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Financial Markets ch.10
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Gravity
Terms in this set (37)
income
-cash investors periodically receive as a result of owning an investment
capital gains/loss
- difference between what the purchase price was and the price you sold it for
total return
- combining the capital gain AND the income
return
-level of profit/reward for investing
-indicates how fast an investor can build wealth
-basis for future expectations= historical performance
expected return
- a vital measure of future performance
-what you THINK the investment will earn in the future determines what you will be willing to pay for it
inflation/deflation
- general level of price changes- either up or down
-rising inflation is accompanied by rising interest rates
time value of money
-the sooner you receive cash, the better
-more periods to compound
-time inc= present value of cash flows dec
satisfactory investment
- present value of benefits (discounted at appropriate rate) equals or exceeds the present value of its costs
1. just equals cost= rate of return equal to discount rate
2. exceeds cost= rate of return greater than discount rate
3. less than the cost= rate of return less than discount rate
-you only want 1 OR 2
real rate of return
- nominal return-inflation rate
- nominal rate= actual return
required return
- rate of return that fully compensates for the investment's risk
-must earn this rate in order to be fully compensated for risk
equation:
= real rate of return + expected inflation premium + risk premium for investment
expected inflation premium
- average rate of inflation expected in the future
-historically 3%
risk-free rate
-rate of return made on a risk-free investment (ex: US Treasury Bill)
=real rate of return + expected inflation premium
risk premium
-depends on type of investment, maturity, and features
-industry and company factors(line of business or financial condition of issuer)
holding period
-period of time over which one wishes to measure the return on an investment
-how long you hold it
realized return
- portion of income received during the period
-capital gains- ONLY realized when the investor sells the asset at the end of the holding period (until sale occurs it is a PAPER RETURN-achieved but not yet EARNED)
holding period return
-total return earned from holding an investment for a specified holding period (usually 1 yr or less)
-equation:
=current income during period + capital gain/loss during the period / beginning investment value
yield (internal rate of return)
-present-value based
-interest rate
-want a yield equal or above the required return- accept investment
-long-term assets have HIGHER interest rates than short-term assets
risk-return tradeoff
-relationship between risk and return
-want to maximize return for a given level of risk
-want to minimize risk for a given level of return
-as risk goes up, return goes up
-positive relationship between risk and return
types of risk
1. business risk
2. financial risk
3. purchasing power risk
4. interest rate risk
5. liquidity risk
6. tax risk
7. event risk
8. market risk
business risk
-degree of uncertainty associated with an investment's earnings and the investment's ability to pay returns
financial risk
- uncertainty surrounding a firm's ability to meet its financial obligations because it has borrowed money
purchasing power risk
- chance that unanticipated changes in price levels (inflation/deflation) will adversely effect investment returns (dollar will be worth less-can get less with it)
interest rate risk
- chance that changes in the interest rates will adversely effect a security's value.
-result from the relationship between the supply of and demand for money
liquidity risk
- the risk of not being able to sell (liquidate) an investment quickly and at a reasonable price
tax risk
- chance congress will make unfavorable changes in tax laws.
event risk
- when something happens to a company that has a sudden and substantial impact on its financial condition
market risk
- risk that investment returns will decline because of market factors independent of the given investment
measuring risk
-BETA
-standard deviation
-measures variation of returns around an asset's average or expected returns
-measures how sensitive an asset is to changes in risk
risk-indifferent investor
-required return does not change as risk changes
risk-averse investor
-required return increases with an increase in risk
-don't like risk, so they require higher expected returns to compensate for the risk
risk-seeking investor
- required return decreases for an increase in risk
- enjoy risk
-willing to give up some return for more risk
systematic risk
- market wide
-affects ALL assets
-can't get rid of it
-also known as "undiversifiable" or "market" risk
-changes in GDP, interest rates, inflation, etc
unsystematic risk
- only affects some assets or a group of similar assets
-"unique" or "asset-specific" risk
-labor strikes, part shortages, etc
term structure of interest rates
-relationship between the time to maturity and the yield
-YIELD CURVE= graphical representation of term structure
BETA
-measures systematic risk:
=1: same systematic risk as the rest of the market
>1: more systematic risk than overall market
<1: less systematic risk than overall market
Effective Annual Rate (EAR)
-actual rate paid/received after accounting for compounding
-use to compare alternative investments with different compounding periods
Annual Percentage Rate (APR)
-annual rate quoted by law on all loans
-period rate x number or periods per year
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