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# INVESTMENT SETTING

MEASURES OF HISTORICAL RATES OF RETURN
Holding Period Return:
HPR= ENDING VALUE OF INVESTMENT
BEGINNING VALUE OF INVESTMENT

A value greater than 1.0 reflects an increase in your wealth
a value less than 1.0 means you suffered an decline in wealth
a HPR of zero indicates that you lost all your money.

Holding Period Yield:
HPR-1
ANNUAL BASIS
Annual HPR= (ending/beginning)(1/n)
Annual HPY=(ending/beginning)-1
Example:
Your investment of 250,000 in stock A is worth 350,000 in two years while the investment of
112,000 in stock B is worth 100,000 in six months. What are the Annual HPRs and HPYs on
these two stocks?
STOCK A
Annual HPR= (350,000/250,000)(1/2)
= 1.1832
Annual HPY= 1.1832-1
= 18.32%
STOCK B
Annual HPR?
Annual HPY?

CALCULATING MEAN HISTORICAL RATES OF RETURN
ARITHMETIC MEAN RETURN (AM)
AM= HPY/ n
*where
HPY= the sum of all the HPYs
n= number of years
GEOMETRIC MEAN RETURN (GM)
GM= [ HPR]1/n-1
*Where HPR = the product of all the HPRs
Example:
Suppose you invested 100,000 3 years ago and it is worth 110,040 today. What are your
arithmetic and geometric average returns?
Year
1

Beg. Value
100,000

Ending value
115,000

HPR
1.15

HPY
.15

16) + (0. Which one is better? States of the economy Good average Bad probability Return A Return B 45% 40% 15% 15% 8% -11% 16% 9% -13% Return A (0.083 ) +0.20 -.4 =0.000 138.000 138.40 ¿ √¿ SD = √ 0.15¿ z SD = 0.083 + 0.7% Return B × 100% .3% Return B (0.08−0.08) + (0.083 z 0.15−0.20 .20 EXPECTED RETURN You go to bank and ask where to put your money.040 1.2 3 115.45 × 0.083 × × 0.07611 = 0.45 ( o .85% Now let’s determine the standard deviation Formula: return (A) = ∑ √ probability (return−expexted return)z z −0.11−0.087 = 8.15 × × 0.15 × -0.09) + (0.45 × 0.15) + (0.0885 × 100% Expected return= 8.11) 100% Expected return= 8.4 = 0.80 .000 110.13) -0.

15 ( 0. R1 = [(1 + NRFR) = [(1 + 8%) = [(1. Formula: R1= [(1 + NRFR) ÷ (1 + rate of inflation)]-1 Example: Determine the real risk free rate if the nominal risk free rate is 8% and the inflation rate is 3%.1 .08) ÷ ÷ (1 + Rate of inflation)]-1 ÷ (1 + 3%)]-1 (1.85% NOMINAL RISK FREE RATE (NRFR)   Conditions in the capital market Expected rate of return Formula: Rnominal = (1 + RRFR) = ( 1 + 3%) × (1 + rate of inflation) – 1 × ( 1 + 3%) .097 z z × 100% = 9.16−0. Risk premium REAL RISK FREE RATE VS NOMINAL RISK FREE RATE REAL RISK FREE RATE (RRFR)    Assumes no inflation.SD = √ 0. Inflation expectation 3. Real rate of return 2.7% 3 KEY COMPONENTS OF TOTAL REQUIRED RATE OF RETURN 1.0885 ) SD = √ 0. Assumes no uncertainty about future cash flows.0946 z SD = 0.09−0.13−0.0885 ) +0.4 ( 0. Influenced by the time preference for consumption of income and investment opportunities in the economy.45 ( 0.03)-1 R1 = 4.0885 ) +0.

03) – 1 .= (1.03) Rnominal = 6.09% × (1.