FIN401- Chapter 5 (exam 2)

# FIN401- Chapter 5 (exam 2) - Chapter 5 Return and Risk...

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Chapter 5 Return and Risk

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Asset Valuation Function of both return and risk At the center of security analysis How should realized return and risk be measured? The realized risk-return tradeoff: based on the past The expected risk-return tradeoff: based on uncertainty
Return Components Returns consist of two elements: 1. Yield: Periodic cash flows such as interest or dividends (income return) 2. Capital Gain Or Loss: Price appreciation or depreciation Total Return = Yield + Price Change

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Measuring Returns Total Return compares performance over time or across different securities » Percentage relating all cash flows received during a given time period , CFt + (Pe – Pb), to the start of the period price, Pb TR = CFt + (Pe- Pb) Pb
Measuring Returns Total Return can be either Positive or negative When cumulating or compounding, negative returns are a problem A Return Relative solves the problem because it is always positive RR = CFt + Pe = 1 + TR Pb

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Summary Statistics for Returns Arithmetic mean Better measure of typical performance over single periods n X X =
Summary Statistics for Returns Geometric mean » Measures compound rate of growth over time » Reflects cumulative returns over more than one period Geometric mean is a better measure of the change in wealth over time

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Geometric Mean Defined as the nth root of the product of n return relatives minus one, or G = [ ] 1 ) TR 1 )...( TR 1 )( TR 1 ( n / 1 n 2 1 - + + +
Arithmetic and Geometric Mean Returns An investment has the following returns over a four-year period: Year Return 1 10% 2 25% 3 -20% 4 25% Find the arithmetic and geometric mean return.

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Arithmetic and Geometric Mean Returns Arithmetic: ra = (.10 +.25-.20+.25)/4 ra = .10 or 10% Geometric: rg= [(1+.10)(1+.25)(1-.20)(1+.25)]^(1/4) - 1 rg= .0829 or 8.29%
APR = annual percentage rate (periods in a year) x (rate per period) EAR = effective annual rate (1+ rate per period)^ (periods per year -1)

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FIN401- Chapter 5 (exam 2) - Chapter 5 Return and Risk...

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