Investments and Historical Returns
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What is meant by 'reversion to the mean' in the context of investment returns?

  • Future returns will always exceed current returns.
  • Investments will return to their average historical return over time. (correct)
  • Investments will always yield the same return every year.
  • Current returns will continue to increase indefinitely.

Which of the following statements best describes the role of historical returns in investment?

  • They only focus on short-term performance of stocks.
  • They help in assessing how an investment might react to future news. (correct)
  • They provide definitive predictions of future stock prices.
  • They are irrelevant to understanding overall risk versus return.

What does a value-weighted index use to calculate average price?

  • Total market value of all shares divided by total number of shares. (correct)
  • Multiplying stock prices and taking the nth root.
  • Only the highest stock price in the index.
  • The simple average of stock prices in the index.

Which of the following indexes is specifically known for including a large number of stocks as compared to others?

<p>S&amp;P 500 (A)</p> Signup and view all the answers

Why might different methods of calculating averages result in varied measures of stock performance?

<p>Each method weighs price changes differently based on shares outstanding. (C)</p> Signup and view all the answers

What is meant by the term 'maturity date' in the context of bonds?

<p>The time at which the principal must be repaid. (A)</p> Signup and view all the answers

Which statement accurately describes 'current yield'?

<p>It is annual income divided by the current price of the security. (A)</p> Signup and view all the answers

How does a normal yield curve typically behave?

<p>Long-term yields are higher than short-term yields. (B)</p> Signup and view all the answers

What is the correct definition of a bond's 'coupon rate'?

<p>The specified interest amount paid annually on the bond’s face value. (A)</p> Signup and view all the answers

What does the bond indenture refer to?

<p>The contract between the company and the bondholders/lenders. (C)</p> Signup and view all the answers

What is one of the main goals of the Federal Reserve?

<p>Ensuring maximum employment (D)</p> Signup and view all the answers

How does the Federal Reserve primarily influence economic activity?

<p>Through manipulation of the money supply (B)</p> Signup and view all the answers

What effect do lower interest rates have on the economy?

<p>They encourage business investment (B)</p> Signup and view all the answers

What is the Federal Funds Rate?

<p>The rate banks charge each other for overnight loans (B)</p> Signup and view all the answers

What is one primary function of fiscal policy?

<p>Adjusting taxation and government spending (A)</p> Signup and view all the answers

What is the dual mandate of the Federal Reserve?

<p>Maximizing employment and stabilizing prices (A)</p> Signup and view all the answers

Which of the following accurately describes monetary policy tools?

<p>Adjustments to the money supply and interest rates (C)</p> Signup and view all the answers

What does the term 'conducting monetary policy' mean?

<p>Setting targets for interest rates and influencing the money supply (B)</p> Signup and view all the answers

What does the Current Yield (CY) measure?

<p>The annual interest payment divided by the bond's current price (D)</p> Signup and view all the answers

What happens when a borrower fails to meet any of the terms of the bond indenture?

<p>The lender can take legal action and force bankruptcy. (C)</p> Signup and view all the answers

How is the semiannual discount rate calculated in the example given?

<p>8% (16%/2) (C)</p> Signup and view all the answers

What is considered when calculating Yield To Maturity (YTM)?

<p>Current income and changes in bond value over time (B)</p> Signup and view all the answers

What is the primary role of a bond trustee?

<p>To uphold the terms of the bond's indenture. (C)</p> Signup and view all the answers

What happens to the price of a bond if it is bought at a premium as it approaches maturity?

<p>The price may decline (D)</p> Signup and view all the answers

Which of the following constitutes a protective covenant in a bond indenture?

<p>Limiting the borrower’s ability to pay dividends. (C)</p> Signup and view all the answers

What is the primary purpose of portfolio construction?

<p>To achieve financial objectives by generating returns (C)</p> Signup and view all the answers

What type of bond is defined by its ownership being registered with the trustee?

<p>Registered Bonds (A)</p> Signup and view all the answers

Which of the following factors does not influence an individual's willingness to bear risk in investments?

<p>Current emotional state (D)</p> Signup and view all the answers

In what scenario could the Current Yield (CY) be misleading?

<p>When changes in bond price are not considered if held to maturity (C)</p> Signup and view all the answers

What does asset allocation aim to achieve in portfolio management?

<p>Balancing investments among various asset classes (D)</p> Signup and view all the answers

What is the approximate YTM of a $1,000 Face Value bond, with a 10% coupon, that sells for $952?

<p>12% (B)</p> Signup and view all the answers

What is referred to as 'default risk' in bond investing?

<p>The failure of the borrower to fulfill the bond terms. (B)</p> Signup and view all the answers

How is unsystematic risk characterized in the context of a portfolio?

<p>Risk that can be eliminated through diversification (B)</p> Signup and view all the answers

Which type of bonds presents significant risk by determining ownership through physical possession?

<p>Bearer Bonds (C)</p> Signup and view all the answers

What is the price/value of the bond as calculated?

<p>$917.56 (A)</p> Signup and view all the answers

What does 'Pull to Par' refer to in bond investing?

<p>The movement of bond prices toward face value as maturity approaches (C)</p> Signup and view all the answers

What is the effect on a portfolio when a market declines by a certain percentage and then increases by the same percentage?

<p>The portfolio's value is lower than before the decline (A)</p> Signup and view all the answers

What is a common factor affecting the default risk of a bond?

<p>The provisions outlined in the bond contract. (C)</p> Signup and view all the answers

Which of the following financial objectives does not typically require investment?

<p>Funds for vacation expenses (C)</p> Signup and view all the answers

Which of these risks refers to fluctuations in interest rates affecting bond values?

<p>Interest Rate Risk (B)</p> Signup and view all the answers

What percentage return is needed to recoup a loss of 38.49% on an investment?

<p>62.78% (C)</p> Signup and view all the answers

What should management regularly assess to ensure a company's effective mission pursuit?

<p>Identified public benefit purpose (B)</p> Signup and view all the answers

Flashcards

Bond

A long-term debt with a fixed interest payment and a set maturity date.

Principal

The borrowed amount that needs to be repaid by the borrower; typically $1,000.

Maturity Date

The date when the borrower must repay the principal (the borrowed amount).

Coupon Rate

The fixed percentage of interest the borrower pays on the principal every year.

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Yield to Maturity (YTM)

The average annual return an investor expects to earn from a bond until its maturity date.

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Reversion to the Mean

The tendency of an investment's return to move back towards its long-term average return over time.

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Historical Returns

Past performance of an investment, used to understand its risk and return profile and predict how it might perform in the future.

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Stock Market Index

A measure of the overall performance of a specific group of stocks, representing a particular market or sector. It is a tool to track market trends and returns.

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Price-Weighted Index

Calculates the average price of stocks in an index by simply averaging their prices.

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Value-Weighted Index

Calculates the average price of stocks in an index by considering the market value of each stock (price x number of shares outstanding).

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Bond Indenture

The legal contract between a bond issuer and bondholders outlining the terms of the bond. It details the interest rate, maturity date, and any conditions required for repayment.

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Protective Covenants

Restrictions within a bond indenture designed to protect bondholders. They may limit dividends, debt issuance, or major business changes without creditor approval.

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Default

When a borrower fails to meet any of the terms of the bond indenture, such as missing a coupon payment or principal repayment.

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Trustee

An appointed entity, typically a commercial bank, responsible for safeguarding bondholders' interests by upholding the terms of the bond indenture.

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Registered Bonds

Bonds whose ownership is recorded with the trustee. This ensures proper distribution of interest and principal payments.

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Default Risk

The risk that a borrower may fail to meet the terms of a bond, leading to potential loss of principal and interest payments.

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Interest Rate Risk

The risk that changes in interest rates will negatively impact the value of a bond.

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Reinvestment Rate Risk

The risk that future interest payments from a bond cannot be reinvested at the same rate of return as the original investment.

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Government's Economic Goals

The government aims for a healthy economy with full employment, stable prices (low inflation), and economic growth.

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Target Inflation Rate

A specific inflation rate set by the government to encourage a healthy economy. Usually around 2%.

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Monetary Policy

The government's way of managing the money supply to impact the economy.

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Fiscal Policy

The government's use of spending and taxes to influence the economy.

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The Federal Reserve (The Fed)

The central bank of the U.S., responsible for setting monetary policy.

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Dual Mandate

The Fed's primary goals: maximum employment and stable prices (low inflation).

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Money Supply

The total amount of money (currency and other liquid investments) available for lending or borrowing in the economy.

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Federal Funds Rate

The interest rate banks charge each other to borrow funds overnight. The base rate in the economy.

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What is yield in relation to bonds?

Yield refers to the return a bond provides, representing the investor's profit from the bond.

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What is the difference between coupon rate and yield?

Coupon rate is fixed and represents the annual interest payment, while yield fluctuates based on market prices and represents the actual return.

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What is the Current Yield (CY)?

The Current Yield is calculated by dividing the annual interest payment by the bond's current market price.

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Why can Current Yield be misleading?

It only considers the current income, ignoring any future price changes as the bond matures.

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What is Pull to Par?

The tendency for a bond's price to move towards its face value as it matures.

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What is Yield To Maturity (YTM)?

YTM considers both the current income from the bond and its price change towards par value at maturity.

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How is YTM calculated?

YTM is calculated using financial formulas that take into account the coupon payments, maturity date, and current price.

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Why is YTM important to investors?

YTM provides a comprehensive measure of the potential return on a bond investment, making informed decisions possible.

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Public Benefit Purpose

The company's stated mission to create positive social or environmental impact.

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Financial Objectives

Specific financial goals an investor wants to achieve, such as saving for retirement or buying a house.

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Portfolio Construction

The process of selecting and allocating assets in a way that aims to meet the investor's financial objectives.

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Income vs. Capital Gains

Two ways to generate returns: income from dividends or interest, and capital gains from asset price appreciation.

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Unsystematic Risk

Risk specific to a particular company or asset that can be reduced by diversification.

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Market Recovery: Loss vs. Gain

It takes a larger percentage gain to recover from a loss than the percentage of the loss itself.

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Asset Allocation

The strategy of distributing investment funds across different asset classes based on the investor's objectives and risk tolerance.

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S&P 500

A stock market index that tracks the performance of 500 large publicly traded companies in the US.

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Study Notes

Historical Returns in Investments

  • Studying historical returns helps investors understand overall risk and return profiles.
  • Past performance is not necessarily indicative of future results.
  • Investors use historical data to form expectations about how an investment might react to new information.
  • Current returns often revert to historical averages.
  • Used in valuation models to estimate fair values of investments in common stocks.

Aggregate Measures of Stock Market

  • Examples of stock market indexes include the Dow Jones and S&P 500.
  • Indexes vary in the stocks they include and how they weight different stocks, i.e. total market value of shares.

Calculating Average Price

  • Price-weighted average: Calculate the simple mean average of prices.
  • Value-weighted average: Average price = Total market value of all shares / Total number of shares.
  • Geometric-weighted average: Multiply prices and take the nth root of the product.

Mean Reversion

  • The tendency for a variable that fluctuates over time to revert to a long-term mean value.
  • A variable that is unusually high will eventually drop.
  • A similarly unusually low value will tend to increase back toward the mean.

Different Methods of Calculation Averages

  • Different calculations yield different results in measures of stock performance, with no single method as inherently superior.
  • Price-weighted averages are disproportionately influenced by higher-price stocks.
  • Value-weighted averages are most heavily influenced by stocks with higher market values.
  • Geometric-weighted averages treat all stocks equally.

Dow Jones and S&P

  • Dow Jones: Indexes of 30 large, well-established companies, used to evaluate general market trends.
  • S&P 500: Broad-based index of 500 firms, common benchmark for performance of the market.

Behavioral Finance

  • Emotions (like fear and greed) influence investment decisions.
  • Anchoring effect: Investors use initial information as a reference point for subsequent decisions.
  • Overconfidence: Investors tend to overestimate their investment abilities.
  • Technical analysis: Study of past market trends is an attempt to mitigate the impact of emotions.

Other Key Concepts

  • Time-Weighted Rate of Return (TWRR) used in the calculation of indexes and individual performance to account for investment flows to the funds and timing of investment.
  • Dollar-weighted rate of return (IRR), which is the discount rate that makes the net present value of all cash flows equal to zero.
  • Risk related to bonds includes: default risk, interest rate risk, reinvestment rate risk, and inflation risk.
  • Time value of money is a concept important when evaluating future cash flows, i.e. value of $1 today is worth more than $1 in the future.
  • Bond Indenture: contract between the borrower and lender outlining the terms and conditions of the investment.

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Related Documents

Lecture 8: Historical Returns in Investments PDF

Description

This quiz explores key concepts related to historical returns in investments, including risk profiles and valuation models. It also covers different stock market indexes and methods for calculating averages. Test your knowledge on these critical investment strategies!

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