Book 3 Pages 52-100 Flashcards

Question

as interest rates rise the value of a bond will \_\_\_

Answer 1

exchange rate risk

Answer 2

John will get 15 million / 12 = $1,250,000 which is a $250,000 gain or 25% gain

Answer 3

Purchasing power risk Reinvestment rate risk interest rate risk market risk exchange rate risk

Answer 4

unsystematic risk

Answer 5

business risk

Answer 6

financial risk

Answer 7

default risk

Answer 8

political risk

Answer 9

investment manager risk

Answer 10

marketability

Answer 11

marketable ; liquid

Answer 12

false, they are both liquid and marketable

Answer 13

marketable

Answer 14

leptokurtic

Answer 15

playkurtic

Answer 16

leptokurtic

Answer 17

lognormal probability distribution

Answer 18

right Note that log-normal distributions are positively skewed with long right tails due to low mean values and high variances in the random variables.

Answer 19

sensitivity analysis

Answer 20

NPV and IRR NPV = Calculated as a present value of cash inflow less present value of cash outflow * Expressed in form of currency return * Absolute measure * CAN be used to evaluate projects or investments where there are changes in cash flow * NPV takes into account additional shareholders wealth for calculating the profitability of the project * DISCOUNT RATE - if discount rate changes, NPV produces different results for the same project IRR = Known as discount rate that make NPV of all cash inflows of a project equal to zero * Expressed in the form of a percentage return a firm expects from a project * Rate of return a project offers over its lifespan * IRR Method cannot be used to evaluate projects where there are changing cash flows * IRR doesn't take into account additional shareholder's wealth for calculating the profitability of the project * DISCOUNT RATE - IRR produces same results even if the discount rate changes for the same project EXAMPLE - IRR 1. Assume Company XYZ must decide whether to purchase a piece of factory equipment for $300,000. The equipment would only last three years, but it is expected to generate $150,000 of additional annual profit during those years. Company XYZ also thinks it can sell the equipment for scrap afterward for about $10,000. Using IRR, Company XYZ can determine whether the equipment purchase is a better use of its cash than its other investment options, which should return about 10%. 2. Here is how the IRR equation looks in this scenario: 1. 0 = -$300,000 + ($150,000)/(1+.2431) + ($150,000)/(1+.2431)2 ($150,000)/(1+.2431)3 + $10,000/(1+.2431)4 3. The investment's IRR is 24.31%, which is the rate that makes the present value of the investment's cash flows equal to zero. From a purely financial standpoint, Company XYZ should purchase the equipment since this generates a 24.31% return for the Company --much higher than the 10% return available from other investments. 4. A general rule of thumb is that the IRR value cannot be derived analytically. Instead, IRR must be found by using mathematical trial-and-error to derive the appropriate rate. However, most business calculators and spreadsheet programs will automatically perform this function. LIMITATIONS OF IRR 1. Also, IRR does not measure the absolute size of the investment or the return. This means that IRR can favor investments with high rates of return even if the dollar amount of the return is very small. For example, a $1 investment returning $3 will have a higher IRR than a $1 million investment returning $2 million. Another short-coming is that IRR can’t be used if the investment generates interim cash flows. Finally, IRR does not consider cost of capital and can’t compare projects with different durations.

Answer 21

inverse (as diversification increases, unsystematic risk decreases

Answer 22

law of diminishing returns

Answer 23

covariance

Answer 24

covariance = correlation x standard deviation of A x standard deviation of B

Answer 25

correlation = .40 Correlation = .0096 / (.20)(.12)

Answer 26

correlation (R or p) 1. There are several types of correlation coefficients but the one that is most common is the Pearson correlation (r). This measures strength and direction of the linear relationship between two variables. It cannot capture nonlinear relationships between two variables and cannot differentiate between dependent and independent variables. 2. The strength of the relationship varies in degree based on the value of the correlation coefficient. For example, a value of 0.2 shows there is a positive relationship between the two variables, but it is weak and likely insignificant. Experts do not consider correlations significant until the value surpasses at least 0.8. However, a correlation coefficient with an absolute value of 0.9 or greater would represent a very strong relationship.

Answer 27

securities move in opposite directions

Answer 28

securities move in same direction

Answer 29

securities are not related

Answer 30

coefficient of determination (R squared) 1. The coefficient of determination is a measure used in statistical analysis that assesses how well a model explains and predicts future outcomes. It is indicative of the level of explained variability in the data set. The coefficient of determination, also commonly known as "R-squared," is used as a guideline to measure the accuracy of the model. 2. Regardless of representation, an R-squared equal to 0 means that the dependent variable cannot be predicted using the independent variable. Conversely, if it equals 1, it means that the dependent of a variable is always predicted by the independent variable. 3. The goodness of fit, or the degree of linear correlation, measures the distance between a fitted line on a graph and all the data points that are scattered around the graph. The tight set of data will have a regression line that's very close to the points and have a high level of fit, meaning that the distance between the line and the data is very small. A good fit has an R-squared that is close to 1.

Answer 31

just square the correlation

Answer 32

unsytematic In statistics, the percentage of a portfolio's performance explainable by the performance of a benchmark index. The R square is measured on a scale of 0 to 100, with a measurement of 100 indicating that the portfolio's performance is entirely determined by the benchmark index, perhaps by containing securities only from that index. A low R square indicates that there is no significant relationship between the portfolio and the index. An R Square is also called the coefficient of determination

Answer 33

beta * Beta coefficient(β)=Covariance(Re,Rm)/Variance(Rm) * Re=the return on an individual stock * Rm=the return on the overall market * Covariance=how changes in a stock’s returns arerelated to changes in the market’s returns * Variance=how far the market’s data points spreadout from their average value The beta calculation is used to help investors understand whether a stock moves in the same direction as the rest of the market, and how volatile or risky it is compared to the market. For beta to provide any insight, the “market” used as a benchmark should be related to the stock. For example, calculating a bond ETF’s beta by using the S&P 500 as the benchmark isn’t helpful because bonds and stocks are too dissimilar. In order to make sure stock is being compared to the right benchmark, it should have a high R-squared value in relation to the benchmark. R-squared is a statistical measure that shows the percentage of a security's historical price movements that could be explained by movements in a benchmark index. For example, a gold exchange-traded fund (ETF), such as the SPDR Gold Shares (GLD), is tied to the performance of gold bullion. Consequently, a gold ETF would have a low beta and R-squared in relation to the S&P 500, for example. When using beta to determine the degree of systematic risk, a security with a high R-squared value, in relation to its benchmark, would increase the accuracy of the beta measurement.

Answer 34

aggressive ; defensive

Answer 35

Beta = Covariance / Variance Covariance = Cov(x,y) = SUM [(xi - xm) \* (yi - ym)] / (n - 1) Divide Covariance by the two Standard Deviations to get the Correlation Coeffiicent.

Answer 36

standard deviation

Answer 37

z score * A Z-score is a numerical measurement used in statistics of a value's relationship to the mean (average) of a group of values, measured in terms of standard deviations from the mean. If a Z-score is 0, it indicates that the data point's score is identical to the mean score. A Z-score of 1.0 would indicate a value that is one standard deviation from the mean. Z-scores may be positive or negative, with a positive value indicating the score is above the mean and a negative score indicating it is below the mean.

Answer 38

(data point - mean) / standard deviation

Answer 39

it means the data is 1.46 standard deviations above the mean

Answer 40

standard deviation squared

Answer 41

standard deviation = 12.29%

Answer 42

= (.30 x .50) + (.45 x .10) + (.25 x -.15) = 15.75%

Answer 43

semivariance

Answer 44

simple interest

Answer 45

principal x interest rate x time

Answer 46

1,000 x .08 x 2 = $160 (this is the interest only)

Answer 47

$1,000 x 1.08 x 1.08 = $1,166.40 or use pv = -$1,000 n = 2 i = 8

Answer 48

(ending value - beginning value +/- cash flows) / beginning value

Answer 49

[(1+12%) x (1-9%) x (1+3%) x (1+5%) x (1-7%)]^1/5 - 1 = 2.51% Default way to compare Fund Managers 1. Treat Each Year as a stand-alone year 2. Holding Period Return for each year 3. Then we take the geometric average of these figures to find the average of these Holding Period Return 4. The TWR measure is often used to compare the returns of investment managers because it eliminates the distorting effects on growth rates created by inflows and outflows of money.

Answer 50

There are two main performance calculations: IRR, or Internal Rate of Return, and TWR, or Time Weighted Rate of Return. **IRR** = The IRR measures how the portfolio’s investments did overall. It is a single rate of return that makes the value of everything added to the portfolio equal to everything taken out of the portfolio, or a constant rate of return that makes the present value of the portfolio’s ending value and all withdrawals precisely equal to the present value of the portfolio’s initial value and all contributions 1. **IRR Calculation** = The IRR cannot be computed directly. The IRR must be computed using a trial and error procedure in which you “guess” an answer, plug the guess into the equation, then modify the guess depending on the results. The new guess is plugged back into the equation, and the process is repeated until a satisfactory degree of precision is achieved. The initial “guess” made by Base Estimation Method, and the final number calculated through this iterative process. 2. **Use When** = Comparing the portfolio’s return to an overall goal. For example, use an IRR if you want to see if the portfolio is growing at least 10% in one year. The IRR return is affected by the size and timing of capital flows – larger flows affect the performance more than smaller flows. IRR is not suitable for determining the relative skill of an account manager or to be compared to a market index, as it is greatly affected by the size and timing of flows an investor decides to add to the portfolio **TWR** = It removes the effect of the client’s decisions to deposit or withdraw money in the account. It measures investment performance (income and price changes) as a percentage of capital “at work,” effectively eliminating the effects of additions and withdrawals of capital and their timing that alter IRR accounting. Stated another way, TWR is designed to remove the effects of capital flows into and out of the portfolio. 1. **TWR Calculation** = [(1 + holding period 1 return) x (1 + holding period 2 return) x (1 + holding period 3 return) x .... -1] x 100 2. **Use When** = Reflects effects of the market and the manager’s choices over which investments to select for the portfolio. Eliminates effects of the size and timing of capital flows that alter IRR return numbers. Weights returns from each period equally no matter how much value is in the portfolio at the time. Comparing the growth of the portfolio to the market’s growth. For example, how did the portfolio perform as compared to a market index like the S&P 500? Comparing the performance of one portfolio manager to another. For example, if the investor moved assets under your management, but wanted to compare your performance to your predecessor **Geometric Mean** = The main benefit of using the geometric mean is the actual amounts invested do not need to be known; the calculation focuses entirely on the return figures themselves and presents an "apples-to-apples" comparison when looking at two investment options over more than one time period. Geometric means will always be slightly smaller than the arithmetic mean, which is a simple average 1. **Geometric Mean Calculation** = Same as TWR Return but raised to the 1/nth power 1. [(1 + holding period 1 return) x (1 + holding period 2 return) x (1 + holding period 3 return) x .... -1] x 100

Answer 51

square root of the following: pv = -1 fv= 1.152 x 1.091 x 1.065 x 1.183 x 1.168 n = 5 pmt = 0 13.09% OR [(1 + r1) x (1 + r2) x (1 +rn) x ... - 1]^1/n

Answer 52

1 + nominal rate / 1 + inflation minus 1 x 100

Answer 53

5.77% Real Rate of Return = (1 + Nominal Rate) / (1 + Inflation Rate) - 1 Real Rate of Return = 1.10 / 1.04 - 1 Real Rate of Return = .0577%

Answer 54

1.25% x 12 = 15% An annual percentage rate (APR) is the annual rate charged for borrowing or earned through an investment. APR is expressed as a percentage that represents the actual yearly cost of funds over the term of a loan. This includes any fees or additional costs associated with the transaction but does not take compounding into account.

Answer 55

effective annual rate

Answer 56

EAR = [1 + (i / n)] ^n - 1 As a result of compounding, the effective interest rate is 12.683%, in which the money grew by $126.83 for one year, even though the interest is offered at only 12%. End Mode 12 P/Y PV = -1.000 N = 12 I% Year = 12% Fv = 1,126.83 THEN 1,126.83/1,000 = 1.12683 - 1 = .12683 \* 100 = 12.683%

Answer 57

[1+ (.0999 / 365)] ^365 - 1 10.5%

Answer 58

time weighted return

Answer 59

time weighted return= [(1 + Holding Period Return₁) \* (1 + Holding Period Return₂) \* (Holding Period Return₃)]^1/3 - 1 * Geometric mean, sometimes referred to as compounded annual growth rate or time-weighted rate of return, is the average rate of return of a set of values calculated using the products of the terms. * The time-weighted return (TWR) multiplies the returns for each sub-period or holding-period, which links them together showing how the returns are compounded over time. * The time-weighted return (TWR) helps eliminate the distorting effects on growth rates created by inflows and outflows of money. **_Scenario 1_** 1. Investor 1 invests _$1 million_ into Mutual Fund A on _December 31_. 2. On _August 15_ of the following year, his portfolio is valued at _$1,162,484_. 3. At that point (_August 15_), he adds _$100,000_ to Mutual Fund A, bringing the total value to _$1,262,484_. 4. By the end of the year, the portfolio has decreased in value to _$1,192,328_. The holding-period return for the **first period**, from _December 31 to August 15_, would be calculated as: 1. **Holding Period Return** = ($1,162,484 - $1,000,000) / $1,000,000 = 16.25% 5. The holding-period return for the **second period**, from August 15 to December 31, would be calculated as: 1. **Holding Period Return** = ($1,192,328 - ($1,162,484 + $100,000)) / ($1,162,484 + $100,000) = -5.56% 6. The **time-weighted return** for the two time periods is calculated by multiplying each subperiod's rate of return by each other. The first period is the period leading up to the deposit, and the second period is after the $100,000 deposit. 1. **Time-weighted return** = (1 + 16.25%) x (1 + (-5.56%)) - 1 = 9.79% 2. TWR = [(1.1625) x .(9444) - 1] x 100 3. TWR = [1.0979 - 1] x 100 4. TWR = 9.79% **_Scenario 2_** 1. Investor 2 invests $1 million into Mutual Fund A on December 31. 2. On August 15 of the following year, her portfolio is valued at $1,162,484. At that point (August 15), she withdraws $100,000 from Mutual Fund A, bringing the total value down to $1,062,484. 3. By the end of the year, the portfolio has decreased in value to $1,003,440. 4. The holding-period return for the **first period**, from December 31 to August 15, would be calculated as: 1. **Holding Period Return** = ($1,162,484 - $1,000,000) / $1,000,000 = 16.25% 5. The holding-period return for the **second period**, from August 15 to December 31, would be calculated as: 1. **Holding Period Return** = ($1,003,440 - ($1,162,484 - $100,000)) / ($1,162,484 - $100,000) = -5.56% 6. The **time-weighted return** over the two time periods is calculated by multiplying or geometrically linking these two returns: 1. **Time-weighted return** = (1 + 16.25%) x (1 + (-5.56%)) - 1 = 9.79%

Answer 60

dollar weighted return

Answer 61

time weighted return

Answer 62

rate of return x (1 - tax rate)

Answer 63

weighted average return

Answer 64

tactical asset allocation

Answer 65

core and satellite

Answer 66

efficient portfolio

Answer 67

Harry Markowitz

Answer 68

the efficient frontier shows the portfolios that provide the highest rate of return for a given risk or the portfolios with the lowest risk for a given rate of return

Answer 69

graph used to measure the risk reward trade offs an investor is willing to make

Answer 70

expected portfolio return

Answer 71

William Sharpe

Answer 72

rf + beta (market return - rf) = expected rate of return

Answer 73

expected rate of return

Answer 74

capital market line

Answer 75

the lending portfolio

Answer 76

borrowing portfolio * The line slopes up and to the right from the point in the middle. Every point on the right half of the line represents a borrowing portfolio. This shows how an investor can buy the market portfolio, and also borrow money in order to buy more of the market portfolio. Therefore, an investor can hold the same market portfolio and increase his risk and expected return. Notice that the slope of the lending portfolio is higher than that of the borrowing portfolio. This is because the rate at which one can borrow money will always be higher than the risk free lending rate. Lending Portfolio * The line slopes down and to the left from this point. All of the points on this left half of the line represent a lending portfolio. A lending portfolio consists of the market portfolio, plus some risk free government securities. These securities serve to reduce the risk profile of the portfolio, while of course also reducing expected returns.

Answer 77

Portfolio Return = Risk Free Rate + ((Market Return - Risk Free Rate)/Standard Dev of Market Returns) x Standard Dev of Portfolio Return

Answer 78

true CML differs from the more popular efficient frontier in that it includes risk-free investments. The intercept point of CML and efficient frontier would result in the most efficient portfolio, called the tangency portfolio. The CML is sometimes confused with the security market line (SML). The SML is derived from the CML. While the CML shows the rates of return for a specific portfolio, the SML represents the market’s risk and return at a given time, and shows the expected returns of individual assets. And while the measure of risk in the CML is the standard deviation of returns (total risk), the risk measure in the SML is systematic risk, or beta. Securities that are fairly priced will plot on the CML and the SML. Securities that plot above the CML or the SML are generating returns that are too high for the given risk and are underpriced. Securities that plot below CML or the SML are generating returns that are too low for the given risk and are overpriced.

Answer 79

same way as CAPM E(r) = R_f + Risk Premium 1. Market Risk Premium = (R_m - R_f) 2. Risk Premium = B(R_m- R_f) NOTE = CML is measured with expected return and standard deviation as x axis. Concerned with actual efficient portfolios SML / CAPM = specific securities, which is measured with expected return and Beta as the x axis. Market Portfolio has a Beta of 1.0.

Answer 80

arbitrage pricing theory Arbitrage pricing theory (APT) is a multi-factor asset pricing model based on the idea that an asset's returns can be predicted using the linear relationship between the asset’s expected return and a number of macroeconomic variables that capture systematic risk. It is a useful tool for analyzing portfolios from a value investing perspective, in order to identify securities that may be temporarily mispriced. The **Formula for the Arbitrage Pricing Theory Model** Is: 1. E(R)_i= E(R)_z + (E(I) − E(R)_z) × β_n 1. E(R)_i = Expected return on the asset 2. R_z = Risk-free rate of return 3. β_n= Sensitivity of the asset price to macroeconomic factor *n* 4. E_i = Risk premium associated with factor *i* The arbitrage pricing theory was developed by the economist Stephen Ross in 1976, as an alternative to the capital asset pricing model (CAPM) APT: 1. Expected return = 3% + (0.6 x 4%) + (0.8 x 2%) + (-0.7 x 5%) + (1.3 x 9%) = 15.2%

Answer 81

efficient market hypothesis

Answer 82

efficient market hypothesis

Answer 83

efficient market hypothesis weak form 1. The **weak form** suggests that today’s stock prices reflect all the data of past prices and that no form of technical analysis can be effectively utilized to aid investors in making trading decisions. 2. The **semi-strong** form efficiency theory follows the belief that because all information that is public is used in the calculation of a stock's current price, investors cannot utilize either technical or fundamental analysis to gain higher returns in the market. 3. The **strong form** version of the efficient market hypothesis states that all information – both the information available to the public and any information not publicly known – is completely accounted for in current stock prices, and there is no type of information that can give an investor an advantage on the market.

Answer 84

efficient market hypothesis semi-strong form

Answer 85

1. Investors, including the likes of Warren Buffett and researchers have disputed the efficient-market hypothesis both empirically and theoretically. 2. **Behavioral economists** attribute the imperfections in financial markets to a combination of cognitive biases such as 1. overconfidence, 2. overreaction, 3. representative bias, 1. 2. In financial markets, one example of this representative bias is when investors automatically assume that good companies make good investments. However, that is not necessarily the case. A company may be excellent at their own business, but a poor judge of other businesses. 4. information bias, and 5. various other predictable human errors in reasoning and information processing. 3. These have been researched by psychologists such as Daniel Kahneman, Amos Tversky and Paul Slovic and economist Richard Thaler. These errors in reasoning lead most investors to avoid value stocks and buy growth stocks at expensive prices, which allow those who reason correctly to profit from bargains in neglected value stocks and the overreacted selling of growth stocks.[citation needed] 4. Empirical evidence has been mixed, but has generally **_not_** supported strong forms of the efficient-market hypothesis. According to Dreman and Berry, in a 1995 paper, low P/E stocks have greater returns. **_PRO Efficient Market Theorists_** - Ray Ball that these higher returns could be attributed to higher beta, whose research had been accepted by efficient market theorists as explaining the anomaly in neat accordance with modern portfolio theory.

Answer 86

Weak form efficiency doesn’t consider technical analysis to be accurate and asserts that even fundamental analysis, at times, can be flawed. It’s therefore extremely difficult, according to weak form efficiency, to outperform the market, especially in the short term Weak form efficiency claims that past price movements, volume and earnings data do not affect a stock’s price and can’t be used to predict its future direction. Weak form efficiency is one of the three different degrees of efficient market hypothesis (EMH). EXAMPLE * Similarly, let’s assume Apple Inc. (APPL) has beaten analysts’ earnings expectation in the third quarter consecutively for the last five years. Jenny, a buy-and-holdinvestor, notices this pattern and purchases the stock a week before it reports this year’s third quarter earnings in anticipation of Apple’s share price rising after the release. Unfortunately for Jenny, the company’s earnings fall short of analysts’ expectations. The theory states that the market is weakly efficient because it doesn’t allow Jenny to earn an excess return by selecting the stock based on historical earnings data. Example * Suppose David, a swing trader, sees Alphabet Inc. (GOOGL) continuously decline on Mondays and increase in value on Fridays. He may assume he can profit if he buys the stock at the beginning of the week and sells at the end of the week. If, however, Alphabet’s price declines on Monday but does not increase on Friday, the market is considered weak form efficient.

Answer 87

technical and fundamental analysis

Answer 88

technical analysis, fundamental analysis, and insider info In strong-form efficiency, share prices reflect all information, **_public_** and **_private_**, and no one can earn excess returns. If there are legal barriers to private information becoming public, as with insider trading laws, strong-form efficiency is impossible, except in the case where the laws are universally ignored. To test for strong-form efficiency, a market needs to exist where investors cannot consistently earn excess returns over a long period of time. Even if some money managers are consistently observed to beat the market, no refutation even of strong-form efficiency follows: with hundreds of thousands of fund managers worldwide, even a normal distribution of returns (as efficiency predicts) should be expected to produce a few dozen "star" performers.

Answer 89

P/E effect

Answer 90

January effect

Answer 91

small firm effect

Answer 92

writing a call option in order to generate premium to pay for a put option

Answer 93

exchange fund (not an ETF) * Because an investor swaps shares with the fund, no sale actually occurs. This allows the investor to defer the payment of capital gains tax until he or she sells the fund's units. An exchange fund (also known as a "swap fund") is a stock fund that allows an investor to exchange his or her large holding of a single stock for units in a portfolio. Exchange funds provide investors with an easy way to diversify their holdings while deferring any taxes from capital gains Exchanged funds may require the potential participants to have a minimum liquidity of $5 million cash in order to join and contribute. As the fund grows, and when enough shares have been contributed, the fund closes to new shares. Then each investor is given interest in the collective shares based on their portion from the original contributions. The shares in the fund moved to the exchange fund are not immediately subject to capital gains taxation.

Answer 94

Beta is a measure of a stock's volatility in relation to the market. It measures the exposure of risk a particular stock or sector has in relation to the market. If you want to know the systematic risk of your portfolio, you can calculate its beta. 1. A beta of 0 indicates that the portfolio is uncorrelated with the market. 2. A beta less than 0 indicates that it moves in the opposite direction of the market. 3. A beta between 0 and 1 signifies that it moves in the same direction as the market, with less volatility. 4. A beta of 1 indicates that the portfolio will move in the same direction, have the same volatility and is sensitive to systematic risk. 5. A beta greater than 1 indicates that the portfolio will move in the same direction as the market, with a higher magnitude, and is very sensitive to systematic risk.

Book 3 Pages 52-100 Flashcards

(158 cards)