Lecture 2 Flashcards
To establish the level of risk we should find in the marketplace
Use historical experience to forecast, there is no theory about the level of risk
Are expected returns/ risk directly observable?
No
Can we observe realised rates of return?
Yes
Total risk-free return formula =
(Par value) / P(T) ) - 1
Investment returns are expressed as
Effective annual rate (EAR)
Effective annual rate (EAR) shows
% increase in funds invested over a 1 year horizon
Gross return =
Terminal value of a $1 investment
EAR formula =
EAR = rf(1)
Gross return formula =
(1 + EAR)
Annual percentage rate (APR) shows
Annual rate charged for borrowing or earned through an investment
As T (years) approaches zero
Effectively approach continuous compounding. The relationship between EAR and APR given by the exponential function.
Holding period =
How long an individual holds an investment for
Realised rate of return depends on (2)
- Price per share at period’s end
- Cash dividends collected over the year
Holding period return assumes
All dividends are received at the end of the period
Holding period return formula =
[ (Ending price of share - starting price) + Cash dividend ] / Starting price
Holding period return ignores
Reinvestment income earned between receipt payment and end holding period if dividends are received during the period
Dividend yield =
% return from dividends
Holding period return simple formula =
Dividend yield + Rate capital gains
Standard deviation of the rate of return is
A measure of risk
Standard deviation =
Square root of variance
Variance =
Expected value of squared deviations from expected returns. Provides measure of uncertainty of outcomes.
Higher the volatility
Higher the variance
Standard variance is a reasonable measure of risk as long as
The probability distribution is symmetric about the mean
Risk premium =
Expected return - risk free rate
