.
IRR = %
NPV = $
Define mean, median, mode and range.
Mean = average
Median = midpoint of distribution
Mode = most common value
Range = difference between the highest and lowest returns
When comparing the arithmetic mean to the geometric mean,
the arithmetic mean will always be higher, unless all of the numbers being used are the same, in which case they will be equal. The reason is because the geometric mean uses imputed compounding.
Define income in perpetuity.
Means income “forever.”
Annual income/expected rate of return = lump sum required for that income perpetually
Beta/Beta Coefficient
(mean the same thing)
Measures the variability between a stock/portfolio’s movement and that of the market in general.
- 50 = more volatile than market
- 70 = less volatile than market
Negative betas move inversely with the market
Beta recommendations for clients:
Conservative clients need securities with low positive betas
Aggressive clients will find betas in excess of 1.00 suitable
Positive alpha
investment performance is better than what would have been anticipated, given the risk in terms of volatility that was taken (outperforming the market)
Negative alpha
underperforming the market
What is the formula for alpha?
(total portfolio return - risk-free rate) - (portfolio beta x [market return - risk-free rate])
Risk-free rate on the exam will always be
the 91-day (13 week) T-bill
Define standard deviation.
measure of the volatility of an investment’s projected returns, computed by using historical performance data
- expressed in %
The higher the SD,
larger the security’s returns are expected to deviate from its average return, and greater the risk/volatility
Lower SD would be more suitable for:
conservative investors
