Quiz 2. Ch. 5
According to the Fisher hypothesis, what is the nominal interest rate if the expected inflation rate is 9% and the real interest rate is 4%? a) 4.8% b) 13.88% c) 13.36% d) 3.60%
1+Rnom = (1+Rreal)(1+i) = (1+ 4%)(1+9%) = 1.1336 1+Rnom = 1.1336 Rnom = 13.36% (C)
What are the four fundamental factors that determine the level of interest rates? Why are these factors important?
1.The supply of funds from savers, primarily households 2.The demand for funds from businesses to be used in finance investments in plant, equipment, and inventories (real assets or capital formation) 3.The government's net demand for funds as modified by actions of the Federal Reserve Bank 4.The expected rate of inflation These factors are important because the level of interest rates is the most important macroeconomic factor to consider in investment analysis. Forecasts of interest rates directly determine expected returns in the fixed-income market.
Calculate the holding-period return (HPR) for a fund that currently has a price of $75, as an investment horizon of 1 year, at year end's price will be $88 and cash dividends over the year amounted to $3.
Answer: HPR= (Ending price of a share - Beginning price + Cash dividend)/Beginning price HPR= (88-75+3)/75 = .213 or 21.3% Page 126
Suppose the nominal interest rate of a 1-year bank deposit had an interest rate of 9% and you expected inflation to be 4%, what would your real rate of interest be?
Answer: rreal=.09-.04/1+.04= 4.8%
Which of the following are fundamental factors that determine the level of interest rates: A) Supply of Funds from Savers and Demands for Funds from businesses B) The expected rate of inflation C) The government's Net Demand for funds as modified by actions of the federal reserve bank D) All of the above E) Answers A & B only
CORRECT ANSWER: D. All of the Above
True or False? ______. 1. The nominal interest rate is the growth rate of your money while the real interest rate is the growth rate of your purchasing power. ______. 2. The nominal rate of return is approximately the real rate of return less inflation. ______. 3. Supply, demand, and government actions are the three basic factors that determine real interest rate.
1. True 2. False - The real rate of return is approximately the nominal rate less inflation. 3. True Text book Pages 118-120.
Define Sharpe Ratio and Sortino ratio. What is the difference between these two? What kinds of portfolios are measured by Sharpe ratio and Sortino ratio?
A Sharpe ratio is calculated by subtracting the rate of return on an investment considered risk-free, such as a U.S. Treasury bill, from the expected or actual return on an equity investment portfolio or on an individual stock, then dividing that number by the standard deviation of the stock or portfolio. The Sortino ratio variation of the Sharpe ratio only factors in the downside, or negative volatility, rather than the total volatility used in calculating the Sharpe ratio. The theory behind the Sortino variation is that upside volatility is a plus for the investment, and it, therefore, should not be included in the risk calculation. Sharpe Ratio includes both upside and downside risk while calculating the ratio. Sortino Ratio only looks at the downside risk of the portfolio. Analysts commonly prefer to use the Sharpe ratio to evaluate low-volatility investment portfolios. Analysts commonly prefer to use the Sharpe ratio to evaluate high-volatility investment portfolios.
Why would a risk manager want to use VaR as a risk measure?
A risk manager would use VaR to measure and control the level of risk exposure of a particular position, a portfolio, or to measure the firm-wide risk exposure.
Q. As inflation rates increase, investors will demand a higher ______ in return??
A. Nominal rate
The real interest rate is defined as
A. the growth rate of your money B. the GDP growth rate C. the growth rate of your purchasing power D. the growth rate of the fed funds rate Answer: C pg 118 Investment textbook
What does the Fisher Hypothesis tell us about the nominal interest rate and inflation?
A: Irving Fisher argued that the nominal rate ought to increase one-for-one with expected inflation, E(i). rnom = rreal + E(i) This implies that when real rates are stable, changes in nominal rates ought to predict changes in inflation rates. While past data does not strongly support the Fisher equation, nominal interest rates seem to predict inflation as well as alternative methods.
Q: What 3 statistical measures must be equal in order to have a true normal distribution bell curve?
A: Mean, median, and mode must all be equal.
What are the two components of a Holding Period Return (HPR)?
A: The dividend yield plus the rate of capital gains .
How do you compare returns on investments with different holding periods?
A: You express all investment returns as an Effective Annual Rate (EAR), which is the percentage increase in funds invested over a 1-year period.
While the probability of losses ___ as the investment horizon lengthens, the magnitude of potential losses ___. a. Grows; Grows b. Grows; Falls c. Falls; Grows d. Falls; Falls
Answer C. This conclusion is based off table 5.5. It shows that the probability of return being less than 0(a negative return) decreases from 1 to 10 year investments and decreases again from 10 to 30 year investments. This implies that long-term investments are less risky than short-term investments, if magnitude is not taken into account. The wealth relative shows that the final value of the portfolio as a fraction of initially invested funds actually decreases from 1 to 10 year investments and decreases from 10 to 30 year investments. This more accurately represents investment risk over time.
The effective annual rate (EAR) and the annual percentage rate (APR) are both used to annualize interest rates. What's the difference between the EAR and APR?
Answer: EAR: -Uses compounded interest -Used to calculate annual interest rates on longer-term investments (> 1year) APR: -Uses simple interest -Used to calculate annual interest rates on shorter-term investments (< 1 year)
Draw the graph and describe the relationship that determines the real interest rate Briefly describe the two entities that can shift the supply and demand curve and how.
Answer: The real interest rate in relation to funds is determined by an upward sloping supply curve and a downward sloping demand curve. The higher the real interest rate the greater the supply of household savings, and the lower the real interest rate the more businesses want to invest due to the lower rate on the funds they would need to finance new projects. Equilibrium real interest rate is the intersection of supply and demand. (Graph Image) The government and the Federal reserve can shift the supply and demand curve. Changes in monetary and fiscal policies can shift the curves to the left or right, i.e an expansionary monetary policy would shift supply to the right.
What factor does NOT determine the level of interest rates? (A) The supply of funds from Savers (B) The demand of funds from Business (C) The bond market (D) The expected rate of inflation
Answer: C Explanation: The bond market has nothing to do with determining the level of interest rates. The Government's net demand of funds influences the level of interest rates in the country (which itself is determined by the FED).
Does holding a risky portfolio becoming safer in the long run?
No, this statement is not true. In fact the opposite is true; the longer you hold an investment the more riskier it becomes. The basis for this argument is the longer that a stock is held, the probability of an investment shortfall becomes lower. However, probability of shortfall is a poor measure of investment safety as it ignores the magnitude of potential losses.
What are the factors needed to determine your investments value after tax and how do they interact?
Rnom: nominal value of interest Rreal: real interest value i: inflation rate t: tax rate The nominal interest rate multiplied by the inverse of tax rate and reduced by inflation: Rnom*(1-t)-i OR the real interest rate multiplied by the inverse of tax rate and reduced by inflation then multiplied by the tax rate: Rreal*(1-t)-i*t OR the real interest rate plus inflation multiplied by the inverse of tax rate reduced by inflation: (Rreal+i)*(1-t)-i
What does it mean to have a high STD versus a low STD?
STD helps determine the market volatility or the spread of prices from their average price. When prices move wildly, STD is high, thus there is a higher risk. However, when prices are steady the STD is less risky.
A portfolio has a risk premium of 4.5% and a standard deviation of excess returns in calculated at 15%. Calculate the Sharpe Ratio. Define the Sharpe Ratio.
Sharpe Ratio = Risk Premium/SD of Excess Returns SR = .045/.15 SR = .3 The Sharpe Ratio measures the trade off between reward (risk premium) and risk (SD of excess returns). It is useful for portfolios but not for individual stocks.
Which return is an investor's tax liability calculated on? What is the impact of inflation?
Tax liability is calculated based on nominal returns. Inflation erodes after-tax real rate of return. Consider this example: you are in a 25% tax bracket, earning 10% returns while inflation is 3%. In reality, your before tax rate of return is roughly 7%, but you will be taxed (25% * 10% = 2.5%) instead of (25% * 7% = 1.75%). The after tax real return decreases by (3% * 25% = 0.75%).
What is Value at Risk (VaR) and expected shortfall?
Value at Risk (VaR) Loss corresponding to a very low percentile of the entire return distribution, such as the fifth or first percentile return Expected Shortfall (ES) Also called conditional tail expectation (CTE), focuses on the expected loss in the worst-case scenario (left tail of the distribution) More conservative measure of downside risk than VaR
In regards to risk, What would it mean if a distribution curve was skewed to the left?
When the distribution is skewed to the left, this means that the standard deviation is underestimating risk. The left skew of the distribution indicates that an investor may expect frequent small gains and few large losses.
Which is true for nominal rate of interest?
a) As the inflation rate decreases, investors will demand higher nominal rates of return b) As the inflation rate increases, investors will demand lower nominal rates of return c) AS the inflation rate increases, investors will demand higher nominal rates of return d) As the inflations rate decreases, investors will demand lower nominal rates of return Answer is C. Reference in chapter 5 power point, slide 6
Which of the following market risk measurements is fully determined by the mean and standard deviation of previous distributions, and measures the loss that will be exceeded with a specified percentage probability?
a) Value-at-risk b) Expected shortfall c) Lower partial standard deviation d) Frequency of extreme returns e) All of the above Answer: A
What is the Fischer Equation?
r(nom) = r(real) + E(i) nominal interest rate = real interest rate + expected inflation