Chapter 4 Terms

Question 1

Why is return important?

Answer 1

Allows us to “keep score” on how our investments are doing compared to our expectations

Question 2

Satisfactory Investment

Answer 2

one for which the present value of benefits equals or exceeds the present value of its costs

Question 3

Required Return

Answer 3

The rate of return an investor must earn on an investment to be fully compensated for its risk

Question 4

Real Rate of Return

Answer 4

Measures the change in purchasing power provided by an investment

Question 5

Expected Inflation Premium

Answer 5

The average rate of inflation expected in the future

Question 6

Risk Premium

Answer 6

Additional return an investor requires on a risky investment to compensate for risks based upon issue and issuer characteristics

Question 7

Holding Period

Answer 7

the period of time over which an investor wishes to measure the return on an investment vehicle

Question 8

Realized Return

Answer 8

current return actually received by an investor during the given return period

Question 9

Paper Return

Answer 9

return that has been achieved but not yet realized (no sale has taken place)

Question 10

Advantages of holding period return

Answer 10

• Easy to calculate
• Easy to understand
• Considers income and growth

Question 11

Disadvantages of Holding Period Return

Answer 11

• Does not consider time value of money
• Rate may be inaccurate if time period is longer than one year

Question 12

Internal Rate of Return

Answer 12

determines the compound annual rate of return earned on an investment held for longer than one year

Question 13

Advantages of Internal Rate of Return

Answer 13

• Uses the time value of money
• Allows investments of different investment periods to be compared with each other
• If the yield is equal to or greater than the required return, the investment is acceptable

Question 14

Disadvantages of Internal Rate of Return

Answer 14

Calculation is complex

Question 15

Reinvestment Rate

Answer 15

the rate of return earned on interest or other income received from an investment over its investment horizon.

Question 16

Fully compounded rate of return

Answer 16

the rate of return that includes interest earned on interest

Question 17

Risk-Return Tradeoff

Answer 17

The relationship between risk and return, in which investments with more risk should provide higher returns, and vice versa

Question 18

Business Risk

Answer 18

is the degree of uncertainty associated with an investment’s earnings and the investment’s ability to pay the returns owed to investors.

Question 19

Financial Risk

Answer 19

the degree of uncertainty of payment resulting from a firm’s mix of debt and equity; the larger the proportion of debt financing, the greater this risk

Question 20

Purchasing Power Risk

Answer 20

the chance that changing price levels (inflation or deflation) will adversely affect investment returns

Question 21

Interest Rate Risk

Answer 21

the chance that changes in interest rates will adversely affect a security’s value

Question 22

Tax Risk

Answer 22

the chance that Congress will make unfavourable changes in tax laws, driving down the after-tax returns and market values of certain investments.

Question 23

Liquidity Risk

Answer 23

the risk of not being able to liquidate an investment conveniently and at a reasonable price

Question 24

Market Risk

Answer 24

the risk of decline in investment returns because of market factors independent of the given investment

Question 25

Event Risk

Answer 25

comes from an unexpected event that has a significant and unusually immediate effect on the underlying value of an investment.