C01 - Reilly1ce Lecture#1

1
Investment Analysis and Portfolio

Management
First Canadian Edition
By Reilly, Brown, Hedges, Chang

Chapter 1
The Investment Setting
What Is An Investment
Return and Risk Measures
Determinants of Required Returns
Relationship between Risk and Return

1-2
Copyright 2010 Nelson Education Ltd.

What is an Investment?
Investment
Current commitment of $ for a period of
time in order to derive future payments
that will compensate for:
Time the funds are committed
Expected rate of inflation
Uncertainty of future flow of funds


1-3
Why Invest?
By investing (saving money now
instead of spending it), individuals can
tradeoff present consumption for a
larger future consumption.


1-4
Pure Rate of Interest
Exchange rate between future
consumption (future dollars) and present
consumption (current dollars)
Market forces determine rate
Example:
If you can exchange $100 today for $104 next year,
this rate is 4% (104/100-1).


1-5
Pure Time Value of Money
People willing to pay more for the money
borrowed and lenders desire to receive a
surplus on their savings (money invested)


1-6
The Effects of Inflation
Inflation
If the future payment will be diminished in value
because of inflation, then the investor will
demand an interest rate higher than the pure
time value of money to also cover the expected
inflation expense.


1-7
Uncertainty: Risk by any Other Name
Uncertainty
If the future payment from the investment is not
certain, the investor will demand an interest rate
that exceeds the pure time value of money plus
the inflation rate to provide a risk premium to
cover the investment risk.


1-8
Required Rate of Return
on an Investment
Minimum rate of return investors require on
an investment, including the pure rate of
interest and all other risk premiums to
compensate the investor for taking the
investment risk


1-9
Historical Rates of Return:
What Did We Earn (Gain)?

Your investment of $250 in Stock A is worth $350 in two
years while the investment of $100 in Stock B is worth
$120 in six months. What are the annual HPRs and the
HPYs on these two stocks?

1-10
Example I:
Your Investments Rise in Value

Stock A
Annual HPR=HPR
1/n
= ($350/$250)
1/2
=1.1832
Annual HPY=Annual HPR-1=1.1832-1=18.32%
Stock B
Annual HPR=HPR
1/n
= ($112/$100)
1/0.5
=1.2544
Annual HPY=Annual HPR-1=1.2544-1=25.44%


1-11
Example I:
Historical Rates of Return:
What Did We Lose?

Your investment of $350 in Stock A is worth $250 in two
years while the investment of $112 in Stock B is worth
$100 in six months. What are the annual HPRs and the
HPYs on these two stocks?

1-12
Example II:
Your Investments Decline in Value

Stock A
Annual HPR=HPR
1/n
= ($250/$350)
1/2
=.84515
Annual HPY=Annual HPR-1=.84514 - 1=-15.48%
Stock B
Annual HPR=HPR
1/n
= ($100/$112)
1/0.5
=.79719
Annual HPY=Annual HPR-1=.79719-1=-20.28%

1-13
Example II:
Calculating Mean Historical Rates of
Return
Suppose you have a set of annual rates of
return (HPYs or HPRs) for an investment.
How do you measure the mean annual
return?

Do you use the arithmetic average? Or do
you use the geometric average?

It depends!


1-14
Arithmetic Mean Return (AM)
Arithmetic Mean Return (AM)
AM= E HPY / n
where E HPY=the sum of all the annual HPYs
n=number of years


1-15
Geometric Mean Return (GM)
Geometric Mean Return (GM)
GM= [t HPY]
1/n
-1

where t HPR=the product of all the annual HPRs
n=number of years


1-16
Arithmetic vs. Geometric Averages
When rates of return are the same for all
years, the AM and the GM will be equal.
When rates of return are not the same for
all years, the AM will always be higher
than the GM.
While the AM is best used as an expected
value for an individual year, while the GM
is the best measure of an assets long-
term performance.


1-17
Comparing Arithmetic vs. Geometric
Averages: Example

Suppose you invested $100 three years ago and it is
worth $110.40 today. What are your arithmetic and
geometric average returns?

1-18
Arithmetic Average: An Example
Year Beg. Value Ending
Value
HPR HPY
1 $100 $115 1.15 .15
2 115 138 1.20 .20
3 138 110.40 .80 -.20
AM= E HPY / n
AM=[(0.15)+(0.20)+(-0.20)] / 3 = 0.15/3=5%

1-19
Geometric Average: An Example
Year Beg. Value Ending
Value
HPR HPY
1 $100 $115 1.15 .15
2 115 138 1.20 .20
3 138 110.40 .80 -.20
GM= [t HPY]
1/n
-1
GM=[(1.15) x (1.20) x (0.80)]
1/3
1
=(1.104)
1/3
-1=1.03353 -1 =3.353%


1-20
Portfolio Historical Rates of Return
Portfolio HPY
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, or the overall
change in the value of the original portfolio.
The weights used in the computation are the
relative beginning market values for each
investment, which is often referred to as dollar-
weighted or value-weighted mean rate of return.


1-21
Expected Rates of Return
What Do We Expect to Earn?
In previous examples, we discussed realized
historical rates of return.
In reality most investors are more interested in the
expected return on a future risky investment.


1-22
Risk and Expected Return
Risk refers to the uncertainty of the future
outcomes of an investment
There are many possible returns/outcomes from
an investment due to the uncertainty
Probability is the likelihood of an outcome
The sum of the probabilities of all the possible
outcomes is equal to 1.0.


1-23
Calculating Expected Returns
=
=
n
i 1
i
Return) (Possible Return) of y Probabilit ( ) E(R

)] R (P .... ) )(R (P ) )(R [(P
n n 2 2 1 1
+ + + =
Where:
Pi = the probability of return on asset i
Ri = the return on asset i

1-24
=
=
n
i
i i
R P
1
) )( (
Perfect Certainty:
The Risk Free Asset

E(Ri) = ( 1) (.05) = .05 or 5%

1-25
If you invest in an asset that has an expected return 5%
then it is absolutely certain your expected return will be
5%

Probability Distribution
0.00
0.20
0.40
0.60
0.80
1.00
-5% 0% 5% 10% 15%

1-26
Risk-Free Investment
Risky Investment with
Three Possible Outcomes
Suppose you are considering an
investment with 3 different potential
outcomes as follows:


Economic
Conditions
Probability Expected Return
Strong Economy 15% 20%
Weak Economy 15% -20%
Stable Economy 70% 10%
1-27
Probability Distribution
0.00
0.20
0.40
0.60
0.80
1.00
-30% -10% 10% 30%

1-28
Risky Investment with 3 Possible
Returns
Calculating Expected Return on a
Risky Asset
=
=
n
i
i i
R P Ri E
1
) )( ( ) (

% 7 07 . )] 10 )(. 70 (. ) (.15)(-.20 ) [(.15)(.20 ) ( = = + + = Ri E
Investment in a risky asset with a probability distribution as
described above, would have an expected return of 7%.
This is 2% higher than the risk free asset.
In other words, investors get paid to take risk!
0.00
0.20
0.40
0.60
0.80
1.00
-30% -10% 10% 30%
1-29
Risk and Expected Returns
Risk refers to the uncertainty of an investment;
therefore the measure of risk should reflect the
degree of the uncertainty.
Risk of expected return reflect the degree of
uncertainty that actual return will be different from
the expect return.
Common measures of risk are based on the
variance of rates of return distribution of an
investment


1-30
Risk of Expected Return
The Variance Measure


=
=
=
=
n
i
i i i
n
i
R E R P
turn
Expected
turn
Possible
x obability
Variance
1
2
2
1
)] ( [
)
Re Re
( ) (Pr
1-31
Standard Deviation ()
square root of the variance
measures the total risk

=
=
n
i
i i i
R E R P
1
2
)] ( [
o

1-32
Coefficient of Variation (CV)
measures risk per unit of expected return
relative measure of risk


) ( R E
Return of Rate Expected
Return of Deviation Standard
CV
o
=
=
1-33
Risk of 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


1-34
Variance of Historical Returns
n / HPY)] ( E HPY [
2
n
1 i
i
2
(
=

=
o

Where:

2
= 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
1-35
Three Determinants of
Required Rate of Return

Time value of money during the time period
Expected rate of inflation during the period
Risk involved


1-36
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


1-37
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


1-38
Risk Premiums: 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.


1-39
Risk Premiums: 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 stocks risk
premium


1-40
Risk Premiums: Liquidity Risk
How long will it take to convert an investment
into cash?
How certain is the price that will be received?


1-41
Risk Premiums: 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.


1-42
Risk Premiums: 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.


1-43
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.


1-44
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 assets total
variance attributable to the variability of the total
market portfolio.
Risk Premium= f (Systematic Market Risk)


1-45
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.


1-46
Expected Return
Risk
(business risk, etc., or systematic risk-beta)
NRFR
Security
Market Line
Low
Risk
Average
Risk
High
Risk
The slope indicates the
required return per unit of risk
SML: Market Conditions or Inflation
A change in RRFR or expected rate of
inflation will cause a parallel shift in the
SML


Risk
NRFR
Original SML
New SML
Expected Return
NRFR'
1-47
SML: Market Conditions or Inflation
When nominal risk-free rate increases, the SML will
shift up, implying a higher rate of return while still
having the same risk premium.


Risk
NRFR
Original SML
New SML
Expected Return
NRFR'
1-48

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Investment Analysis and Portfolio

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