Week 1- Risk and Return

Question 1

Name 3 types of financial asset

Answer 1

• Fixed-income/Debt securities
• Equity
• Derivative Securities

Question 2

What do Fixed-income/Debt securities promise?

Answer 2

Either a fixed stream of income or a stream of
income determined by a specified formula (for example, corporate bond)

Question 3

What does owning equity represent?

Answer 3

Equity represents an ownership share in a firm (for example, common stock)

Question 4

What does the payoff for derivative securities depend on?

Answer 4

Payoff depends on the value of other financial variables such as stock prices, interest rates, or exchange rates.

Question 5

Define the Present Value:

Answer 5

The value today of a future cash flow discounted at the appropriate discount rate

Question 6

Define the Future Value:

Answer 6

The amount to which an investment will grow after earning interest

Question 7

Give 3 reasons why the value of money changes over time:

Answer 7

• Preferences
• Inflation
• Risk

Question 8

How is the Future Value in n years calculated?

Answer 8

FVn = PV(1+r)^n

Question 9

What does the compounding of interest refer to?

Answer 9

This refers to the frequency with wich interest is computed and added to the principle balance (ie interest earned on interest)

Question 10

Which term in the PV(1+r)^n formula capture the 3 elements of why the value of money changes over time?

Answer 10

r

Question 11

What is the objective for companies investing in real assets, and why are Present Value calculations important?

Answer 11

Firms want to work out present valuations of real assets (ie machinery), and therefore want to find assets that are worth more than they cost.

Question 12

How is Present Value calculated?

Answer 12

PV = FVn/ (1+r)^n

Question 13

What is the Net Present Value?

Answer 13

Net present value is simply the present value plus any immediate cash flows (usually an outflow) – in other words a project’s net contribution.

Question 14

How do we calculate NPV?

Answer 14

NPV = PV - required investment

Question 15

What does ln(1.08)^t simplify to using log laws?

Answer 15

tln(1.08)

Question 16

What does ln(80/35) simplify down to using log laws?

Answer 16

ln(80) - ln(35)

Question 17

What can a return sometimes be referred to when the holding period is 1?

Answer 17

The net Holding Period Return (HPR)

Question 18

Calculate the HPR

Answer 18

(Ending Value of Investment/ Beginning Value of Investment) -1

Question 19

If an NPV is negative, should the project be undertaken?

Answer 19

No, the project should only be undertaken with a positive NPV (ie it is worth more than its cost)

Question 20

Apart from seeing if the NPV is positive, what is another way to determine if a project is worth undertaking?

Answer 20

A project is worth undertaking if its rate of return exceeds the cost of capital.

Question 21

Under simple returns, how do you work out the rate of return?

Answer 21

𝑟= (𝑛√FV/PV) −1

Question 22

When are “average returns” often used?

Answer 22

For investments over a given horizon

Question 23

How can Arithmetic Mean Return (AM) be calculated?

Answer 23

AM = (𝑟1 + 𝑟2 + 𝑟3 … . 𝑟𝑛)/𝑛

Question 23

What is Arithmetic Mean Return useful for?

Answer 23

Telling you what your return in a typical year over a particular period was.

Question 24

What is Geometric Mean useful for?

Answer 24

This tells you what you actually earned on per year average over a particular period, compounded annually.

Question 25

How is Geometric Mean (GM) calculated?

Answer 25

GM = [(1 + 𝑟1)(1 + 𝑟2) … . . (1 + 𝑟𝑛)]^(1/𝑛) − 1

Question 25

What is the 3rd way of calculating returns called?

Answer 25

Expected Returns

Question 26

Why are expected returns calculated?

Answer 26

As there are many possible returns/outcomes from an investment due to the uncertainty.

Question 27

How do we calculate expected returns?

Answer 27

Total up the products of the rate of return of an event and the probability of its occurrence.

Question 28

What are the 3 kinds of interest rates?

Answer 28

• Stated or quoted interested rate
• Effective Annual Rate (EAR)
• Annual Percentage Rate (APR)

Question 29

How do we calculate the EAR, and what is it?

Answer 29

EAR = (1+ Quoted Rate/𝑛)^𝑛 - 1
The EAR is the rate you will actually earn, as it takes into account the fixed effect of compounding

Question 30

What is the Annual Percentage Rate (APR)?

Answer 30

The harmonized interest rate that expresses the total cost (interest payment and management fees) of borrowing or
investing as a percentage interest rate.

Question 31

In the UK, what 3 things must all creditors state?

Answer 31

• The APR (including all costs)
• The total amount paid at the end of the loan
• The total charge for credit

Question 32

What is discrete compounding?

Answer 32

Where we can count the number of compounding periods per year (𝑛)

Question 33

What is continuous compounding? How is this calculated?

Answer 33

This is when there is an infinite number of compounding periods.
EAR= e^quoted rate -1

Question 34

Give 2 measures of how actual values differ from the expected values (ie in arithmetic mean) for a given series of values.

Answer 34

• Variance
• Standard Deviation

Question 35

What does risk create for businesses and investors?

Answer 35

Problems and opportunities

Question 36

What is the risk associated with investments determined by?

Answer 36

The spread (dispersion) which is measured
by the variance of the return.

Question 37

How do we work out the risk measure for historical returns (standard deviation)? Assume equal probability

Answer 37

• Work out the mean average
• Then total up all the following formulae:
• ((Event Outcome- Mean)^2 ) /𝑛
• Square root the sum