Investment Analysis and Portfolio Management

Investment Analysis and Portfolio
Management
1
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
Copyright © 2010 Nelson Education Ltd. 1-2

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

Why Invest?
• By investing (saving money now

instead of spending it), individuals can
tradeoff present consumption for a
larger future consumption.

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).

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)

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.

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.

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

Measures of Historical Return and
Risk
• The period during which you own an
investment is called its holding period, and
the return for that period is the holding
period return (HPR).

HPR= Ending Value of Investment
Beginning Value of Investment
Example: You commit $200 to an investment at the beginning

of the year and you bet back $220 at the end of the year,
what is your return for the period?

Historical Return and Risk
• This value will always be zero or greater—that is, it can never be a negative value.
• A value greater than 1.0 reflects an increase in your wealth, which means a positive rate
of return during the period.
• The value less than 1.0 means that you suffered a decline in wealth. An HPR of zero
indicates that you lost all your money.
• Investors generally evaluate returns in percentage terms on an annual basis. This
conversion to annual percentage rate makes it easier to directly compare alternative
investments.

Historical Return and Risk

Historical Rates of Return:
What Did We Earn (Gain)?
Example I:
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?

Your Investments Rise in Value
Example I:
• Stock A
– Annual HPR=HPR1/n = ($350/$250)1/2 =1.1832
– Annual HPY=Annual HPR-1=1.1832-1=18.32%
• Stock B
– Annual HPR=HPR1/n = ($112/$100)1/0.5 =1.2544
– Annual HPY=Annual HPR-1=1.2544-1=25.44%

Historical Rates of Return:
What Did We Lose?
Example II:
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?

Your Investments Decline in Value
Example II:
• Stock A
– Annual HPR=HPR1/n = ($250/$350)1/2 =.84515
– Annual HPY=Annual HPR-1=.84514 - 1=-15.48%
• Stock B
– Annual HPR=HPR1/n = ($100/$112)1/0.5 =.79719
– Annual HPY=Annual HPR-1=.79719-1=-20.28%

Calculating Mean Historical Rates of
Return
• Over a number of years, a single
investment will likely give high rates of
return during some years and low rates of
return, or possibly negative rates of
return.
• In single investment and portfolio
investments , we also consider mean rates
of return. .

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!

Arithmetic Mean Return (AM)
• Arithmetic Mean Return (AM)

AM=  HPY / n
where  HPY=the sum of all the annual HPYs
n=number of years

Geometric Mean Return (GM)
• Geometric Mean Return (GM)

GM= [ HPY] 1/n -1
where  HPR=the product of all the annual HPRs
n=number of years

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.

Comparing Arithmetic vs. Geometric
Averages: Example
Suppose you invested $100 three years ago and it is

worth $110.40 today. What are your arithmetic and
geometric average returns?

Arithmetic Average: An Example
Year Beg. Value Ending HPR HPY
Value
1 $100 $115 1.15 .15
2 115 138 1.20 .20
3 138 110.40 .80 -.20
AM=  HPY / n
AM=[(0.15)+(0.20)+(-0.20)] / 3 = 0.15/3=5%

Geometric Average: An Example
Year Beg. Value Ending HPR HPY
Value
1 $100 $115 1.15 .15
2 115 138 1.20 .20
3 138 110.40 .80 -.20
GM= ([ 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%

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.

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.

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.

Calculating Expected Returns
n
E(R i )   ( Probabilit y of Return)  (Possible Return)
i 1
 [(P1 )(R 1 )  (P2 )(R 2 )  ....  (Pn R n )]

n
  ( Pi )( Ri )
i 1
Where:
Pi = the probability of return on asset i
Ri = the return on asset i

Perfect Certainty:
The Risk Free Asset
If you invest in an asset that has an expected return 5%

then it is absolutely certain your expected return will be
5%
• E(Ri) = ( 1) (.05) = .05 or 5%

Probability Distribution
Risk-Free Investment
1.00
0.80
0.60
0.40
0.20
0.00
-5% 0% 5% 10% 15%

Risky Investment with
Three Possible Outcomes
• Suppose you are considering an
investment with 3 different potential
outcomes as follows:
Economic Probability Expected Return
Conditions
Strong Economy 15% 20%
Weak Economy 15% -20%
Stable Economy 70% 10%

Probability Distribution
Risky Investment with 3 Possible

Returns
1.00
0.80
0.60
0.40
0.20
0.00
-30% -10% 10% 30%

Calculating Expected Return on a
Risky Asset
1.00
n
E ( Ri )   ( Pi )( Ri ) 0.80
0.60
i 1 0.40
0.20
0.00
-30% -10% 10% 30%
E ( Ri )  [(.15)(.20 )  (.15)(-.20)  (. 70 )(. 10 )]  .07  7 %

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!

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

Three Determinants of
Required Rate of Return
• Time value of money during the time period

• Expected rate of inflation during the period
• 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

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

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.

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

Risk Premiums: Liquidity Risk
• How long will it take to convert an investment

into cash?
• How certain is the price that will be received?

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.

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.

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.

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)

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.
Expected Return
Security
Low Average High
Risk Risk Risk Market Line
The slope indicates the

NRFR required return per unit of risk
Risk
(business risk, etc., or systematic risk-beta)
SML: Market Conditions or Inflation
• A change in RRFR or expected rate of

inflation will cause a parallel shift in the
SML
Expected Return
New SML
Original SML
NRFR'
NRFR
Risk

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.
Expected Return
New SML
Original SML
NRFR'
NRFR
Risk

Investment Analysis and Portfolio Management

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Investment Analysis and Portfolio

Copyright © 2010 Nelson Education Ltd. 1-2

Copyright © 2010 Nelson Education Ltd. 1-3

• By investing (saving money now

Copyright © 2010 Nelson Education Ltd. 1-4

• Exchange rate between future

Copyright © 2010 Nelson Education Ltd. 1-5

• People willing to pay more for the money

Copyright © 2010 Nelson Education Ltd. 1-6

Copyright © 2010 Nelson Education Ltd. 1-7

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Copyright © 2010 Nelson Education Ltd. 1-9

Example: You commit $200 to an investment at the beginning

Copyright © 2010 Nelson Education Ltd. 1-10

Copyright © 2010 Nelson Education Ltd. 1-11

Copyright © 2010 Nelson Education Ltd. 1-12

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

Copyright © 2010 Nelson Education Ltd. 1-13

Copyright © 2010 Nelson Education Ltd. 1-14

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

Copyright © 2010 Nelson Education Ltd. 1-15

Copyright © 2010 Nelson Education Ltd. 1-16

Copyright © 2010 Nelson Education Ltd. 1-17

• Do you use the arithmetic average? Or do

Copyright © 2010 Nelson Education Ltd. 1-18

• Arithmetic Mean Return (AM)

Copyright © 2010 Nelson Education Ltd. 1-19

• Geometric Mean Return (GM)

Copyright © 2010 Nelson Education Ltd. 1-20

• When rates of return are the same for all

Copyright © 2010 Nelson Education Ltd. 1-21

Suppose you invested $100 three years ago and it is

Copyright © 2010 Nelson Education Ltd. 1-22

1 $100 $115 1.15 .15

2 115 138 1.20 .20

3 138 110.40 .80 -.20

Copyright © 2010 Nelson Education Ltd. 1-23

1 $100 $115 1.15 .15

2 115 138 1.20 .20

3 138 110.40 .80 -.20

GM= ([ HPY] 1/n ) -1

Copyright © 2010 Nelson Education Ltd. 1-24

Copyright © 2010 Nelson Education Ltd. 1-25

Copyright © 2010 Nelson Education Ltd. 1-26

• Risk refers to the uncertainty of the future

Copyright © 2010 Nelson Education Ltd. 1-27

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

Copyright © 2010 Nelson Education Ltd. 1-28

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

• E(Ri) = ( 1) (.05) = .05 or 5%

Copyright © 2010 Nelson Education Ltd. 1-29

Copyright © 2010 Nelson Education Ltd. 1-30

Copyright © 2010 Nelson Education Ltd. 1-31

Risky Investment with 3 Possible

Copyright © 2010 Nelson Education Ltd. 1-32

E ( Ri )  [(.15)(.20 )  (.15)(-.20)  (. 70 )(. 10 )]  .07  7 %

Copyright © 2010 Nelson Education Ltd. 1-33

• Risk refers to the uncertainty of an investment;

Copyright © 2010 Nelson Education Ltd. 1-34

• Time value of money during the time period

Copyright © 2010 Nelson Education Ltd. 1-35

Copyright © 2010 Nelson Education Ltd. 1-36

• Conditions in the capital market