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十八 Portfolio Management Capital Market Theory Basic Concepts

十八 Portfolio Management Capital Market Theory Basic Concepts

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十十 Portfolio Management: Capital Market Theory: Basic Concepts 1.A: The Investment Setting a: Explain the concept of required rate of return and discuss the three components of an investor's required rate of return. Determinants of the required rate of return . The nominal rate of return investors require to take investments varies over time and is a function of the: The real risk free rate of interest . The real risk free rate of interest is determined by the supply and demand for funds in the economy. The inflation premium is an adjustment to the real risk free rate to compensate investors for expected changes in the price indexes and money market conditions being tightened or eased due to inflationary expectations. The risk premium is what investors demand for the uncertainty associated with an investment. The fundamental view of risk is that it is caused by factors such as: business risk, financial risk, liquidity risk, exchange rate risk, and country risk. b: Describe the real risk-free rate and compute nominal and real risk-free rates of return. The real risk-free rate of interest. The real risk-free rate of interest is the price charged for the exchange between current goods and future goods by investors in the economy. This price is influenced by a subjective and an objective factor. These two factors are: 1. Consumer preferences for current consumption ( time preference ). 2. the set of investment opportunities available in the economy ( investment opportunities ). The inflation premium is an adjustment to the real risk-free rate to compensate investors for expected changes in the price indexes and money market conditions being tightened or eased due to inflationary expectations. This adjustment is not a simple summation of the real risk free rate of return and inflation expectations, rather the correct adjustment is: nominal risk free rate = (1 + real risk free rate)(1 + inflation rate) – 1 On the exam it might be handy to know: 1. The nominal risk free rate is approximated by: Real risk free rate + Inflation rate. 2. The real risk free rate = [(1 + nominal risk free rate) / (1 + inflation rate)] – 1 c: Explain the risk premium and the associated fundamental sources of uncertainty. The risk premium is what investors demand for the uncertainty associated with an investment. The fundamental view of risk is that it is caused by factors such as: business risk, financial risk, liquidity risk, exchange rate risk, and country risk. The nominal required rate = (1+real rate)(1+expected inflation rate)(1+risk premium). The risk premium addresses the following types of risk exposure:
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Business risk is the uncertainty of income flows caused by the nature of a firm’s business. Caused by the nature of the firm itself.
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