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Introduction
Overview of Financial Markets and Investment
Risk and Return
Investment Management Process
1. Setting investment Objective
2. Establishing Investment Policy
3. Selecting a portfolio strategy
4. Selecting the assets
5. Measuring and Evaluating Performance
1.Setting investment Objective Understand profiles and risk tolerant level
in order to set objective to satisfy the obligations stipulated in the policy.
i.e. pension fund, insurance company, retirement person etc.
2.Establishing Investment Policy Must be correspond with the objectives Make asset allocation decision
Investment Management Process
Investment AlternativesMajor
Categories
Financial Assets
Real Assets
Direct Investing
Indirect Investing
Real Estate
Precious Metals
Fix Assets
Mutual Funds
Hedge Funds
Non marketable Money market Capital market Derivative Securities
-Saving deposit
-CD
-Whole Life Insurance
-T-bill
-NCD
-Commercial Paper i.e. B/E and P/N
-Foreign Exchange
-Fixed Income i.e. Gov.bond, State Enterprise bond, Corporate bond, T-note, Prefer stocks, Mortgage pass-through
-Common Stock
- Options i.e.Calls/Puts
- Corporate created i.e Convertibles, Warrants
- Forward
- Futures
Investment Alternatives
The Historical Record:A First Look
McGraw Hill / Irwin
Investment Alternatives
McGraw Hill / Irwin
Average Returns: The First Lesson
Market sizes of developed stock markets
Market coverage of developed stock market
Market capitalization of emerging markets
Size of govy bond market
3. Selecting a portfolio strategy
4.Selecting the assets Picking securities to build your portfolio Efficient portfolio – provides the greatest
expected return at a given level of risk
Actives - use information and forecasting techniques to seek a better performance
Passives – diversification Structured – match the funds received from
contributions to the future liabilities
Investment Management Process
5. Measuring and Evaluating Performance
Benchmark Return vs. Risk Risk management
Investment Management Process
Risk and Return Two key observations emerge
There is a reward for bearing risk, and at least on average, that reward has been substantial.
Greater rewards are usually accompanied by greater risks.
In summary, high risk should compensated by high return
Return Components
Returns consist of two elements:– Periodic cash flows such as interest or
dividends (income return)– Price appreciation or depreciation (capital
gain or loss)
Total Return =Yield +Price Change
B
BEt
P)P(PCF
TR
B
BEt
P)P(PCF
TR
Measuring Returns
For comparing performance over time or across different securities
Total Return is a percentage relating all cash flows received during a given time period, denoted CFt +(PE - PB), to the start of period price, PB
Example: Calculating Returns Suppose you invested $1,000 in a stock at
$25 per share. After one year, the price increases to $35. For each share, you also received $2 in dividends.
Total dollar return = 48% of $1,000 = $480 At the end of the year, the value of your
$1,000 investment is $1,480.
$2+($35-$25) = 48%
$25
t E B
B
CF (P P )TR
P
$2+($35-$25) = 48%
$25
t E B
B
CF (P P )TR
P
Measuring Returns
RR CF PPt E
B
1 TR RR CF PPt E
B
1 TR
Total Return can be either positive or negative– When cumulating or compounding,
negative returns are problem
A Return Relative solves the problem because it is always positive
Measuring Returns
Example: What is Relative Return in the previous
example?
1 =1+48%=1.48RR TR 1 =1+48%=1.48RR TR
Measuring Returns
)nTR1)...(2TR1)(1TR1(0WI
To measure the level of wealth created by an investment rather than the change in wealth, need to cumulate returns over time
Cumulative Wealth Index, CWIn, over
n periods, =
Measuring Returns
Example: The Return Relatives of a particular stock
investment in two consecutive years are 1.48 and 0.95, assume CW0 is $1000, what is Cumulative Wealth Index, CWI2, over these 2 years?
C (1 )(1 ) $1000*1.48*0.95 $14062 0 1 2
WI WI TR TR
Measuring Returns
nX
X
Measures Describing a Return Series Arithmetic mean, or simply mean,
Arithmetic Versus Geometric
Arithmetic mean does not measure the compound growth rate over time– Does not capture the realized change in
wealth over multiple periods– Does capture typical return in a single
period
Geometric mean reflects compound, cumulative returns over more than one period
Defined as the n-th root of the product of n return relatives minus one or G =
Difference between Geometric mean and Arithmetic mean depends on the variability of returns, s
1)TR1)...(TR1)(TR1( n/1n21
sX1G1 222
Geometric Mean
TR IA
TRCPI
11
1
Adjusting Returns for Inflation
Returns measures are not adjusted for inflation
– Purchasing power of investment may change over time
– Consumer Price Index (CPI) is possible measure of inflation
s
X X
n 1
2 1/2
Measuring Risk
Risk is the chance that the actual outcome is different than the expected outcome
Standard Deviation measures the deviation of returns from the mean
Financial Risk– Tied to debt
financing
Liquidity Risk– Marketability with-
out sale prices
Exchange Rate Risk
Country Risk– Political stability
Risk Sources Interest Rate Risk
– Affects income return
Market Risk– Overall market
effects
Inflation Risk– Purchasing power
variability
Business Risk
Risk Types
Two general types:– Systematic (general) risk
• Pervasive, affecting all securities, cannot be avoided
• Interest rate or market or inflation risks
– Nonsystematic (specific) risk• Unique characteristics specific to issuer
Total Risk =General Risk +Specific Risk
Risk Premiums Premium is additional return earned or
expected for taking additional risk
Equity risk premium is the difference between stock and risk-free returns
Equity Risk Premium, ERP, =
1RF1
CSTR1
Risk and Return
McGraw Hill / Irwin
The Lesson
The greater the potential reward, the greater the risk.