Lecture 1

Question 1

Geometric vs arithmetic average

Answer 1

Geometric average always less than or equal to arithmetic average

Question 2

The Risk Premium For Arithmetic Returns

Answer 2

Average rate of return for equity minus risk free interest rate

Question 3

When decisions are being taken on a forward-looking basis

Answer 3

The arithmetic mean (rA) is the appropriate measure

Question 4

Why arithmetic mean is better for forward-looking

Answer 4

• Represents the mean of all the returns that may possibly occur over the investment holding period
• Best estimator of expected (short-term) future return
• The best gauge of the expected risk premium - Expected return above risk free interest rate

Question 5

When to use geometric average

Answer 5

• When past performance is being considered

Question 6

How to Find Relation Between Risk and Return?

Answer 6

• Have a look at the historical records – returns – for assets with different risks
• Caveat

Question 7

Investors demand compensation for

Answer 7

1. Abstaining from consuming today and waiting until tomorrow
2. Taking on risk – measured by the risk premium

Question 8

Equity Risk premium

Answer 8

Difference between the return on equities and the return on a risk-free asset, typically treasury bills (and government bonds)

Question 9

The risk premium matters because it is central to

Answer 9

• Projecting future investment returns
• Calculating a company’s cost of equity capital
• Valuing companies and shares
• Appraising investment projects
• Determining fair rates of return for regulated utilities