investment analysis and portfolio management
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Investment Analysis and Portfolio Management. Chapter 1. Chapter 1 The Investment Setting. Questions to be answered: Why do individuals invest ? What is an investment ? How do we measure the rate of return on an investment ? - PowerPoint PPT PresentationTRANSCRIPT
Chapter 1
Chapter 1The Investment SettingQuestions to be answered:Why do individuals invest ?What is an investment ?How do we measure the rate of return on
an investment ?How do investors measure risk related to
alternative investments ?
Chapter 1The Investment SettingWhat factors contribute to the rates of
return that investors require on alternative investments ?
What macroeconomic and microeconomic factors contribute to changes in the required rate of return for individual investments and investments in general ?
Why Do Individuals Invest ?By saving money (instead of spending it), individuals tradeoff present consumption for a future larger consumption.
Why Do Individuals Invest ?Which would you rather have:
$1 todayor $2 tomorrow ?
What Is An Investment ?Is hiding money in a mattress or keeping it in a piggy bank an investment ?
What Is An Investment ?Is hiding money in a mattress or keeping it in a piggy bank an investment ?
No. It does not increase
over time.
What Is An Investment ?How about baseball cards or Beanie Babies ? Are they an investment?
What Is An Investment ?How about baseball cards or Beanie Babies ? Are they an investment?
Maybe so, but there are no
guarantees of increases.
? ? ?
What Is An Investment ?Grandpa may be pleased that you are putting your money in CDs…
What Is An Investment ?Grandpa may be pleased that you are putting your money in CDs…... instead of spending it on music.
04.1$%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 and present consumption.
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.
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.
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.
Defining an InvestmentA current commitment of $ for a period of time to derive future payments that will compensate for:the time the funds are committedthe expected rate of inflationuncertainty of future payments.
These are the required rate of return.
How Do Investors Measure Risk and Return for Alternative Investments ?
Historical rates of returnAverage rates over timeAverage rate of a portfolioVariance and standard deviation
Expected rates of returnMeasures of uncertainty
Measures of Historical Rates of Return
Holding Period Return
10.1 $200$220
Investment of Value BeginningInvestment of Value EndingHPR
1.1
Measures of Historical Rates of Return
Holding Period YieldHPY = HPR - 11.10 - 1 = 0.10 = 10%
1.2
Measures of Historical Rates of Return
Annual Holding Period ReturnAnnual HPR = HPR 1/n
where n = number of years investment is held
Annual Holding Period YieldAnnual HPY = Annual HPR - 1
1.3
Measures of Historical Rates of Return
Arithmetic Mean1.4
yields period holding annual of sum the HPY
:whereHPY/AM
n
Measures of Historical Rates of Return
Geometric Mean1.5
n
n
HPRHPRHPR
:follows as returns period holding annual theofproduct the
:where1HPR GM
21
1
Measures of Historical Rates of Return
Arithmetic mean return over timeGeometric mean will be lower than arithmetic
mean if returns vary over time
YR
Begin End HPR HPY
1 50 100 2.00 1.002 100 50 0.50 -0.50
Arithmetic mean = 0.25Geometric mean = 0.00
Portfolio of InvestmentsWeighted average of HPYs for the individual investments in the portfolio is the mean historical rate of return (HPY) for a portfolio
Computation of HoldingPeriod Yield for a Portfolio
# Begin Beginning Ending Ending Market Wtd.Stock Shares Price Mkt. Value Price Mkt. Value HPR HPY Wt. HPY
A 100,000 10$ 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$ 20,000,000$
HPY = 1.095 - 1 = 0.095
= 9.5%
HPR = = 1.095
Table 1.1
Expected Rates of ReturnRisk is uncertainty of returnPoint estimates are most likely expected return
Range of possible returnsProbabilities of various possible returns
Risk Premiumand Fundamental RiskBusiness riskFinancial riskLiquidity riskExchange rate riskCountry risk
Business RiskUncertainty of income flows caused by the nature of a firm’s business affect income flows to an investor.
Investors demand a risk premium based on the uncertainty caused by the basic business of the firm.
Financial RiskUncertainty is introduced by the method
by which the firm finances its investments.
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 RiskUncertainty 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?Investors increase their required rate of
return to compensate for liquidity risk.
Exchange Rate RiskUncertainty of return is introduced by acquiring securities denominated in a currency different from your own.
Changes in exchange rates affect the investors return when converting an investment back into the “home” currency.
Country RiskPolitical 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
Total RiskRisk Premium is a function of
Business Risk, Financial RiskLiquidity RiskExchange Rate RiskCountry Risk
Measures of RiskVariance of rates of returnStandard deviation of rates of return
Coefficient of variation of rates of return (standard deviation/means)
Covariation of returns with the market portfolio (beta)
Sources of RiskBusiness RiskFinancial RiskLiquidity RiskExchange Rate RiskCountry Risk
Relationship BetweenRisk and Return Figure 1.4
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)
Market Portfolio RiskThe market risk premium for the market portfolio (contains all the risky assets in the market) can be computed:
RPm = E(Rm)- NRFR where:RPm = risk premium on the market portfolio
E(Rm) = expected return on the market portfolio
NRFR = expected return on a risk-free asset
1.14