Finance 310 9th Edition Exam 2 Study Guide Chapter 5 1 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 2 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 3 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 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