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.
 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%
 Holding period return
• HPR t = Pt+1+ CF t+1 - 1
Pt
 Measures of
Historical Rates of Return
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
 Measures of
Historical Rates of Return
1.5

Geometric Mean
GM   HPR  n  1
1

where :

  the product of the annual

holding period returns as follows :
 HPR 1    HPR 2    HPR n 
A Portfolio of Investments
The mean historical rate of return
for a portfolio of investments is
measured as the weighted average
of the HPYs for the individual
investments in the portfolio.
 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 0.075
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 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

 (Probabilit y of Return)  (Possible Return)

i 1

[(P1 )(R 1 )  (P2 )(R 2 )  ....  (Pn R n )

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
 Probability Distributions
Exhibit 1.2

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

Risky Investment with 3 Possible Returns

1.00
0.80
0.60
0.40
0.20
0.00
-30% -10% 10% 30%
 Probability Distributions
Exhibit 1.4
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%
 Measuring the Risk of 1.7
Expected Rates of Return
Variance ( ) 
n

 (Probabilit
i 1
y)  (Possible Return - Expected Return) 2

 i i
(P
i 1
)[R  E(R i )] 2
 Measuring the Risk of 1.8
Expected Rates of Return
Standard Deviation is the square
root of the variance
 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)
• The coefficient of variation (CV) is the
ratio of the standard deviation to the mean.
The higher the coefficient of variation, the
greater the level of dispersion around the
mean. It is generally expressed as a
percentage. ... The lower the value of
the coefficient of variation, the more
precise the estimate.
 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
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
– Conditions in 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
• 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)
It is not wise to put all eggs in INTRODUCTION

one Basket

Lubna Maroof
48
 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
 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
 Relationship Between
Risk and Return Exhibit 1.7

Ra teof Re turn (Expected)

S e curity
Low Ave ra ge High Ma rke t Line
Ris k Ris k Ris k

The s lope indica te s the

re quire d re turn pe r unit of ris k
RFR

Ris k
(bus ine s s ris k, e tc., or s ys te ma tic ris k-be ta )
Changes in the Required Rate of Return
Due to Movements Along the SML
Expe cte d Exhibit 1.8
Ra te
S e curity
Ma rke t Line

Move me nts a long the curve

tha t re fle ct cha nge s in the
RFR ris k of the a s s e t

Ris k
(bus ine s s ris k, e tc., or s ys te ma tic ris k-be ta )
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
 Change in
Market Risk Premium
Exhibit 1.10

E(R) Return
Expected
Ne w S ML

Rm'
Rm´
Origina l S ML
Rm
Rm

NRFR
RFR
Ris k
 Capital Market Conditions,
Expected Inflation, and the SML
Exhibit 1.11

Ra te of ReReturn
Expected turn
Ne w S ML

Origina l S ML
RFR'
NRFR´

NRFR
RFR
Ris k
 The Internet
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www.wsj.com www.barrons.com
www.cob.ohio-state.edu/dept/fin/osudata.htm
 Future Topics
Chapter 2
• The asset allocation decision
• The individual investor life
cycle
• Risk tolerance
• Portfolio management