Investment Analysis and Portfolio Management: Risk and Return Week 2
Investment Analysis and Portfolio Management: Risk and Return Week 2
Portfolio Management
Risk and Return
week 2
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 larger
future consumption.
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
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.
Rate of Return
• Arithmetic
$ 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
Risk-free Investment
1.00
0.80
0.60
0.40
0.20
0.00
-5% 0% 5% 10% 15%
Probability Distributions
Exhibit 1.3
1.00
0.80
0.60
0.40
0.20
0.00
-40% -20% 0% 20% 40%
Expected Rates of Return
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 1.7
Expected Rates of Return
Variance ( )
n
i i
(P
i 1
)[R E(R i )] 2
Measuring the Risk of
Expected Rates of Return
Measuring the Risk of 1.8
Expected Rates of Return
Standard Deviation is the square
root of the variance
Measuring the Risk of
Expected Rates of Return
Measuring the Risk of 1.9
Expected Rates of Return
Coefficient of variation (CV) a measure of
relative variability that indicates risk per unit
of return
Standard Deviation of Returns
Expected Rate of Returns
i
E(R)
Measuring the Risk of
Expected Rates of Return
Measuring the Risk of
Expected Rates of Return
Facets of Fundamental
Risk
• Business risk
• Financial risk
• Liquidity risk
• Exchange rate risk
• Country risk
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.
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.
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?
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.
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
Risk Premium
f (Business Risk, Financial Risk,
Liquidity Risk, Exchange Rate
Risk, Country Risk)
or
f (Systematic Market Risk)
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
Relationship Between
Risk and Return Exhibit 1.7
Risk
(business risk, etc., or systematic risk-beta)
Changes in the Required Rate of Return
Due to Movements Along the SML
Expected Exhibit 1.8
Rate
Security
Market Line
Risk
(business risk, etc., or systematic risk-beta)
Change in
Market Risk Premium
Exhibit 1.10
E(R) Return
Expected
New SML
Rm'
Rm´
Original SML
Rm
Rm
NRFR
RFR
Risk
Capital Market Conditions,
Expected Inflation, and the SML
Exhibit 1.11
Rate of Return
Expected Return
New SML
Original SML
RFR'
NRFR´
NRFR
RFR
Risk
Stock Data Gathering
• Yahoo Finance
• Data for calculating Return, Expected
Return, Risk (standard deviation)
• You may try this at home.
• Basic information for stock picking.