College of Business and Economics

Department of Accounting and Finance

Investment and Portfolio Management
Lecture Note
BA in Accounting and Finance
 Chapter one
Introduction to Investment
 1.1. What is investment?
• An investment is the current commitment of money for a period
of time in order to derive future payments that will compensate
the investor for
(1) The time the funds are committed,
(2) The expected rate of inflation, and
(3) The uncertainty of the future payments.
• It refers to the concept of deferred consumption, which involves:
• purchasing an asset,
• giving a loan or
• keeping funds in a bank account with the aim of generating
future returns.
• Various investment options are available, offering differing risk-
reward tradeoffs.
 Investment vs. Speculation vs. Gambling
• A speculator defined as someone that seeks to buy and sell in
order to take advantage of market price fluctuations.
• An investor is someone who holds on the securities that provide
a good income.
• Distinction between the investor and the speculator is found in
their attitude toward market movements.
• The speculator's primary interest lies in anticipating and
profiting from market fluctuations.
• The investor's primary interest lies in acquiring and holding
suitable securities at suitable prices.
 Cont…
• Gambling is an act putting money at risk by betting on an
uncertain outcome with the hope that you might win money.
• It is an act of taking the risk of losing money in the expectation
of a desired result.
• Investing means committing money in order to earn a financial
return.
• The definitions seem to indicate a higher element of chance or
randomness in gambling, while investing appears to be more
rational.
 Characteristics of Investment
• Major investment features are:
Risk: refers to the loss of principal amount of an investment.
• It is one of the major characteristics of an investment. The
risk depends on the following factors:
• Maturity period is longer: investor will take larger risk.
• Governmental bodies issuing securities which have less
risk.
• Debt instrument/fixed deposit, the risk of investment is less
due to their secured and fixed interest payable on them.
E.g. Debentures.
Cont…
• Ownership instrument like equity/preference shares, the risk
is more due to their unsecured nature and variability of their
return and ownership character.
• The risk of degree of variability of returns is more in the case
of ownership capital compare to debt capital.
• The tax provisions would influence the return or risk.
 Cont…
Return: expected rate of return from an investment.
• Return is the major factor which influences the pattern of
investment that is made by the investor.
Safety: refers to the protection of investor principal amount and
expected rate of return.
• Investor prefers safety about his capital.
• Capital is the certainty of return without loss of money or it will
take time to retain it.
• Government bonds less risk securities
• Private Securities high rate of return & Safety of these securities is low.
 Cont…
Liquidity: refers to an investment ready to convert into cash
position.
• Liquidity means that investment is easily realizable, saleable
or marketable.
• When the liquidity is high, then the return may be low.
Marketability: refers to buying and selling of Securities in
market.
• Marketability means transferability or sale ability of an asset.
• Public Limited Companies shares are more easily
transferable than those of private limited companies.
 Cont…
Conceal ability: means investment to be safe from social disorders,
government confiscations or unacceptable levels of taxation
• Property must be concealable and leave no record of income
received from its use or sale.
• Gold and precious stones have long been esteemed for these
purposes, because they combine high value with small bulk and
are readily transferable.
Capital Growth: refers to appreciation of investment.
• It is recognizing in connection between corporation and
industry growth and very large capital growth.
• Investors and their advisers are constantly seeking ‘growth
stock’ in the right industry and bought at the right time.
 Cont…
Purchasing Power Stability: refers to the buying capacity of investment
in market.
• It has become one of the important traits of investment.
• Investment always involves the commitment of current funds with the
objective of receiving greater amounts of future funds.
Stability of Income: refers to constant return from an investment.
• Every investor always considers stability of monetary income and
stability of purchasing power of income.
Tax Benefits: refer to plan an investment program without regard to
one’s status may be costly to the investor.
• Two problems:
• Amount of income paid by the investment and
• The burden of income tax upon that income
 Investment Activity
• It includes buying and selling of the financial assets, physical
assets and marketable assets in primary and secondary
markets.
• Financial Assets are: Cash, Bank Deposits, Pension Scheme,
Post Office Certificates and Deposits
• Physical Assets are: House, Land, Building and Flats, Gold,
Silver and other Metals, Consumer Durables
• Marketable Assets are: Shares, Bonds, Government Securities,
etc.
• Investment activity involves the use of funds or savings for
further creation of assets or acquisition of existing assets.
 Classification of Investment
• On the Basis of Physical Investments: House, Land, Building,
Gold and Silver, Precious stones
• On the Basis of Financial Investment: Financial investments
further classified on the basis of:
• Marketable and Transferable investments: Shares,
Debentures of public limited companies, Bonds of public
sector unit, government securities, etc…
• Non-Marketable Investments: Bank Deposits, Provident and
Pension Funds, Insurance Certificates, Post office Deposits,
National Saving Certificates, Company Deposits, Private
Companies Shares etc.
 Investment alternatives
• Indirect investing: It is buying and selling of the shares of
investment companies which hold portfolios of securities.
• E.g. The assets of mutual funds are the most popular type of Investment
Company.
• Households also own a large, and growing, amount of pension fund
reserves, and they are actively involved in the allocation decisions of
pension funds through plans and other self-directed retirement plans.
• Direct Investing: involves securities that investors not only buy
and sell themselves but also have direct control over.
• Investors invest directly in financial markets either using a
broker or by other means
• Investors have a wide variety of assets from which to choose.
 Cont…
Investment opportunities:
• Non-marketable investment opportunities.
• Marketable securities may be classified into:
• Money market securities: Investors typically will not own
these securities directly, choosing instead of own them
through the money market funds.
E.g. Treasury bills
• Capital market securities classified as either fixed income or
equity securities.
• Derivative securities: The market value of these securities is
derived from an underlying security such as common stock.
 Cont…
• Securities: is a legal document that shows an ownership
interest.
• Securities have historically been associated with financial
assets such as stocks and bonds
• but in recent years have also been used with real assets.
• Securitization is the process of converting an asset or
collection of assets into a more marketable forum.
• Security Groupings: are placed in one of three categories:
1. Equity Securities: The most important equity security is
common stock.
• Stock represents ownership interest in a corporation.
 Cont…
2. Fixed Income Securities: usually provides a known cash flow
with no growth in the income stream.
• Bonds are the most important fixed income securities.
• A bond is a legal obligation to repay a loan’s principal and
interest, but carries no obligation to pay more than this.
• Accountants classify preferred stock as an equity security
• But the investment characteristics of preferred stock are
more like those of a fixed income security.
• Most preferred stocks pay a fixed annual dividend that does
not change overtime consequently.
 Cont…
3. Derivative Assets: the value of such an asset derives from the
value of some other asset or the relationship between several
other assets.
• Future and options contracts are the most familiar derivative
assets.
 Investment companies
• They are financial intermediaries that collect funds from
individual investors and invest those funds in a potentially wide
range of securities or other assets.
• Each investor has a claim to the portfolio established by the
investment company in proportion to the amount invested.
• These companies thus provide a mechanism for small investors
to “team up” to obtain the benefits of large-scale investing.
• An investment company is a financial service organization
• sells their own shares to the public and
• uses the funds it raises to invest in a portfolio of securities.
 Types of Investment Companies
• Investment companies are classified as: unit investment trusts
and managed investment companies.
Unit Investment Trusts
• Unit investment trusts are pools of money invested in a portfolio
that is fixed for the life of the fund.
• To form a unit investment trust a brokerage firm buys a
portfolio of securities which are deposited into a trust.
• It then sells to the public shares, or “units,” in the trust, called
redeemable trust certificates.
• All income and payments of principal from the portfolio are
paid out by the fund’s trustees (a bank or trust company) to the
shareholders.
 Cont…
• There is little active management because once established, the
portfolio composition is fixed;
• Hence these trusts are referred to as unmanaged.
• Trusts tend to invest in relatively uniform types of assets
E.g. One trust may invest in municipal bonds, another in corporate bonds.
• The uniformity of the portfolio is consistent with the lack of
active management.
• The lack of active management of the portfolio implies that
management fees can be lower than those of managed funds.
• Sponsors or brokers earn their profit by selling shares in the
trust at a premium to the cost of acquiring the underlying assets.
 Cont…
• Investors who wish to liquidate their holdings may sell the
shares back to the trustee for net asset value.

• The trustees can either sell enough securities from the asset
portfolio to obtain the cash necessary to pay the investor, or they
may instead sell the shares to a new investor (again at a slight
premium to net asset value).
 Cont…
Managed Investment Companies
• Securities in their investment portfolios continually are bought
and sold.
• That is why the portfolios are managed.
• There are two types: closed-end and open-end.
• In both cases, the fund’s board of directors, which is elected by
shareholders, hires a management company to manage the
portfolio for an annual fee that typically ranges from 2% to 1.5%
of assets.
• In many cases the management company is the firm that
organized the fund.
 Cont…
1. Closed-End Investment Companies:
• Usually sells no additional shares of its own stock after the
initial public offering.
• Therefore, their capitalizations are fixed, unless a new public
offering is made.
• The shares are traded in the secondary markets.
• To buy and sell, investors use their brokers, paying (receiving)
the current price at which the shares are selling plus (less)
broker commissions.
 Cont…
2. Open-End Investment Companies (Mutual Funds):
• The most familiar type of managed company are popularly
referred to as mutual funds.
• Continue to sell shares to investors after the initial sale of shares
that starts the fund.
• The capitalization is continually changing
• as new investors buy additional shares and
• some existing shareholders cash in by selling their shares back to
the company.
 Cont…
• Mutual funds typically are purchased either:
• Directly from a fund company, using mail or telephone, or at the
company's office locations.
• Indirectly from a sales agent, including securities firms, banks, life
insurance companies, and financial planners.
• Mutual funds may be affiliated with an underwriter, which
usually has an exclusive right to distribute shares to
investors.
• Mutual funds are either corporations or business trusts
typically formed by an investment advisory firm that selects
the/board of trustees (directors) for the company.
 Cont…
• The trustees, in turn, hire a separate management company,
normally the investment advisory firm, to manage the fund.

• The management company is contracted by the investment

company to perform necessary research and to manage the
portfolio, as well as to handle the administrative chores, for
which it receives a fee.
 Cont…
Major Type’s mutual funds
• There are two major types of mutual funds:
• Money market mutual funds
• Stock (also called equity) funds and bond & income funds
• These types of funds parallel of money markets and capital
markets.
• Money market funds concentrate on short-term investing by
holding portfolios of money market assets,
• Stock funds and bond & income funds concentrate on longer
term investing by holding mostly capital market assets
Functions of Investment Companies
• Record keeping and administration.
• issue periodic status reports,
• keeping track of capital gains distributions,
• dividends,
• investments, and
• redemptions, and
• they may reinvest dividend and interest income for
shareholders.
• Diversification and divisibility. By pooling their money,
investment companies enable investors to hold fractional
shares of many different securities.
• They can act as large investors even if any individual
shareholder cannot.
 Cont…
• Professional management. Most investment companies have
full-time staffs of security analysts and portfolio managers
who attempt to achieve superior investment results for their
investors.
• Lower transaction costs. Because they trade large blocks of
securities, investment companies can achieve substantial
savings on brokerage fees and commissions.
 Cont…
• They need to divide claims to those assets among those
investors.
• Investors buy shares in investment companies, and
ownership is proportional to the number of shares
purchased.
• The value of each share is called the net asset value, or NAV.
• Net asset value equals assets minus liabilities expressed on a
per-share basis.
 Security market
• Securities are tradable financial assets used as a proof of
ownership of stocks, bonds or other investment instruments.
• Security markets are the centers that provide facilities for
buying and selling of financial claims (securities) and services.
• The corporations, financial institutions, individuals, &
governments trade in financial products on these markets either
directly or through brokers and dealers on organized exchanges
or off exchanges.
• The term "market" is sometimes used for what are more
strictly exchanges.
e.g., a stock exchange, foreign exchange or commodity exchange.
 Cont…
• This may be a physical location (like the NYSE) or an electronic
system (like NASDAQ).
• In finance, financial markets facilitate:
• The raising of capital (in the capital markets)
• The transfer of risk (in the derivatives markets)
• The transfer of liquidity (in the money markets)
• International trade (in the foreign exchange markets)
• And are used to match those who want capital to those
who have it.
 Types of financial markets
• Capital markets which consist of:
• Stock markets, which provide financing through the
issuance of shares or common stock, and enable the
subsequent trading thereof.
• Bond markets, which provide financing through the issuance
of bonds, and enable the subsequent trading thereof.
• Primary markets, Newly issued securities are bought or sold.
• Secondary markets allow investors to sell securities that they
hold or buy existing securities.
• Money markets provide short term debt financing and
investment.
 Cont…
• Commodity markets, which facilitate the trading of
commodities.
• Derivatives markets, which provide instruments for the
management of financial risk.
• Futures markets, which provide standardized forward
contracts for trading products at some future date.
• Insurance markets, which facilitate the redistribution of various
risks.
• Foreign exchange markets, which facilitate the trading
of foreign currencies.
 Functions of Financial Markets
• Time Preference: refers to the value of money spent now relative
to money available for spending in the future.
• Businesses are frequently making decisions among short-term
and long-term uses of funds, and
• Business executives must judge between outlays which provide
a return in the near term and those which pay off many years
from now.
• Risk Distribution: The financial markets distribute economic risks.
• Employment and investment risks are separated by the creation
and distribution of financial securities.
 Cont…
• On a larger scale, the money and capital markets transfer the
massive risks from people actually performing the work
(employment risks) to savers who accept the risk of an uncertain
return.
Financial markets allow individuals to diversify among
investments.

• Diversification means combining securities with different

attributes into a portfolio.
 Cont…
• Ordinarily, a diversified portfolio of financial claims is less risky
than a portfolio consisting of one or at most a handful of similar
securities.
• Total risk is reduced because losses in some investments are
offset by gains in others.
• The benefits of diversification are possible due to the existence
of large, diversified financial markets where investors may buy
and sell securities with minimum transactions cost, regulatory
interference, and so forth.
The End
 CHAPTER TWO

REGULATIONS AND ADMINISTRATION OF INVESTMENTS

IN ETHIOPIA
 Investment Opportunities in Ethiopia

• Ethiopian investment commission (EIC) and Regional

Investment Bureaus are responsible for investment in Ethiopia

• Legal Base of Investment Activities in Ethiopia

• Commercial Code of 1960

• The 1994 Ethiopian constitution, Article 40

• Investment Proclamation No. 769/2012 (amended in 2014)

• Regulation No. 313/2014

• Directives by EIC and Regional Investment Bureaus

41
Cont…
Type of Investors in Ethiopia
• Domestic investor : includes an Ethiopian, a foreign national
permanently residing in Ethiopia, a government and public
enterprises, cooperative societies established in accordance with the
relevant law, a foreign national who is Ethiopian by birth and
wishing to be considered as a domestic investor
• Foreign investor is a foreign national who has invested foreign
capital in Ethiopia, an existing enterprise owned by foreign
investors, Ethiopian, permanently residing abroad and preferring to
be treated as a foreign investor and a joint venture established
between a foreign investor and a domestic investor.

42
Cont…

Common investment opportunities in Ethiopia

Agriculture
Manufacturing
 Agro processing
 Textile
 Leather and Leather Processing
 Chemical and Pharmaceutical
Metal and Engineering

43
 Agricultural investment opportunities

Food crops
• Livestock farming
Beverage crops
Cotton • Horticulture
Sugar cane plantation
Rubber and palm tree • Floriculture
plantation • Forestry and related
activities, etc.

44
 Investment opportunities in
manufacturing
Leather and leather processing

• Leather footwear and garment

• Luggage, handbags and gloves
• Saddle and harness
• Integrated tanning and
Manufacturing

45
Chemicals and chemical products industry

• Fertilizers and nitrogen compound

• Caustic soda and soda ash

• Soap and detergent

• Paints, varnishes, writing and painting inks

• Man-made fibers

• Magnesium chloride

• Hydrogen peroxide

• Coal phosphate
46
 Paper and paper products
manufacturing
• Pulp, paper and paper packages

• Plastic and plastic products

• Plastic products used as inputs for construction of

building, vehicles or other industrial products

• Plastic pipes or tubes

47
Non-metallic Mineral products Industry
• Glass and Glass Products
• Ceramics

Building materials
 Limestone  Wall cladding and roofing tiles (not
from cement)
 Gypsum
 Tubes
 Marble
 Pipes
 Granite
 Fittings

48
Agro processing
 Processing of meat
products
 Processing of fruits and
vegetables
 Integrated dairy farm/or
processing of dairy
products
 Processing of crude and
refined edible oil
 Processing of starch,
cornflakes and edible oil
from maize

49
 Cont.…

 Processing of coffee and spices

 Manufacturing of baby food and

similar food products

 Production of spaghetti, macaroni

and other similar products

 Brewing and wine making

 Sugar and sugar related

50
 Construction

• There is a construction boom in

Ethiopia; urban housing, road,
railway, power interconnections,
etc…
• Real estate developments

Source:- ethiopicture.com

51
Other investment opportunities

• Information and Communication Technology (ICT)

• Mining

• Tourism

• Cargo Air transport Service

• Health

• Education

52
Trend of investment in Ethiopia
Sector 2008/9 2009/10 2010/11 2011/12 2012/13
Domestic private Investment 34.91% 42.4% 16.9% 40.58% 31%
Foreign Direct Investment 30.52% 57.22% 21.4% 57.45% 44%
Public Investment 34.6% 0.04% 61.7% 1.97% 25%
Total 100% 100% 100% 100% 100%

53
 Areas of Investment Reserved for
Domestic Investors
• Besides areas exclusively reserved for domestic
investors, areas exclusively reserved for Ethiopian
nationals include.
• - Banking, insurance and micro-credit and saving
services;
• Shipping agency services;
• - Broadcasting services; and
• - Air transport services using aircraft with a seating
capacity of up to 20 passengers.
• Besides allowing private sectors to investment
areas, government also exclusively reserved and
jointly allowed certain investment areas for the
government.
FDI and Other Financing
Inflows in Ethiopia
FDI Inflows to Ethiopia

• In 2014, Ethiopia emerged as the 8th-largest

recipient of FDI projects in Africa, up from 14th
position in 2013
• FDI inflows to the country were at a mere US$3.9
million in 1970
• representing a very negligible share in global investment
flows.
• This figure has substantially increased to US$953
million in 2013
• although its share in the global FDI flows is still decimal.
 FDI Inflows to Ethiopia…….cont’d
• FDI increased from a period’s average of 5.9 million
US$ during the ‘Derg’ regime to around 270 US$ in
the EPRDF regime.
• The ups and downs (due to the global financial crises
in 2008, war with Eritrea from 1998-2000, among
other things), net FDI inflows reached nearly 1.2 bln
US$ in 2014.
• This may be of mainly due to the various
liberalization policies, better economic performance ,
incentives and fairly stable country that characterize
the current period
FDI Inflows to Ethiopia…….cont’d
• Total FDI flows as percentage of Gross fixed capital
formation was around 0.7 % in 1990
• This figure has reached around 7 % in 2014, albeit
the ups and downs over the years [Notice it is not
that big!]
• FDI in by sector
• Manufacturing leads the list (with 70.6 % share of Total
FDI inflow)
• Service (10.7%)
• Agriculture(8.7%)
FDI Inflows to Ethiopia…….cont’d
Summary of operational projects by sectors from 1992-2013

Sector No of Projects Capital in Billions % Share in Total

of Birr FDI inflow

Agriculture 275 11.2 10.7%

Manufacturing 925 74.1 70.6%
Service 1,023 19.6 18.7%
(Source: EIC 2014)
FDI from the Emerging Economies in Ethiopia

• The three most important emerging economies in

the FDI inflows to Ethiopia are
• China
• India
• And Turkey
• According UNCTAD (2015), FDI flow from China to
Ethiopia increased from just about a 1mln $ in2003
to an annual amount of US$122 mln in 2012.
 Chapter three
Risk and Return
 Return
• In finance, rate of return is known as return on investment
(ROI), rate of profit or also called as return.
• Rate of Return is the ratio of money gained or lost generated on
an investment relative to the amount of money invested,
whether realized or unrealized.
• The amount of money gained or lost may be referred to as
interest, profit/loss, gain/loss, or net income/net loss.
Components of Return
• In financial theory, the rate of return at which an investment
trades is the sum of five different components. These are:
 Cont…
• Real Risk-Free Interest Rate- is the rate of return an investor can
earn without any risk in a world with of no inflation.
• Inflation Premium- is the rate that is added to an investment to
adjust it for the market’s expectation of future inflation.
For example, the inflation premium required for a one year
corporate bond might be a lot lower than a ten year corporate
bond by the same company because investors think that inflation
will be low over the short-run, but pick up in the future.
 Cont…
• A Liquidity Premium- Thinly traded investments such as
stocks and bonds in a family controlled company require
a liquidity premium.
• Investors are not going to invest if there is a very real
possibility that issuer of bonds/shares will not be able to repay
in a short period of time because buyers are scarce.
This is expected to compensate investors for the potential lose
of buying.
• The size of the liquidity premium is dependent upon an
investor’s perception of how active a particular market is.
 Cont…
• Default Risk Premium: Investors believe that the issuer
company will default (unable to repay) on its obligation or go
bankrupt, and as a result of investors demanding a default
risk premium.
This is expected to compensate investors for the potential lose
of the repay.
• Maturity Premium: The further in the future the maturity of a
company’s bonds, the greater the price will fluctuate when
interest rates change.
It is expected to compensate for potential price fluctuation.
 Measuring Returns
• Returns on the investments can be seen in two ways. These are:
Ex-post returns and ex-ante returns.
• Ex Post Returns: Return calculations done ‘after-the-fact,’ in
order to analyze what rate of return was earned.
• Ex-post return is based on historical data.
• Ex Ante Returns: Return calculations may be done ‘ before-the-
fact,’ in which case; assumptions must be made about the
future.
• Ex-ante return forecasted returns for the future.
 Measuring Historical Returns
(Ex Post Returns)
• Earned on a security or a class of securities
• Allows us to identify trends or tendencies that may be useful in
predicting the future.
• One of the measurements of return is the holding period
return (HPR),
Holding Period Return (HPR): The simplest measure of return.
• It represents the return an investor received for holding an
investment for a certain period of time.
• It is a return that has already taken place over a single period.
• It is independent of the passage of time and incorporates only
a beginning point and an ending point.
 Cont…
• The formula for determining the HPR is as follows:
HPR = (Ending value – Beginning value) + Income
Beginning value
(Sale price  Purchase price)  Current income
HPR 
or Purchase price
Capital gain/loss  Current income

Purchase price

Example 1: Assume Mr. X has purchased 100 common shares at $25

per share, receives a 10 cents per share dividend, and later sell the
shares for $30. What is holding period return of Mr. X?
HPR = $(30 x 100) – $(25 x 100) + $(0.10 x 100)
$(25 x 100)
= $3,000 – $2,500 + $10 = 20.4%
ETB2500
• Has this investment done well? The answer depends on how much
time passed between the purchase and the sale. Assume, if these
shares were acquired in 2003 and sold in 2013, the total gain of
20.4% is less than what could have been earned in the bank saving
account which pays 5% annual interest rate. If, however, the stocks
were purchased after 2010, the return is attractive.
• Example 2: At the beginning of the year a stock was selling for birr 40
per share and at a time AtoAbebe purchased 100 shares. Over the
year the stock paid 5 per share and year-end market price became
45. What is the return of AtoAbebe from the investment?
• Dividend = 5* 100= 500
• Capital gain = (45-40) * 100 =500
• Total return = 500+500 = 1000
 Cont…
Average rate of return
• Used to determine the investment returns over multiple periods.
• There are two different types’ of measures for ex post mean
average returns:
• Arithmetic average
• Geometric mean
Arithmetic Average Returns: It is also called Arithmetic Mean.
• It is an appropriate measure of the central tendency of a
distribution consisting of returns calculated for a particular time
period.
• However, when percentage changes in value over time are
involved, as a result of compounding, the arithmetic mean of
these changes can be misleading.
 Cont…
• It is a sum of all returns divided by the total number of
observations (periods).
n

r i
Arithmetic Average (AM)  i 1

n
Where: ri = the individual returns
n = the total number of observations
Example: 1) Assume the following ex-post returns of Mr. X from his
investment for the three years:
Year Returns
1 20%
2 -30%
3 40%

2) ABC co reported a return of 10%, 12%, 14%, 8% and 6% returns

form year 2000 to 2004. What is the average return of ABC co?
 Cont…
Geometric Mean Returns: measures the compound rate of
growth over time.
• It is often used in investments and finance to reflect the steady
growth rate of invested funds over some past period .
• It allows us to measure the realized change in wealth over
multiple periods.
• It is a good estimate (better than arithmetic) for the true return
over a multi-period horizon.
1
Geometric Mean (GM)  [( 1  r1 )( 1  r2 )( 1  r3 )...( 1  rn )] -1
n

Where: ri = the individual returns

n = the total number of observations
 Cont…
Example: 1) Assume that an investment appreciates 20% during
the first year, loses 30% during the second year, and then
gains 40% during the third year.

2) ABC co reported a return of 10%, 12%, 14%, 8% and -6%

returns form year 2000 to 2004. What is the Geometric
average return of ABC co?
 Arithmetic Mean vs. Geometric
Mean
• The arithmetic mean is a better measure of average (typical)
performance over single periods.
• It is also used to estimate of the expected return for next period.
• The geometric mean is a better measure of the change in wealth
over the past (multiple periods).
• It is a backward-looking concept, measuring the realized
compound rate of return at which money grew- over a specified
period.
 Measuring Expected (Ex-Ante)
Returns
• Investor’s are most concerned with future returns.
• Sometimes, historical average returns will not be realized in the
future.
• Developing ex ante returns involves use of forecasting discrete
scenarios with outcomes and probabilities of occurrence.
• Scenario analysis is a better measure for short term forecasts
because:
• the current situation has large bearing on what is likely to happen
over a short period.
 Cont…
Scenario analysis: Forecast multiple rates of return and their
probabilities of occurrence.
• Forecasted return is the probability weighted sum of the various
rates of return.
• The general formula for estimating Ex-ante (forecast) returns is
presented as follows:
n
Expected Return (ER)   (ri  Prob i )
i 1

Where: ER = the expected return on an investment

Ri = the estimated return in scenario i
Probi= the probability of state i occurring
 Cont…
• Example: This is type of forecast data that are required to make
an ex ante estimate of expected return.
Probability of Possible Returns on
State of the Economy Occurrence Stock A in that State
Economic Expansion 25.0% 30%
Normal Economy 50.0% 12%
Recession 25.0% -25%

• Required: forecast the following based on three state of the

economy:
 Cont…
• Example: Suppose an investor is considering an investment of
200,000 in the stock of XYZ co or ABC co. hoping to gain
dividend and selling it at appreciated price after one yr. Over
the year it is presumed that the economy will be 20% at boom,
60% at normal and 20% at recession. What is the expected
return from the investment given the following rate of returns
in various economic conditions?
Economic Probabilities Return of XYZ Return of ABC
conditions
Boom 0.2 10% -4%
Normal 0.6 11% 20%
Recessions 0.2 26% 40%
 Risk
• It is the probability of earning lesser return than the expected
one or incurring loss.
• Risk is often associated with the dispersion in the likely
outcomes.
• Dispersion is a chance of unfavorable event to occur.
For example; if an investor expects a 10% rate of return on a given
investment, then any return less than 10% is considered harmful.
• If an asset's return has no variability, in effect it has no risk.
• E.g. Government treasury securities.
• When it comes to investments, there are always some levels of
uncertainty associated with future holding period returns.
• Such uncertainty is commonly known as the risk of the
investment.
 Cont…
Components of causes of uncertainty of an investment’s return:
Business risk: is the uncertainty regarding the earnings (or
profitability) of a firm as a result of changes in:
• demand,
• input prices, and
• technological obsolescence.
Default risk: is the uncertainty regarding an issuing firm’s ability
to pay:
• interest, and
• principal, on its debt instruments.
 Cont…
Inflation risk: is the uncertainty over future rates of inflation.
• It is also known as purchasing power risk.
• The investor will receive a lesser amount of purchasing power than
what was originally invested because the cost of buying everything has
gone up.
Market risk: represents the changes in an investment’s price (or
market value) as a result of an event that affects the entire
market.
• E.g. the impact of a market correction or a market crash on
an investment’s return.
 Cont…
Interest rate risk: represents the fluctuation in the value of an
investment when market interest rate changes.
• This has a big impact on interest-paying investments because as market
interest rate rises (falls), an investor’s money is tied up in a bond that
pay less (more) than the going rate, and hence the value of the investor’s
bond decreases (increases).
Liquidity risk: is the risk of not being able to sell an investment
immediately with a reasonable price.
Political risk: is caused by changes in the political environment
that affect an investment’s market value.
• It can be classified as either domestic or foreign political risk.
E.g. Change in the tax laws (domestic), & change in a foreign
government’s policy regarding capital outflow (foreign).
 Cont…
Call-ability risk: is the risk that an investment is recalled (or
retired) prior to the original stated date.
• most applicable to long-term bonds and preferred stocks.
• This usually happens when the issuing firms find the market
conditions favorable in “refinancing” such investments.
Exchange rate risk: is the uncertainty regarding the changes in
exchange rates that might affect the value of an investment.
• It has an impact on both domestic and foreign investments.
• There are two kinds of risks that the investors will deal with:
• Unsystematic Risk
• Systematic Risk
 Cont…
Unsystematic risk: It also called diversifiable risk, unique risk, or
firm-specific risk.
• It is a risk that associated to a particular security, such as; risk
created from employee strikes or management decision change.
• For example, if the asset under consideration is stock in a single
company,
• The negative NPV projects will tend to decrease the value of stock.
• Unanticipated lawsuits, industrial accidents, strikes etc will decrease the
share values.
• Unsystematic risk is essentially eliminated by diversification, so
a portfolio with many assets has almost no unsystematic risk.
 Cont…
Systematic risk: is a risk that will affect all in the same manner.
• It also called as undiversifiable risk, unavoidable risk, or market
risk.
• It affects an overall market.
E.g. changes in nation’s economy
tax reforms
change is world energy situation
• These are the risks that affect securities overall (whether in a
portfolio or single) and, consequently, cannot be diversified
away.
• Therefore: Total Risk = Unsystematic Risk + Systematic Risk
 Measuring risk
• A risk of an investment can be measured in absolute term using
standard deviations and variance or coefficient of variation.
• Variability of returns can be measured by either of range or
standard deviation.
RANGE: Range can be used as a measure of variability (difference
between the maximum and minimum return),
• However it is a poor measure since it only uses 2 observations.
Standard Deviation (σ): An absolute measure of risk
• The most commonly used measure of dispersion
• It measures the deviation of each observation from the
arithmetic mean of the observations
• It is a reliable measure of variability, because all the information
in a sample is used.
 Cont…
• A standard deviation is useful to evaluate investments, which
have approximately equaled in expected returns.
• Standard deviation can be calculated based on both forecasted
returns and historical returns.
Ex-post Standard Deviation
• The formula used for calculate historical Standard Deviation is:
n where: σ = the standard deviation
 (r  AR)
i
2
AR = Average return
Ex post   i 1
ri = possible return in time i
n 1 n = number of observations
• EXAMPLE: Assume the following historical returns for the past
four consecutive on investment of stock A and estimate the
standard deviation: 10%, 24%, -12%, 8% and 10%.
 Cont…
Estimating Ex-ante Standard Deviation
• It can be calculated in a similar way to ex-ante returns.
• Scenario based standard deviation is as below:
n
Where: Probi= probability of scenario i
Ex - ante    (Prob
i 1
i )  (ri  ERi ) 2
ri = possible return at scenario i
ERi = Expected return of the security I

EXAMPLE: Assume the following possible returns on investment of

stock A under three scenarios, estimate the standard deviation:
State of the Economy Probability Possible Returns on Security A
Recession 25.0% -22.0%
Normal 50.0% 14.0%
Boom 25.0% 35.0%
 Cont…
Coefficient of variation: A relative measure of risk
• It measures the standard deviation in relation to expected
return.
• So as the coefficient of variation increases, so the risk of an asset
increases.
Coefficient of variation= SD/ ER Where: SD: standard deviation
ER: expected return
Example: Which one of the securities is highly risky?
• XYZ coefficient of variation = 6.11/13.8=0.44
• ABC coefficient of variation =13.95/19.2=0.73
 Relationship between Risk and Return
• The relationship among risk and return is positive which means
an increase of one result an increase to the other.
• For this reason, there will be always a risk return trade off.
Required rate of return = Risk free rate of return+ Risk premium
Risk premium is a potential reward that an investor expects to
receive when making a risky investment.
• This is based on a theory that investors are risk averse that is
they expect an average to be compensated for the risk that they
assume when making investment.
Risk fee rate of return: It is the return available on security with
no risk of default.
Risk free rate of return= Real rate of return + Expected inflation premium
 Cont…
Real rate of return: is the return that investors would require from
security having no risk of default in a period of no expected
inflation.
• Real rate of return is a return necessary to convince investors to
postpone current, real consumption opportunities.
• It is determined by the interaction of the supply of funds made
available by savers and the demand for funds for investment.
 Cont…
Determinants of Risk premium
• It is the potential reward that an investor expects to receive
when making a risky investment.
• And it is a function of several different risk elements:
1. Maturity risk premium
• This is the return required on a security is influenced by the
maturity of the security.
• Generally the longer the time to maturity, the higher the
required return on the security.
2. The default risk premium
• The more the default risk, the higher the required rate of return
will be.
 Cont…
3. Seniority risk premium
• It is the difference in securities with respect to their claim on the
cash flows generated by the company and the claim on the
company’s assets in the case of default.
• The less senior the claims of the security holders, the greater the
required rate of return demanded by the investor in the security.
4. Marketability risk premium
• It is the ability of the investor to buy and sell a company’s
securities quickly and without a significant loss of value.
• The marketability risk premium can be significant for securities
that are not regularly traded.
 Cont…
5. Business and financial risk
• Business risk: is the variability in the firm’s operating earnings
over time.
• It is influenced by many factors including:
• the variability in sales,
• operating cost over a business cycle,
• the diversity of a firms,
• production line,
• the market power of the firm, and
• the choice of production technology.
• Financial risk: refers to the additional variability in a company’s
earnings per share that result from the use of fixed cost sources
of funds, such as debt and preferred stock.
 Cont…
• Business and financial risk are reflected in the default risk
premium applied by investors to firm securities.
• The higher these risks are the higher the risk premium and
required rate of return on the firm’s securities.