The
Investment
Setting Chapter 1
Presented by:
Diño
Garcia
Luistro
Investment - putting money into
something with the expectation of profit.
Why do individuals invest?
to earn profit
beat inflation
passive income
MEASURES OF RETURN AND RISK
Measures of Computing Calculating
Historical Rates Mean Historical Expected Rates
of Return Returns of Return
Measuring the
Risk Measures
Risk and
for Historical
Expected Rates
Return
of Return
Measures
of
Historical
Rates
of Return
What is Rate of Return?
A Rate of Return (ROR) is the gain or loss of
an investment over a certain period of time. In
other words, the rate of return is the gain (loss)
compared to the cost of an initial investment,
typically expressed in the form of percentage.
Measures of Historical Rates
of Return
Holding Period Return (HPR)
HPR=Ending Value of Investment / Beginning Value of Investment
Holding Period Yield (HPY)
HPY=HPR-1
Computing
Mean Historical
Returns
Over a number of years, a single
investment will likely give high rates of return
during some years and low rates of return, or
possibly negative rates of return, during
others. Your analysis should consider each
of these returns, but you also want a
summary figure that indicates this
investment’s typical experience, or the rate of
return you should expect to receive if you
owned this investment over an extended
period of time. You can derive such a
summary figure by computing the mean
annual rate of return for this investment over
some period of time.
Calculating
Expected
Rates
of Return
The purpose of calculating the expected return on an
investment is to provide an investor with an idea of
probable profit vs risk. This gives the investor a basis for
comparison with the risk-free rate of return.
Measuring the Risk and Expected
Rates of Return
Help us visualize the dispersion of
possible returns, most investors want
to quantify this dispersion using
statistical techniques. These
statistical measures allow you to
compare the return and risk measures
for alternative investments directly.
Risk Measures
for Historical
Return
DETERMINANTS OF
REQUIRED RATES OF RETURN
SEVERAL FACTORS THAT WE NEED
TO TAKE INTO CONSIDERATION
TIME VALUE EXPECTED RISK
OF MONEY RATE OF INVOLVED
INFLATION
The analysis and estimation of the
required rate of return are
complicated by the behavior of
REQUIRED RATES OF
DETERMINANTS OF
market rates over time. First, a
wide range of rates is available for
alternative investments at anytime.
RETURN
Second, the rates of return on
specific assets change
dramatically over time. Third, the
difference between the rates
available (that is, the spread) on
different assets changes over
time.
REAL RISK- FREE
The real risk-free rate (RRFR) is
the basic interest rate, assuming
no inflation and no uncertainty
RATE
about future flows. An investor in
an inflation-free economy who
knew with certainty what cassh
flows he or she would receive at
what time would demand the
RRFR on an investment.
TWO FACTORS OF RRFR
SUBJECTIVE OBJECTIVE
[Link]
A nominal rate of
NOMINAL RISK-FREE
interest that prevail in
RATE (NRFR)
the market are
determined by real
estate of interest, such
as the expected rate of
inflation and the
monetary environment.
TWO FACTORS OF NRFR
RELATIVE EASE OR THE EXPECTED
TIGHTNESS IN THE RATE OF
CAPITAL MARKETS INFLATION
[Link]
-An investor typically is not
completely certain of the income to
RISK PREMIUM be received or when it will be
received.
-Most investors require higher rates
of return on investments if they
perceive that there is any uncertainty
about the expected rate of return.
-This increase in the required rate of
return over the NRFR is the risk
premium (RP). Although the required
risk premium represents a
composite of all uncertainty, it is
possible to consider several
fundamental sources of uncertainty
WARNER & SPENCER
THE MAJOR SOURCES OF
UNCERTAINTY ARE:
BUSINESS RISK FINANCE RISK
LIQUIDITY RISK EXCHANGE RATE RISK
COUNTRY Cont
(POLITICAL)
RISK
The return on investment,
such as shares, bond, and real
estate will be affected by
general economic conditions.
Return will also be affected by
SYSTEMIC
issues that are specific to the
AND SPECIFIC particular investment.
RISK
WARNER & SPENCER
TWO TYPES OF RISK
BUSINESS RISK FINANCE RISK
Systematic risk Specific Risk
COUNTRY (POLITICAL)
RISK
WARNER & SPENCER
TWO TYPES OF RISK
SYSTEMATIC RISK SPECIFIC RISK
The risk created by general economic conditions is known Risk that is specific to a certain company or security
as systematic or market risk because the risk stems from is variously known as specific, idiosyncratic, non-
the wider economic system. systematic, or unsystematic risk.
RELATIONSHIP BETWEEN RISK
AND RETURN
Exhibit 1.7 graphs the expected relationship
between risk and return. It shows that
investors increase their required rates of
return as perceived risk (uncertainty)
increases. The line that reflects the
combination of risk and return available on
alternative investments is referred to as the
security market line (SML).
Beginning with an initial SML, three changes
can occur. First, individual investments can
change positions on the SML because of
changes in the perceived risk of the
investments. Second, the slope of the SML
can change because of a change in the
attitudes of investors toward risk; that is,
investors can change the returns they require
per unit of risk. Third, the SML can experience EXHIBIT 1.7
a parallel shift due to a change in the RRFR or
the expected rate of inflation—that is, a
change in the NRFR.
RELATIONSHIP BETWEEN
RISK AND RETURN
MOVEMENTS ALONG THE SML
CHANGES IN THE REQUIRED RATE OF RETURN
DUE TO MOVEMENTS ALONG THE SML
Investors place alternative investments somewhere
along the SML based on their perceptions of the risk of
the investment. Obviously, if an investment’s risk
changes due to a change in one of its risk sources
(business risk, and such), it will move along the SML.
Any change in an asset that affects its fundamental
risk factors or its market risk (that is, its beta) will cause
the asset to move along the SML as shown in Exhibit
1.8.
EXHIBIT 1.8
RELATIONSHIP BETWEEN
RISK AND RETURN
CHANGES IN THE SLOPE OF THE SML
The slope of the SML indicates the return per unit of If a point on the SML is identified as the portfolio that
risk required by all investors. Assuming a straight line, it is contains all the risky assets in the market (referred to as
possible to select any point on the SML and compute a the market portfolio), it is possible to compute a market
risk premium (RP) for an asset through the equation. RP as follows:
i
RP = E(R i) – NRFR RPm = E(Rm) – NRFR
where: where:
i
RP = risk premium for asset RPm = risk premium on the market portfolio
i
E(R ) = the expected return for asset E(Rm) = the expected return on the market portfolio
NRFR = the nominal return on a risk-free asset NRFR = the nominal return on a risk-free asset
RELATIONSHIP BETWEEN RISK
AND RETURN
These differences in yields are referred to as
yield spreads, and these yield spreads change over
time. As an example, if the yield on a portfolio of
Aaa-rated bonds is 7.50 percent and the yield on a
portfolio of Baa-rated bonds is 9.00 percent, we
would say that the yield spread is 1.50 percent.
This 1.50 percent is referred to as a credit risk
premium because the Baa-rated bond is
considered to have higher credit risk—that is,
greater probability of default. This Baa–Aaa yield
spread is not constant over time. For an example of
changes in a yield spread, note the substantial EXHIBIT 1.9
changes in the yield spreads on Aaa-rated bonds
and Baa-rated bonds shown in Exhibit 1.9.
CHANGES IN THE SLOPE OF THE SML
Although the underlying risk factors for the portfolio of bonds in
the Aaa-rated bond index and the Baa-rated bond index would
probably not change dramatically over time, it is clear from the time-
series plot in Exhibit 1.9 that the difference in yields (i.e., the yield
spread) has experienced changes of more than 100 basis points (1
percent) in a short period of time. Such a significant change in the
yield spread during a period where there is no major change in the
risk characteristics of Baa bonds relative to Aaa bonds would imply a
change in the market RP. Specifically, although the risk levels of the
bonds remain relatively constant, investors have changed the yield
spreads they demand to accept this relatively constant difference in
risk.
This change in the RP implies a change in the slope of the SML.
Such a change is shown in Exhibit 1.10. The exhibit assumes an
increase in the market risk premium, which means an increase in the
slope of the market line. Such a change in the slope of the SML (the
risk premium) will affect the required rate of return for all risky
EXHIBIT 1.10
assets. Irrespective of where an investment is on the original SML, its
required rate of return will increase, although its individual risk
characteristics remain unchanged.
RELATIONSHIP BETWEEN
RISK AND RETURN
CHANGES IN CAPITAL MARKET CONDITIONS OR EXPECTED INFLATION
The graph in Exhibit 1.11 shows what happens to the
SML when there are changes in one of the following
factors: (1) expected real growth in the economy, (2)
capital market conditions, or (3) the expected rate of
inflation. For example, an increase in expected real growth,
temporary tightness in the capital market, or an increase in
the expected rate of inflation will cause the SML to
experience a parallel shift upward. The parallel shift occurs
because changes in expected real growth or in capital
market conditions or a change in the expected rate of
inflation affect all investments, no matter what their levels
of risk are.
EXHIBIT 1.11
RELATIONSHIP BETWEEN
RISK AND RETURN
CONCLUSION The relationship between risk and the required rate of
return for an investment can change in three ways:
1. A movement along the SML demonstrates a change
in the risk characteristics of a specific investment, such
as a change in its business risk, its financial risk, or its
systematic risk (its beta). This change affects only the
individual investment.
2. A change in the slope of the SML occurs in response
to a change in the attitudes of investors toward risk.
Such a change demonstrates that investors want either
higher or lower rates of return for the same risk. This is
also described as a change in the market risk premium.
A change in the market risk premium will affect all risky
investments.
3. A shift in the SML reflects a change in expected real
growth, a change in market conditions (such as ease or
tightness of money), or a change in the expected rate of
inflation. Again, such a change will affect all
investments.
THANK YOW!