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  1. 1. Lecture Presentation Software to accompany Investment Analysis and Portfolio Management Seventh Edition by Frank K. Reilly & Keith C. Brown
  2. 2. Chapter 1The Investment SettingQuestions to be answered:• Why do individuals invest ?• What is an investment ?• How do we measure the rate of return on an investment ?• How do investors measure risk related to alternative investments ?
  3. 3. Chapter 1The Investment Setting• What factors contribute to the rates of return that investors require on alternative investments ?• What macroeconomic and microeconomic factors contribute to changes in the required rate of return for individual investments and investments in general ?
  4. 4. Why Do Individuals Invest ?By saving money (instead ofspending it), individuals tradeoffpresent consumption for a largerfuture consumption.
  5. 5. How Do We Measure The Rate Of Return On An Investment ? The pure rate of interest is the exchange rate between future consumption and present consumption. Market forces determine this rate. $1.00 + 4% = $1.04
  6. 6. How Do We Measure The Rate Of Return On An Investment ? People’s willingness to pay the difference for borrowing today and their desire to receive a surplus on their savings give rise to an interest rate referred to as the pure time value of money.
  7. 7. How Do We Measure The Rate Of Return On An Investment ? If the future payment will be diminished in value because of inflation, then the investor will demand an interest rate higher than the pure time value of money to also cover the expected inflation expense.
  8. 8. How Do We Measure The Rate Of Return On An Investment ? If the future payment from the investment is not certain, the investor will demand an interest rate that exceeds the pure time value of money plus the inflation rate to provide a risk premium to cover the investment risk.
  9. 9. Defining an Investment A current commitment of $ for a period of time in order to derive future payments that will compensate for: – the time the funds are committed – the expected rate of inflation – uncertainty of future flow of funds.
  10. 10. Measures of Historical Rates of Return Holding Period Return 1.1 Ending Value of InvestmentHPR = Beginning Value of Investment $220 = = 1.10 $200
  11. 11. Measures ofHistorical Rates of Return 1.2 Holding Period Yield HPY = HPR - 1 1.10 - 1 = 0.10 = 10%
  12. 12. Measures of Historical Rates of ReturnAnnual Holding Period Return –Annual HPR = HPR 1/n where n = number of years investment is heldAnnual Holding Period Yield –Annual HPY = Annual HPR - 1
  13. 13. Measures of Historical Rates of Return 1.4 Arithmetic Mean AM = ∑ HPY/nwhere :∑ HPY = the sum of annual holding period yields
  14. 14. Measures of Historical Rates of Return 1.5Geometric Mean GM = [π HPR ] 1 n −1where :π = the product of the annual holding period returns as follows : ( HPR 1 ) × ( HPR 2 )  ( HPR n )
  15. 15. A Portfolio of InvestmentsThe mean historical rate of returnfor a portfolio of investments ismeasured as the weighted averageof the HPYs for the individualinvestments in the portfolio.
  16. 16. Computation of Holding Exhibit 1.1 Period Yield for a Portfolio # Begin Beginning Ending Ending Market Wtd.Stock Shares Price Mkt. Value Price Mkt. Value HPR HPY Wt. HPY A 100,000 $ 10 $ 1,000,000 $ 12 $ 1,200,000 1.20 20% 0.05 0.010 B 200,000 $ 20 $ 4,000,000 $ 21 $ 4,200,000 1.05 5% 0.20 0.010 C 500,000 $ 30 $ 15,000,000 $ 33 $ 16,500,000 1.10 10% 0.75 0.075Total $ 20,000,000 $ 21,900,000 0.095 $ 21,900,000 HPR = = 1.095 $ 20,000,000 HPY = 1.095 -1 = 0.095 = 9.5%
  17. 17. Expected Rates of Return• Risk is uncertainty that an investment will earn its expected rate of return• Probability is the likelihood of an outcome
  18. 18. Expected Rates of Return 1.6Expected Return = E(R i ) n∑ (Probability of Return) × (Possible Return) i =1 [(P1 )(R 1 ) + (P2 )(R 2 ) + .... + (Pn R n ) n ∑ (P )(R ) i =1 i i
  19. 19. Risk AversionThe assumption that most investorswill choose the least riskyalternative, all else being equal andthat they will not accept additionalrisk unless they are compensated inthe form of higher return
  20. 20. Probability Distributions Exhibit 1.2 Risk-free Investment1.000.800.600.400.200.00 -5% 0% 5% 10% 15%
  21. 21. Probability Distributions Exhibit 1.3Risky Investment with 3 Possible Returns1.000.800.600.400.200.00 -30% -10% 10% 30%
  22. 22. Probability Distributions Exhibit 1.4Risky investment with ten possible rates of return1.000.800.600.400.200.00 -40% -20% 0% 20% 40%
  23. 23. Measuring the Risk of 1.7Expected Rates of Return Variance (σ ) = n∑ (Probability) × (Possible Return - Expected Return) i =1 2 n∑ (Pi )[R i − E(R i )]i =1 2
  24. 24. Measuring the Risk of 1.8Expected Rates of ReturnStandard Deviation is the square root of the variance n ∑ Pi [R i - E(R i )] i =1 2
  25. 25. Measuring the Risk of 1.9 Expected Rates of ReturnCoefficient of variation (CV) a measure ofrelative variability that indicates risk per unitof return Standard Deviation of Returns Expected Rate of Returns σi = E(R)
  26. 26. Measuring the Risk of Historical Rates of Return 1.10 n σ = ∑ [HPYi − E(HPY) 2 2/n i =1 σ2 = variance of the series HPYi = holding period yield during period IE(HPY) = expected value of the HPY that is equal to the arithmetic mean of the series n= the number of observations
  27. 27. Determinants ofRequired Rates of Return• Time value of money• Expected rate of inflation• Risk involved
  28. 28. The Real Risk Free Rate (RRFR)– Assumes no inflation.– Assumes no uncertainty about future cash flows.– Influenced by time preference for consumption of income and investment opportunities in the economy
  29. 29. Adjusting For Inflation 1.12 Real RFR = (1 + Nominal RFR)  (1 + Rate of Inflation)  −1 
  30. 30. Nominal Risk-Free RateDependent upon– Conditions in the Capital Markets– Expected Rate of Inflation
  31. 31. Adjusting For Inflation 1.11 Nominal RFR =(1+Real RFR) x (1+Expected Rate of Inflation) - 1
  32. 32. Facets of Fundamental Risk• Business risk• Financial risk• Liquidity risk• Exchange rate risk• Country risk
  33. 33. Business Risk• Uncertainty of income flows caused by the nature of a firm’s business• Sales volatility and operating leverage determine the level of business risk.
  34. 34. Financial Risk• Uncertainty caused by the use of debt financing.• Borrowing requires fixed payments which must be paid ahead of payments to stockholders.• The use of debt increases uncertainty of stockholder income and causes an increase in the stock’s risk premium.
  35. 35. Liquidity Risk• Uncertainty is introduced by the secondary market for an investment. – How long will it take to convert an investment into cash? – How certain is the price that will be received?
  36. 36. Exchange Rate Risk• Uncertainty of return is introduced by acquiring securities denominated in a currency different from that of the investor.• Changes in exchange rates affect the investors return when converting an investment back into the “home” currency.
  37. 37. Country Risk• Political risk is the uncertainty of returns caused by the possibility of a major change in the political or economic environment in a country.• Individuals who invest in countries that have unstable political-economic systems must include a country risk-premium when determining their required rate of return
  38. 38. Risk Premiumf (Business Risk, Financial Risk, Liquidity Risk, Exchange Rate Risk, Country Risk) orf (Systematic Market Risk)
  39. 39. Risk Premium and Portfolio Theory• The relevant risk measure for an individual asset is its co-movement with the market portfolio• Systematic risk relates the variance of the investment to the variance of the market• Beta measures this systematic risk of an asset
  40. 40. Fundamental Risk versus Systematic Risk• Fundamental risk comprises business risk, financial risk, liquidity risk, exchange rate risk, and country risk• Systematic risk refers to the portion of an individual asset’s total variance attributable to the variability of the total market portfolio
  41. 41. Relationship Between Risk and Return Exhibit 1.7 Rateof Return (Expected) Security Low Average High Market Line Risk Risk Risk The slope indicates the required return per unit of riskRFR Risk (business risk, etc., or systematic risk-beta)
  42. 42. Changes in the Required Rate of Return Due to Movements Along the SMLExpected Exhibit 1.8 Rate Security Market Line Movements along the curve that reflect changes in theRFR risk of the asset Risk (business risk, etc., or systematic risk-beta)
  43. 43. Changes in the Slope of the SML 1.13 RPi = E(Ri) - NRFR where:RPi = risk premium for asset iE(Ri) = the expected return for asset iNRFR = the nominal return on a risk-free asset
  44. 44. Market Portfolio Risk 1.14 The market risk premium for the market portfolio (contains all the risky assets in the market) can be computed:RPm = E(Rm)- NRFR where:RPm = risk premium on the market portfolioE(Rm) = expected return on the market portfolioNRFR = expected return on a risk-free asset
  45. 45. Change in Market Risk Premium Exhibit 1.10 E(R)Expected Return New SML Rm Rm´ Original SML Rm Rm RFRNRFR Risk
  46. 46. Capital Market Conditions,Expected Inflation, and the SML Exhibit 1.11 Rate of Return Expected Return New SML Original SML RFR NRFR´ RFR NRFR Risk
  47. 47. The Internet Investments
  48. 48. Future Topics Chapter 2• The asset allocation decision• The individual investor life cycle• Risk tolerance• Portfolio management