Essentials of Investment Analysis and Portfolio Management by Frank K. Reilly

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Essentials of Investment Analysis and
Portfolio Managementby Frank K. Reilly Keith
C. Brown
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• Chapter 1
• The Investment Setting

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Why Do Individuals Invest ?

• By saving money (instead of spending it),
  individuals tradeoff present consumption for a
  larger future consumption.
• (consumption choice)

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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.

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How Do We Measure the Rate Of Return On An
Investment ?

• Peoples 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.

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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.

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• 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 a
  risk premium to cover the investment risk.

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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.

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• A central question in investments
• How investors select investments that will give
  them their required rate of return.

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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 portfolio

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Measures of Historical Rates of Return

• Holding Period Return

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Holding Period Yield HPY HPR - 1 Prior
example 1.10 - 1 0.10 10
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• Annual Holding Period Return
• Annual HPR HPR 1/n
• n number of years the investment is held
• Annual Holding Period Yield
• Annual HPY Annual HPR - 1

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• For instance (page 7)
• A two-year HPR350/2501.4
• Annual HPR1.4 (1/2) 1.1832
• Annual HPY1.1832-118.32 (Annual HPY is thus
  assumed constant for each year)

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• However, if the prior example is for a time
  period of 6 months, what is the annual HPR?

(Try it out!)
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Computing mean historical returns

• Arithmetic Mean (AM) for an investment over a
  number of time periods

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• Geometric Mean (GM)

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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.

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

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Computation example of HPY for a portfolio
Exhibit 1.1
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Expected Rates of Return

• Risk uncertainty that an investment will earn
  its expected rate of return (historical
  returnrealized return)
• Point estimate He/she expects to earns 10 over
  a year.

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Computing expected return
See the detailed computation shown on page 12.
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Probability Distributions

• Risk-free Investment (perfect certainty)

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Probability Distributions

• Risky investment with 3 possible rates of returns

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Probability Distributions

• Risky investment with 10 possible rates of return

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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.
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Measuring the risk of expected rates of return
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Measuring the risk of expected rates of return

• Standard deviation is the square root of the
  variance

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Measuring the risk of expected rates of return

• Coefficient of variation (CV) a measure of
  relative variability that indicates risk per unit
  of return.

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Measuring the risk of historical rates of return
1.10
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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
• Cross-section
• Time series
• Yield spread

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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)

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Factors for nominal risk-free rate (NRFR)
1Nominal RFR (1Real RFR)(1Rate of Inflation)
Real RFR
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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

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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.

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The major sources of uncertainty (fundamental
risk)

• Business risk
• Financial risk
• Liquidity risk
• Exchange rate risk
• Country risk

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Business Risk

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

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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
  stocks risk premium.

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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.

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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.

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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.

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Risk Premium

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

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• 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

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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!)