Chapter One

  1. Investment
    Current commitment of $ for a period of time in order to derive future payments.
  2. Pure Rate of Interest
    Exchange rate between future compensation ($) and present consumption ($).

    Market forces determine rate.
  3. Pure Time Value of Money
    People are willing to pay more for the money borrowed.
  4. Required Rate of Return
    Minimum rate of return an investor requires on an investment.

    Includes pure rate of interest and risk premiums.
  5. Holding Period Return (HPR)
    HPR = End $ / Beginning $
  6. Holding Period Yield (HPY)
    HPY = HPR - 1
  7. Standard Deviation
    Measures the total risk

    Square root of the variance
  8. Coefficient of Variation (CV)
    Measures the risk per unit of expected return.

    Relative measure of risk.

    CV = Std Dev of Return / Expected Rate of Return
  9. Components of Required Return
    - Time value of money during the time period

    - Expected rate of inflation during the period

    - Risk involved
  10. Complications of Estimating Required Return
    - Wide range of rates available for alternative investments at any time.

    - Rates of return on specific assets change dramatically over time.

    - Difference between the rates available on different assets change over time.
  11. Real Risk Free Rate (RRFR)
    - Assumes no inflation

    - Assumes no uncertainty about future cash flows

    - Influenced by time preference for consumption of income and investment opportunities in the economy
  12. Nominal Risk-Free Rate (NRFR)
    - Conditions in the capital market

    - Expected rate of inflation
  13. Types of Risk
    • - Business
    • - Financial
    • - Liquidity
    • - Exchange Rate
    • - Country
  14. Security Market Line (SML)
    Relationship between risk and return for all risky assets in the capital market at a given time.

    Investors select investments that are consistent with their risk preferences.
  15. Movement Along the SML
    Reflect changes in the risk of the asset.
  16. Changes in the Slope of the SML
    Reflects a change in the attitude of investors toward risk.

    More risk adverse = steeper slope = higher risk premium for the same risk level.
  17. Parallel Shift in the SML
    Reflects a change in the real risk free rate or the expected rate of inflation.

    Nominal risk-free rate increases = SML shifts up = higher rate of return for the same risk premium
  18. Arithmetic Mean
    AM = sum HPY / n
  19. Geometric Mean
    GM = (sqr root HPR)^(1/n) - 1
  20. Arithmetic and Geometric Mean
    AM = GM if rates of return are equal for all years.

    AM > GM if rates of return differ

    AM best used as an expected value for an individual year.

    GM best measure of an asset's long term performance
  21. Risk
    Uncertainty that an investment will earn its expected rate of return.
  22. Measures of Market Risk
    Variance of rates of return

    Std Dev of rates of return

    Coefficient of variation of rates of return (Std Dev / means)

    Covariance of returns with the market portfolio (beta)
Card Set
Chapter One
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