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Chapter 1 - The Investment Setting

1. This document discusses key concepts related to investment including rationale for investment, measures of return and risk, expected rates of return, and the relationship between risk and return. It defines terms like holding period return, arithmetic and geometric mean, variance, standard deviation, and required rate of return. 2. Risk and return are positively related - higher risk investments require higher expected returns. This relationship is demonstrated by the security market line. An asset's required rate of return depends on factors like the risk-free rate, risk premium, and its systematic risk relative to the market. 3. Changes in the economy, capital markets, and inflation can cause the security market line to shift, impacting required rates of return across

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59 views

Chapter 1 - The Investment Setting

1. This document discusses key concepts related to investment including rationale for investment, measures of return and risk, expected rates of return, and the relationship between risk and return. It defines terms like holding period return, arithmetic and geometric mean, variance, standard deviation, and required rate of return. 2. Risk and return are positively related - higher risk investments require higher expected returns. This relationship is demonstrated by the security market line. An asset's required rate of return depends on factors like the risk-free rate, risk premium, and its systematic risk relative to the market. 3. Changes in the economy, capital markets, and inflation can cause the security market line to shift, impacting required rates of return across

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asmi
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CHAPTER 1 - THE INVESTMENT SETTING

Rationale for Investment


Income streams and spending needs do not coincide
1. If income is greater than spending people tend to invest the surplus
2. If spending is greater than income people tend to borrow to cover the
deficit
B. People would be willing to forgo current consumption only if they can
achieve greater consumption in the future.
C. The rate of exchange between future consumption and present consumption
is the pure rate of interest. Market forces determine this rate.
D. Investment is the current commitment of funds for a period of time to obtain
a future flow of funds that will compensate the investor for the time the
funds are committed, for the expected rate of inflation, and for the
uncertainty of the future flow of funds.

II.

Measures of Return and Risk


A. Measures of Historical Rates of Return
1. Holding Period Return (HPR) - the total return from an investment,
including all sources of income, for a given period of time. A value of
1.0 indicates no gain or loss.
HPR

Ending Value of Investment (including cash flow during the holding period)
Beginning Value of Investment

2. Holding Period Yield (HPY) - the total return from an investment for a
given period of time stated as a percentage.
HPY = HPR - 1
Annual HPR = HPR1/n
where n is the number of years the investment is held

B. Computing Mean Historical Returns


1. Mean rate of return - the average of an investment's returns over time.
2. Single Investment
a. Arithmetic Mean (AM) - a measure of mean return equal to the sum
of annual returns divided by the number of years.
Arithmetic Mean = HPY/n
b. Geometric Mean (GM) - the nth root of the product of the annual
holding period returns for n years, minus one (1).
GM ={[HPR]1/n }- 1
where = the product of the annual holding period returns, i.e.,
(HPR)x(HPR2) x...(HPRn)
3. A 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.
C. Calculating Expected Rates of Return
1. Risk - the uncertainty that an investment will earn its expected rate of
return.
2. Probability the likelihood of an outcome
3. To compute the expected rate of return, the investor assigns probability
values to all possible returns. These probabilities range from zero (no
chance) to one (complete certainty).
4. Expected Return

Expected Return (Prob. of Return) x (Possible Return)


i 1
n

E(R i ) (Pi )(R i )


i 1

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.
Measuring the Risk of Expected Rates of Return
1. Variance - a measure of risk equal to the sum of the probability of return
times the squares of a return's deviation from the mean.
n

Variance (Prob.)(Possible Return - Expected Return) 2


i 1
n

2 (Pi )[R i - E(R i )]2


i 1

2. Standard Deviation () - a measure of risk equal to the square root of


variance.
3. Coefficient of variation (CV) - a measure of relative variability that
indicates risk per unit of return. It is used to compare alternative
investments whose rates of return and standard deviation vary widely.

CV

Standard Deviation of Returns


Expected Rate of Return

Determinants of Required Rates of Return


A. Rates of Return - vary over time and across investments (Exhibit 1.5).
B. The Real Risk-Free Rate (RRFR) - the basic interest rate assuming no
inflation or uncertainty.
1. Factors that influence this rate
A. Time preference for consumption of income

B. Investment opportunities in the economy.


2. This real risk-free rate is determined by the real growth rate of the
economy that is
impacted by growth rate of labor force, hours
worked, and rate of productivity
3. A positive relationship exists between the real growth rate in the economy
and the RRFR
C. The Nominal Risk-Free Rate (NRFR) incorporates inflation
1. Note the substantial variation in government T-bill rates over time
(Exhibit 1.6)
2. Factors that influence NRFR
A. Conditions in the Capital Markets - Relative ease or tightness (this is a
short-run phenomenon)
B. Expected Rate of Inflation - this is a major influence (Exhibit 1.6)
Nominal RRFR = (1 + RRFR)(1 + Expected Rate of Inflation) -1
RRFR

(1 Nominal RFR)
-1
(1 Rate of Inflation)

3. The Common Effect all factors discussed thus far affects all investments
equally irrespective of type or form.
D. Risk Premium varies from asset to asset and is responsible for differences
in rates of return between assets at a certain point in time. The major
determinants of the risk premium are:
1. 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
2. Financial risk uncertainty caused by the use of debt financing
3. Liquidity risk - the inability to buy or sell an asset quickly with little price
change.
4. Exchange rate risk - the uncertainty of returns on securities acquired in a
foreign currency.
5. Country risk - uncertainty due to the possibility of major political or
economic change in the country where an investment has been made.
E. Risk Premium and Portfolio Theory
- The relevant risk measure for an individual asset is its comovement with
the market
portfolio

F. Fundamental Risk versus Systematic Risk


- Fundamental risk comprises business risk, financial risk, liquidity risk,
exchange rate risk, and country risk, while systematic risk refers to the
portion of an individual assets total variance attributable to the variability of
the total market portfolio
G. Required Rate of Return minimum acceptable rate of return from an
investment. Determined by RRFR, NRFR, and risk premium
IV.

Relationship between Risks and Return


A. Security Market Line (Exhibit 1.7)
B. Movements along the SML - A movement along the line indicates a change
in the level of risk for a given company or asset. (Exhibit 1.8)
C. Changes in the Slope of the SML - A change in the slope of the SML
indicates a change in the attitudes of investors toward risk--i.e., a change in
the required risk premium for a given asset or asset class. (Exhibit 1.10)
Shift in the SML (Exhibit 1.8)
Can be caused by a change in any of the following:
2. expected real growth in the economy
3. capital market conditions
4. expected rate of inflation.
E. Summary of Changes in the Required Rate of Return

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