Unit 10 Flashcards
Formula to Compute Alpha
(Total Portfolio - Risk Free Rate) - (Portfolio Beta x [Market Return - Risk Free Rate])
If no risk free rate is given, simply remove it from the formula to calculate.
If comparing 2 portfolios:
S’s beta = 1.25
C’s beta = 1.50
C should put perform S by 1.5/1.2 = 1.25 or 125% better. THEN
(Cs return - RF) - 1.25 x (S return - RF)
Formula to Compare 2 Portfolios Based on Beta
(Portfolio 1 - RF) - Beta Ratio x (Portfolio 2 - RF)
Ex: (20-2) - (1.25 x (12-2))
1.25 or 125% rec’d from 1.50/1.20 P1/P2 Beta = 1.25 or 125% better performance based on higher beta
Formula: Compute Alpha when RF Rate is not given
Answer: Simply remove RF Rate from normal alpha formula:
Portfolio Return - (Beta x Market Return)
Rule of 72 Definition
Formula to calculate how long it would take an investment to double, or at what rate.
Simply divide 72 by the rate, OR the time to receive the other answer. Ex: 72/9 years = 8% to double. 72/8% = 9 years to double
NPV +/-
Difference between an investment’s present value, and its cost. (Remember PV calculation. PV of future cash flows).
Expressed in dollars and not in rate.
Projecting future cash flows and discounting them to their present value at the required rate of return.
Present Value - Cost (CMV)
$1136.78- $1100 = $36.78 NPV
$110 is a discounted PV
Positive is good, negative is bad
IRR
Internal Rate of Return
Always a percentage, not a $ like NPV)
The discount rate that makes the NPV of an investment equals zero. (r)
Used to determine whether an investment meets the investors required rate of return.
Takes into consideration time value of money
Uses iteration to compuete (trial and error)
Method of computing long term returns and Takes into consideration Time Value of Money
YTM of a bond = its IRR
NPV more important than IRR
When IRR = Discount Rate or Required Rate of return to make NPV = 0. This is an efficient market.
Can be used to calculate if an investment meets the investors required rate of return.
If an investor requires an investment return of 10% and the IRR for a proposed investment is 12% the investor will view that investment as attractive.
Arithmetic Mean vs. Geometric Mean
Arithmetic Mean = Normal Mean
Geometric Mean is complicated but will be lower than arithmetic mean (unless all numbers are the same)
How to predict a portfolio outperformed another? (Mean, Median or Mode?)
Highest Mean
Formula: Income in Perpetuity
Desired Annual Income / Average Expected Rate of Return
Formula: Exhausting the Principal
Shortcut: Take the Principal investment / Withdrawal amount…then go to the next number up because you know there will be some interest earned
Principal Investment x (Interest Rate x 100) - Withdrawal. Repeat this until at 0.
Standard Deviation and Example of how it relates to stock. (7.5% Std Dev.) (Expected return 12%)
The amount of variability around an average (the mean)
Measure of a stock’s volatility. Expressed as a percentage. Higher = more volatile and more risky for the investor. Higher volatility = possibility of higher returns. A std dev. of 7.5 means a stock may vary by 7.5% above or below it’s predicted return about 2/3 of the time, and 15% (2 std deviations) about 95% of the time. A stock with a 12% expected return and 7.5 std dev. would be from 7% - 17% about 67% of the time and 2% - 22% about 95% of the time. If given a choice of 2 investments with the same return but one has a higher std. dev…the investory would be better with the lower std. dev. bc less volatility and same return expected.
Another example:
investor expected return = 12%
Std deviation = 5%
So, the investor can expect the returns to range from 7% - 17% about 67% of the time and 2% - 22% about 95% of the time
Beta vs. Std. Deviation
Beta measures volatility of a security compared to overall market (systematic risk).
Std. Dev. measures volatility compared to systematic (market) AND unsystematic risk (measures total risk).
Correlation
+1 = moves in same direction equally. -1 = moves in opposite directions equally. 0.8+ is strong correlation. Opposite correlations for portfolio diversification.
Balance Sheet Ratios that measure liquidity (3)
Working Capital = CA - CL
Current Ratio = CA / CL
Quick Asset Ratio (Acid Test) = CA - Inventory / CL
- OR -
Quick Asset Ratio: Add all current assets together (except inventory), and divide that number by CL
If it doesn’t show inventory, don’t assume?
Debt-to-Equity
found on balance sheet
Debt-to-Equity (Total Capitalization Ratio): Measures the amount of financial leverage being used by the company. LTD / Total Capitalization (LTD and Equity)
