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w01-02-Introduction Risk vs Return
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w01-02-Introduction Risk vs Return

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