FM8 Review PDF

**FM8 REVIEW** - **Mean-variance analysis** is a useful tool for investors to calculate the risk and reward of their investments - **Mean-variance analysis** - They can determine the value of their investments and fully round out their portfolio by understanding how likely their in...

**FM8 REVIEW** - **Mean-variance analysis** is a useful tool for investors to calculate the risk and reward of their investments - **Mean-variance analysis** - They can determine the value of their investments and fully round out their portfolio by understanding how likely their investments are to return the expected amount of profit - **The Mean-Variance Criterion** evaluates investments based on the trade-off between their expected returns (mean) and risk (variance). - **The mean**, or e**xpected return**, - represents the average outcome of an investment over time. - **Variance-** measures how much the returns of an investment vary from the mean (risk). - **Mean-variance analysis** is the process of weighing risk, expressed as variance, against expected return. - **Mean-variance analysis** allows investors to find the biggest reward at a given level of risk or the least risk at a given level of return. - The **Mean-Variance Criterion** involves calculating the mean (average return) and variance (risk) of investments. - **Mean-Variance Criterion:** A fundamental concept in portfolio theory that evaluates investments based on their expected returns and risk. - **Risk-Return Trade-off**: Investors use this framework to balance the potential for profit with the level of uncertainty associated with investments. - **Mean-Variance Analysis:** A quantitative technique that helps investors identify the optimal portfolio allocation based on their risk tolerance and return objectives. - **Inflation** represents the general increase in prices over time, eroding the purchasing power of money. - **Nominal** returns must be adjusted for inflation to determine the actual growth in an investor\'s purchasing power. - Investors are particularly concerned with inflation because it can reduce the real value of fixed-income securities like bonds, which pay a fixed amount of interest that may lose value as [ Effects on Investment ] **1. Demand-Pull Inflation:** Occurs when demand for goods and services exceeds supply, leading to higher prices. **2. Cost-Push Inflation:** Results from an increase in the costs of production (e.g., wages, raw materials), causing producers to raise prices to maintain profit margins. **3. Built-In Inflation:** Also known as wage-price inflation, it occurs when businesses increase prices in anticipation of higher wage demands from employees. - **The real rate of interest** is the nominal interest rate adjusted for inflation. It reflects the true earning power of money, as it accounts for the loss of purchasing power due to inflation [Importance ] - **Investment Decisions:** Investors use the real rate to assess the attractiveness of various investments. A *positive real rate* indicates that an investment\'s return *exceeds inflation*, enhancing purchasing power. - **Economic Indicators:** Central banks monitor real interest rates to guide monetary policy. Low or negative real rates may prompt adjustments to stimulate economic activity. - **Cost of Borrowing:** For borrowers, the real interest rate affects the cost of loans. If the real rate is low or negative, borrowing costs are effectively reduced, potentially leading to increased consumer spending and business investment. [Relationship] - **Nominal vs. Real Rates:** The nominal interest rate is the stated interest rate on loans and investments, while the real rate is adjusted for inflation. When inflation rises, if nominal rates do not increase correspondingly, real rates fall. - **Expectations:** If investors anticipate higher inflation in the future, they will demand higher nominal rates to compensate for the expected loss of purchasing power, which can lead to higher real interest rates. - **Economic Effects:** When real interest rates are high, borrowing becomes more expensive, which can slow down economic growth. Conversely, low real rates can encourage borrowing and spending, stimulating economic activity