1. The Investment Setting
Shahadat Hosan
Faculty, MBA Program
Stamford University, Bangldesh
May 13, 2011

2. Chapter Objectives
After Studying this chapter, you would be able to answer:
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
$100
Today

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
$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 Holding Period Return for a Portfolio
This table is in the book on page 11. It is also provided in the Investment Templates spreadsheet in an interactive spreadsheet form.

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 investor’s 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 Inflation: Fisher 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 firm’s 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 stock’s 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 asset’s total variance attributable to the variability of the total market portfolio

33. Relationship Between Risk and Return
(Expected)
Rate of
Return
Beta
Risk free
Rate
Security
Market Line
(SML)
Low
Risk
Average
High
Slope of the SML indicates the
required return per unit of risk

34. Changes in the Required Rate of Return Due to Movements Along the SML
Expected
Rate
Lower Risk
Higher 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 Internet Investments Online

39. Thank You