L2 - Risk and Return Flashcards

1
Q

How would you derive the perpetuity formula?

A
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2
Q

PV of an annuity?

A
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3
Q

Why do we use the EAR?

A

Dont use APR, use EAR for all discounting (taking into account you reinvesting all extra payments where over that period)

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4
Q

Annual Percentage rate?

A

EAR > than APR except for when n = 1 then they are the same

  • monthly interest would be APR/12 and not account for any gains from reinvested interest
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5
Q

How do we covert from APR to EAR?

A
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6
Q

How do you compound continuously?

A
  • (1+EAR) = eAPR
    • To get the PV formula just sub into the bottom of the fraction the above formula and rearrange algebraically
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7
Q

How do you convert between real and nominal interest rates?

A
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8
Q

What is the Fisher Equation for nominal interest rate?

A
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9
Q

What does a probability distribution of returns look like?

A
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10
Q

Why do we use standard deviation over variance as a measure of risk?

A
  • of the same units as expected return
    • While variances and Covariances could be used,
    • But we are making the assumption that returns are normally distributed over time, and scattered around the mean, so s.d. is a good measure to go with e.g. 68% of results should be within 1 s.d. of the mean
      • 2 s.d. –> 95%
      • 3 s.d. –> 99.7%
  • What is the distribution is skewed or not normal
    • lots happening at extremes or attendance to be positive/negatively skewed
    • using s.d. in this case you could be under/overestimating the risk involved in the investment
    • in this case, we need other moments to measure risk
      • skewness and kurtosis of the distribution
    • usually in the distribution isn’t normal you can log the distribution then treat it as if it was noraml
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11
Q

how do calculate holding period returns?

A
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12
Q

When do we use expected returns and variance using probability over arithmetic mean and variances?

A
  • use the later on historical returns
    • remember to adjust for 1 degree of freedom in the variance calculation
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13
Q

the historical trade-off between risk and return of different asset classes

A
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14
Q

How do you calculate correlation and covariance between two stocks?

A
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