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Exam 2 FIN 306
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Gravity
Terms in this set (47)
key measure of investors' success
the rate at which their funds have grown during the investment period
holding-period return (HPR)
(ending price-beginning price+ cash dividend)/beginning price
(sale price-buy price+cash flow)/buy price
rate of return
dollars earned over the investment period (price appreciation as well as dividends) per dollar invested
total return
capital gains + dividends
Arithmetic average
the sum of returns in each period divided by the number of periods
-ignores compounding
-good when no info beyond historical info is given
geometric average
the single per-period return that gives the same cumulative performance as the sequence of actual returns
-compound the actual period by period returns then find the per period rate
time-weighted average return ( geometric average)
([(1+.10)
(1+.25)
(1-.20)*(1+.20)]^(1/4))-1=geometric return
dollar-weighted average return (IRR) (internal rate of return on investment)
the interest rate that sets the present value of the cash flows realized on the portfolio equal to the initial cost of establishing the portfolio
uncertainty surrounding the investment
there is an expected return but, due to risk, the actual return could be a lot more or a lot less than expected
scenario analysis
come up with a list of possible economic outcomes or scenarios and specify not the likelihood of each scenario and the HPR the asset will realize in that scenario
probability distribution
the actual list of possible HPRs and the associated probabilities
lets us derive measurements for both the reward and the risk of the investment
expected return (mean of the distribution of HPRs and the mean return)
the reward from the investment...the average HPR you would earn if you were to repeat an investment in the asset menu times
surprise return
difference between the actual return and the expected return
variance
the expected value of the squared deviation from the mean
standard deviation
gives the measure of risk in the same dimension as expected return (5)...the sort of variance
scenario analysis
possible economic scenarios; specify likelihood and HPR
probability distribution
possible outsource with probabilities
expected return
mean value of distribution of HPR or the mean return
variance
expected value of spurred deviation from mean
standard deviation
square root of variance
normal distribution
central to the theory and practice of investments...symmetric, bell-shaped curve...identical values for mean, median and mode
normal distribution mean
the expected value
normal distribution median
the value above and below which we expect 50% of the observations
normal distributions mode
the most likely value
the standard deviation (SD)
a measure of how spread out numbers are
the appropriate measure of risk for a portfolio of assets with normally distributed returns
value at risk (VaR)
cutoff of the worst loss that can be suffered at a certain probability...a loss averse investor would limit the loss corresponding to a probability of 5%
short-term HPRs are normal
long-term HPRs deviate from normality...need additional info
kurtosis
measure of fatness of tails of probability distribution
what compares the frequency of extreme values to that of the normal distribution
kurtosis
what indicates likelihood of extreme outcomes
kurtosis
what does a positive kurtosis value indicate
higher frequency of extreme values than this benchmark
what does a negative kurtosis value suggest
extreme values are less frequent than with normal distribution
what does higher kurtosis indicate
higher frequencies of outcomes at the extreme negative and positive ends of the distribution curve
skewness
measure of asymmetry of a probability distribution
negative skew
suggests that extreme negative values are more frequent than extreme positive ones
nonzero values for kurtosis and skew indicate that special attention should be paid to the VaR
in addition to the use of standard deviation as a measure of portfolio risk
reward at an index fund
measure the difference between the expected HPR on the index fund and the risk-free rate
risk free rate
rate of return that can be earned with certainty...rate earned on treasury bills
risk premium
expected return in excess of that on risk-free securities
risk aversion
reluctance to accept risk
sharp ratio (reward to volatility)
ranks portfolios in terms of risk-return trade-off
risk-free asset
has risk premium of zero and standard deviation of zero
the higher the Sharpe ratio
the better reward per unit of volatility, in other words, a more efficient portfolio
Sharpe ratio
a valid statistic only for ranking portfolios...not valid for ranking individual assets
mean-variance analysis
the process of ranking portfolios by Sharpe ratios
classes from highest average historical return to lowest average historical return from 1926 to 2010
1) small stocks
2) large stocks
3) long-term bonds
4) T-bills
hierarchy of risk
small stocks, large stocks, long-term bonks, t-bills...from most to least risky/volatile.......higher risk...higher return
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