Lecture Presentation Software to accompany

Investment Analysis and Portfolio Management

Eighth Editionby

Frank K. Reilly & Keith C. Brown

Why Do Individuals Invest ?

By saving money (instead of spending it), individuals tradeoff present consumption for a larger future consumption.

04.1$%400.1$

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

The pure rate of interest is the exchange rate between future consumption (future dollars) and present consumption (current dollars). Market forces determine this rate.

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.

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

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.

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

Defining an InvestmentA 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.

Measures of Historical Rates of Return

Arithmetic Mean1.4

yields period holding annual of sum the HPY

:whereHPY/AM

n

Measures of Historical Rates of Return

Geometric Mean1.5

n

n

HPRHPRHPR

:follows as returns period holding annual theofproduct the

:where1HPR GM

21

1

A Portfolio of Investments

The 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

Expected Rates of Return

• Risk is uncertainty that an investment will earn its expected rate of return

• Probability is the likelihood of an outcome

Expected Rates of Return

n

i 1

i

Return) (Possible Return) ofy Probabilit(

)E(R Return Expected

)R(P....))(R(P))(R[(P nn2211

))(RP(1

ii

n

i

1.6

Risk Aversion

The assumption that 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

Probability Distributions

Risk-free Investment

0.00

0.20

0.40

0.60

0.80

1.00

-5% 0% 5% 10% 15%

Exhibit 1.2

Probability Distributions

Risky Investment with 3 Possible Returns

0.00

0.20

0.40

0.60

0.80

1.00

-30% -10% 10% 30%

Exhibit 1.3

Probability Distributions

Risky investment with ten possible rates of return

0.00

0.20

0.40

0.60

0.80

1.00

-40% -20% 0% 20% 40%

Exhibit 1.4

Measuring the Risk of Expected Rates of Return

2n

1i

Return) Expected-Return (Possibley)Probabilit(

)( Variance

2iii

1

)]E(R)[RP(

n

i

1.7

Measuring the Risk of Expected Rates of ReturnStandard Deviation is the square

root of the variance

1.8

Measuring the Risk of Expected Rates of Return

Coefficient of variation (CV) a measure of relative variability that indicates risk per unit of return

Standard Deviation of ReturnsExpected Rate of Returns

E(R)i

1.9

Measuring the Risk of Historical Rates of Return

variance of the series

holding period yield during period I

expected value of the HPY that is equal to the arithmetic mean of the series

the number of observations

2/nn

1ii

2 HPY)(EHPY[

n

E(HPY)

HPY

i

2

1.10

Determinants of Required Rates of Return

• Time value of money during the period of investment

• Expected rate of inflation during the period

• Risk involved

Nominal Risk-Free Rate

The quoted rate (T-Bill)

Dependent upon– Conditions in the Capital Markets

– Expected Rate of Inflation

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

Adjusting For InflationReal RFR =

1Inflation) of Rate(1

RFR) Nominal1(

1.12

Facets of Fundamental Risk

• Business risk

• Financial risk

• Liquidity risk

• Exchange rate risk

• Country risk

Risk Premium

f (Business Risk, Financial Risk, Liquidity Risk, Exchange Rate Risk, Country Risk)

orf (Systematic Market Risk)

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.

Financial Risk• 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.

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?

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.

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 Premium and Portfolio Theory

• 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

Fundamental Risk versus Systematic Risk

• Fundamental risk comprises business risk, financial risk, liquidity risk, exchange rate risk, and country risk

• Systematic risk refers to the portion of an individual asset’s total variance attributable to the variability of the total market portfolio

Relationship BetweenRisk and Return Exhibit 1.7

Rateof Return

Risk(business risk, etc., or systematic risk-beta)

RFR

SecurityMarket LineLow

RiskAverageRisk

HighRisk

The slope indicates therequired return per unit of risk

(Expected)

Changes in the Required Rate of Return Due to Movements Along the SML

Rate

Risk(business risk, etc., or systematic risk-beta)

RFR

SecurityMarket Line

Expected

Movements along the curvethat reflect changes in therisk of the asset

Exhibit 1.8

Change in Market Risk Premium

Exhibit 1.10

Risk

RFR

Original SML

New SML

Rm

Rm'

E(R)

NRFR

Expected Return

Rm´

Rm

Capital Market Conditions, Expected Inflation, and the SML

Exhibit 1.11

Risk

RFR

Original SML

New SMLRate of Return

RFR'

NRFR

NRFR´

Expected Return

The InternetInvestments Online

http://www.finpipe.com

http://www.investorguide.com

http://www.aaii.com

http://www.economist.com

http://www.online.wsj.com

http://www.forbes.com

http://www.barrons.com

http://fisher.osu.edu/fin/journal/jofsites.htm

http://www.ft.com

http://www.fortune.com

http://www.smartmoney.com

http://www.worth.com

http://www.money.cnn.com

Future TopicsChapter 2

• The asset allocation decision

• The individual investor life cycle

• Risk tolerance

• Portfolio management