Essentials of

Investment Analysis
and
Portfolio Management
by Frank K. Reilly & Keith C. Brown
 Chapter 1
The Investment Setting

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Why Do Individuals Invest ?

By saving money (instead of spending

it), individuals tradeoff present
consumption for a larger future
consumption.
(consumption choice)

3
How Do We Measure the Rate Of Return
On An Investment ?

The pure rate of interest is the

exchange rate between future
consumption and present
consumption. Market forces
determine this rate.

4
How Do We Measure the Rate Of Return
On An Investment ?

People’s willingness to pay the

difference for borrowing today
and their desire to receive a
surplus on their savings give rise
to an interest rate referred to as
the pure time value of money.

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How Do We Measure the Rate Of Return
On An Investment ?

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.
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If the future payment from the
investment is not certain
(uncertainty), 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.

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Defining an Investment

A current commitment of $ for a period

of time in order to derive future
payments that will compensate for:
• the time the funds are committed
• the expected rate of inflation
• uncertainty of future flow of funds.

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•A central question in
investments:
How investors select
investments that will give them
their required rate of return.

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Measures of return and risk

We have to know:
• Historical rate of return for an individual investment
over one period of time
• Average historical return for an individual
investment over a number of time periods
• Average return for a portfolio

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Measures of
Historical Rates of Return

Holding Period Return

Ending Value of Investment
HPR 
Beginning Value of Investment
$220
for example :  1.10
$200

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Holding Period Yield
HPY = HPR - 1

Prior example:
1.10 - 1 = 0.10 = 10%

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Annual Holding Period Return
•Annual HPR = HPR 1/n
n = number of years the investment is held

Annual Holding Period Yield

•Annual HPY = Annual HPR - 1

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For instance (page 8)
• A two-year HPR=$350/$250=1.4
• Annual HPR=1.4 (1/2) =1.1832
• Annual HPY=1.1832-1=18.32% (Annual HPY is
thus assumed constant for each year)

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• However, if the prior example is for a time period
of 6 months, what is the annual HPR?

(Try it out!)

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Computing mean historical
returns
Arithmetic Mean (AM) for an investment over a
number of time periods

AM 
 HPY
n
where:
 HPY  the sum of annual
holding perio d yields

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Geometric Mean (GM)

GM  π HPR  n  1
1

where:
π  the product operator
π HPR  HPR1  HPR2    HPRn 

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HPY for a portfolio

The mean historical rate of return for a portfolio is

measured as the weighted average of the HPYs for
the individual investments.

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• You can also consider the mean historical rate of
return of a portfolio as the overall change in value of
the original portfolio.

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 Computation example of HPY for
a portfolio
Exhibit 1.1
# Begin Beginning Ending Ending Market Wtd.
Stock Shares Price Mkt. Value Price Mkt. Value HPR HPY Wt. HPY
A 100,000 $ 10 $ 1,000,000 $ 12 $ 1,200,000 1.20 20% 0.05 0.010
B 200,000 $ 20 $ 4,000,000 $ 21 $ 4,200,000 1.05 5% 0.20 0.010
C 500,000 $ 30 $ 15,000,000 $ 33 $ 16,500,000 1.10 10% 0.75 0.075
Total $ 20,000,000 $ 21,900,000 0.095

$ 21,900,000
HPR = = 1.095
$ 20,000,000

HPY = 1.095 -1 = 0.095

= 9.5%

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Expected Rates of Return

• Risk: uncertainty that an investment will earn its expected

rate of return (historical return=realized return)
• Point estimate: He/she expects to earns 10% over a year.

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Computing expected return

Expected Return  E(Ri )

n
  (Probabili ty of Return)  (Possible Return)
i 1

 P1 R1  P2 R2  ...  Pn Rn
n
  Pi Ri
i 1

See the detailed computation shown on page 12.

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 Probability Distributions
Risk-free Investment (perfect certainty)

1.00

0.80

0.60

0.40

0.20

0.00
-5% 0% 5% 10% 15%

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 Probability Distributions

Risky investment with 3 possible rates of returns

1.00

0.80

0.60

0.40

0.20

0.00
-30% -20% -10% 0% 10% 20% 30%

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 Probability Distributions
Risky investment with 10 possible rates of return
1.00

0.80

0.60

0.40

0.20

0.00
-40% -30% -20% -10% 0% 10% 20% 30% 40% 50%

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Risk Aversion

Most investors will choose the least risky

alternative, all else being equal and that
they will not accept additional risk unless
they are compensated in the form of
higher return.

Compare the perfect certainty case and the risky

investment case on page 12.

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Measuring the risk of
expected rates of return

Variance
n
  (Probabilit y)  (Possible Return - Expected Return) 2
i 1
n
  Pi  [ Ri  E ( Ri )]2
i 1

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Measuring the risk of
expected rates of return

Standard deviation is the square root

of the variance =

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Measuring the risk of
expected rates of return

Coefficient of variation (CV) a measure of relative

variability that indicates risk per unit of return.

σi
C.V. 
E(R)

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 1.10

Measuring the risk of

historical rates of return

n
σ   [HPYi  E(HPY)] /n
2 2

i 1

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Determinants of
required rates of return

• Time value of money

• Expected rate of inflation
• Risk involved

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• Required rate of return: the minimum rate
of return to compensate for deferring
consumption.

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The components that determine the required rate
of return

The Real Risk Free Rate (RRFR)

• The basic interest rate
• Assumes no inflation
• Assumes no uncertainty about future cash flows.
• Pure time value of money
• Influenced by time preference for consumption of income
(subjective) and investment opportunities in the economy
(objective)

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 Factors for nominal risk-free rate
(NRFR)

1+Nominal RFR
=(1+Real RFR)(1+Rate of Inflation)

 (1  Nominal RFR) 
Real RFR =   1
 (1  Rate of Inflation) 

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• Real RFR is quite stable over time.
• Nominal RFR can be affected by
• The relative ease or tightness in the capital markets
• Expected rate of inflation

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Risk Premium
• We demand a higher return on an investment if we perceive that
its uncertainty about expected return is higher.
• The increase in required return over the NRFR is called risk
premium.

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The major sources of uncertainty (fundamental
risk)
• Business risk
• Financial risk
• Liquidity risk
• Exchange rate risk
• Country risk

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Business Risk
• Uncertainty of income flows
• Sales or earnings volatility leverage affects the level of
business risk.

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Financial Risk (financial leverage)
• Uncertainty caused by the use of debt
financing.
• Borrowing requires fixed payments which
must be paid ahead of payments to
stockholders.
• The use of debt increases uncertainty of
stockholder income and causes an increase in
the stock’s risk premium.

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Liquidity Risk
• Uncertainty is introduced by the secondary
market for an investment.
• How long will it take to convert an investment
into cash?
• How certain is the price that will be received?
• US T-bills has almost no liquidity risk.

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Exchange Rate Risk
• Uncertainty of return is introduced by
acquiring securities denominated in a
foreign currency.

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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.

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Risk Premium

Basically,
Risk premium= f (Business Risk, Financial Risk, Liquidity
Risk, Exchange Rate Risk, Country Risk)

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