C01 Reilly1ce

1
Investment Analysis and Portfolio

Management
First Canadian Edition
By Reilly, Brown, Hedges, Chang
Chapter 1
The Investment Setting
What Is An Investment
Return and Risk Measures
Determinants of Required Returns
Relationship between Risk and Return
Copyright 2010 Nelson Education Ltd.
1-2
What is an Investment?
Investment
Current commitment of $ for a period of
time in order to derive future payments
that will compensate for:
Time the funds are committed
Expected rate of inflation
Uncertainty of future flow of funds
1-3
Why Invest?
By investing (saving money now
instead of spending it), individuals can
tradeoff present consumption for a
larger future consumption.
1-4
Pure Rate of Interest

Exchange rate between future
consumption (future dollars) and present
consumption (current dollars)
Market forces determine rate
Example:
If you can exchange $100 today for $104 next year,
this rate is 4% (104/100-1).
1-5
Pure Time Value of Money

People willing to pay more for the money
borrowed and lenders desire to receive a
surplus on their savings (money invested)
1-6
The Effects of Inflation

Inflation
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.
1-7
Uncertainty: Risk by any Other Name

Uncertainty
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.
1-8
Required Rate of Return

on an Investment
Minimum rate of return investors require on
an investment, including the pure rate of
interest and all other risk premiums to
compensate the investor for taking the
investment risk
1-9
Historical Rates of Return:

What Did We Earn (Gain)?
Example I:
Your investment of $250 in Stock A is worth $350 in two
years while the investment of $100 in Stock B is worth
$120 in six months. What are the annual HPRs and the
HPYs on these two stocks?
1-10
Your Investments Rise in Value

Example I:
Stock A
Annual HPR=HPR1/n = ($350/$250)1/2 =1.1832
Annual HPY=Annual HPR-1=1.1832-1=18.32%
Stock B
Annual HPR=HPR1/n = ($112/$100)1/0.5 =1.2544
Annual HPY=Annual HPR-1=1.2544-1=25.44%
1-11
Historical Rates of Return:

What Did We Lose?
Example II:
Your investment of $350 in Stock A is worth $250 in two
years while the investment of $112 in Stock B is worth
$100 in six months. What are the annual HPRs and the
HPYs on these two stocks?
1-12
Your Investments Decline in Value

Example II:
Stock A
Annual HPR=HPR1/n = ($250/$350)1/2 =.84515
Annual HPY=Annual HPR-1=.84514 - 1=-15.48%
Stock B
Annual HPR=HPR1/n = ($100/$112)1/0.5 =.79719
Annual HPY=Annual HPR-1=.79719-1=-20.28%
1-13
Calculating Mean Historical Rates of

Return
Suppose you have a set of annual rates of
return (HPYs or HPRs) for an investment.
How do you measure the mean annual
return?
Do you use the arithmetic average? Or do
you use the geometric average?
It depends!
1-14
Arithmetic Mean Return (AM)

Arithmetic Mean Return (AM)
AM= HPY / n
where HPY=the sum of all the annual HPYs
n=number of years
1-15
Geometric Mean Return (GM)

Geometric Mean Return (GM)
GM= [ HPY]
1/n
-1
where HPR=the product of all the annual HPRs

n=number of years
1-16
Arithmetic vs. Geometric Averages

When rates of return are the same for all
years, the AM and the GM will be equal.
When rates of return are not the same for
all years, the AM will always be higher
than the GM.
While the AM is best used as an expected
value for an individual year, while the GM
is the best measure of an assets longterm performance.
1-17
Comparing Arithmetic vs. Geometric

Averages: Example
Suppose you invested $100 three years ago and it is
worth $110.40 today. What are your arithmetic and
geometric average returns?
1-18
Arithmetic Average: An Example

Year
Beg. Value
Ending
Value
HPR
HPY
$100
$115
1.15
.15
115
138
1.20
.20
138
110.40
.80
-.20
AM= HPY / n
AM=[(0.15)+(0.20)+(-0.20)] / 3 = 0.15/3=5%
1-19
Geometric Average: An Example

Year
Beg. Value
Ending
Value
HPR
HPY
$100
$115
1.15
.15
115
138
1.20
.20
138
110.40
.80
-.20
GM= [ HPY] 1/n -1

GM=[(1.15) x (1.20) x (0.80)]1/3 1
=(1.104)1/3 -1=1.03353 -1 =3.353%
1-20
Portfolio Historical Rates of Return

Portfolio HPY
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, or the overall change
in the value of the original portfolio.
The weights used in the computation are the

relative beginning market values for each
investment, which is often referred to as dollarweighted or value-weighted mean rate of return.
1-21
Expected Rates of Return

What Do We Expect to Earn?
In previous examples, we discussed realized
historical rates of return.
In reality most investors are more interested in the
expected return on a future risky investment.
1-22
Risk and Expected Return

Risk refers to the uncertainty of the future
outcomes of an investment
There are many possible returns/outcomes from
an investment due to the uncertainty
Probability is the likelihood of an outcome
The sum of the probabilities of all the possible
outcomes is equal to 1.0.
1-23
Calculating Expected Returns

n
E(R i ) (Probability of Return) (Possible Return)

i 1
[(P1 )(R 1 ) (P2 )(R 2 ) .... (Pn R n )]

n
( Pi )( Ri )
i 1
Where:
Pi = the probability of return on asset i

Ri = the return on asset i
1-24
Perfect Certainty:
The Risk Free Asset
If you invest in an asset that has an expected return 5%
then it is absolutely certain your expected return will be
5%
E(Ri) = ( 1) (.05) = .05 or 5%
1-25
Probability Distribution
Risk-Free Investment
1-26
Risky Investment with

Three Possible Outcomes
Suppose you are considering an
investment with 3 different potential
outcomes as follows:
Economic
Conditions
Probability
Expected Return
Strong Economy
15%
20%
Weak Economy
15%
-20%
Stable Economy
70%
10%
1-27
Probability Distribution
Risky Investment with 3 Possible
Returns
1-28
Calculating Expected Return on a

Risky Asset
n
E ( Ri ) ( Pi )( Ri )
i 1
E ( Ri ) [(.15)(.20) (.15)(-.20) (.70)(.10)] .07 7%

Investment in a risky asset with a probability distribution as
described above, would have an expected return of 7%.
This is 2% higher than the risk free asset.
In other words, investors get paid to take risk!
1-29
Risk and Expected Returns

Risk refers to the uncertainty of an investment;
therefore the measure of risk should reflect the
degree of the uncertainty.
Risk of expected return reflect the degree of
uncertainty that actual return will be different from
the expect return.
Common measures of risk are based on the variance
of rates of return distribution of an investment
1-30
Risk of Expected Return

The Variance Measure
Variance
n
Possible Expected 2
(Pr obability ) x (
)
Re turn
Re turn
i 1
n
Pi [ Ri E ( Ri )]2
i 1
1-31

Standard Deviation ()
square root of the variance
measures the total risk
Pi [ Ri E ( Ri )]
i 1
1-32

Coefficient of Variation (CV)
measures risk per unit of expected return
relative measure of risk
Standard Deviation of Return

Expected Rate of Return
E (R )
CV
1-33
Risk of Historical Returns

Given a series of historical returns measured by
HPY, the risk of returns can be measured using
variance and standard deviation
The formula is slightly different but the measure of
risk is essentially the same
1-34
Variance of Historical Returns
2
[
HPY
E
(
HPY)]
i
/n
i 1
Where:
2 = the variance of the series
HPY i = the holding period yield during period I
E(HPY) = the expected value of the HPY equal to the arithmetic
mean of the series (AM)
n = the number of observations
1-35
Three Determinants of
Required Rate of Return
Time value of money during the time period
Expected rate of inflation during the period
Risk involved
1-36
The Real Risk Free Rate (RRFR)

Assumes no inflation
Assumes no uncertainty about future cash flows
Influenced by time preference for consumption of
income and investment opportunities in the
economy
1-37
Nominal Risk Free Rate (NRFR)

Conditions in the capital market
Expected rate of inflation
NRFR=(1+RRFR) x (1+ Rate of Inflation) - 1
RRFR=[(1+NRFR) / (1+ Rate of Inflation)] - 1
1-38
Risk Premiums: Business Risk

Uncertainty of income flows caused by the nature
of a firms business
Sales volatility and operating leverage determine
the level of business risk.
1-39
Risk Premiums: Financial Risk

Uncertainty caused by the use of debt financing
Borrowing requires fixed payments which must be
paid ahead of payments to stockholders
Use of debt increases uncertainty of stockholder
income and causes an increase in the stocks risk
premium
1-40
Risk Premiums: Liquidity Risk

How long will it take to convert an investment
into cash?
How certain is the price that will be received?
1-41
Risk Premiums: 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.
1-42
Risk Premiums: 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.
1-43
Risk Premiums and Portfolio Theory

From a portfolio theory perspective, the relevant
risk measure for an individual asset is its comovement with the market portfolio.
Systematic risk relates the variance of the
investment to the variance of the market.
Beta measures this systematic risk of an asset.
According to the portfolio theory, the risk
premium depends on the systematic risk.
1-44
Fundamental versus Systematic Risk

Fundamental risk
Risk Premium= f (Business Risk, Financial Risk,
Liquidity Risk, Exchange Rate Risk, Country Risk)
Systematic risk
refers to the portion of an individual assets total
variance attributable to the variability of the total
market portfolio.
Risk Premium= f (Systematic Market Risk)
1-45
Risk and Return:

The Security Market Line (SML)
Shows relationship between risk and return for all
risky assets in the capital market at a given time
Investors select investments that are consistent
with their risk preferences.
ExpectedReturn
Low
Average
Risk
Risk
NRFR
High
Risk
Security
Market Line
The slope indicates the

required return per unit of risk
Risk
(business risk, etc., or systematic risk-beta)
1-46
SML: Market Conditions or Inflation

A change in RRFR or expected rate of
inflation will cause a parallel shift in the
SML
Expected Return
New SML
Original SML
NRFR'
NRFR
Risk
1-47
SML: Market Conditions or Inflation

When nominal risk-free rate increases, the SML will
shift up, implying a higher rate of return while still
having the same risk premium.
Expected Return
New SML
Original SML
NRFR'
NRFR
Risk
1-48

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1

Investment Analysis and Portfolio

Copyright 2010 Nelson Education Ltd.

Copyright 2010 Nelson Education Ltd.

Copyright 2010 Nelson Education Ltd.

Pure Rate of Interest

Copyright 2010 Nelson Education Ltd.

Pure Time Value of Money

Copyright 2010 Nelson Education Ltd.

The Effects of Inflation

Copyright 2010 Nelson Education Ltd.

Uncertainty: Risk by any Other Name

Copyright 2010 Nelson Education Ltd.

Required Rate of Return

Copyright 2010 Nelson Education Ltd.

Historical Rates of Return:

Copyright 2010 Nelson Education Ltd.

Your Investments Rise in Value

Copyright 2010 Nelson Education Ltd.

Historical Rates of Return:

Copyright 2010 Nelson Education Ltd.

Your Investments Decline in Value

Copyright 2010 Nelson Education Ltd.

Calculating Mean Historical Rates of

Arithmetic Mean Return (AM)

Copyright 2010 Nelson Education Ltd.

Geometric Mean Return (GM)

where HPR=the product of all the annual HPRs

Copyright 2010 Nelson Education Ltd.

Arithmetic vs. Geometric Averages

Comparing Arithmetic vs. Geometric

Copyright 2010 Nelson Education Ltd.

Arithmetic Average: An Example

Copyright 2010 Nelson Education Ltd.

Geometric Average: An Example

GM= [ HPY] 1/n -1

Copyright 2010 Nelson Education Ltd.

Portfolio Historical Rates of Return

The weights used in the computation are the

Copyright 2010 Nelson Education Ltd.

Expected Rates of Return

Copyright 2010 Nelson Education Ltd.

Risk and Expected Return

Copyright 2010 Nelson Education Ltd.

Calculating Expected Returns

E(R i ) (Probability of Return) (Possible Return)

[(P1 )(R 1 ) (P2 )(R 2 ) .... (Pn R n )]

Pi = the probability of return on asset i

Copyright 2010 Nelson Education Ltd.

Copyright 2010 Nelson Education Ltd.

Copyright 2010 Nelson Education Ltd.

Risky Investment with

Copyright 2010 Nelson Education Ltd.

Copyright 2010 Nelson Education Ltd.

Calculating Expected Return on a

E ( Ri ) [(.15)(.20) (.15)(-.20) (.70)(.10)] .07 7%

Copyright 2010 Nelson Education Ltd.

Risk and Expected Returns

Copyright 2010 Nelson Education Ltd.

Risk of Expected Return

Copyright 2010 Nelson Education Ltd.

Risk of Expected Return

Copyright 2010 Nelson Education Ltd.