Overview

Chapters 1 thru 6 of the text describe the background against which individual investors (like you and me) and institutional investors (Citigroup, Merrill Lynch etc.) invest. These chapters are mostly descriptive and not intensively analytical.

Chapter 1: The Investment Setting

What is investment? The basic issue: There is a mismatch between investors income and consumption. If Current income > Current consumption, there are a few $$ left over as savings. Investments provide a way of converting these current savings $$ into future $$ used for future consumption Determinants of the required rate of return Example: Lets say you have $100 of savings today. You can consume only pizzas which sell for $20 per pizza i.e. you can choose to blow your savings on 5 pizzas today Or, if youre like me, you can choose to postpone pizza consumption till tomorrow. You can do this by lending your $100 to Joe until tomorrow.
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 You think, Hmmm..I am parting with money today and waiting for it until tomorrow. I better get back enough money from Joe to buy me not 5, but 5.50 pizzas tomorrow. i.e. 5.50 $20 = $110. You have eectively traded 5 pizzas today (current consumption) for 5.50 pizzas tomorrow (future consumption). This rate of exchange is (5.50-5.00)/5.00=10 % is your pizza rate of return. The text refers to this as the pure rate of interest or real risk-free rate (RRFR). But you then realize...pizza prices will not stay the same. You expect pizza prices to go up by 3% to $20.60 each. This increase in prices is called ination. Ination means that the purchasing power of each dollar is going down. e.g. $110 from Joe would not buy you 5.5 pizzas as you wanted, but only $110 $20.60 = 5.34 pizzas. You obviously want to cover yourself against this expected rise in pizza prices. So you now demand from Joe money to buy you 5.50 pizzas tomorrow at the increased prices i.e. 5.50 $20.60 = $113.30 Now your expected rate of return (including ination) from Joe is (113.30-100)/100 = 0.133 = 13.30%. The text refers to this rate of return as the nominal risk-free rate (NRFR) Note that: 13.30% = 113.30 100 113.30 5.50 20.60 = 1 = 1 100 100 100 = 5(1 + 0.10) 20(1 + 0.03) 1 100
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13.30% = 0.133 = (1 + 0.10)(1 + 0.03) 1 or, in generic terms, NRFR =(1+RRFR)(1 + expected rate of ination)-1 ... equation 1.11 in text this equation can be rearranged to give: RRF R = (1 + N RF R) 1 (1 + inf lation) ... equation 1.12 in text Factors inuencing the NRFR are: 1. Capital market conditions e.g. unexpected changes in scal and monetary policy 2. Expected rate of ination The Risk Premium Continuing our example, you now realize that lending to Joe may not be completely without risk. For one he may not be willing to pay you back tomorrow; secondly, he may not be able to pay you back. Strictly speaking, even if Joe is your best friend, there is a (very tiny) positive probability that Joe may die or go bankrupt without repaying you. Let us say that to compensate for this risk, you decide to lend to Joe at 16%. Then, the dierence between 16% and 13.3% i.e. 2.7% is called the risk premium. Risk premium=Expected rate of return - NRFR Fundamental factors inuencing the Risk Premium are:
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1. Business risk: Volatility of income ows of business e.g. Auto industry has more business risk compared to Retail Food industry. In bad times, people cut spending on cars much more than they cut spending on eating. 2. Financial risk: If the rm borrows money, the lenders have to be paid before the shareholders get to touch any money. So, the greater the borrowing, the greater the nancial risk to the shareholders 3. Liquidity risk: If I buy an investment today, and want to sell it and convert it into cash tomorrow, I will need a willing buyer tomorrow. If there are not enough willing buyers, then there is no liquidity in my investment. In general, liquidity risk is greater if: It takes me a longer time to convert my investment into cash There is a greater uncertainty about what price I can get for my investment 4. Exchange rate risk: lets say GE had an income in Japan of 105 million yen last year, when the exchange rate was 105 yen to a dollar. Thats $ 1 million. This year, GE had an income of 140 million yen i.e. a 33% growth in yen earnings. What if the yen weakened in the past year to 150 yen/$? In US $, GE made only 140 million yen 150 = $ 0.933 million. This is exchange rate risk. 5. Country risk: Uncertainty in political and economic conditions of a country. e.g. In 1975, without warning, the Indian government asked several American companies, including IBM and Coca-Cola to leave. The in4

come to these companies from Indian operations evaporated overnight! Thats country risk for you. In summary, Risk premium = f(Business risk, Financial risk, Liquidity risk, Exchange rate risk, Country risk) Risk Premium and Portfolio Theory We shall study portfolio theory in detail later. For now remember the following points. According to portfolio theory, the risk premium for any asset is determined only by its covariance or degree of comovement with the market portfolio. This is called the systematic risk of the asset and is measured by a quantity called beta. Example of beta: If Microsoft stock goes up 20% when the market goes up 10% and falls 20% when the market falls 10%, it has a beta of 2.0. In this example, how is the market dened? What is the relationship between beta and the risk premium? For answers to such questions, we have to wait until later chapters. According to this view, Risk premium = f(Systematic risk) Research has shown that these two views of risk are closely related.

Measures of return and risk: Formulas and Computation

Historical Data

Holding Period Return (HPR) and Holding Period Yield (HPY): If the value of your investment (a share of stock, for instance) is $ 100 at the beginning of the year and $ 115 at the end of the year, the holding period return (HPR) is calculated as: HP R = Ending value of investment Beginning value of investment 115 = = 1.15 100

Holding Period Yield (HPY) is calculated as: HPY = HPR - 1 = 1.15 -1 = 15% Annual HPR and Annual HPY: If the total holding period extends over several periods, then Annual HPR and Annual HPY are useful. The formulas are: Annual HP R = (T otal HP R)1/n Annual HP Y = Annual HP R 1 Lets consider an investment that grew in value from $100 to $200 in 3 years. The Annual HPR is calculated as follows: 200 = 2.00 T otal HP R = 100 Annual HP R = (T otal HP R)1/n = (2.00)1/3 = 1.2599
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Annual HP Y = Annual HP R1 = 1.25991 = 0.2599 = 25.99% Check: 100 (1.2599) (1.2599) (1.2599) = 200 Mean and Standard Deviation: Mean Returns or Average returns are used to measure average performance over several periods. Given a series of historical annual returns, we can calculate two kinds of mean return: Arithmetic Mean and Geometric Mean Formulas are: Arithmetic mean = Geometric mean = HP Y , and n HP R
1/n

= [(HP R1 ) (HP R2 ) (HP Rn )]1/n 1 Example: Given data on three year returns: HP R1 = 1.15, HP R2 = 1.20, HP R3 = 0.80, nd the arithmetic and geometric means Given data implies that HP Y1 = 0.15, HP Y2 = 0.20 and HP Y3 = 0.20 Arithmetic mean = 0.15 + 0.20 0.20 HP Y = = 0.05 = 5% n 3

Geometric mean = [(HP R1 ) (HP R2 ) (HP R3 )]1/3 1 = [(1.15) (1.20) (0.80)]1/3 1 = 3.353%
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 Standard Deviation is a useful measure of volatility. It is the square root of Variance. F ormulaf orV ariance : = In the above example, (0.15 0.05)2 + (0.20 0.05)2 + (0.20 0.05)2 = 3
2 2 n i=1 [HP Yi

E(HP Y )]2 n

(0.10)2 + (0.15)2 + (0.25)2 = = 0.03167 3 and the standard deviation is 0.03167 = 0.1779 = 17.79%
Future (Expected) Data

The more interesting measures are not the historical ones we just discussed but the ones that summarize investors expectations and uncertainty regarding the future prospects of their investment. It is very important to understand these forward-looking measures thoroughly. A story illustration: Imagine you invested your retirement money in a stock. Now, imagine the following dialogue between you and me. Me: Can you tell me exactly what return your stock will yield over the next year? You: How can I? Im not a fortune-teller! Me: Point taken. But do you have a rough idea regarding its prospects?
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You: Well, I reckon if the economy doesnt take o from the current slump, I might not make any money at all, but neither will I lose any. On the other hand, if the economy really takes o, with all the tax cuts and interest rate cuts, I could make as much as a third in a year. And... Me: Aaaah! Now, were in business. You are talking about likely states of the economy, and possible returns in each state. I notice you havent thought about what will happen if the economy really tanks into recession. You: As a matter of fact, I did. If you wouldnt have butted in, I would have told you that in that state, my stock could lose about half of its value. Me: Wow, that would be such disaster. Anyway, lets think about this for a second. Call the states, Boom, Unchanged and Recession. In the boom state you think you think the possible return is 33%, in the unchanged state the possible return is 0% and in the recession state, you think it is -50%. You: Whatever.. Me: Have you assigned probabilities to these likely states of nature? You: Say that again this time in plain English, please.. Me: Fine! On a scale of 0 to 1, what is the chance that each of these events will happen? You: I have been reading up a lot lately. I think the economy is going to go into overdrive by next year. Id say there is a 50% chance of that happening. On the other hand, there are still some lingering doubts, so I wouldnt put it past this economy to go into a slump. Id say a 30% chance of that happening. As for the Unchanged state....
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Me: Well, if there is a 50% chance of Boom and a 30% chance of Recession, elementary probability tells us that the only remaining state Unchanged has a 20% probability. You: OK, Sherlock, since you are so smart, why dont you tell me what this is all about? Me: Lets rst put all this information in a table, and start punching some numbers. State Probability Return Boom 0.50 0.33 Unchanged 0.20 0.00 Recession 0.30 -0.50 You: Neat! But what do we do with this? Me: Lets rst calculate your Expected return. It is simply the probability-weighted average return. The formula is:
n

Expected return =
i=1

(P robability of return)(Return)
n

=
I=1

Pi R i

You: Let me see...In this case, it would be (0.50 0.33) + (0.20 0.00) + (0.30 0.50) = 0.015 or 1.5 %, right? Me: This means that you forecast your average return over the next year at 1.5%. You: Thats all Ill make? Boy, this investment sure is a loser!
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Me: The 1.5% number is merely your best guess of what will happen tomorrow on average. By next year, you will know which state has occurred and if your guesses are worth anything, the return will correspond to that state. In any case, lets move on to variance and standard deviation, which are useful to see how widely these possible returns are spread about the average (or expected value). The formulas are:
n

V ariance, =
i=1

Pi [Ri E(Ri )]2 V ariance

Standard Deviation, = You: Boy, thats some formula!

Me: Its not as intimidating as it looks! Lets set up another table that makes this calculation super easy. (1) (2) (3) (4)=(3)-E(R) (5) = (4)2 (2) (5) State Prob. Return Deviation Sq Dev Product B 0.50 0.33 (0.33-0.015) (0.315)2 0.0496 2 U 0.20 0.00 (0.00-0.015) (0.015) 0.0000 2 R 0.30 -0.50 (-0.50-0.015) (0.515) 0.0796 Variance= 0.1292 You: This means the variance is 0.1292 and the standard deviation is 0.1292 which is, lets see...0.3595 = 35.95% by my calculator! Me: Cannot be..The square root of a number is bigger than the number itself?

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You: Of course! These are numbers smaller than 1, and the square root of such a number is always bigger then the original number! Me: OK! OK!! I goofed up there! This calculation means that based on your forecast, your return could swing about 35.95% away from the average or expected return of 1.5%, on either side. You: Man, talk about a volatile investment! Relationship between risk and return We shall come back to this section after we complete discussion of Chapter 9.

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