Measures of Historical Rates of Return: Lesson 1: The Investment Setting What Is Investment?

LESSON 1: THE INVESTMENT SETTING
What is Investment?
Investment – the current commitment of funds for a period of time in order to derive future
payments that will compensate the investor for;
(1) the time the funds are committed
(2) the expected rate on inflation during this time period
(3) the uncertainty of the future payments
MEASURES OF RETURN AND RISK
1. Measures of Historical Rates of Return
 When you are evaluating alternative investments for inclusion in your portfolio, you
will often be comparing investments with widely different prices or lives.
 To properly evaluate investments, you must accurately compare their historical rates
of returns.
 When we talk about a return on an investment, we are concerned with the change in
wealth resulting from this investment.
Holding Period – the period during which you own an investment.

Holding Period Return (HPR) – the rate of return for the period during you own an
investment.
HPR = Ending Value of Investment
Beginning Value of Investment
This HPR value will always be zero or greater.

Greater than 1.0 = increase in your wealth
Less than 1.0 = decline in wealth
HPR at zero = losing all the wealth invested in the asset.
Holding Period Yield (HPY) – the percentage change in value of an investment.
HPY = HPR – 1
To derive an annual HPY, you compute an annual HPR and subtract 1. Annual HPR is found
by:
Annual HPR = HPR 1/n
Where:
n = number of years the investment is held
2. Computing Mean Historical Returns
Mean Rate of Return – An average of the subperiod returns, calculated by summing the
subperiod returns and dividing by the number of subperiods.
Single Investment
Given a set of annual rates of return (HPYs) for an individual investment, there are
two summary measures of return performance. The first is the arithmetic mean return, the
second is the geometric mean return. To find the arithmetic mean (AM), the sum (Σ) of
annual HPYs is divided by the number of years (n) as follows:
AM = ΣHPY/n
Where: ΣHPY = the sum of annual holding period yields
An alternative computation, the geometric mean (GM), is the nth root of the
product of the HPRs for n years minus one.
GM = [πHPR]1/n − 1
Where:
π = the product of the annual holding period returns as follows:
(HPR1) × (HPR2) . . . (HPRn)
To illustrate these alternatives, consider an investment with the following data:
Year Beginning Value Ending Value HPR HPY

1 100.0 115.0 1.15 0.15
2 115.0 138.0 1.20 0.20
3 138.0 110.4 0.80 −0.20
AM = [(0.15) + (0:20) + (− 0.20)]_= 3

= 0.15/3
= 0.05 = 5%
GM = [(1.15) x (1.20) x (0.80)]1/3 – 1

= (1.104)1/3 − 1
= 1.03353 − 1
= 0.03353 = 3.353%
Portfolio of Investments
The mean historical rate of return (HPY) for a portfolio of investments is measured as
the weighted average of the HPYs for the individual investments in the portfolio, or the
overall percent change in value of the original portfolio.
Computation of Holding Period Yield for a Portfolio

End.
Number Beg. Beg. Market Ending Market Wieghted
Investment Market HPR HPY
of Shares Price Value Price Weight HPY
Value
A 100,000 P10 P1,000,000 P12 1,200,000 1.20 20% 0.05 0.01
B 200,000 20 4,000,000 21 4,200,000 1.05 5 0.20 0.01
C 500,000 30 15,000,000 33 16,500,000 1.10 10 0.75 0.075
Total P20,000,000 21,900,000 0.095
3. Calculating Expected Rates of Return
An investor determines how certain the expected rate of return on an investment is

by analyzing estimates of possible returns.
Risk - the uncertainty that an investment will earn its expected rate of return.
Probability distribution – a listing of all possible outcomes, or events, with a probability
(chance of occurrence) assigned to each outcome.
Expected rate of return (k) – the rate of return expected to be realized from the investment;
the mean value of the probability distribution of possible results.
k = P1k1 + P2k2 + …. + Pnkn

n
= åPiki
i=1
Economic Conditions Probability Rate of Return

Strong economy, no inflation 0.15 0.20
Weak economy, above-average inflation 0.15 -0.20
No major change in economy 0.70 0.10
Probability Distribution for Risky Investment with Three Possible Rates of Return
4. Measuring the Risk of Expected Rates of Return
Variance - measures the variability (volatility) from an average or mean.
Standard deviation - the square root of the variance.
Coefficient of Variation - Standardized measure of the risk per unit of return; calculated as
the standard deviation divided by the expected return.
5. Risk Measures for Historical Returns
• Given a series of historical returns measured by HPY, the risk of returns can be
measured using variance and standard deviation
• The formula is slightly different but the measure of risk is essentially the same
Variance of Historical Returns

n 
 2  å [ HPYi  E( HPY)]2  / n
 i1 
Where:
σ2 = the variance of the series
HPY i = the holding period yield during period I
E(HPY) = the expected value of the HPY equal to the arithmetic mean of the series (AM)
n = the number of observations
Determinants of Required Rates of Return

 Time value of money during the time period
 Expected rate of inflation during the period
 Risk involved
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
Nominal Risk Free Rate (NRFR)

– Conditions in the capital market
– Expected rate of inflation
NRFR=(1+RRFR) x (1+ Rate of Inflation) - 1
RRFR=[(1+NRFR) / (1+ Rate of Inflation)] - 1
Risk Premiums
Business Risk
– Uncertainty of income flows caused by the nature of a firm’s business
– Sales volatility and operating leverage determine the level of business risk.
Financial Risk
– Uncertainty caused by the use of debt financing
– Borrowing requires fixed payments which must be paid ahead of payments to
stockholders
– Use of debt increases uncertainty of stockholder income and causes an
increase in the stock’s risk premium
Liquidity Risk
– 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.
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.
Risk Premiums and Portfolio Theory

– From a portfolio theory perspective, 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.
– According to the portfolio theory, the risk premium depends on the
systematic risk.
Fundamental versus Systematic Risk

• Fundamental risk
– Risk Premium= f (Business Risk, Financial Risk, Liquidity Risk, Exchange Rate
Risk, Country Risk)
• Systematic risk
– refers to the portion of an individual asset’s total variance attributable to the
variability of the total market portfolio.
– Risk Premium= f (Systematic Market Risk)
Relationship Between Risk and Return

Risk and Return:
The Security Market Line (SML)
– Shows relationship between risk and return for all risky assets in the capital
market at a given time
– Investors select investments that are consistent with their risk preferences.
SML: Market Conditions or Inflation
– A change in RRFR or expected rate of inflation will cause a parallel shift in the
SML
RRFR
Risk
Original SML
– When nominal risk-free rate increases, the SML will shift up, implying a higher
rate of return while still having the same risk premium.

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LESSON 1: THE INVESTMENT SETTING

MEASURES OF RETURN AND RISK

1. Measures of Historical Rates of Return

Holding Period – the period during which you own an investment.

This HPR value will always be zero or greater.

Holding Period Yield (HPY) – the percentage change in value of an investment.

2. Computing Mean Historical Returns

Year Beginning Value Ending Value HPR HPY

AM = [(0.15) + (0:20) + (− 0.20)]_= 3

GM = [(1.15) x (1.20) x (0.80)]1/3 – 1

Computation of Holding Period Yield for a Portfolio

3. Calculating Expected Rates of Return

An investor determines how certain the expected rate of return on an investment is

k = P1k1 + P2k2 + …. + Pnkn

Economic Conditions Probability Rate of Return

4. Measuring the Risk of Expected Rates of Return

Variance - measures the variability (volatility) from an average or mean.

Standard deviation - the square root of the variance.

5. Risk Measures for Historical Returns

Variance of Historical Returns

Determinants of Required Rates of Return

Nominal Risk Free Rate (NRFR)

Risk Premiums and Portfolio Theory

Fundamental versus Systematic Risk

Relationship Between Risk and Return

SML: Market Conditions or Inflation

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