Reading 6: Discounted Cash Flow Applications-LOS c, (Part 1) 2010, following, interpret, between, return

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Session 2: Quantitative Methods: Basic Concepts
Reading 6: Discounted Cash Flow Applications

LOS c, (Part 1): Calculate, interpret, and distinguish between the money-weighted and time-weighted rates of return of a portfolio.

 

 

 

Which of the following is most accurate with respect to the relationship of the money-weighted return to the time-weighted return? If funds are contributed to a portfolio just prior to a period of favorable performance, the:

A) time-weighted rate of return will tend to be elevated.

B) money-weighted rate of return will tend to be depressed.

C) money-weighted rate of return will tend to be elevated.

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The time-weighted returns are what they are and will not be affected by cash inflows or outflows. The money-weighted return is susceptible to distortions resulting from cash inflows and outflows. The money-weighted return will be biased upward if the funds are invested just prior to a period of favorable performance and will be biased downward if funds are invested just prior to a period of relatively unfavorable performance. The opposite will be true for cash outflows.

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Why is the time-weighted rate of return the preferred method of performance measurement?

A) Time weighted allows for inter-period measurement and therefore is more flexible in determining exactly how a portfolio performed during a specific interval of time.

B) There is no preference for time-weighted versus money-weighted.

C) Time-weighted returns are not influenced by the timing of cash flows.

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Money-weighted returns are sensitive to the timing or recognition of cash flows while time-weighted rates of return are not.

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The money-weighted return also is known as the:

A) return on invested capital.

B) measure of the compound rate of growth of $1 over a stated measurement period.

C) internal rate of return (IRR) of a portfolio.

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It is the IRR of a portfolio, taking into account all of the cash inflows and outflows.

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Which of the following statements regarding the money-weighted and time-weighted rates of return is least accurate?

A) The money-weighted rate of return removes the effects of the timing of additions and withdrawals to a portfolio.

B) The time-weighted rate of return reflects the compound rate of growth of one unit of currency over a stated measurement period.

C) The time-weighted rate of return is the standard in the investment management industry.

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The money-weighted return is actually highly sensitive to the timing and amount of withdrawals and additions to a portfolio. The time-weighted return removes the effects of timing and amount of withdrawals to a portfolio and reflects the compound rate of growth of $1 over a stated measurement period. Because the time-weighted rate of return removes the effects of timing, it is the standard in the investment management industry.

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An analyst managed a portfolio for many years and then liquidated it. Computing the internal rate of return of the inflows and outflows of a portfolio would give the:

A) money-weighted return.

B) time-weighted return.

C) net present value.

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The money-weighted return is the internal rate of return on a portfolio that equates the present value of inflows and outflows over a period of time.

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Time-weighted returns are used by the investment management industry because they:

A) result in higher returns versus the money-weighted return calculation.

B) take all cash inflows and outflows into account using the internal rate of return.

C) are not affected by the timing of cash flows.

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Time-weighted returns are not affected by the timing of cash flows. Money-weighted returns, by contrast, will be higher when funds are added at a favorable investment period or will be lower when funds are added during an unfavorable period. Thus, time-weighted returns offer a better performance measure because they are not affected by the timing of flows into and out of the account.