Unit 20: Analytical Methods Flashcards
Future Value
= PV * (1+r)^n
-r rate of return
-n number of years
Present Value
= FV * (1+r)^n
-r rate of return
-n number of years
the discount factor
(1+r)^n portion of PV/FV formula
Rule of 72
shortcut for figuring out how long an investment will take to double with compound earnings
72/rate=number of years to double
commonly used for a known expense like college, home purchase, or retirement to figure out how many years/return is needed.
Net Present Value
difference between current cost and present value. expressed in dollar value, not rate of return.
typically more useful than IRR
IRR
the discount rate that makes the future value equal to its present value
-bond’s YTM=IRR
-not used for stock, since there is no end date
“How much should be invested today for [event] in [number of years]?”
looking for present value
-not net present value (that would determine if security is priced correctly), or IRR (used to analyze past performance)
Bond duration
two components: interest rate and maturity date
-price sensitivity to change in interest rates
When should you lengthen the average duration of a bond portfolio?
if interest rates are expected to decline (and bond prices will rise)
duration and coupon payments
always shorter than maturity of bond
-if zero coupon, then duration = maturity
The most useful component in determining the price volatility of a bond to change in interest rate
convexity
-the higher the convexity, the more interest rate risk protection.
interest rate and discount rate
the higher interest rates are, the higher discount rates are
use a discounted cash flow method to find
the FAIR VALUE of a security, not CMV or rate of return.
The yield to maturity is
the discount rate which equates:
-the present value of the bond’s future cash flows until maturity to its price.
geometric vs arithmetic mean
arithmetic mean will be higher until there is no variance in returns.
skewed distribution
the median and mean are not equal
-whichever direction the mean is from the median (higher or lower) determines which kind of outliers there were.
Beta
measures a stocks correlation with S&P500
-1 means exact correlation
-1.5 would mean 1.5x returns as the S&P
-negative beta would be a positive return when the market is down
Alpha
positive alpha means the portfolio is outperforming the market
calculating alpha
(portfolio return - risk-free) - (portfolio beta * (market return - risk free))
-the portion of return that is not explained by beta
Standard deviation
used to measure the volatility of an investment’s projected returns. the higher the SD, the more you can expect returns to deviate from average.
-quoted percentage is 1 SD, ie, 8% SD is range expected 68% of the time, and then 16% 95%
-if returns are equal, one would prefer the one with lower SD
SD and beta
beta- measures only market risk (systematic)
SD- measures both systematic and unsystematic risk
Correlation
1=perfectly correlated
0=completely uncorrelated
-1=perfect negative correlation
the lower the correlation, the more diversified
working capital
current assets - current liabilities
Factors that increase working capital
-sale of securities (long-term debt or equity);
-profits from operations;
-sale of noncurrent assets, such as equipment no longer in use.
