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 portfolios o Treynor measure Evaluates return relative to beta a measure of systematic risk Ignores unsystematic risk so appropriate for both individual securities and portfolios o 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 value Note Actual purchases are likely to head to higher costs due to commissions bid ask spread market trends and liquidity impact 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 flows in 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 income o 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 portfolio o 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 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 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 establishing settlement prices v providing for delivery Know how to price foreign currency futures contracts Interest rate parity states that securities with similar characteristics should differ in price by an amount equal to but opposite in sign from the difference between national interest rates in the two countries Understand how the value of a margin account is adjusted for changes in the commodity price Settlement prices i Are analogous to the closing price on the stock exchanges ii are normally an average of the high and low prices during the last minute or so of trading iii are established by the clearing corporation Be able to distinguish between the three theories of futures contract pricing 1 Expectations hypothesis The futures price for a commodity is what the marketplace expects the cash price to be when the delivery month arrives Note Price discovery Market consensus about likely future prices for a commodity 2 Normal backwardation Attributes to