Test Three Book Terms Chapter 10

Holding Period Return

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Discussion of Arithmatic Average return and Blume's Equation.

Arithmetic Average Return or Geometric Average Return? When we look at historical returns, the difference between the geometric and arithmetic average returns isn't too hard to understand. To put it slightly ifferently, the geometric average tells you what you actually earned per year on average, compounded annually. The arithmetic average tells you what you earned in a typical year. You should use whichever one answers the question you want answered. A somewhat trickier question concerns forecasting the future, and there's a lot of confusion about this point among analysts and financial planners. The problem is this. If we have estimates of both the arithmetic and geometric average returns, then the arithmetic average is probably too high for longer periods and the geometric average is probably too low for shorter periods. The good news is that there is a simple way of combining the two averages, which we will call Blume's formula . Suppose we calculated geometric and arithmetic return averages from N years of data and we wish to use these averages to form a T -year average return forecast, R ( T ), where T is less than N . Here's how we do it: BLUME's EQUAtion (T-1/N-1) X Gmetric Mean + (N-T/N-1) X Arith Mean

A large enough sample drawn from a _________ ______ looks like the bell- shaped curve

normal distribution

Capital Gains

the change in the price of the stock divided by the initial price

arithmetic average return

...Arithmetic versus Geometric Averages Let's start with a simple example. Suppose you buy a particular stock for $100. Unfortunately, the first year you own it, it falls to $50. The second year you own it, it rises back to $100, leaving you where you started (no dividends were paid). What was your average return on this investment? Common sense seems to say that your average return must be exactly zero since you started with $100 and ended with $100. But if we calculate the returns year-by-year, we see that you lost 50 percent the first year (you lost half of your money). The second year, you made 100 percent (you doubled your money). Your average return over the two years was thus (- 50 percent + 100 percent)/2 = 25 percent! So which is correct, 0 percent or 25 percent? The answer is that both are correct; they just answer different questions. The 0 percent is called the geometric average return . The 25 percent is called the arithmetic average return . The geometric average return answers the question, "What was your average compound return per year over a particular period?" The arithmetic average return answers the question, "What was your return in an average year over a particular period?" Notice that, in previous sections, the average returns we calculated were all arithmetic averages, so we already know how to calculate them. What we need to do now is (1 ) learn how to calculate geometric averages and (2) learn the circumstances under which one average is more meaningful than the other.

Risk Premium (NEEDS EDITING)

risk- free return on T- bills and the very risky return on common stocks. This difference between risky returns and risk- free returns is often called the excess return on the risky asset . It is called excess because it is the additional return resulting from the riskiness of common stocks and is interpreted as an equity risk premium .

Risk-Free Return

this debt is virtually free of the risk of default. Thus we will call this the risk- free return over a short time ( one year or less).

The ______ and its square root, the ________, are the most common measures of variability or dispersion.

variance /standard deviation