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**Investment Analysis and Portfolio
**

Management

First Canadian Edition

By Reilly, Brown, Hedges, Chang

Chapter 1

The Investment Setting

• What Is An Investment

• Return and Risk Measures

• Determinants of Required Returns

• Relationship between Risk and Return

1-2

Copyright © 2010 Nelson Education Ltd.

What is an Investment?

• Investment

• Current commitment of $ for a period of

time in order to derive future payments

that will compensate for:

• Time the funds are committed

• Expected rate of inflation

• Uncertainty of future flow of funds

Copyright © 2010 Nelson Education Ltd.

1-3

Why Invest?

• By investing (saving money now

instead of spending it), individuals can

tradeoff present consumption for a

larger future consumption.

Copyright © 2010 Nelson Education Ltd.

1-4

Pure Rate of Interest

• Exchange rate between future

consumption (future dollars) and present

consumption (current dollars)

• Market forces determine rate

• Example:

• If you can exchange $100 today for $104 next year,

this rate is 4% (104/100-1).

Copyright © 2010 Nelson Education Ltd.

1-5

Pure Time Value of Money

• People willing to pay more for the money

borrowed and lenders desire to receive a

surplus on their savings (money invested)

Copyright © 2010 Nelson Education Ltd.

1-6

The Effects of Inflation

• Inflation

‒ 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.

Copyright © 2010 Nelson Education Ltd.

1-7

Uncertainty: Risk by any Other Name

• Uncertainty

• 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.

Copyright © 2010 Nelson Education Ltd.

1-8

Required Rate of Return

on an Investment

• Minimum rate of return investors require on

an investment, including the pure rate of

interest and all other risk premiums to

compensate the investor for taking the

investment risk

Copyright © 2010 Nelson Education Ltd.

1-9

Historical Rates of Return:

What Did We Earn (Gain)?

Copyright © 2010 Nelson Education Ltd.

Your investment of $250 in Stock A is worth $350 in two

years while the investment of $100 in Stock B is worth

$120 in six months. What are the annual HPRs and the

HPYs on these two stocks?

1-10

Example I:

Your Investments Rise in Value

• Stock A

– Annual HPR=HPR

1/n

= ($350/$250)

1/2

=1.1832

– Annual HPY=Annual HPR-1=1.1832-1=18.32%

• Stock B

– Annual HPR=HPR

1/n

= ($112/$100)

1/0.5

=1.2544

– Annual HPY=Annual HPR-1=1.2544-1=25.44%

Copyright © 2010 Nelson Education Ltd.

1-11

Example I:

Historical Rates of Return:

What Did We Lose?

Copyright © 2010 Nelson Education Ltd.

Your investment of $350 in Stock A is worth $250 in two

years while the investment of $112 in Stock B is worth

$100 in six months. What are the annual HPRs and the

HPYs on these two stocks?

1-12

Example II:

Your Investments Decline in Value

• Stock A

– Annual HPR=HPR

1/n

= ($250/$350)

1/2

=.84515

– Annual HPY=Annual HPR-1=.84514 - 1=-15.48%

• Stock B

– Annual HPR=HPR

1/n

= ($100/$112)

1/0.5

=.79719

– Annual HPY=Annual HPR-1=.79719-1=-20.28%

Copyright © 2010 Nelson Education Ltd.

1-13

Example II:

Calculating Mean Historical Rates of

Return

• Suppose you have a set of annual rates of

return (HPYs or HPRs) for an investment.

How do you measure the mean annual

return?

• Do you use the arithmetic average? Or do

you use the geometric average?

It depends!

Copyright © 2010 Nelson Education Ltd.

1-14

Arithmetic Mean Return (AM)

• Arithmetic Mean Return (AM)

AM= E HPY / n

where E HPY=the sum of all the annual HPYs

n=number of years

Copyright © 2010 Nelson Education Ltd.

1-15

Geometric Mean Return (GM)

• Geometric Mean Return (GM)

GM= [t HPY]

1/n

-1

where t HPR=the product of all the annual HPRs

n=number of years

Copyright © 2010 Nelson Education Ltd.

1-16

Arithmetic vs. Geometric Averages

• When rates of return are the same for all

years, the AM and the GM will be equal.

• When rates of return are not the same for

all years, the AM will always be higher

than the GM.

• While the AM is best used as an “expected

value” for an individual year, while the GM

is the best measure of an asset’s long-

term performance.

Copyright © 2010 Nelson Education Ltd.

1-17

Comparing Arithmetic vs. Geometric

Averages: Example

Copyright © 2010 Nelson Education Ltd.

Suppose you invested $100 three years ago and it is

worth $110.40 today. What are your arithmetic and

geometric average returns?

1-18

Arithmetic Average: An Example

Year Beg. Value Ending

Value

HPR HPY

1 $100 $115 1.15 .15

2 115 138 1.20 .20

3 138 110.40 .80 -.20

AM= E HPY / n

AM=[(0.15)+(0.20)+(-0.20)] / 3 = 0.15/3=5%

Copyright © 2010 Nelson Education Ltd.

1-19

Geometric Average: An Example

Year Beg. Value Ending

Value

HPR HPY

1 $100 $115 1.15 .15

2 115 138 1.20 .20

3 138 110.40 .80 -.20

GM= [t HPY]

1/n

-1

GM=[(1.15) x (1.20) x (0.80)]

1/3

– 1

=(1.104)

1/3

-1=1.03353 -1 =3.353%

Copyright © 2010 Nelson Education Ltd.

1-20

Portfolio Historical Rates of Return

• Portfolio HPY

‒ 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, or the overall

change in the value of the original portfolio.

• The weights used in the computation are the

relative beginning market values for each

investment, which is often referred to as dollar-

weighted or value-weighted mean rate of return.

Copyright © 2010 Nelson Education Ltd.

1-21

Expected Rates of Return

What Do We Expect to Earn?

• In previous examples, we discussed realized

historical rates of return.

• In reality most investors are more interested in the

expected return on a future risky investment.

Copyright © 2010 Nelson Education Ltd.

1-22

Risk and Expected Return

• Risk refers to the uncertainty of the future

outcomes of an investment

• There are many possible returns/outcomes from

an investment due to the uncertainty

• Probability is the likelihood of an outcome

• The sum of the probabilities of all the possible

outcomes is equal to 1.0.

Copyright © 2010 Nelson Education Ltd.

1-23

Calculating Expected Returns

¿

=

× =

n

i 1

i

Return) (Possible Return) of y Probabilit ( ) E(R

Copyright © 2010 Nelson Education Ltd.

)] R (P .... ) )(R (P ) )(R [(P

n n 2 2 1 1

+ + + =

Where:

Pi = the probability of return on asset i

Ri = the return on asset i

1-24

¿

=

=

n

i

i i

R P

1

) )( (

Perfect Certainty:

The Risk Free Asset

• E(Ri) = ( 1) (.05) = .05 or 5%

Copyright © 2010 Nelson Education Ltd.

1-25

If you invest in an asset that has an expected return 5%

then it is absolutely certain your expected return will be

5%

Probability Distribution

0.00

0.20

0.40

0.60

0.80

1.00

-5% 0% 5% 10% 15%

Copyright © 2010 Nelson Education Ltd.

1-26

Risk-Free Investment

Risky Investment with

Three Possible Outcomes

• Suppose you are considering an

investment with 3 different potential

outcomes as follows:

Copyright © 2010 Nelson Education Ltd.

Economic

Conditions

Probability Expected Return

Strong Economy 15% 20%

Weak Economy 15% -20%

Stable Economy 70% 10%

1-27

Probability Distribution

0.00

0.20

0.40

0.60

0.80

1.00

-30% -10% 10% 30%

Copyright © 2010 Nelson Education Ltd.

1-28

Risky Investment with 3 Possible

Returns

Calculating Expected Return on a

Risky Asset

¿

=

=

n

i

i i

R P Ri E

1

) )( ( ) (

Copyright © 2010 Nelson Education Ltd.

% 7 07 . )] 10 )(. 70 (. ) (.15)(-.20 ) [(.15)(.20 ) ( = = + + = Ri E

Investment in a risky asset with a probability distribution as

described above, would have an expected return of 7%.

This is 2% higher than the risk free asset.

In other words, investors get paid to take risk!

0.00

0.20

0.40

0.60

0.80

1.00

-30% -10% 10% 30%

1-29

Risk and Expected Returns

• Risk refers to the uncertainty of an investment;

therefore the measure of risk should reflect the

degree of the uncertainty.

• Risk of expected return reflect the degree of

uncertainty that actual return will be different from

the expect return.

• Common measures of risk are based on the

variance of rates of return distribution of an

investment

Copyright © 2010 Nelson Education Ltd.

1-30

Risk of Expected Return

• The Variance Measure

Copyright © 2010 Nelson Education Ltd.

¿

¿

=

=

÷ =

÷ =

n

i

i i i

n

i

R E R P

turn

Expected

turn

Possible

x obability

Variance

1

2

2

1

)] ( [

)

Re Re

( ) (Pr

1-31

Risk of Expected Return

• Standard Deviation (σ)

• square root of the variance

• measures the total risk

¿

=

÷ =

n

i

i i i

R E R P

1

2

)] ( [

o

Copyright © 2010 Nelson Education Ltd.

1-32

Risk of Expected Return

• Coefficient of Variation (CV)

• measures risk per unit of expected return

• relative measure of risk

Copyright © 2010 Nelson Education Ltd.

) ( R E

Return of Rate Expected

Return of Deviation Standard

CV

o

=

=

1-33

Risk of Historical Returns

• Given a series of historical returns measured by

HPY, the risk of returns can be measured using

variance and standard deviation

• The formula is slightly different but the measure of

risk is essentially the same

Copyright © 2010 Nelson Education Ltd.

1-34

Variance of Historical Returns

n / HPY)] ( E HPY [

2

n

1 i

i

2

(

¸

(

¸

÷ =

¿

=

o

Copyright © 2010 Nelson Education Ltd.

Where:

σ

2

= the variance of the series

HPY

i

= the holding period yield during period I

E(HPY) = the expected value of the HPY equal to the arithmetic

mean of the series (AM)

n = the number of observations

1-35

Three Determinants of

Required Rate of Return

• Time value of money during the time period

• Expected rate of inflation during the period

• Risk involved

Copyright © 2010 Nelson Education Ltd.

1-36

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

Copyright © 2010 Nelson Education Ltd.

1-37

Nominal Risk Free Rate (NRFR)

• Conditions in the capital market

• Expected rate of inflation

NRFR=(1+RRFR) x (1+ Rate of Inflation) - 1

RRFR=[(1+NRFR) / (1+ Rate of Inflation)] - 1

Copyright © 2010 Nelson Education Ltd.

1-38

Risk Premiums: 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.

Copyright © 2010 Nelson Education Ltd.

1-39

Risk Premiums: Financial Risk

• Uncertainty caused by the use of debt financing

• Borrowing requires fixed payments which must

be paid ahead of payments to stockholders

• Use of debt increases uncertainty of stockholder

income and causes an increase in the stock’s risk

premium

Copyright © 2010 Nelson Education Ltd.

1-40

Risk Premiums: Liquidity Risk

• How long will it take to convert an investment

into cash?

• How certain is the price that will be received?

Copyright © 2010 Nelson Education Ltd.

1-41

Risk Premiums: 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.

Copyright © 2010 Nelson Education Ltd.

1-42

Risk Premiums: 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.

Copyright © 2010 Nelson Education Ltd.

1-43

Risk Premiums and Portfolio Theory

• From a portfolio theory perspective, 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.

• According to the portfolio theory, the risk

premium depends on the systematic risk.

Copyright © 2010 Nelson Education Ltd.

1-44

Fundamental versus Systematic Risk

• Fundamental risk

• Risk Premium= f (Business Risk, Financial Risk,

Liquidity Risk, Exchange Rate Risk, Country Risk)

• Systematic risk

• refers to the portion of an individual asset’s total

variance attributable to the variability of the total

market portfolio.

• Risk Premium= f (Systematic Market Risk)

Copyright © 2010 Nelson Education Ltd.

1-45

Risk and Return:

The Security Market Line (SML)

• Shows relationship between risk and return for all

risky assets in the capital market at a given time

• Investors select investments that are consistent

with their risk preferences.

Copyright © 2010 Nelson Education Ltd.

1-46

Expected Return

Risk

(business risk, etc., or systematic risk-beta)

NRFR

Security

Market Line

Low

Risk

Average

Risk

High

Risk

The slope indicates the

required return per unit of risk

SML: Market Conditions or Inflation

• A change in RRFR or expected rate of

inflation will cause a parallel shift in the

SML

Copyright © 2010 Nelson Education Ltd.

Risk

NRFR

Original SML

New SML

Expected Return

NRFR'

1-47

SML: Market Conditions or Inflation

• When nominal risk-free rate increases, the SML will

shift up, implying a higher rate of return while still

having the same risk premium.

Copyright © 2010 Nelson Education Ltd.

Risk

NRFR

Original SML

New SML

Expected Return

NRFR'

1-48

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