WVU FIN 310 - Final Exam Study Guide (4 pages)

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Final Exam Study Guide

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Final Exam Study Guide


Study Guide
West Virginia University
Fin 310 - Investments
Investments Documents
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FIN 310 1st Edition Final Exam Study Guide Arithmetic vs Geometric Average Returns Arithmetic The sum of returns in each period divided by the number of periods Statistic ignores compounding Does not represent and equivalent single quarterly rate for the year Without information beyond the historical sample arithmetic average is the best to forecast performance for the next quarter Geometric The single per period return that gives the same cumulative performance as the sequence Also called time weighted return because it ignores quarter to quarter variation in funds under management Arithmetic is simply the sum of the quarterly returns divided by the number of the quarters while the geometric is calculated by compounding the actual period by period returns and then finding the perperiod rate that will compound to the same final value Nominal vs Real Rates of Interest Nominal Interest The Interest rate in terms of nominal not adjusted for purchasing power Nominal is the growth rate of money itself Nominal real interest loss of purchasing power inflation Real Interest The excess of the interest rate over the inflation rate The growth rate of purchasing power derived from an investment Real interest nominal loss of purchasing power inflation Factors that Affect Interest Rates Supply households Demand business s Government s Net Supply and or Demand Federal Reserve Actions Yield Curve Yield curve A graph of yield to maturity as a function of term to maturity Also called term structure of interest because it relates yields to maturity to the term of each bond yield vs yield to maturity Published regularly and found in The Wall Street Journal Theories of term structure of interest Expectations Theory theory that yields to maturity are determined solely by the expectations of future short term interest rates Liquidity Preference Theory the theory that investors demand a risk premium on longterm bonds Market Segmentation Theory addressed supply and demand or certain maturity sectors and determines interest rates for those sectors It can explain almost every type of yield curve an investor can find Basically means that trading in the distinct segments determines the various rates Subjective Returns and Standard Deviation Subjective Returns psrs p s probability of a state r s return if a state occurs Standard Deviation variance 1 2 Var ps x rs E r 2 Utility Maximization and Scores Utility Based on the expected return and risk of a portfolio can be used as a means of ranking portfolios Utility Score U E r 005 A s 2 A measures the level of risk aversion Types of Risk Systematic remains even when there is diversification some factors are business cycle inflation and interest rates Unsystematic Firm specific eliminated through diversification Total Risk Systematic Unsystematic Level of Risk Aversion Investors level of Risk Aversion has a big impact on the types of assets they will choose Price of Asset must be proportional to level of risk for an investor Capital Allocation Line plot of risk return combinations available by varying portfolio allocation between a risk free asset and a risky portfolio Dominance Principle Dominance Principle A dominates B if E rA E rB AND A B Investors will prefer A over B if it has a higher mean return and a lower variance or standard deviation stock will dominate another stock because these criteria lead to higher expected return and lower volatility Correlation and Covariance key determinant for portfolio risk is determining the extent in which two assets vary either in tandem or opposition portfolio risk depends on covariance between the returns of the assets in the portfolio Covariance COV rA rB Pr s rA s E rA rB s E rB Correlation Coefficient is a pure number range from values of 1 to 1 a correlation coefficient of 1 means that one asset s return is perfectly inverse with the others A B COV rA rB A B Optimal Risky Portfolio The best combination of risky assets to be mixed with safe assets to form the complete portfolio Return on Portfolio The rate of return on a portfolio is a weighted average of the rates of return of each asset comprising the portfolio with the portfolio proportions as weights rp W1r1 W2r2 W1 Proportion of funds in Security 1 W2 Proportion of funds in Security 2 r1 Expected return on Security 1 r2 Expected return on Security 2 Portfolio Risk When two risky assets with variances s12 and s22 respectively are combined into a portfolio with portfolio weights w1 and w2 respectively the portfolio variance is given by sp2 w12s12 w22s22 2W1W2 Cov r1r2 Asset Allocation Diversification Investments are made in a wide variety of assets so that exposure to the risk of any particular security is limited An Investors personal risk drives asset allocation Risk must be outweighed by return according to level of risk aversion Portfolio Risk with risk free Asset When a risky asset is combined with a risk free asset the portfolio standard deviation equals the risky asset s standard deviation multiplied by the portfolio proportion invested in the risky asset p wriskyasset riskyasset

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