Saturday, September 1, 2012

Sample Rate of Return Exercise - Cash Flow Timing

A Principles Level candidate emailed me the following problem, and asked me about how to interpret the timing of the cash flows:

In this case, given that they tell you that the fair valuations are inclusive of the flows, my interpretation would be that the timing of cash flows is end of day.  Thus, your sub-period returns would be based on this assumption as follows:

The first sub-period return is:

The second sub-period return is:

The third sub-period return is: 

The return for the month is then the geometrically linked sub-period returns:

(1+1.8182%)*(1+6.40%)*(1+7.6923%) – 1 = 16.67%.

Note:  in previous years, there was a Learning Outcome Statement that explicitly required candidates to know how to calculate sub-period returns when cash flows were at the start or end of the period.  In this exam window, the Learning Outcome Statements have been rephrased, so this is no longer explicitly stated, BUT, your reading still contains the discussion that covers these scenarios (see page 257) and this is a normal dilemma faced by performance analysts on an on-going basis.  Return calculations will be different depending on whether cash flows are assumed to be at the start or end (or during) an evaluation period.  Performance analysts must be able to interpret the data accordingly and calculate returns.

In an upcoming blog post, I will cover this subject in greater detail.

Happy studying!

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