EKRP 2 1: Chapter 1 Investment Setting

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Questions and Answers

What are the three components of the required rate of return?

Time value of money, operating costs, expected inflation

Time value of money, expected inflation, risk involved (correct)

Time value, corporate earnings, capital gains

Expected returns, economic growth, market volatility

What does RRFR represent in regards to investments?

The price for exchanging current goods for future goods

The risk premium added to investments

The nominal rate of return observed in markets

The real risk-free rate of return (correct)

How is the required return (RR) calculated?

RR = NRFR X RP

RR = NRFR - RP

RR = RRFR + RP

RR = NRFR + RP (correct)

Which factor does NOT influence the nominal risk-free rate (NRFR)?

Stock market performance Signup and view all the answers

What determines the demand and supply conditions in the capital market?

Monetary and fiscal policy Signup and view all the answers

What is included when calculating the required return besides the nominal risk-free rate?

Risk premium Signup and view all the answers

What does expected inflation affect in terms of rates of return?

It directly affects the nominal risk-free rate Signup and view all the answers

Which statement best describes risk-free investments?

They provide certainty regarding returns and timing. Signup and view all the answers

What is the primary purpose of wealth creation?

To earn a return that exceeds the opportunity cost of making an investment Signup and view all the answers

What does opportunity cost primarily represent?

The return from the best alternative investment Signup and view all the answers

Which of the following factors should compensation for investment returns address?

Expected inflation and uncertainty of future benefits Signup and view all the answers

How can net worth be increased?

By investing in assets that appreciate over time Signup and view all the answers

What is the key factor in successful investment?

Asset allocation Signup and view all the answers

What differentiates investment from speculation?

Investment is based on fundamental research, whereas speculation relies on assumptions about future profits Signup and view all the answers

What is the primary motivation behind gambling in an investment context?

To enjoy the thrill of uncertainty and risk Signup and view all the answers

What does the required rate of return represent?

The minimum return an investor should accept to defer consumption Signup and view all the answers

Study Notes

Investment Definitions and Concepts

Wealth: Created by effectively using assets to earn returns that surpass alternative investment opportunities.
Opportunity Cost: Represents the potential return lost when choosing one investment over another.
Returns Compensation: Investors expect compensation for:
- Time funds are tied up
- Anticipated inflation rate
- Risks associated with future financial benefits
- Wealth costs, assessed via present value of income streams or the available funds for consumption.

Key Financial Terms

Net Worth: Calculated as the difference between assets and liabilities, can be increased by asset investments or paying off debts.
Asset Allocation: The strategic distribution of an investor's wealth across various countries and asset classes essential for wealth creation.
Investment: Long-term commitment of funds in real or financial assets based on fundamental research to accumulate wealth.
Speculation: Investment made with the hope of high returns based on assumptions regarding risks and rewards.
Gambling: Involves risk-taking for enjoyment rather than profit, accepting any level of return, including loss.

Required Rate of Return (RRR)

Definition: The minimum return needed to justify the deferral of consumption.
Components:
- Time value of money during the investment period.
- Expected inflation rate.
- Risk involved.
Risk-Free Rate of Return (RRFR): The baseline return for investments that is free from risk, used to calculate the required return.

Risk-Free Investments

Examples include T-Bills, which promise certainty about the amount and timing of returns.
There are no truly risk-free rates; nominal risk-free rate is calculated and then adjusted for risk premium (RP).

Rates of Return

Nominal Risk-Free Rate (NRFR): Influenced mainly by:
- Expected inflation.
- Conditions within the capital market.

Relationship Between Rates

Inflation's Role:
- The real risk-free rate (RRFR) relates to the nominal rate (NRFR) using the formula:
  - RRFR = (1 + NRFR) / (1 + EI) - 1
Required Rate of Return Calculation:
- RRR = NRFR + RP

Capital Market Dynamics

Monetary Policy: Central bank policies that influence interest rates based on growth expectations, economic conditions, inflation, and currency exchange rates.
Fiscal Policy: Government financial decisions impacting the economy, significant for managing capital market demand and supply.

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Description

This quiz covers the fundamental concepts of investment as presented in Chapter 1 of EKRP 2 1. It focuses on the definitions of wealth and opportunity cost, as well as the factors that should compensate an investor, including time, inflation, and uncertainty. Test your understanding of these key financial principles.