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Investment Analysis and Portfolio Management Eighth Edition by Frank K. Reilly

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Portfolio Management Eighth Edition by Frank K. Reilly & Keith C. Brown Chapter 1 The Investment Setting Questions to be answered: Why do individuals invest ? – PowerPoint PPT presentation

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Title: Investment Analysis and Portfolio Management Eighth Edition by Frank K. Reilly


1
Investment Analysis and Portfolio
ManagementEighth Editionby Frank K. Reilly
Keith C. Brown
2
Chapter 1The Investment Setting
  • Questions to be answered
  • 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 factors contribute to the rate of return
    that an investor requires on an investment?
  • What macroeconomic and microeconomic factors
    contribute to changes in the required rate of
    return for an investment?

3
Why Do Individuals Invest ?
  • By saving money (instead of spending it),
    individuals forego consumption today in return
    for a larger consumption tomorrow.

4
How Do We Measure The Rate Of Return On An
Investment ?
  • The real rate of interest is the exchange rate
    between future consumption (future dollars) and
    present consumption (current dollars). Market
    forces determine this rate.

Tomorrow
If you are willing to exchange a certain payment
of 100 today for a certain payment of 104
tomorrow, then the pure or real rate of interest
is 4
104
Today
100
5
How Do We Measure The Rate Of Return On An
Investment ?
  • If the purchasing power of the future payment
    will be diminished in value due to inflation, an
    investor will demand an inflation premium to
    compensate them for the expected loss of
    purchasing power.
  • If the future payment from the investment is not
    certain, an investor will demand a risk premium
    to compensate for the investment risk.

6
Defining an Investment
  • Any investment involves a current commitment of
    funds for some period of time in order to derive
    future payments that will compensate for
  • the time the funds are committed (the real rate
    of return)
  • the expected rate of inflation (inflation
    premium)
  • uncertainty of future flow of funds (risk premium)

7
Measures of Historical Rates of Return
1.1
  • Holding Period Return

Where HPR Holding period return P0
Beginning value P1 Ending value
8
Measures of Historical Rates of Return
  • Annualizing the HPR

Where EAR Equivalent Annual Return HPR
Holding Period Return N Number of years
Example You bought a stock for 10 and sold it
for 18 six years later. What is your HPR EAR?
9
Calculating HPR EAR
  • Solution

Step 1
Step 2
10
Measures of Historical Rates of Return
Arithmetic Mean
Where AM Arithmetic Mean GM Geometric
Mean Ri Annual HPRs N Number of years
Geometric Mean
11
Example
  • You are reviewing an investment with the
    following price history as of December 31st each
    year.
  • Calculate
  • The HPR for the entire period
  • The annual HPRs
  • The Arithmetic mean of the annual HPRs
  • The Geometric mean of the annual HPRs

1999 2000 2001 2002 2003 2004 2005 2006
18.45 21.15 16.75 22.45 19.85 24.10 24.10 26.50
12
A Portfolio of Investments
  • The mean historical rate of return for a
    portfolio of investments is measured as the
    weighted average of the HPRs for the individual
    investments in the portfolio, or the overall
    change in the value of the original portfolio

13
Computation of HoldingPeriod Return for a
Portfolio
14
Expected Rates of Return
  • Risk is the uncertainty whether an investment
    will earn its expected rate of return
  • Probability is the likelihood of an outcome

15
Risk Aversion
  • Much of modern finance is based on the principle
    that investors are risk averse
  • Risk aversion refers to the assumption that, all
    else being equal, most investors will choose the
    least risky alternative and that they will not
    accept additional risk unless they are
    compensated in the form of higher return

16
Probability Distributions
  • Risk-free Investment

17
Probability Distributions
  • Risky Investment with 3 Possible Returns

18
Probability Distributions
  • Risky investment with ten possible rates of return

19
Measuring Risk Historical Returns
Where Variance (of the pop) HPR
Holding Period Return i E(HPR)i Expected HPR N
Number of years
The E(HPR) is equal to the arithmetic mean of
the series of returns.
20
Measuring Risk Expected Rates of Return
Where Variance Ri Return in period
i E(R) Expected Return Pi Probability of Ri
occurring
Note Because we multiply by the probability of
each return occurring, we do NOT divide by N. If
each probability is the same for all returns,
then the variance can be calculated by either
multiplying by the probability or dividing by N.
21
Measuring Risk Standard Deviation
  • Standard Deviation is the square root of the
    variance

Standard Deviation is a measure of dispersion
around the mean. The higher the standard
deviation, the greater the dispersion of returns
around the mean and the greater the risk.
22
Coefficient of Variation
1.9
  • Coefficient of variation (CV) is a measure of
    relative variability
  • CV indicates risk per unit of return, thus making
    comparisons easier among investments with large
    differences in mean returns

23
Determinants of Required Rates of Return
  • Three factors influence an investors required
    rate of return
  • Real rate of return
  • Expected rate of inflation during the period
  • Risk

24
The Real Risk Free Rate
  • Assumes no inflation.
  • Assumes no uncertainty about future cash flows.
  • Influenced by the time preference for consumption
    of income and investment opportunities in the
    economy

25
Adjusting For InflationFisher Equation
  • The nominal risk free rate of return is
    dependent upon
  • Conditions in the Capital Markets
  • Expected Rate of Inflation

26
Components of Fundamental Risk
  • Five factors affect the standard deviation of
    returns over time.
  • Business risk
  • Financial risk
  • Liquidity risk
  • Exchange rate risk
  • Country risk

27
Business Risk
  • Business risk arises due to
  • Uncertainty of income flows caused by the nature
    of a firms business
  • Sales volatility and operating leverage determine
    the level of business risk.

28
Financial Risk
  • Financial risk arises due to
  • 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.

29
Liquidity Risk
  • Liquidity risk arises due to the uncertainty
    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?

30
Exchange Rate Risk
  • Exchange rate risk arises due to the uncertainty
    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.

31
Country Risk
  • Country risk (also called political risk) refers
    to 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

32
Risk Premium and Portfolio Theory
  • When an asset is held in isolation, the
    appropriate measure of risk is standard deviation
  • When an asset is held as part of a
    well-diversified portfolio, the appropriate
    measure of risk is its co-movement with the
    market portfolio, as measured by Beta
  • This is also referred to as
  • Systematic risk
  • Nondiversifiable risk
  • Systematic risk refers to the portion of an
    individual assets total variance attributable to
    the variability of the total market portfolio

33
Relationship BetweenRisk and Return
34
Changes in the Required Rate of Return Due to
Movements Along the SML
Expected Rate
Higher Risk
Lower Risk
Security Market Line
Movements along the SML reflect changes in the
market or systematic risk of the asset
Risk free Rate
Beta
35
Changes in the Slope of the SML
  • The slope of the SML indicates the return per
    unit of risk required by all investors
  • The market risk premium is the yield spread
    between the market portfolio and the risk free
    rate of return
  • This changes over time, although the underlying
    reasons are not entirely clear
  • However, a change in the market risk premium will
    affect the return required on all risky assets

36
Change in Market Risk Premium
Note that as the slope of the SML increases, so
does the market risk premium
Expected Return
New SML
Rm
Original SML
Rm
Risk Free Rate
Beta
37
Capital Market Conditions, Expected Inflation,
and the SML
The SML will shift in a parallel fashion if
inflation expectations, real growth expectations
or capital market conditions change. This will
affect the required return on all assets.
Rate of Return
New SML
Original SML
Risk free Rate
Risk
38
The InternetInvestments Online
  • http//www.finpipe.com
  • http//www.investorguide.com
  • http//www.aaii.com
  • http//www.economist.com
  • http//www.online.wsj.com
  • http//www.forbes.com
  • http//www.barrons.com
  • http//fisher.osu.edu/fin/journal/jofsites.htm
  • http//www.ft.com
  • http//www.fortune.com
  • http//www.smartmoney.com
  • http//www.worth.com
  • http//www.money.cnn.com

39
Future TopicsChapter 2
  • The asset allocation decision
  • The individual investor life cycle
  • Risk tolerance
  • Portfolio management
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