Unit 3 - Session 12 - Methods of Quantitative Analysis

Question 1

Time Value of Money

Answer 1

the difference in the value of money today (present value) and its value sometime in the future (ts future value)

Question 2

TMV Example

Answer 2

If an investor were to invest $38.55 today and earn a 10% compounded annually he would have $100 in 10 years.

Calculation: 38.55 x 110% = 42.405 x 110% = 46.6455 x 110% = 51.31…and continue for 10x until get to $100

Question 3

Future Value

Answer 3

indicates what an amount invested today at a given rate will be worth at some period in the future

FV = PC x (1+r)^n

n= number of years over which it is invested
r=rate of return

Question 4

Present Value

Answer 4

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

PV = FV / (1+r)^n

(1+r)^n = discount factor

Question 5

Rule of 72

Answer 5

Shortcut method for determining the number of years it takes for an investment to double in value assuming compounded earnings. To find the number of years for an investment to double simply divide the number 72 by the interest rate the investment pays. for example, an investment of $2,000 earning 6% will double in 12 years (72 / 6 = 12)

The rule works in reverse. If you know the number of years you have you can computer the required earnings rate to double by using 72 in the numerator. if you have nine years before you need to retire what will you have to earn in order for a deposit made today to double (72/9=8%).

Question 6

Net Present Value

Answer 6

the difference between an investment’s present value and its cost. usually used by corporations to determine whether to invest in a capital project. If the discounted PV (discount rate assigned by company) of the project income is greater than the cost of the factory, the project has a positive NPV. If this is the case, the project will add value to the company b/c its return is more than the company’s cost of capital. If the NPV is negative, the project will drain value from the firm.

Question 7

The internal rate of return (IRR)

Answer 7

The discount rate the makes the future value of an investment equal to the its present value. IRR can be thought of as the “r” in PV and FV calculations. This method of computing long-term returns that takes into consideration of time value of money. The yield to maturity of a bond reflects its IRR.

Question 8

Mean

Answer 8

Sum of variables and divided by the number of occurrences.

Question 9

Median

Answer 9

Midpoint of a distribution. There are as many variables as above as there are below. List the numbers and find the number in the middle. If even numbers take the two middle numbers and average them

Question 10

Mode

Answer 10

Measures the most common value in a distribution of numbers

Question 11

Geometric Mean

Answer 11

mutiply all of the numbers together and then taking the nth root of them. The arithmetic mean will always be higher than the geometric

Question 12

Range

Answer 12

the difference between the highest and lowest returns in the sample being viewed.

Question 13

Income in Perpetuity

Answer 13

Providing annual income forever. Take the monthly income convert to a per year income and divide by rate of return to arrive at the lump some.

$1,000 per month = $12,000 / yr x 5% return = $240,000 lump sum required

Question 14

Beta / Beta Coefficient

Answer 14

Measures the variability between a particular stock’s (or portfolio’s) movement and that of the market in general.. Beta of 1.00 will tend to have a market risk similar to that of the market as a whole (usually measured against the S&P 500). Beta of 1.5 will be considerable more volatile than that market; .70 will me much less volatile. Negative beta moves up when the markets decline. Beta of 1.00 means the stock will rise of fall by 10%.

Question 15

Alpha

Answer 15

Investment performance that is better than what would have been anticipated, given the risk in terms of volatility that was taken. If alpha is negative, then the portfolio is under-preforming the market.

(total portfolio return - risk free rate) - (portfolio beta x [market return - risk free rate])

This compares performance after eliminating the risk free rate

Portfolio Return: 10%
Risk-Free Rate: 2%
Market Return rate: 8%
Beta: 1.2

(10% - 2%) = 8%; (1.2*{8 - 2]) = 7.2; 8 - 7.2 = 0.8 alpha

If the risk-free rate is not given, proceed with the same calculation w/o it

Question 16

Standard Deviation

Answer 16

Measure of the volatility of an investment’s projected returns computer by historical performance data. Measures the variability around an average. The larger the variability the higher the standard deviation. the higher the standard deviation, the larger the security’s returns are expected to deviate from its average returns, providing greater risk. Stocks with lower standard deviation are more suitable for conservative investors. Can be used to compare risk and reward between investments

Expressed in terms of a percentage. A security will usually deviate one standard deviation 2/3rds of the time and deviate within two standard deviation 95% of the time.

A security with an expected return of 12% and a SD of 5%. the investor can expect a return range of 7%-17% 67% of the time and a range of 2%-22% about 95% of the time.

Question 17

Beta v. Standard Deviation

Answer 17

Beta is a volatility measure of security compared with the overall market measuring only systematic (market risk).

SD is a volatility measure of a security compared with its expected performance and includes boy systematic risk and unsystematic risk, so SD measures the total risk of a security,.

Question 18

Correlation

Answer 18

Correlation means securities move in the same direction. A strong or perfect correlation means securities prices move in the perfect positive linear relationship with each other

Question 19

Correlation Coefficient

Answer 19

Number that ranges from -1 to +1. Perfectly correlated securities have a correlation coefficient of +1. Securities with price movements that are unrelated have a correlation coefficient of 0. If price move in perfectly opposite directions they are negatively correlated and have a correlation coefficient of -1. Generally, correlation coefficient of .80 and up are considered to be very high correlation.

Question 20

Price to Earnings Ratio (P/E)

Answer 20

Provides investors with a rough idea of the relationship between the prices of different common stocks compared with the earnings that accrue to one share of stock.

PE Ratio = current market price of common share / earnings per share (EPS)

Growth companies usually have higher PE ratios than do cyclically companies. Investors are usually willing to pay more per dollar of current earnings if a company’s future earnings are expected to be dramatically higher than earnings for stocks that rise and fall with business cycles. Speculative stock often sell at extremely high or low PE ratios. Low PE ratios indicate the company is apart of a declining industry.

If the PE ratio is known the earnings per share can be calculated:

EPS = current mkt price of common stock / PE ratio

Some analyst believe a company’s sales to earnings ratio is more valuable than the PE ratio b/c different accounting methods can impact earnings much more than sale.

Earnings per share assumes preferred dividends were paid.

Question 21

Price to Book Ratio

Answer 21

reflects the market price of the common stock relative to its book value per share. Book value is the theoretical value of a company (stated in dollars per share) in the even of liquidation and bears no relationship to the stock’s current trading price.

Question 22

Systematic Risk

Answer 22

the risk in the return of an investment that is associated with the macroeconomic factors or the risk that changes in the overall economy will have an adverse effect on individual securities, regardless of the company’s circumstances

Question 23

Interest Rate Risk

Answer 23

Interest rates fluctuate in the market all the time. When interest rates rise, the market price of bonds falls and that is why this is a systematic risk. Rising interest rates can be bearish for some common stock prices, particularly those of highly leveraged companies such as public utilities.

Question 24

Reinvestment Risk

Answer 24

reinvestment risk as to interest in principal. an investors receiving periodic cash flow from an investment such as interest on a debt security may be unable to reinvest the income at the same rate as the security itself is paying.

Question 25

Inflation Risk

Answer 25

Reduces the buying power of a dollar. Modest inflation is healthy for a growing economy, uncontrolled inflation causes uncertainty

Question 26

Unsystematic Risk

Answer 26

Risks unique to a specific industry or business enterprise and would include things such as labor union strikes, lawsuits, and produce failures.

Question 27

Business Risk

Answer 27

Operating risk, generally caused by poor management decisions. At best earnings are lowered, worst, company goes out of business and common stockholder lose their money

Question 28

Financial Risk

Answer 28

Relates to primarily to those companies that use debt financing. An inability to meet those debt obligations could lead to bankruptcy. Aka credit risk or default risk.

Question 29

Regulatory Risk

Answer 29

Sudden changes in the regulatory climate by bureaucrats and court judgments that change the rules business must adhere by. I.e. EPA rulings change requirements for oil and gas industries

Question 30

Legislative Risk

Answer 30

Results in change of law versus a change in regulations. Only legislatures change the laws, where is governmental agencies are able to change regulations i.e. changes to the tax law

Question 31

Political Risk

Answer 31

Attributes to instability in the political underpinnings of the country (such as coup). typically more likely in emerging economies

Question 32

Sovereign Risk

Answer 32

Risk ratings of a country defaulting on its commercial debt obligations

Question 33

Country Risk

Answer 33

Monitors the political and economic stability of countries. Measures total risk of the country; default risk, risk of losing direct investment, risk to global business dealings, etc.

Question 34

Liquidity Risk

Answer 34

Measures the speed or ease of converting an investment into cash without causing a price disruption. When an investors wants to dispose of an investment, non will be willing to buy it, or that a very large purchase or sale would not be possible at the current price aka marketability risk

Question 35

Opportunity Cost

Answer 35

the foregone return or the return given up on an alternative investment. The opportunity cost defined as the highest valued alternative that must be sacrificed as a result of choosing among alternatives. Any returns that deviates from the risk-free return represents your opportunity gained or lost

Question 36

Liquidation Priority

Answer 36

Wages - 180 days up the bankruptcy 
Taxes
1.) Secured Creditors
2.) Unsecured Creditors
3.) Subordinated debt holders
4.) Preferred stockholders
5.) Common stockholders