w01-02-Introduction Risk vs Return


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w01-02-Introduction Risk vs Return

  1. 1. Introduction Overview of Financial Markets and Investment Risk and Return
  2. 2. Investment Management Process <ul><li>Setting investment Objective </li></ul><ul><li>Establishing Investment Policy </li></ul><ul><li>Selecting a portfolio strategy </li></ul><ul><li>Selecting the assets </li></ul><ul><li>Measuring and Evaluating Performance </li></ul>
  3. 3. 1.Setting investment Objective <ul><li>Understand profiles and risk tolerant level in order to set objective to satisfy the obligations stipulated in the policy. </li></ul><ul><li>i.e. pension fund, insurance company, retirement person etc. </li></ul>2.Establishing Investment Policy <ul><li>Must be correspond with the objectives </li></ul><ul><li>Make asset allocation decision </li></ul>Investment Management Process
  4. 4. Investment Alternatives Major Categories Financial Assets Real Assets Direct Investing Indirect Investing Real Estate Precious Metals Fix Assets Mutual Funds Hedge Funds Non marketable Money market Capital market Derivative Securities <ul><li>Saving deposit </li></ul><ul><li>CD </li></ul><ul><li>Whole Life Insurance </li></ul><ul><li>T-bill </li></ul><ul><li>NCD </li></ul><ul><li>Commercial Paper i.e. B/E and P/N </li></ul><ul><li>Foreign Exchange </li></ul><ul><li>Fixed Income i.e. Gov.bond, State Enterprise bond, Corporate bond, T-note, Prefer stocks, Mortgage pass-through </li></ul><ul><li>Common Stock </li></ul><ul><li>Options i.e.Calls/Puts </li></ul><ul><li>Corporate created i.e Convertibles, Warrants </li></ul><ul><li>Forward </li></ul><ul><li>Futures </li></ul>
  5. 5. Investment Alternatives The Historical Record: A First Look McGraw Hill / Irwin
  6. 6. Investment Alternatives McGraw Hill / Irwin Average Returns: The First Lesson
  7. 7. Market sizes of developed stock markets
  8. 8. Market coverage of developed stock market
  9. 9. Market capitalization of emerging markets
  10. 10. Size of govy bond market
  11. 11. 4.Selecting the assets <ul><li>Picking securities to build your portfolio </li></ul><ul><li>Efficient portfolio – provides the greatest expected return at a given level of risk </li></ul>3. Selecting a portfolio strategy <ul><li>Actives - use information and forecasting techniques to seek a better performance </li></ul><ul><li>Passives – diversification </li></ul><ul><li>Structured – match the funds received from contributions to the future liabilities </li></ul>Investment Management Process
  12. 12. 5. Measuring and Evaluating Performance <ul><li>Benchmark </li></ul><ul><li>Return vs. Risk </li></ul><ul><li>Risk management </li></ul>Investment Management Process
  13. 13. Risk and Return <ul><li>Two key observations emerge </li></ul><ul><ul><li>There is a reward for bearing risk, and at least on average, that reward has been substantial. </li></ul></ul><ul><ul><li>Greater rewards are usually accompanied by greater risks. </li></ul></ul><ul><li>In summary, high risk should compensated by high return </li></ul>
  14. 14. Return Components <ul><li>Returns consist of two elements: </li></ul><ul><ul><li>Periodic cash flows such as interest or dividends (income return) </li></ul></ul><ul><ul><li>Price appreciation or depreciation (capital gain or loss) </li></ul></ul><ul><li>Total Return =Yield +Price Change </li></ul>
  15. 15. Measuring Returns <ul><li>For comparing performance over time or across different securities </li></ul><ul><li>Total Return is a percentage relating all cash flows received during a given time period, denoted CF t +(P E - P B ), to the start of period price, P B </li></ul>
  16. 16. <ul><li>Example: Calculating Returns </li></ul><ul><li>Suppose you invested $1,000 in a stock at $25 per share. After one year, the price increases to $35. For each share, you also received $2 in dividends. </li></ul><ul><li>Total dollar return = 48% of $1,000 = $480 </li></ul><ul><li>At the end of the year, the value of your $1,000 investment is $1,480. </li></ul>Measuring Returns
  17. 17. <ul><li>Total Return can be either positive or negative </li></ul><ul><ul><li>When cumulating or compounding, negative returns are problem </li></ul></ul><ul><li>A Return Relative solves the problem because it is always positive </li></ul>Measuring Returns
  18. 18. <ul><li>Example: </li></ul><ul><li>What is Relative Return in the previous example? </li></ul>Measuring Returns
  19. 19. <ul><li>To measure the level of wealth created by an investment rather than the change in wealth, need to cumulate returns over time </li></ul><ul><li>Cumulative Wealth Index, CWIn, over </li></ul><ul><li>n periods, = </li></ul>Measuring Returns
  20. 20. <ul><li>Example: </li></ul><ul><li>The Return Relatives of a particular stock investment in two consecutive years are 1.48 and 0.95, assume CW 0 is $1000, what is Cumulative Wealth Index, CWI 2 , over these 2 years? </li></ul>Measuring Returns
  21. 21. Measures Describing a Return Series <ul><li>Arithmetic mean, or simply mean, </li></ul>
  22. 22. Arithmetic Versus Geometric <ul><li>Arithmetic mean does not measure the compound growth rate over time </li></ul><ul><ul><li>Does not capture the realized change in wealth over multiple periods </li></ul></ul><ul><ul><li>Does capture typical return in a single period </li></ul></ul><ul><li>Geometric mean reflects compound, cumulative returns over more than one period </li></ul>
  23. 23. <ul><li>Defined as the n-th root of the product of n return relatives minus one or G = </li></ul><ul><li>Difference between Geometric mean and Arithmetic mean depends on the variability of returns, s </li></ul>Geometric Mean
  24. 24. Adjusting Returns for Inflation <ul><li>Returns measures are not adjusted for inflation </li></ul><ul><ul><li>Purchasing power of investment may change over time </li></ul></ul><ul><ul><li>Consumer Price Index (CPI) is possible measure of inflation </li></ul></ul>
  25. 25. Measuring Risk <ul><li>Risk is the chance that the actual outcome is different than the expected outcome </li></ul><ul><li>Standard Deviation measures the deviation of returns from the mean </li></ul>
  26. 26. <ul><li>Financial Risk </li></ul><ul><ul><li>Tied to debt financing </li></ul></ul><ul><li>Liquidity Risk </li></ul><ul><ul><li>Marketability with-out sale prices </li></ul></ul><ul><li>Exchange Rate Risk </li></ul><ul><li>Country Risk </li></ul><ul><ul><li>Political stability </li></ul></ul>Risk Sources <ul><li>Interest Rate Risk </li></ul><ul><ul><li>Affects income return </li></ul></ul><ul><li>Market Risk </li></ul><ul><ul><li>Overall market effects </li></ul></ul><ul><li>Inflation Risk </li></ul><ul><ul><li>Purchasing power variability </li></ul></ul><ul><li>Business Risk </li></ul>
  27. 27. Risk Types <ul><li>Two general types: </li></ul><ul><ul><li>Systematic (general) risk </li></ul></ul><ul><ul><ul><li>Pervasive, affecting all securities, cannot be avoided </li></ul></ul></ul><ul><ul><ul><li>Interest rate or market or inflation risks </li></ul></ul></ul><ul><ul><li>Nonsystematic (specific) risk </li></ul></ul><ul><ul><ul><li>Unique characteristics specific to issuer </li></ul></ul></ul><ul><li>Total Risk =General Risk +Specific Risk </li></ul>
  28. 28. Risk Premiums <ul><li>Premium is additional return earned or expected for taking additional risk </li></ul><ul><li>Equity risk premium is the difference between stock and risk-free returns </li></ul><ul><li>Equity Risk Premium, ERP, = </li></ul>
  29. 29. Risk and Return McGraw Hill / Irwin
  30. 30. The Lesson <ul><li>The greater the potential reward, the greater the risk. </li></ul>