Financial Markets Exam Two Study Guide Bullet Points 25 Multiple Choice Questions on the exam 30 Review Bullet Points FIN 3244 02 RISK Standard Deviation Indentify Expected Rates of Return and standard deviation AS TO An absolute measure of risk It measures the variation of returns around the investments expected returns The standard deviation can be used as a quantitative tool when comparing the risk associated with different investments The greater the standard deviation of the investment from its expected return the riskier the investment is because it is more volatile Risk Factors That Rise Lower Risk Fluctuating currency exchange rates increase risk The amount of debt an issuer is wrapped up in increases risk Uncertainty increases risk Fluctuating market interest rate levels increase risk A thinly trading market increases liquidity risk because you might not be able to sell your securities at a reasonable price Calculate Total Return The total return is calculated by combining the capital gain or loss with the current income generated by the investment You also add or subtract in the changes in currency exchange rates when dealing with foreign investments Example You have a capital gain of 500 after selling some stock Current income During the time you owned that stock you received 100 in dividends Your total return would be 600 500 100 Cash that is periodically received as a result of being the owner of a specific investment This can take the form of dividends or interest Uses For Holding Period Returns and Required Return Required Returns Holding Period Return The rate of return that completely compensates for the risk associated with an investment The greater the risk the greater the required return the investor will want for taking on that risk investment for a certain period of time Usually used for a holding period of one year or less This is a good way of comparing multiple investments of different sizes to see which ones will provide you with the best return over a specified period of time Be sure to use The total return earned from holding an investments with the same holding period when comparing to get the best results The biggest downfall of the holding period return is that it fails to take into consideration the time value of money Equation Holding Period Return Current income during the period Capital gain or loss during the period Beginning investment value Calculate future value Enter each given value into your financial calculator and then hit compute followed by the value key you are looking for An example of this is shown at the bottom of page 155 in the text book Risk Measures Impact on Return The greater the risk tied to an investment the greater the required return would have to be to gain an investor s interest Types of Risk That Pertain to an Investment Business Risk Purchasing Power Risk The chance that inflation or deflation will The degree of uncertainty associated with an The uncertainty that an investment will be able to pay investment s earnings and the ability of the investment to pay its returns to its investors Debt holders are more likely to get some of their returns than stockholders because their preferential treatment Businesses that are relatively alike in nature tend to have similar business risk Financial Risk out its returns based on the firms mix of equity and debt Larger amounts of debt in the firm tend to correlate with higher financial risk negatively affect investment returns If inflation is too high the returns will not be able to purchase as much as they were once capable of Investments with fixed returns have high purchasing power risk because their values do not fluctuate with inflation negatively affect a securities value As the interest rate changes the prices of many investments fluctuate Another aspect is that if you invest in a short term investment you may have to reinvest those returns in an investment with lower yields If you initially invest in a long term investment you can lock in a return for a period of years Most investments are subject to interest rate risk although fixed income securities are most affected to convert an investment into cash The risk that you won t be able to conveniently be able The chance that changes in interest rates will Interest Rate Risk Liquidity Risk Example And investment purchased for 2 000 would not be seen as liquid if it could be only be sold on the spot for 1 000 Investments sold in markets where demand is small tend to be less liquid Tax Risk The chance that Congress with make changes in tax laws that negatively affect your investment Examples include elimination of tax exemptions limitation of deductions and increases in tax rates Market Risk The risk that returns will decline due to factors that are Municipal bonds and real estate generally have higher tax risk not directly related to the investment The more volatile the investments price the more market risk is associated with it Examples include political economic and social events and changes in investor s preferences The degree and direction of change in return differs for different types of investment vehicles Event Risk When something substantial happens to a firm that causes a sudden impact on its financial statements Example The CEO of a major firm dies unexpectedly This could lead to a sudden drop in the share price of that company Calculate Rate of Return Time Value of Money Question Used for investments that are held for longer than one year If the rate of return is equal to or greater than the required rate of return the investment is acceptable Enter each given value into your financial calculator and then hit compute followed by the value key you are looking for An example of this is shown at the bottom of page 155 in the text book Elements of Holding Period Return The elements of the holding period return are found in its equation Equation Holding period return Current income for the period Capital gain or loss for the period beginning investment value Calculate Market or Risk Free Rate from Components of Required Return Equation for Required Return Real rate of return Expected inflation premium Risk Premium for investment Real rate of return The rate of return that could be earned in a perfect world where all outcomes are known and certain to occur i e A WORLD WITHOUT RISK The book suggests using a real rate of return of 2 Expected inflation premium The average rate of inflation expected in the future The
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