Lecture Presentation Software
to accompany
Investment Analysis and
Portfolio Management
Sixth Edition
by
Frank K. Reilly & Keith C. Brown
Chapter 1
Saif Ullah
[email protected]
[email protected]
+923216633271
Chapter 1
The Investment Setting
Questions 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 ?
Chapter 1
The 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 ?
Why Do Individuals
Invest ?
By saving money (instead of
spending it), individuals tradeoff
present consumption for a future
larger consumption.
Why Do Individuals
Invest ?
Which would you rather have:
$1 today or $2 tomorrow ?
What Is An Investment ?
Is hiding money in a mattress or keeping it
in a piggy bank an investment ?
What Is An Investment ?
Is hiding money in a mattress or keeping it
in a piggy bank an investment ?
No.
It does not increase
over time.
What Is An Investment ?
How about baseball cards or Beanie
Babies ? Are they an investment?
What Is An Investment ?
How about baseball cards or Beanie
Babies ? Are they an investment?
Maybe so, but
there are no ??
guarantees of
increases. ?
SAIF ULLAH,
[email protected], +923216633271
What Is An Investment ?
Grandpa may be pleased that you are
putting your money in CDs…
What Is An Investment ?
Grandpa may be pleased that you are
putting your money in CDs…
... instead of spending it on music.
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.
$1.00 4% $1.04
SAIF ULLAH, [email protected], +923216633271
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.
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.
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.
Defining an Investment
A current commitment of $ for a
period of time to derive future
payments that will compensate for:
– the time the funds are committed
– the expected rate of inflation
– uncertainty of future payments.
These are the required rate of return.
SAIF ULLAH,
[email protected], +923216633271
How Do Investors Measure Risk and
Return for Alternative Investments ?
• Historical rates of return
• Average rates over time
• Average rate of a portfolio
• Variance and standard deviation
• Expected rates of return
• Measures of uncertainty
SAIF ULLAH,
[email protected], +923216633271
Measures of
Historical Rates of Return
1.1
Holding Period Return
Ending Value of Investment
HPR
Beginning Value of Investment
$220
1.10
$200
Measures of
Historical Rates of Return
1.2
Holding Period Yield
HPY = HPR - 1
1.10 - 1 = 0.10 = 10%
Measures of
Historical Rates of Return
1.3
Annual Holding Period Return
–Annual HPR = HPR 1/n
–where n = number of years investment is held
Annual Holding Period Yield
–Annual HPY = Annual HPR - 1
Measures of
Historical Rates of Return
1.4
Arithmetic Mean
AM HPY/n
where :
HPY the sum of annual
holding period yields
SAIF ULLAH,
[email protected], +923216633271
Measures of
Historical Rates of Return
1.5
Geometric Mean
GM HPR
1
n 1
where :
the product of the annual
holding period returns as follows :
HPR 1 HPR 2 HPR n
SAIF ULLAH, [email protected], +923216633271
Measures of
Historical Rates of Return
Arithmetic mean return over time
Geometric mean will be lower than arithmetic
mean if returns vary over time
Y Begin End HPR HPY
R
1 50 100 2.00 1.00
2 100 50 0.50 -0.50
Arithmetic mean = 0.25
Geometric mean = 0.00
SAIF ULLAH, [email protected], +923216633271
Portfolio of Investments
• Weighted average of HPYs for the
individual investments in the
portfolio is the mean historical rate
of return (HPY) for a portfolio
Computation of Holding Table 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 0.075
Total $ 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%
Expected Rates of Return
• Risk is uncertainty of return
• Point estimates are most likely
expected return
• Range of possible returns
• Probabilities of various possible
returns
SAIF ULLAH,
[email protected], +923216633271
Expected Rates of Return
Expected Return E(R i ) 1.6
(Probability of Return) (Possible Return)
i 1
[(P1 )(R 1 ) (P2 )(R 2 ) .... (Pn R n )
n
(P )(R )
i 1
i i
Probability Distributions
Figure 1.1
Risk-free Investment
1.00
0.80
0.60
0.40
0.20
0.00
-5% 0% 5% 10% 15%
SAIF ULLAH, [email protected], +923216633271
Probability Distributions
Figure 1.2
Risky Investment with 3 Possible Returns
1.00
0.80
0.60
0.40
0.20
0.00
-30% -10% 10% 30%
SAIF ULLAH,
[email protected], +923216633271
Probability Distributions
Figure 1.3
Risky investment with ten possible rates of return
1.00
0.80
0.60
0.40
0.20
0.00
-40% -20% 0% 20% 40%
SAIF ULLAH, [email protected], +923216633271
Measuring the Risk of 1.7
Expected Rates of Return
Variance ( )
n
(Probability) (Possible Return - Expected Return)
i 1
2
i i
(P
i 1
)[R E(R i )] 2
Measuring the Risk of 1.8
Expected Rates of Return
Standard Deviation
square root of the variance
Measuring the Risk of 1.9
Expected Rates of Return
Coefficient of variation (CV) measures risk
relative to expected return:
Standard Deviation of Returns
Expected Rate of Returns
i
E(R)
SAIF ULLAH,
[email protected], +923216633271
Measuring the Risk of
Historical Rates of Return 1.10
n
[HPYi E(HPY)
2 2/n
i 1
2 variance of the series
HPYi holding period yield during period I
E(HPY) expected value of the HPY that is equal
to the arithmetic mean of the series
n the number of observations
Determinants of
Required Rates of Return
• Time value of money
• Expected rate of inflation
• Risk involved
Promised Yields
on Alternative Bonds Table 1.2
Type of Bond 1992 1993 1994 1995 1996 1997 1998
U.S. Govt. 3-Month T-bills 3.43% 3.00% 4.25% 5.49% 5.01% 5.06% 4.78%
U.S. Govt. long-term bonds 7.52% 6.59% 7.41% 6.93% 6.80% 6.67% 5.69%
Aaa corporate bonds 8.14% 7.77% 7.97% 7.59% 7.37% 7.27% 6.53%
Baa corporate bonds 8.98% 7.93% 8.63% 7.83% 8.05% 7.87% 7.22%
Source: Federal Reserve Bulletin , various issues
Time Value of Money
The real risk-free rate (RFR)
– Assumes no inflation.
– Assumes no uncertainty about future
cash flows.
– Is the price charged for exchanging
current goods and future goods.
Nominal Risk-Free Rate
Dependent upon
– Expected rate of inflation
– Monetary environment
Adjusting For Inflation 1.11
Nominal RFR =
(1+Real RFR) x (1+Expected Rate of Inflation) -
1
Adjusting For Inflation 1.12
Real RFR =
(1 Nominal RFR)
(1 Rate of Inflation) 1
Three-Month T-Bill Yields
and Rates of Inflation Table 1.3
Table 1.3 Three-Month Treasury Bill Yields and Rates of Inflation
3-Month Rate of 3-Month Rate of
Year T-Bills Inflation Year T-Bills Inflation
1978 7.19% 7.70% 1989 8.11% 4.65%
1979 10.07% 11.30% 1990 7.50% 6.11%
1980 11.43% 7.70% 1991 5.38% 3.06%
1981 14.03% 10.40% 1992 3.43% 2.90%
1982 10.61% 6.10% 1993 3.33% 2.75%
1983 8.61% 3.20% 1994 4.25% 2.67%
1984 9.52% 4.00% 1995 5.49% 2.54%
1985 7.48% 3.80% 1996 5.01% 3.32%
1986 5.98% 1.10% 1997 5.06% 1.70%
1987 5.78% 4.40% 1998 4.78% 1.60%
1988 6.67% 4.42%
Risk Premium
and Fundamental Risk
• Business risk
• Financial risk
• Liquidity risk
• Exchange rate risk
• Country risk
SAIF ULLAH,
[email protected], +923216633271
Business Risk
• Uncertainty of income flows caused by
the nature of a firm’s business affect
income flows to an investor.
• Investors demand a risk premium
based on the uncertainty caused by the
basic business of the firm.
Financial Risk
• Uncertainty is introduced by the method by
which the firm finances its investments.
• 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.
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?
• Investors increase their required rate of
return to compensate for liquidity risk.
SAIF ULLAH,
[email protected], +923216633271
Exchange Rate Risk
• Uncertainty of return is introduced by
acquiring securities denominated in a
currency different from your own.
• Changes in exchange rates affect the
investors return when converting an
investment back into the “home” currency.
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
Total Risk
Risk Premium is a function of
– Business Risk,
– Financial Risk
– Liquidity Risk
– Exchange Rate Risk
– Country Risk
SAIF ULLAH,
[email protected], +923216633271
Risk Premium
and Portfolio Theory
• Systematic risk relates the
variance of the investment to
the variance of the market
• Beta measures this systematic
risk of an asset
Fundamental Risk
versus Systematic Risk
Risk Premium =
f (Business Risk, Financial Risk,
Liquidity Risk, Exchange Rate Risk,
Country Risk)
or
f (Systematic Market Risk)
SAIF ULLAH,
[email protected], +923216633271
Measures of Risk
• Variance of rates of return
• Standard deviation of rates of return
• Coefficient of variation of rates of
return (standard deviation/means)
• Covariation of returns with the
market portfolio (beta)
Sources of Risk
• Business Risk
• Financial Risk
• Liquidity Risk
• Exchange Rate Risk
• Country Risk
SAIF ULLAH,
[email protected], +923216633271
Relationship Between
Risk and Return Figure 1.4
Rate of Return (Expected)
Security
Low Average High
Risk Risk Risk Market Line
The slope indicates the
RFR required return per unit of risk
Risk
(business risk, etc., or systematic risk-beta)
Changes in the Required Rate of Return
Due to Movements Along the SML
Expected Figure 1.5
Rate
Security
Market Line
Movements along the curve
that reflect changes in the
RFR risk of the asset
Risk
(business risk, etc., or systematic risk-beta)
SAIF ULLAH,
[email protected], +923216633271
Changes in the Slope of the SML
1.13
RPi = E(Ri) - NRFR
where:
RPi = risk premium for asset i
E(Ri) = the expected return for asset i
NRFR = the nominal return on a risk-free asset
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 portfolio
E(Rm) = expected return on the market portfolio
NRFR = expected return on a risk-free asset
SAIF ULLAH,
[email protected], +923216633271
Plot of Moody’s Corporate Bond Yield Spreads
(Baa - Aaa): Monthly 1966 - 1998
3.00
2.50 Figure 1.6
2.00
1.50
1.00
0.50
-
1966 1970 1974 1978 1982 1986 1990 1994 1998
Plot of Moody’s Corporate Bond Yield
Monthly 1919 - 1998
20.0
18.0 Aaa
16.0
Baa
14.0
12.0
Spread
10.0
8.0
6.0
4.0
2.0
0.0
1919 1929 1939 1949 1959 1969 1979 1989
Change in
Market Risk Premium
Figure 1.7
E(R) Return
Expected
New SML
Rm'
Rm´
Original SML
Rm
Rm
RFR
NRFR
Risk
SAIF ULLAH, [email protected], +923216633271
Capital Market Conditions,
Expected Inflation, and the SML
Figure 1.8
Rate of Return
Expected Return
New SML
Original SML
RFR'
NRFR´
RFR
NRFR
Risk
SAIF ULLAH, [email protected], +923216633271
The Internet
Investments Online
www.financecenter.com www.ft.com
www.investorama.com www.fortune.com
www.moneyadvisor.com
www.money.com
www.investorguide.com
www.forbes.com
www.finweb.com
www.aaii.org www.worth.com
www.wsj.com www.barrons.com
www.cob.ohio-state.edu/dept/fin/osudata.htm
End of Chapter 1
–The Investment Setting
Future Topics
Chapter 2
• The asset allocation decision
• The individual investor life
cycle
• Risk tolerance
• Portfolio management
SAIF ULLAH,
[email protected], +923216633271
