Wk 7 - Measuring Returns Flashcards by C B

what are Fixed income (debt) securities

They pay a specified cash flow over a specific period

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What is Equity

An ownership share in a corporation

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What are derivative securities

Securities providing payoffs that depend on the value of assets

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What is the informational role of financial markets

Investors decide whether a company lives or dies.

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What is Consumption timing

Some earn > consume (buy shares),
Others consume > earn (sell shares)

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What is The separation of ownership and management

Agency problem (conflict of interest)

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What is Holding Period Return

(HPR) - Total return on an investment / asset over a period of time, (Usually as %)

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What is the calculation for HPR

HPR = Capital gain yield + dividend yield (cash dividend / share price)

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What is the formula for HPR

HPR = (P1 - P0 + D1)/P0
HPR = (Ending price - Beginning Price + Dividend) / Beginning Price

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What is Arithmetic Average (AAR)

The sum of returns in each period / no. periods

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What is the formula for AAR

AAR = (r1 + r2 + r3 … +rn) / n

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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)

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How Do you calculate GAR

Compound the actual period returns and then finding the equivalent single per-period return

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What is the formula for GAR

GAR = {[(1+ra)(1+rb)…(1+rn)]}*^1/n - 1

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When should you use AAR

If you are NOT reinvesting any cashflows received before the end of the period

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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