Chapter 1: An Overview of the
Investment Process
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.
Defining an Investment
• When we invest, & talk about a return
on an investment, we are concerned
with the change in wealth resulting
from this investment. This change in
wealth can be either due to cash
inflows, such as interest or dividends,
or caused by a change in the price of
the asset (positive or negative).
How Do We Measure The Rate
Of Return On An Investment ?
1. Historical rate of return
2. Expected rate of return
Measures of
Historical Rates of Return
1.1
Holding Period Return-single asset
• The period during which you own an
investment is called its holding period, and
the return for that period is the holding
period return (HPR).
• If you commit $200 to an investment at
the beginning of the year and you get
back $220 at the end of the year, what
is your return for the period?
1-Measures of
Historical Rates of Return
1.1
Holding Period Return-single asset
Things to remember about HPR
• HPR will always be zero or greater—that is,
it can never be a negative value.
• A value greater than 1.0 reflects an increase
in your wealth.
• A value less than 1.0 means that you
suffered a decline in wealth.
• An HPR of zero indicates that you lost all
your money (wealth) invested in this asset.
• Although HPR helps us express the change
in value of an investment, investors
generally evaluate returns in percentage
terms on an annual basis.
• This conversion to annual percentage
rates makes it easier to directly compare
alternative investments that have markedly
different characteristics.
STEP 1
• Measure HROR of individual investment
over holding period
Measures of
Historical Rates of Return
1.2
Holding Period Yield
HPY = HPR - 1
1.10 - 1 = 0.10 = 10%
Measures of
Historical Rates of Return
Annual Holding Period Return
–Annual HPR = HPR 1/n
where n = number of years investment is held
Annual Holding Period Yield
–Annual HPY = Annual HPR - 1
Example 1 from Book
• Consider an investment that cost $250 and
is worth $350 after being held for two years.
calculate annual HPY.
Remember one final
point
• The ending value of the investment can be the
result of
1. a positive or negative change in price for the
investment alone (for example, a stock going from
$20 a share to $22 a share),
2. income from the investment alone,
3. or a combination of price change and income.
• Ending value includes the value of everything
related to the investment.
STEP 2
• Measure average HROR of individual
investment over number of time periods
• WHY??
• Cause 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,
• Single Investment:
[Link] mean return,
[Link] mean return.
Measures of
Historical Rates of Return
1.4
Arithmetic Mean
Measures of
Historical Rates of Return
1.5
Geometric Mean
Points to remember
• When rates of return are the same for all years,
the GM will be equal to the AM.
• If the rates of return vary over the years, the
GM will always be lower than the AM.
• AM is best used as an expected value for an
individual year in the future. It is biased upwards
if we attempt long term performance
measurement.
• GM is the best measure of long-term performance
since it measures the compound annual rate of
return for the asset being measured.
example
Step 3
• Measure average ROR for a portfolio of
investment
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.
Computation of Holding Exhibit 1.1
Period Yield for a Portfolio
Beginning
mkt
value/total
beginning
mkt value
Hpy*mkt wt
Expected Rates of Return
• Risk is uncertainty that an investment
will earn its expected rate of return
• Probability is the likelihood of an
outcome(0-no chance,1 100 percent
chance, subjective, historical values).
Expected Rates of Return
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
Measuring the Risk of 1.7
Expected Rates of Return
Two possible measures of risk (uncertainty)
[Link]
[Link] deviation
Measuring the Risk of 1.7
Expected Rates of Return
Measuring the Risk of 1.7
Expected Rates of Return
The larger the variance for an expected rate
of return, the greater the dispersion of
expected returns and the greater the
uncertainty, or risk, of the investment.
Variance of 0 shows no risk.
Measuring the Risk of 1.8
Expected Rates of Return
Standard Deviation is the square
root of the variance
Measuring the Risk of 1.9
Expected Rates of Return
• If conditions for two or more investment
alternatives are not similar—that is, if there
are major differences in the expected rates of
return—it is necessary to use a measure of
relative variability.
• A widely used relative measure of risk is the
coefficient of variation (CV)
Measuring the Risk of 1.9
Expected Rates of Return
Coefficient of variation (CV) a measure of
relative variability that indicates risk per unit
of return
Standard Deviation of Returns
Expected Rate of Returns
Determinants of
Required Rates of Return
• Pure time value of money(real risk free rate)
• Expected rate of inflation(nominal risk free rate)
• Risk involved (risk premium)
• The summation of these three components is
called the required rate of return.
• This is the minimum rate of return that you
should accept from an investment to compensate
you for deferring consumption.
The Real Risk Free Rate
(RRFR)
– Assumes no inflation.
– Assumes no uncertainty about future
cash flows.
– Influenced by time preference for
consumption of income (subjective)
and investment opportunities in
the economy (objective, effected by
real growth rate of economy which
has a positive relationship with
RRFR)
Nominal Risk-Free Rate
Dependent upon
• Conditions in the Capital Markets
• Expected Rate of Inflation
1.11
Adjusting For Inflation
Nominal RFR =
(1+Real RFR) x (1+Expected Rate of Inflation) - 1
1.12
Adjusting For Inflation
Real RFR =
Risk Premium
• A risk-free investment was defined as one for
which the investor is certain of the amount and
timing of the expected returns.
• Normally that’s not true.
• 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).
Facets of Fundamental
Risk
• Business risk
• Financial risk
• Liquidity risk
• Exchange rate risk
• Country risk
Business Risk
• Uncertainty of income flows caused by
the nature of a firm’s business
• Sales volatility determines the level of
business risk.
• Retail food chain Vs. Airline
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?
– Govt T Bill Vs. Real Estate in a remote area
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
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. It consists
of the day-to-day fluctuations in a stock's price
and can be mitigated only by being hedged (such
as derivatives, short selling). But it can’t be
eliminated through diversification.
Risk Premium
and Portfolio Theory
• The relevant risk measure for an
individual asset is its systematic risk.
• Beta measures this systematic risk of an
asset.
• Fundamental or unsystematic risks are
attributed to asset’s unique features and
hence not relevant as they can be
eliminated in a large, diversified portfolio.
Fundamental versus Systematic
Risk
• Fundamental risk
– Risk Premium= f (Business Risk, Financial Risk,
Liquidity Risk, Exchange Rate Risk, Country Risk)
• Systematic risk
– Risk Premium= f (Systematic Market Risk)
1-48
Relationship Between
Risk and Return
(Expected)
Changes in the Required Rate of Return
Due to Movements Along the SML
Exhibit 1.8
Changes in the Slope of the SML
1.13
RPi = E(Ri) - NRFR
where:
RPi = risk premium for asset i
E(Ri) = the expected return for asset i
NRFR = the nominal return on a risk-free asset
1.14
Market Portfolio Risk
The 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
Change in
Market Risk Premium
Exhibit 1.10
Expected Return
Rm´
Rm
NRFR
Capital Market Conditions,
Expected Inflation, and the SML
Exhibit 1.11
Expected Return
NRFR´
NRFR
• Movement along SML affects individual
investments.
• Change in slope of SML affects all risky
investments.
• A parallel shift in SML affects all
investments.