different rates of return

[shanlane]

Hello,

I appologize in advance for the vague questions, but I remember at some point doing a problem (I think it was from the market risk section) from part 2 where the rate of return was computed differently than most problems I have seen. It made perfect intuitive sense, but I was hoping you could tell me what the method was called and exactly when it would be used as opposed to other methods.

My example:

Buy today: S0=$104
Sell at the end of one year: S1=$117
Assume constnat spot rate: r=5%

This simple return would just be (117-104)/104=12.5%, but in this problem, the return was
[(117/1.05)-104]/104=7.14%.

Sorry again for the out-of-the-blue question, but I am reading some of the investment material now and this just came back to me.

Thanks!

Shannon

 

[David Harper CFA FRM]

Hi Shannon,

I don't recognize it "as-is." IMO, "assume constant spot rate" is a bit open to interpretation; e.g., maybe that is expected constant growth in the spot rate? Functionally, it looks like it is effectively discounting the 5% as a hurdle rate: your simple return was 12.5% but, say, after the cost to carry (finance) the commodity, the "net" simple return was 7.14%. Could wrap a PV argument around it, too, but i'm not sure.

 

[shanlane]

Sorry about that. I will look through some of the old questions tonight and hopefully find it. My numbers were completely made up, it was just the fact that the future price was discounted that made it different than the other problems. By constant spot rate, I just meant that interest rates were a constant 5%. The logic of the discounting makes sense, but I cannot remember the exact context to save my life.

Thanks anyway! If I do find it I will let you know.

Shannon

 

[shanlane]

Hello,

I found the problem I was referring to when I initially asked this question. It is 68.1 in the market risk section. The question asks about the present value of P/L, it is from Ch 3 in Dowd. I guess my question is: would we ever use this concept unless we were explicitly asked for the "present value of the P/L"?

Thanks!

Shannon

 

[David Harper CFA FRM]

Hi Shannon,

Okay, thanks, I see, question does source Dowd: http://forum.bionicturtle.com/threads/l2-t5-68-historical-simulation-value-at-risk-hs-var.3642/

But it is not a rate of return, he is just computing the present value of a dollar loss.

• In the question: Present value (P/L) = [P(t) + D)/(1+d)] - P(t-1) = (112 + 1)/(1.03) - 100 = 9.7087 = $9.71;
• Which in your example, I think should correspond to $117/(1+5%) - $104 = $7.43,
• Put another way, the FV terms gain = $117 - 104(1+5%) but discount that to PV with: [$117 - 104(1+5%)]/(1+5%) = 117/(1+5%) - 104 = $7.43

 

[shanlane]

Makes perfect sense.

Thanks!

Shannon