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 Beginning

Investment of Value EndingHPR

1.1

Measures of Historical Rates of Return

Holding Period Yield

HPY = HPR - 1

1.10 - 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 1.00

2 100 50 0.50 -0.50Arithmetic mean = 0.25

Geometric 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