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Level 96

Measuring Risk & Return


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Holding Period Return (single period):
HPR tells us what we earned, but investments are based on what we EXPECT to earn
Expected Return:
The weighted average of the possible returns
Nominal Dollar:
The dollar in your wallet, or bank account
Real Dollar:
Refers to purchasing power
Nominal interest rate:
Growth rate of your money
Real interest rate:
Growth rate of your purchasing power
Inflation rate:
The general decline in what a dollar can purchase
Equilibrium Nominal Rate of Interest:
As the inflation rate increases, investors will demand higher nominal rates of return
Nominal rate =
real rate + inflation forecast
Risk Premium:
Difference between the expected RoR and the risk-free rate
Excess Return:
Difference between the actual RoR and the risk-free rate
Variance (σ^2):
Measures the dispersion of possible outcomes around expected return
Higher variance:
Implies a higher dispersion of possible outcomes; more uncertainty
Geometric Average Return:
Used to compute the average compound return of an investment over multiple periods
The geometric average will be:
Less than the arithmetic average unless all the returns are equal
Arithmetic average is an:
Overly optimistic estimate of future returns for long horizons
The geometric average is an:
Overly pessimistic estimate of future returns for short horizons
Forecasting Return:
To achieve a more accurate estimate of expected returns, one can use Blume's formula
Value at Risk (VaR):
What is the worse loss that an investment will suffer, given a probability (often 5%)
Non-Normal Distributions:
When distributions are non-normal we need to consider more than mean and variance
Distribution Characteristics: Mean:
Most likely outcome
The spread of possible outcomes
Distribution Characteristics: Variance or Standard Deviation:
Distribution Characteristics: Skewness:
How asymmetrical is the distribution
Distribution Characteristics: Kurtosis:
Flat or "Peakie;" which means that it compares the frequency of extreme values to that of the normal distribution
Dollar-weighted average return:
Is the internal rate of return of the project, which is the interest rate that sets the present value of the cash flows realized on the portfolio
Scenario analysis:
Process of devising a list of possible economic scenarios and specifying the likelihood of each one, as well as the HPR that will be realized in each case
Probability distribution:
List of possible outcomes with associated probabilities
Expected Return Definition:
The mean value of the distribution of HPR
Variance Definition:
The expected value of the squared deviation from the mean
Skew Definition:
Measure of the asymmetry of a probability distribution
Risk-free Rate:
The rate of return that can be earned with certainty
Risk Premium Definition:
An expected return in excess of that on risk-free securities
Risk Aversion:
Reluctance to accept risk
Price of Risk:
The ratio of portfolio risk premium to variance
Mean-variance Analysis:
Ranking portfolios by their Sharpe ratios
Inflation Rate Definition
The rate at which prices are rising, measured as the rate of increase of the CPI
Nominal Interest Rate Definition:
The interest rate in terms of nominal (not adjusted for purchasing power) dollars
Asset Allocation:
Portfolio choice among broad investment classes
Capital Allocation:
The choice between risky and risk-free assets
Complete Portfolio:
The entire portfolio including risky and risk-free assets
Capital Allocation Line (CAL):
Plot of risk-return combinations available by varying portfolio allocation between a risk-free asset and a risky portfolio
Passive Investment Strategy:
Based on the premise that securities are fairly priced, and it avoids the costs involved in undertaking security analysis
Capital Market Line (CML):
The capital allocation line using the market index portfolio as the risky asset
Speculators expect a risk-return trade-off
Speculation is undertaken despite the risk because:
Also called the time-weighted average return
The geometric average rate of return is _______:
Treasury securities are free of default risk
Treasury securities are commonly regarded as risk-free assets because _______:
Securities are fairly priced
A passive investment strategy is based on the premise that _______:
The Real Interest Rate
The excess of the interest rate over the inflation rate is called:
What is the "technical" part of capital allocation?
Finding the available combinations of risk and return is the ''technical" part of capital allocation; it deals only with the opportunities available to investors
The 1930s and 1940s show us:
that very volatile levels of unexpected inflation can play havoc with
Diversified sample of
Until 1969, the "World Portfolio" of stocks was constructed from a:
Inflation rate
The rate of change of the price level, usually measured as a percentage change per year
The complete portfolio is:
The overall portfolio composed of the risk-free asset and the risky portfolio and it includes the investor's wealth
Real Interest Rate
The growth rate of purchasing power derived from an investment is the:
The complete portfolio includes:
The entire investor's wealth
What is the Capital Market Line?
The capital allocation line provided by one-month T-bills and a broad index of common stocks; A passive strategy using the broad stock market index as the risk portfolio generates an investment opportunity set tha…
A nominal interest rate
The interest rate in terms of "non adjusted for purchasing power" dollars is called:
Weighted-average of returns in all possible outcomes
In scenario analysis, the HPR is calculated by computing:
Annual percentage rate (APR) is always:
Less than or equal to effective annual rate