Introduction to Investment

Analysis and
Portfolio Management
 The Investment Setting
Questions to be answered:
 Why do individuals invest ?
 What is an investment ?
 Why Do Individuals Invest ?

 By saving money (instead of spending

it), individuals forego consumption
today in return for a larger
consumption tomorrow.
How Do We Measure The Rate Of
Return On An Investment ?
The real rate of interest is the exchange rate between
future consumption (future dollars) and present
consumption (current dollars). Market forces
determine this rate.
Tomorrow If you are willing to exchange
$104 a certain payment of $100
today for a certain payment of
$104 tomorrow, then the pure
or real rate of interest is 4%

$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.

 If the future payment from the investment is not

certain, an investor will demand a risk premium to
compensate for the investment risk.
 Defining an Investment

 Any investment involves a current commitment of

funds for some period of time in order to derive
future payments that will compensate for:
 the time the funds are committed (the real rate of return)
 the expected rate of inflation (inflation premium)
 uncertainty of future flow of funds (risk premium)
 Measures of
Historical Rates of Return
 Holding Period Return 1.1

P1  P0
HPR  Where:
P0
HPR = Holding period return
$220 - 200
 P0 = Beginning value
$200
 0.10 or 10% P1 = Ending value

 HPR = Ending Value of Inv/Beg. Value of Inv.

 HPY = HPR – 1
 Annual HPR = HPR1/n
 Measures of
Historical Rates of Return
 Annualizing the HPR Where:
1 EAR = Equivalent Annual Return
EAR  1  HPR   1 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 1
HPR 
P0 EAR  1  HPR   1
N

1

$18 - 10  1.80   1
6
$10
 10.29%
 0.80 or 80%