Lesson 1
Lesson 1
Lesson 1
CHAPTER 1
Chapter 1
The Investment Setting
Questions to be answered:
Why do individuals invest ?
What is an investment ?
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 ?
$1.00 4% $1.04
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 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.
Measures of
Historical Rates of Return
Holding Period Return 1.1
AM HPY/ n
where :
$ 21,900,000
HPR = = 1.095
$ 20,000,000
= 9.5%
Expected Rates of Return
Risk is uncertainty that an investment
will earn its expected rate of return
Probability is the likelihood of an
outcome
Expected Rates of Return
1.6
Expected Return E(R i )
n
i i
(P
i 1
)(R )
Risk Aversion
The assumption that most investors will
choose the least risky alternative, all
else being equal and that they will
not accept additional risk unless they
are compensated in the form of
higher return
Measuring the Risk of
Expected Rates of Return 1.7
Variance ( )
n
(Probabilit
i 1
y) (Possible Return - Expected Return) 2
i i
(P )[R
i 1
E(R i )] 2
Measuring the Risk of
Expected Rates of Return 1.8
Risk involved
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
Adjusting For Inflation 1.12
Real RFR =
(1 Nominal RFR)
(1 Rate of Inflation) 1
Nominal Risk-Free Rate
Dependent upon
Conditionsin the Capital Markets
Expected Rate of Inflation
Adjusting For Inflation 1.11
Nominal RFR =
(1+Real RFR) x (1+Expected Rate of Inflation) - 1
Facets of Fundamental Risk
Business risk
Financial risk
Liquidity risk
Country risk
Business Risk