Finance 310 9th EditionExam # 2 Study Guide Chapter 51. Arithmetic vs Geometric Average ReturnsArithmetic: - 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 per-period rate that will compound to the same final value2. Nominal vs. Real Rates of InterestNominal 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)3. Yield CurveYield 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- Published regularly and found in The Wall Street JournalTheories of term structure of interestExpectations Theory: theory that yields to maturity are determined solely by the expectations of future short-term interest ratesLiquidity Preference Theory: the theory that investors demand a risk premium on long-term