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Investment Analysis and Portfolio Management by Reilly and Brown Chapter 1
Investment Analysis and Portfolio Management by Reilly and Brown Chapter 1
Portfolio Management
Eighth Edition
by
Frank K. Reilly & Keith C. Brown
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 ?
What factors contribute to the rate of return that an
investor requires on an investment?
What macroeconomic and microeconomic factors
contribute to changes in the required rate of return for an
investment?
Why Do Individuals Invest ?
$100 Today
How Do We Measure The Rate Of
Return On An Investment ?
If the purchasing power of the future payment will
be diminished in value due to inflation, an investor
will demand an inflation premium to compensate
them for the expected loss of purchasing power.
EAR 1 HPR 1
1 EAR = Equivalent Annual Return
N
HPR = Holding Period Return
N = Number of years
Example: You bought a stock for $10 and sold it for $18 six years
later. What is your HPR & EAR?
Calculating HPR & EAR
Solution:
Step #1: Step #2:
P1 P0
EAR 1 HPR 1
1
HPR N
P0
1.80 1
1
$18 - 10
6
$10
10.29%
0.80 or 80%
Measures of
Historical Rates of Return
Arithmetic Mean Where:
AM = Arithmetic Mean
R1 R2 ... RN
AM GM = Geometric Mean
N
Ri = Annual HPRs
N = Number of years
Geometric Mean
1
GM 1 R1 1 R2 ... 1 RN 1
N
Example
You are reviewing an investment with the following
price history as of December 31st each year.
1999 2000 2001 2002 2003 2004 2005 2006
$18.45 $21.15 $16.75 $22.45 $19.85 $24.10 $24.10 $26.50
Calculate:
The HPR for the entire period
The annual HPRs
The Arithmetic mean of the annual HPRs
The Geometric mean of the annual HPRs
A Portfolio of Investments
The mean historical rate of return for a
portfolio of investments is measured as
the weighted average of the HPRs for
the individual investments in the
portfolio, or the overall change in the
value of the original portfolio
Computation of Holding
Period Return for a Portfolio
# Begin Beginning Ending Ending Market Wtd.
Stock Shares Price Mkt. Value Price Mkt. Value HPR Wt. HPR
A 100,000 $ 10 $ 1,000,000 $ 12 $ 1,200,000 0.20 0.05 0.010
B 200,000 $ 20 $ 4,000,000 $ 21 $ 4,200,000 0.05 0.20 0.010
C 500,000 $ 30 $ 15,000,000 $ 33 $ 16,500,000 0.10 0.75 0.075
Total $ 20,000,000 $ 21,900,000 0.095
P1 P0
HPRPortfolio
P0
21,900, 000 20, 000, 000
20, 000, 000
9.5%
Expected Rates of Return
Risk is the uncertainty whether an investment will earn its
expected rate of return
Probability is the likelihood of an outcome
n
E(R i ) (Probabilit y of Return) (Possible Return)
i 1
n
(Pi )(R i )
i 1
Risk Aversion
Risk-free Investment
1.00
0.80
0.60
0.40
0.20
0.00
-5% 0% 5% 10% 15%
Probability Distributions
Risky Investment with 3 Possible Returns
1.00
0.80
0.60
0.40
0.20
0.00
-30% -10% 10% 30%
Probability Distributions
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 Risk: Historical Returns
HPR E HPRi
2 Where:
i
2 = Variance (of the pop)
2 i 1
n
Where:
(Pi ) R i E(R)
2 2
i 1 2 = Variance
Ri = Return in period i
Note: Because we multiply by E(R) = Expected Return
the probability of each return
occurring, we do NOT divide by Pi = Probability of Ri occurring
N. If each probability is the
same for all returns, then the
variance can be calculated by
either multiplying by the
probability or dividing by N.
Measuring Risk: Standard
Deviation
Standard Deviation is the square root of the variance
n
Standard Deviation is a measure of
P [R -E(R )]
i 1
i i i
2
dispersion around the mean. The
1
higher the standard deviation, the
n
greater the dispersion of returns
Pi [R i -E(R i )]2
2
Assumes no inflation.
Assumes no uncertainty about future cash
flows.
Influenced by the time preference for
consumption of income and investment
opportunities in the economy
Adjusting For Inflation:
Fisher Equation
Beta
Changes in the Required Rate of Return
Due to Movements Along the SML
Expected
Rate
Lower Higher
Risk Risk Security
Market Line
Beta
Changes in the Slope of the SML
The slope of the SML indicates the return per unit
of risk required by all investors
The market risk premium is the yield spread
between the market portfolio and the risk free rate
of return
This changes over time, although the underlying
reasons are not entirely clear
However, a change in the market risk premium will
affect the return required on all risky assets
Change in
Market Risk Premium
Note that as the slope
of the SML increases,
so does the market risk
Expected premium New
Return SML
Rm´
Original
SML
Rm
Risk Free
Rate
Beta
Capital Market Conditions,
Expected Inflation, and the SML
The SML will shift in a parallel fashion if inflation
expectations, real growth expectations or capital
market conditions change. This will affect the required
return on all assets.
Rate of
Return New SML
Original SML
Risk free
Rate
Risk
The Internet
Investments Online
http://www.finpipe.com http://www.ft.com
http://www.investorguide.com http://www.fortune.com
http://www.aaii.com http://www.smartmoney.com
http://www.economist.com http://www.worth.com
http://www.online.wsj.com http://www.money.cnn.com
http://www.forbes.com
http://www.barrons.com
http://fisher.osu.edu/fin/journal/jofsites.htm
Future Topics
Chapter 2
The asset allocation decision
The individual investor life
cycle
Risk tolerance
Portfolio management