FIN4514: Exam 3 Review Chapter 19:- Be familiar with the principals of mutual fund performance evaluation Two key points: (1) Use geometric mean! Investment returns are not independent from each other, so the arithmetic mean is not useful for evaluating growth.(2) Dollars are more important than percentages. Investors want a larger return, so it doesn’t particularly matter how much you invest up front, as long as you get the most bang for your buck. The correct way to determine the return of both funds combined is to weigh the funds’ returns by the dollar amounts.Dollar-weighted return = [(Fund A / Total funds)*(Percentage return A)] + [(Fund B / Total funds)*(Percentage return B)]- Know how to compute the traditional performance measures o Sharpe measure: Evaluates return relative to standard deviation, a measure of total risk. Includes systematic risk, so only appropriate for well-diversified portfolioso Treynor measure: Evaluates return relative to beta, a measure of systematic risk. Ignores unsystematic risk, so appropriate for both individual securities and portfolioso Jensen measure: Directly related to CAPM. In theory, alpha should be zero ie have no excess return. If the alpha is positive, that means the portfolio manager is better-than-average.- Be prepared to calculate the volume-weighted average price Volume-weighted average price = Dollar transaction volume / Share volume over time period- Know how to compute the implementation shortfall “On-paper” theoretical portfolio value – Actual portfolio purchase valueNote: Actual purchases are likely to head to higher costs due to commissions, bid-ask spread, market trends, and liquidity impactSharpe measureTreynor measurewhere average returnrisk-free rate standard deviation of returns betafffR RR RRRσβσβ−=−=====( )it ft i mt ftR R R Rα β − = + − - Be familiar with performance measures that can be used in the presence of cash deposits and withdrawals o Daily valuation method: Requires determining a value for the portfolio each time a cash flow occurs MVEi = market value of the portfolio at the end of period i before any cash flowsin period i but including accrued income for the period MVBi = market value of the portfolio at the beginning of period i including any cash flows at the end of the previous subperiod and including accrued incomeo Modified BAI method: Approximates the internal rate of return for the investment over the period in question. Complicated by a large portfolio with daily cash flows *Solves for R o Approximate Method (proposed by the American Association of Individual Investors) ** Only one we must know how to compute. Most approximate method of the three- Know how to measure performance when options are involved Nonsymmetrical returns, so cannot use traditional beta, standard deviation, etc.Both of the following focus on whether an optioned portfolio outperforms an unoptioned portfolioo Incremental risk-adjusted return (IRAR): Indicates the contribution of option(s) to overall portfolio performance. When negative, the portfolio would have done better without the options. When positive, the options helped.daily11where niiiiR SMVESMVB== −=∏100.5(Net cash flow)10.5(Net cash flow)where net cash flow is the sum of inflows and outflowsPRP−= −+( )where Sharpe measure of the optioned portfolio Sharpe measure of the unoptioned portfolio standard deviation of the optioned portfolioo u oouoIRAR SH SHSHSHσσ= −===o Residual option spread (ROS): As with the IRAR, when positive, indicates the use of options resulted in more terminal wealth than only holding the stock, but does not necessarily mean that the incremental wealth is appropriate given the risk (Not proportional!)Chapter 21:- Understand the function of the commodity futures market Futures contracts are promises in which the seller will deliver a quantity of a standardized commodity to a designated delivery point during the delivery month and the buyer will pay a predetermined price for the goods upon delivery.Each exchange has a clearing corporation who (i) ensures the integrity of the futures contract, (ii) assumes responsibility for open positions if financial distress is present, and (iii) requires good faith deposits to ensure financial capacity.**The basic function of the commodity futures market is to transfer risk from the hedger to the speculator, who assumes the risk because of the profit opportunity. Without this, there would be added price risk and the price to the consumer would be significantly higher.- Know how to compute the profit or loss of a position in the futures market Net profit/loss to seller = (# contracts)*(Amount per contract)*(Selling price – Spot price)(See HW Part 2: #1)Question: A farmer sold 2 soybean contracts for $6.05 per bushel. Each contract calls for the delivery of 5,000 bushels of soybeans in July. (i) What is the farmer’s profit or loss if the spot price on the delivery date is $6.08? (ii) What if the spot price is $6.01?Answer: (i) Spot price of $6.08: (2 contracts)*(5,000 bushels)*($6.05-$6.08)= -$300, Net loss of $300(ii) Spot price of $6.01: (2 contracts)*(5,000 bushels)*($6.05-$6.01)= $400, Net proft of $400- Be familiar with the handling of performance bonds Performance bonds deposited by member firms remain with the clearing corporation until the member either (i) closes out their position by making an offsetting trade or (ii) closes out their position by delivery of the commodity. Then when successful delivery occurs, (i) good faith deposits are returned to both parties, (ii) payment for the commodity is received from the buyer and given to the seller, and (iii) the warehouse receipt for the goods is given to the buyer.Note: Intramarket settlements: If commodity prices move so much in a single day that good faith deposits are eroded, may result in a market variation call, a call on members to deposit more funds (collateral!) into their accounts during the day.1 11where / value of portfolio in Period n not utt tt t ttROS G GG V VV t= =−= −==∏ ∏- Be able to identify the functions performed by the clearing process The clearing process performs the following functions: (i) Matching trades, (ii) supervising the account for performance bonds, (iii) handling intramarket settlements (see above), (iv)