DEPARTMENT OF COMMERCE

ASSIGNMENT

TOPIC:

INVESTMENT SETTINNG

SUBMITTED BY:

Syed Shabi-ul-Hassan (F20.A.09)

Muhammad Mouzam (F20.A.37)

SUBMITTED TO:

Sir, Syed Zahgam Abbas

 INVESTMENT SETTING
INVESTMENT:

An investment is a current commitment of dollars for a period of time to derive future

payments that compensate for the time, inflation rate, and uncertainty of future
payments. It includes all types of investments, including individual investments in
stocks, bonds, commodities, or real estate. People invest to earn a return from savings
due to deferred consumption, seeking a rate of return that compensates for the time
period, inflation rate, and future cash flows uncertainty.

MEASURES OF RETURN AND RISK

This book aids investors in selecting investment assets by estimating and evaluating
risk-return trade-offs. It covers methods to quantify return and risk, historical and
expected rates of return, and measures of uncertainty or risk.

1 Measures of Historical Rates of Return

When evaluating alternative investments, it's crucial to compare their historical rates
of return. A return on an investment refers to the change in wealth resulting from the
investment, which can be due to cash inflows or asset price changes. The holding
period return (HPR) is the return for the period an investment is owned, calculated as
the end value of the investment divided by the beginning value of the investment.HPR
= Ending Value of Investment divided by Beginning Value of Investment = $220
divided $200 = 1:10The first step in converting an HPR to an annual percentage rate
is to derive a percentage return, referred to as the holding period yield (HPY). The
HPY is equal to the HPR minus 1

2 Computing Mean Historical Returns

mean rates of return for a single investment and for a portfolio of investments. Over a
number of years, arithmetic mean (AM), the sum (Σ) of annual HPYs is divided by
the number of years (n) as follows: AM = ΣHPY/n

An alternative computation, the geometric mean (GM), is the nth root of the product
of the HPRs for n years minus one. GM = [πHPR] 1/n − 1

3 Calculating Expected Rates of Return

Risk refers to the uncertainty an investment will earn its expected rate of return. An
investor expects a certain rate of return, which is their most likely estimate. A larger
range of possible returns indicates the investor's uncertainty regarding the actual
return. To determine the expected rate of return, an investor assigns probability values
to all possible returns, ranging from zero to one. These probabilities are subjective
estimates based on historical performance and future expectations. For example, an
investor might know that 30% of the time the investment's rate of return was 10%.

4 Measuring the Risk of Expected Rates of Return:

The expected rate of return and risk of an investment can be calculated by identifying
the range of possible returns and assigning each return a weight based on probability.
Statistical techniques like variance and standard deviation are used to quantify the
dispersion of possible returns around the expected rate of return, allowing direct
comparison of return and risk measures.

5 Risk Measures for Historical Returns:

The risk measures for historical returns are similar to expected returns, but
considering historical holding period yields (HPYs). The variance and standard
deviation are used to measure the deviation from the expected value of the series. This
method is common for presenting standard deviation as a measure of risk for a series
or asset class.

DETERMINANTS OF REQUIRED RATES OF RETURN

1 The Real Risk-Free Rate:

The real risk-free rate (RRFR) is the basic interest rate in an inflation-free economy,
where investors demand the RRFR on investments. It represents the price charged for
the risk-free exchange between current and future goods.

2 Factors Influencing the Nominal Risk-Free Rate (NRFR):

An investor is willing to forgo current consumption to increase future consumption at

a risk-free rate of interest. Real rates of interest adjust for changes in the general price
level, while nominal rates are determined by real rates of interest and factors like
inflation and the monetary environment. The RRFR is stable over time, but rates on
three-month T-bills were not stable from 2004 to 2010, as shown in Exhibit 1.6. T-
bills are considered default-free investments, as the government has unlimited
income-generating power. The nominal risk-free rate (NRFR) is influenced by
relative ease in capital markets and the expected rate of inflation. Understanding these
factors is crucial for investors to make informed decisions.

3 Risk Premium and Portfolio Theory:

Markowitz and Sharpe's work in portfolio and capital market theory suggests that
investors should use an external market measure of risk. They suggested that the
relevant risk measure for an individual asset is its comovement with the market
portfolio, known as systematic risk. This measure is the proportion of an asset's total
variance attributable to the total market portfolio's variability. Unsystematic risk, due
to unique features, is considered unimportant. Under these assumptions, the risk
premium for an individual earning asset is a function of its systematic risk with the
aggregate market portfolio.

4 Fundamental Risk versus Systematic Risk:

The relationship between market measure of risk (systematic risk) and fundamental
determinants of risk (business risk) has been studied, concluding that both measures
can be complementary. This is because the market measure of risk reflects the
fundamental risk characteristics of the asset, while the fundamental risk measures may
not. A firm with high business and financial risk may have a higher level of
systematic risk due to unique unsystematic risk.

5Summary of Required Rate of Return:

The required rate of return on alternative investments is determined by three

variables: the economy's RRFR, which is influenced by long-run real growth rate;
NRFR, which is influenced by short-run capital market tightness and inflation rate;
and the risk premium, which can be related to fundamental factors or asset systematic
market risk.

RELATIONSHIP BETWEEN RISK AND RETURN:

This section discusses the risk-return combinations available for alternative

investments and the factors causing changes. It illustrates the expected relationship
between risk and return, highlighting that investors increase their required rates of
return as perceived risk increases. The security market line (SML) reflects these
combinations, reflecting investors' risk preferences.

1 Movements along the SML:

Investors place alternative investments along the SML based on their perception of
risk. Changes in an investment's fundamental risk sources, such as business risk,
cause it to move along the SML. For example, a firm selling a large bond issue
increases financial risk, making its common stock riskier. Changes in an asset's beta
affect its position on the SML.

2 Changes in the Slope of the SML:

The SML slope indicates investor return per risk unit, allowing for asset risk premium
computation using the equation 1.13 RPi = E(Ri) - NRFR.

3 Changes in Capital Market Conditions or Expected Inflation:

The graph in Exhibit 1.11 illustrates the impact of factors such as expected real
growth, capital market conditions, or inflation on the SML. An increase in growth,
temporary market tightness, or an increase in inflation causes a parallel shift upward,
as these changes affect the economy's nominal risk-free rate (NRFR), which affects
all investments regardless of their risk levels.

4 Summary of Changes in the Required Rate of Return:

The relationship between risk and the required rate of return for an investment can
change in three ways:

1) a change in the risk characteristics of a specific investment, such as business,

financial, or systematic risk, affects only the individual investment

; 2) a change in the slope of the SML due to a change in investors' attitudes towards
risk, resulting in higher or lower rates of return for the same intrinsic risk; and

3) a shift in the SML due to changes in expected real growth, market conditions, or
inflation rate.