Portfolio Management Ch 1 Formulas and Terms

Required Rate of Return (RRR)

the minimum return an investor will accept; RRR = Time Value of Money + Inflation + Risk Premium

Holding Period Return (HPR)

shows how much your investment grew over the whole investment period; formula when there’s income: HPR = Ending Value + Income / Beginning Value

Holding Period Yield (HPY)

the percentage return earned over the holding period

Annual Returns Formulas

Annual HPR converts HPR into a 1-year return. Annual HPY shows the annual percentage return

Arithmetic Mean (AM)

average yearly return (results in %);ΣHPY = Sum of all Holding Period Yields

n = Number of years

Geometric Mean Return (GM)

the true average annual return over multiple years

Portfolio HPY

the average return of the whole portfolio; Portfolio Return = Σ (Weigh x Return)

Expected Return

The average return you expect to earn in the future.

Variance (σ²)

Measures how spread out the possible returns are from the expected return. σ² = ΣProbability (Possible return - Expected return)²

Standard deviation (σ)

The square root of variance. Measures the total risk.

Coefficient of Variation (CV)

Measures risk per unit of expected return.

Risk of Historical Returns

Measures the risk of past returns (HPYs).

The Real Risk Free Rate (RRFR)

The risk-free return with no inflation and no risk. It’s affected by time preference and investment opportunities. Real = no inflation

Nominal Risk-Free Rate (NRFR)

The risk-free return, including expected inflation. Nominal = real +inflation

Security Market Line (SML)

A graph showing the relationship between risk and expected return.The slope shows how much extra return investors require for taking more risk.

Movement Along the SML

When the risk of one investment changes, its expected return also changes. → The investment moves along the same SML.; More risk → Move up/right. Less risk → Move down/left.

What does nominal mean?

It means “market” (Nominal risk free rate = market risk free rate

Investment

putting money in now to earn money later

Pure rate of interest

the return of waiting only (assumes no inflation and no risk)

Pure time value of money

money today is worth more than money tomorrow

Inflation

Money loses its value over time (→ investors want higher returns)

Uncertainty (Risk)

more risk → investors require extra return (risk premium)

Risk premium

extra return for taking risk

What does pure mean?

Time only

Market Risk Premium (MRP)

extra return expected above the risk-free rate for taking a bigger risk

Systematic risk

= Market risk; cannot diversify, affects all securities

Unsystematic risk

can diversify; UNsystematic = UNique company

Business risk

uncertainty of operating income (sales & operation)

Financial risk

uncertainty caused by debt/borrowing

Liquidity risk

not being able to sell quickly at a fair price

Exchange rate risk

risk from currency exchange rate changes

Country risk

risk from political/economic instability

Total risk

measured by standard deviation (for variance)