Title: Investment Analysis and Portfolio Management Eighth Edition by Frank K. Reilly
1Investment Analysis and Portfolio
ManagementEighth Editionby Frank K. Reilly
Keith C. Brown
2Chapter 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?
3Why Do Individuals Invest ?
- By saving money (instead of spending it),
individuals forego consumption today in return
for a larger consumption tomorrow.
4How 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
5How 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.
6Defining 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)
7Measures of Historical Rates of Return
1.1
Where HPR Holding period return P0
Beginning value P1 Ending value
8Measures of Historical Rates of Return
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?
9Calculating HPR EAR
Step 1
Step 2
10Measures of Historical Rates of Return
Arithmetic Mean
Where AM Arithmetic Mean GM Geometric
Mean Ri Annual HPRs N Number of years
Geometric Mean
11Example
- 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
12A 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
13Computation of HoldingPeriod Return for a
Portfolio
14Expected Rates of Return
- Risk is the uncertainty whether an investment
will earn its expected rate of return - Probability is the likelihood of an outcome
15Risk 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
17 Probability Distributions
- Risky Investment with 3 Possible Returns
18 Probability Distributions
- Risky investment with ten possible rates of return
19Measuring 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.
20Measuring 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.
21Measuring 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.
22Coefficient 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 -
23Determinants 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
24The 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
25Adjusting For InflationFisher Equation
- The nominal risk free rate of return is
dependent upon - Conditions in the Capital Markets
- Expected Rate of Inflation
26Components of Fundamental Risk
- Five factors affect the standard deviation of
returns over time. - Business risk
- Financial risk
- Liquidity risk
- Exchange rate risk
- Country risk
27Business 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.
28Financial 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.
29Liquidity 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?
30Exchange 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.
31Country 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
32Risk 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
33Relationship BetweenRisk and Return
34Changes 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
35Changes 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
37Capital 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
38The 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
39Future TopicsChapter 2
- The asset allocation decision
- The individual investor life cycle
- Risk tolerance
- Portfolio management