Essentials of

Investment Analysis
and
Portfolio Management
by Frank K. Reilly & Keith C. Brown
 Chapter 1
The Investment Setting

2
 Why Do Individuals Invest ?

By saving money (instead of

spending it), individuals
tradeoff present consumption
for a larger future
consumption.
(consumption choice)

3
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.
Market forces determine
this rate.
4
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 5
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. 6
If the future payment
from the investment is
not certain
(uncertainty), the
investor will demand an
interest rate that
exceeds the pure time
value of money plus the
inflation rate to provide 7
a risk premium to cover
 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. 8
• A central question in
investments:
How investors select
investments that will
give them their required
rate of return.

9
Measures of return and risk
We have to know:
• Historical rate of return for
an individual investment
over one period of time
• Average historical return
for an individual
investment over a number
of time periods
• Average return for a
10
portfolio
 Measures of
Historical Rates of Return

Holding Period Return

Ending Value of Investment
HPR =
Beginning Value of Investment
$220
for example : = 1.10
$200

11
Holding Period Yield
HPY = HPR - 1

Prior example:
1.10 - 1 = 0.10 = 10%

12
Annual Holding Period
Return
•Annual HPR = HPR 1/n

n = number of years the investment is

held

Annual Holding Period

Yield 13
For instance (page 7)
• A two-year HPR=$350/$250=1.4
• Annual HPR=1.4 (1/2) =1.1832
• Annual HPY=1.1832-1=18.32%
(Annual HPY is thus assumed
constant for each year)

14
• However, if the prior
example is for a time
period of 6 months, what
is the
(Try annual HPR?
it out!)

15
Computing mean historical
returns
Arithmetic Mean (AM) for an
investment over a number of time
∑
periods
AM =
HPY
n
where:
∑ HPY = the sum of annual
holding period yields

16
Geometric Mean (GM)

GM = [ π HPR ]
1
n −1
where:
π = the product operator
π HPR = ( HPR1 ) × ( HPR2 ) × × ( HPRn )

17
 HPY for a portfolio

The mean historical rate of

return for a portfolio is
measured as the weighted
average of the HPYs for the
individual investments.

18
• You can also consider the
mean historical rate of
return of a portfolio as the
overall change in value of
the original portfolio.

19
 Computation example of
HPY for a portfolio
Exhibit 1.1
# 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
HPR = = 1.095
$ 20,000,000

HPY = 1.095 -1 = 0.095

= 9.5%

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Expected Rates of Return

• Risk: uncertainty that an

investment will earn its
expected rate of return
(historical return=realized
return)
• Point estimate: He/she
expects to earns 10% over a
year.
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Computing expected return

Expected Return = E(Ri )

n
= ∑ (Probability of Return) × (Possible Return)
i =1

= P1 R1 + P2 R2 + ... + Pn Rn
n
= ∑ Pi Ri
i =1

See the detailed computation shown on page 12.

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 Probability Distributions
Risk-free Investment (perfect
1.00
certainty)
0.80

0.60

0.40

0.20

0.00
-5% 0% 5% 10% 15%

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 Probability Distributions

Risky investment with 3 possible rates of

returns
1.00

0.80

0.60

0.40

0.20

0.00
-30% -20% -10% 0% 10% 20% 30%

24
 Probability
Distributions
Risky investment with 10 possible rates of
return
1.00

0.80

0.60

0.40

0.20

0.00
-40% -30% -20% -10% 0% 10% 20% 30% 40% 50%

25
 Risk Aversion

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.
Compare the perfect certainty case and the risky
investment case on page 12.

26
 Measuring the risk of
expected rates of return
Variance
n
= ∑ (Probability) × (Possible Return - Expected Return) 2
i =1
n
= ∑ Pi × [ Ri − E ( Ri )]2
i =1

27
 Measuring the risk of
expected rates of return

Standard deviation is the

square root of the variance
= n

∑ i i
P [R
i =1
- E(R i )]2

28
 Measuring the risk of
expected rates of return

Coefficient of variation (CV) a

measure of relative variability
that indicates risk per unit of
return.C.V. = σ i
E(R)

29
 1.10

Measuring the risk of

historical rates of return

n
σ = ∑ [HPYi − E(HPY)] /n
2 2

i =1

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 Determinants of
required rates of return

• Time value of money

• Expected rate of
inflation
• Risk involved

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• Required rate of return: the
minimum rate of return to
compensate for deferring
consumption.
Find out the characteristics of the yield data in
Exhibit 1.5:
2. Cross-section
3. Time series
4. Yield spread

32
The components that determine the
required rate of return
The Real Risk Free Rate (RRFR)
• The basic interest rate
• Assumes no inflation
• Assumes no uncertainty about future cash
flows.
• Pure time value of money
• Influenced by time preference for
consumption of income (subjective) and
investment opportunities in the economy
(objective)

33
Factors for nominal risk-free rate
(NRFR)

1+Nominal RFR
=(1+Real RFR)(1+Rate of Inflation)

 (1 + Nominal RFR) 
Real RFR =   −1
 (1 + Rate of Inflation) 

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• Real RFR is quite stable over
time.
• Nominal RFR can be affected by
– The relative ease or tightness in the
capital markets
– Expected rate of inflation

35
 Risk Premium
• We demand a higher return on
an investment if we perceive that
its uncertainty about expected
return is higher.
• The increase in required return
over the NRFR is called risk
premium.

36
The major sources of uncertainty
(fundamental risk)
• Business risk
• Financial risk
• Liquidity risk
• Exchange rate risk
• Country risk

37
 Business Risk

• Uncertainty of income flows

• Sales or earnings volatility
leverage affects the level of
business risk.

38
Financial Risk (financial leverage)
• 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.

39
 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?
• US T-bills has almost no liquidity
risk.

40
 Exchange Rate Risk
• Uncertainty of return is
introduced by acquiring securities
denominated in a foreign
currency.
• To measure exchange rate risk:
Use absolute variability of exchange
rate relative to a composite
exchange rate.

41
 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.

42
 Risk Premium

Basically,
Risk premium= f (Business
Risk, Financial Risk, Liquidity
Risk, Exchange Rate Risk,
Country Risk)

43
Pages 22-27
•Risk premium and portfolio theory
•Fundamental risk vs systematic risk
•Relationship between risk and
return
→Will be further discussed in the
later chapters

44
 Exercises
• Do Problem 1, 5, 7, 9.
• Read Appendix of Chapter 1 (This
is extra reading. Of course you
need to read the contents of all
chapters we discuss!)

45
• 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

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