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BF 320: Investment

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BF 320: Investment & Portfolio Management. ... Investment Setting . Objectives: Why do individuals invest? What is an investment? How . do we measure the rate of ... – PowerPoint PPT presentation

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Title: BF 320: Investment


1
BF 320 Investment Portfolio Management
2
Investment Setting
  • Objectives
  • Why do individuals invest? What is an investment?
  • How do we measure the rate of return on an
    investment?
  • How do investors measure risk related to
    alternative investments?
  • What macroeconomic and microeconomic factors
    contribute to changes in the required rate of
    return for investments?

3
Why Do Individuals Invest ?
  • 2 choices with your earnings
  • Save and tradeoff present consumption for a
    larger future consumption
  • Riskier option of investments

4
Required Rate Of Return
  • The pure rate of interest is the exchange rate
    between future consumption and present
    consumption. Market forces determine this rate.
  • Ex if you can exchange K5 of certain income
    today for K50 tomorrow this rate is 5/5010.
    AKA pure time value of money

5
Pure Rate of Interest
6
Required Rate Of Return
  • 2. 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.
  • Ex Investor in Zambia would expect 7
    compensation for inflation

7
Required Rate Of Return
  • 3. 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.
  • Ex A return of 2
  • Therefore from above examples an investor would
    need compensation of 1072 19

8
Defining an Investment
  • A current commitment of money (K) 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.
  • These three make up required rate of return

9
Measures of Historical Rates of Return
  • Holding Period Return

10
Measures of Historical Rates of Return
Holding Period Yield HPY HPR - 1 1.10 - 1
0.10 10
11
Measures of Historical Rates of Return
  •  

12
Measures of Historical Rates of Return
  • Arithmetic Mean

13
Measures of Historical Rates of Return
  • Geometric Mean

14
Measures of Historical Rates of Return
  •  

Year Beginning Value of Investment End Value of Investment HPR HPY
1 100 115.0 1.15 0.15
2 115 138.0 1.20 0.2
3 138 110.4 0.8 -0.2
15
Arithmetic Mean versus Geometric Mean
For A the AM is not true (25) since
investment went from 10 to 20 to 10. Therefore GM
is better measure. For B 10(1.15)(1.15)13.23
which should be 12. However 10(1.0954)(1.0954)12.
Therefore GM is better measure
Inv beg Y1 Y2 HPR HPY AM GM
A 10 20 10 Yr120/102 Yr210/200.5 Yr1 2-11 Yr2 0.5-1-0.5
B 10 8 12 Yr1 8/100.8 Yr2 12/81.5 Yr1 0.8-1-0.2 Yr21.5-10.5
16
Portfolio of Investments
  • The 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. Example to follow

17
Computation of HoldingPeriod Yield for a
Portfolio
Begin Beginning Ending Ending Market Wtd.
Stock Shares   Price   Mkt. Value   Price   Mkt. Value HPR HPY Weight HPY
A 100,000 K10 1 000 000 K12 1 200 000 1.20 20 0.05 0.010
B 200,000 K20 4 000 000 K21 4 200 000 1.05 5 0.20 0.010
C 500,000 K30 15 000 000 K33 16 500 000 1.10 10 0.75 0.075
Total K20 000 000 K21 900 000 0.095

HPR K21 900 000 1.095
HPR K20 000 000 1.095

HPY 1.095- 1 0.095

9.5
Market Weights based on Beginning Mkt Value
18
Expected Rates of Return
  • Risk is uncertainty that an investment will earn
    its expected rate of return
  • Probability is the likelihood of an outcome

19
Risk Aversion
  • The assumption that 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

20
Probability Distributions
  • Risk-free Investment

Probability
Return
21
Probability Distributions
  • Risky Investment with 3 Possible Returns

Probability
Return
22
Probability Distributions
  • Risky investment with ten possible rates of return

Probability
23
Measuring the Risk of Expected Rates of Return
24
Measuring the Risk of Expected Rates of Return
  • Standard Deviation is the square root of the
    variance

25
Measuring the Risk of Expected Rates of Return
  • Coefficient of variation (CV) a measure of
    relative variability that indicates risk per
    unit of return
  • Standard Deviation of Returns
  • Expected Rate of Returns

26
Measuring the Risk of Expected Rates of Return
Investment A Investment B
Expected Return 0.07 0.12
Standard Deviation 0.05 0.07

Coefficient of Variation 0.05/0.07 0.714 0.07/0.12 0.583
B has less risk per unit and is therefore better investment
27
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
  • Take note RRFR was earlier called pure time
    value of money as only sacrifice investor made
    was deferring use of money

28
Nominal Risk-Free Rate
  • Rate of interest stated in money terms
  • Dependent upon
  • Conditions in the Capital Markets
  • Expected Rate of Inflation

29
Adjusting For Inflation
  • Nominal RFR
  • (1Real RFR) x (1Expected Rate of Inflation)
    1
  • Ex If you require a real growth in the
    purchasing power of your investment of 8, and
    you expect the rate of inflation over the next
    year to be 3, what is the lowest nominal return
    that you would be satisfied with? (10.08) x
    (10.03) - 1 0.1124

30
Systematic Risk
  • Business risk
  • Financial risk
  • Liquidity risk
  • Exchange rate risk
  • Country risk

31
Systematic Risk
  • 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.
  • Financial Risk
  • Uncertainty caused by the use of debt financing.
  • AKA leveraging risk
  • 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.
  • Q Does a company utilizing only common stock to
    finance their investments suffer financial risk?

32
Systematic Risk
  • 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?
  • 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.

33
Systematic Risk
  • 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
  • f (Business Risk, Financial Risk, Liquidity Risk,
    Exchange Rate Risk, Country Risk)

34
Systematic Risk
  • The relevant risk measure for an individual asset
    is its co-movement 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

35
Security Market Lines
36
Changes in the Required Rate of Return Due to
Movements Along the SML
37
Change in Market Risk Premium
Expected Return
Rm
Rm
NRFR
38
Capital Market Conditions, Expected Inflation,
and the SML
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