Investments Chapter 5

What is a normal distribution? what is the empirical rule?

-Bell shaped curve described by mean and variance -empirical rule = 68% of values lie within one standard deviation, 95% are within two, and 99.7% are within 3

How does the historical records of portfolios with different types of assets look like?

-Short term tbills: safe, short term, with a small concentrated historical return -30-year treasury bonds: safe, but longer term so returns are more dispersed -common stock: most volatile and super spread out

What is expected return? How is it measured?

-expected return has the estimated return (how much you can get from your investment realistically) and required return (min return you should get for your amount of risk) -measured using scenario analysis which is when we examine our HPRs in different economic conditions and situations

What is the difference between geomatric and arithmetic theroatically?

1) geometric return -better for quantifying past returns -accurate representation of what an investment yields -not necessarily appropriate for forecasting 2) arithmetic return -better to quantify what you will be earning in the future -suitable to forecast return for the next period, rather than just characterizing past returns

What are different components of rates of return?

1) risk-free rate: rate of return on riskless investments (treasury bills are considered risk free rate) 2) risk premium: excess return on risky asset over the risk free rate (REWARD FOR BEARING RISK!!)

How are rates of return computed?

Holding period return, arithmetic return, geometric return

Holding Period Return

Rate of return over ONE investment period. takes into consideration capital gains and dividends. HPR = (P1 - P0 + Div) / P0

What is a sharp ratio? Why is it useful?

Sharpe ratio is the excess returns you get for every unit of risk you take on S = portfolio risk premium / standard deviation of excess returns

Arithmetic Return

The sum of the HPRs divided by the number of years. r = r1 + r2 + r3 .... / n

Can you redeem underlying assets of ETF?

Yes! if ETF is trading for less than underlying assets, it is undervalued to buy and then sell the underlying assets to make profit

What do you use for multiple periods?

arithmetic return and geometric return

What is risk premium? How is it computed?

excess return for risky asset (expected return - risk free rate)

What is standard deviation? How is it measured?

how much the return deviates from the mean

Geomatric average

single period return that gives the same cumulative performance as the sequence of actual returns. Takes compounding into consideration r = [(1 + r1) x (1 + r2) x (1 + r3) ] ^ 1/n - 1