Reading 1: Rates and Returns

Interest rates measure…

The time value of money

What are the three ways interest rates can be used?

Required rate of return

Discount rates

Opportunity costsand pricing of securities

Equilibrium interest rates

required rate of return that lenders and borrowers agree upon for credit to be exchanged

Real-Risk Free Rate

the theoretical rate on a loan that has no expectation of inflation and zero chance of default

What does the Real-Risk Free Rate represent?

Time preference

Time preference

the degree to which consumption is preferred to equal future consumption

What does the real rate of return represent?

Investors’ increase in purchasing power

Default risk

risk that a borrower will not make payments

Liquidity risk

risk of receiving less than fair value on an investment if it must be sold quickly for cash

Maturity risk

prices of longer-term bonds are more volatile; more time for interest rates to change

Are the geometric mean and annual return always the same?

No, the geometric mean doesn’t have to be in years and could be subject to more compounding periods

What is the Harmonic Mean used for?

Cost-averaging

Cost averaging

purchasing the same dollar amount of mutual fund shares every period

Relationship between arithmetic, geometric, and harmonic?

Harmonic < Geometric < Arithmetic

Means that deal with outliers?

Trimmed mean

Winsorized mean

Internal rate of return (IRR)

the interest rate at which discounted cash inflows = discounted cash outflows

Money-Weighted Return

The IRR of a portfolio

Time-Weighted Return

measures the compound growth

When would you use Money-Weighted? Time-Weighted?

Money: When the manager has complete control over the cash flows of the account

Time: When the manager doesn’t have control over the time of cash flows in an account

When is Money-Weighted > than Time-Weighted? Vice Versa?

Money > Time: If funds are contributed before high performance

Time > Money: If funds are contributed before low performance

Which is not affected by the timing of cash flows: Money- or Time-Weighted?

Time-Weighted

Annualized return

average annual return over a period of time

If there more compounding periods, what increases: FV or PV?

FV increases

PV decreases

Gross return

the total return after deducting commissions

Net return

The gross return after management and admin fees

Pretax Nominal Return

return before paying taxes

After-Tax Nominal Return

return after tax liability is deducted

Real return

nominal return adjusted for inflation

Leveraged return

the amplified return an investor receives on their invested money by using borrowed capital to increase the size of the investment

Nominal Rate Equation

Nominal Rate = Real-Risk-Free Rate + Expected Inflation Rate