Wk 7 - Measuring Returns Flashcards
what are Fixed income (debt) securities
They pay a specified cash flow over a specific period
What is Equity
An ownership share in a corporation
What are derivative securities
Securities providing payoffs that depend on the value of assets
What is the informational role of financial markets
Investors decide whether a company lives or dies.
What is Consumption timing
- Some earn > consume (buy shares),
- Others consume > earn (sell shares)
What is The separation of ownership and management
Agency problem (conflict of interest)
What is Holding Period Return
(HPR) - Total return on an investment / asset over a period of time, (Usually as %)
What is the calculation for HPR
HPR = Capital gain yield + dividend yield (cash dividend / share price)
What is the formula for HPR
HPR = (P1 - P0 + D1)/P0
HPR = (Ending price - Beginning Price + Dividend) / Beginning Price
What is Arithmetic Average (AAR)
The sum of returns in each period / no. periods
What is the formula for AAR
AAR = (r1 + r2 + r3 … +rn) / n
What is Geometric Average
GAR - The single per-period return that gives the same cumulative performance as the sequence of actual returns
(Time-weighted returns)
How Do you calculate GAR
Compound the actual period returns and then finding the equivalent single per-period return
What is the formula for GAR
GAR = {[(1+ra)(1+rb)…(1+rn)]}*^1/n - 1
When should you use AAR
If you are NOT reinvesting any cashflows received before the end of the period
When should you use GAR
If you ARE reinvesting any cash flows received before the end of the period
What is Effective Annual Rates
EAR
The actual return on a savings account or other interest-bearing investments when the effects of compounding are considered
What is the formula for EAR
(1+ rate for period)^n periods per year -1
What is the relation between APR & EAR
1+EAR = (1+Rate per period)^n = (1+APR/n)^n
Rearranged:
APR = [(1+EAR)^1/n -1]*n
What are the risks involved in investments
Macroeconomic fluctuations
Shifts in industry
Unexpected asset-specific developments
What is Probability Distribution of HPRs
The list of possible outcomes (HPRs) with associated probabilities
What is Scenario Analysis
Process of devising a list of possible economic scenarios and specifying the likelihood of each one, as well as the HPR that will be realised in each case
What is expected return
The mean value of the distribution of HPR
What is required to implement scenario analysis and the probability distributions
Mean Return:
- The mean of the distribution/most likely value
Variance:
- The expected value of the squared deviation from the mean
or
- The expected value of the squared “Surprise” across scenarios
Standard Deviation:
- The square root of the variance
How do you measure Expected Return, E(r)
E(r) = The sum of the probabilities of each scenario * the return of each scenario
E(r) = (probability A * return A) + (probability B * return B) … + (probability N * return N)
What is Variance
The expected value of the squared deviation from the mean
(The expected value of the squared “surprise” across scenarios)
The deviation is squared to deal with negative values
What is the calculation for the Variance
VAR = deviation^2
= sum of [ probability of scenario * (return of scenario - Expected return of scenario)^2 ]
= Sum of p(s) * [ r(s) - E(r) ]^2
What is Standard Deviation
The square root of the variance
How do you calculate Standard Deviation
SD(r) = Square root VAR(r)
SD(r) = VAR(r)^1/2
Key Points for Normal Distribution
Probabilities are highest for outcomes near the mean
e.g. return of 15% not important if SD = 20%, but v unusual if SD = 5%
What are the 2 critical theoretical and practical realisations of investment management
What do they imply
1) The return of a portfolio of 2+ assets whoes returns are normally distributed will also be normally distributed
2) The normal distribution is fully described by its mean and SD
Implies that SD is an appropriate measure of risk for a portfolio comprised of assets with normally distributed returns
What is the difference between Equity and Fixed-Income (debt) security
Equity = lower-priority claim. Represents an ownership share in a corporation
Fixed-income (debt) security = higher-priority claim but has no ownership interest.
Fixed-income (debt) security pays a specified cash flow at pre-contracted intervals until the last payment on the maturity date. Equity has an indefinite life.
What are the features of Equity Securities
Ownership:
- Represents ownership shares in a corporation
Claim Priority:
- Lower priority (after creditors)
Payments:
- Dividends not guaranteed, depends on
profits and reinvestment
Life Span:
- Indefinite
Risk and Returns:
Higher risk, returns depend on
company performance and market
conditions
What are the features of Fixed-Income Securities
Ownership:
- Does not confer ownership interest
Claim Priority:
- Higher priority (before equity holders)
Payments:
- Fixed cash flows paid at contracted
intervals until maturity
Life Span:
- Fixed term, principal repaid at maturity
Risk and Returns:
- Lower risk, more stable returns based
on interest rates and issuer’s credit
status
What are the differences between real and financial assets?
Real assets are assets used to produce goods and services. Financial assets are claims on real assets
or the income generated by them
