Overview of The Investment Process

Course
: Z1462 Investment Analysis

and Portfolio Management
Effective Period : February 2016
An Overview of the
Investment Process
Session 1 & 2
Acknowledgement
These slides have been adapted from:

Frank K. Reilly & Keith C. Brown. (2012). Analysis
of Investments and Management of Portfolios. 10.
Cengage Learning. ISBN: 9780538482486
Chapter 1: An Overview of the

Investment Process
Analysis of Investments &
Management of Portfolios
10TH EDITION
Reilly
& Brown
2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
What Is An Investment?
Defining Investment: A current commitment of
$ for a period of time in order to derive future
payments that will compensate for:
The time the funds are committed
The expected rate of inflation
Uncertainty of future flow of funds
Reason for Investing: 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
It is the exchange rate between future consumption
(future dollars) and present consumption (current
dollars). Market forces determine this rate.
Example: If you can exchange $100 today for $104
next year, this rate is 4% (104/100-1).
Pure Time Value of Money

The fact that people are willing to pay more for the
money borrowed and lenders desire to receive a
surplus on their savings (money invested) gives rise
to the value of time referred to as the pure time
value of money.
1-5
Other Factors Affecting Investment Value
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.
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 Pure Time
Value of Money.
1-6
The Notion of Required Rate of Return
The minimum rate of return an investor require on
an investment, including the pure rate of interest
and all other risk premiums to compensate the
investor for taking the investment risk.
Investors may expect to receive a rate of return
different from the required rate of return, which is
called expected rate of return. What would occur if
these two rates of returns are not the same?
1-7
Historical Rates of Return

Return over A Holding Period
Holding Period Return (HPR)
Ending Value of Investment
HPR
Beginning Value of Investment
Holding Period Yield (HPY)
HPY=HPR-1
Annual HPR and HPY
Annual HPR=HPR1/n
Annual HPY= Annual HPR -1=HPR1/n 1
where n=number of years of the investment
1-8

Example: Assume that you invest $200 at the beginning
of the year and get back $220 at the end of the year.
What are the HPR and the HPY for your investment?
HPR=Ending value / Beginning value

=$220/200
=1.1
HPY=HPR-1=1.1-1=0.1
=10%
1-9

Example: 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?
Stock A
Annual HPR=HPR1/n = ($350/$250)1/2 =1.1832
Annual HPY=Annual HPR-1=1.1832-1=18.32%
Stock B
Annual HPR=HPR1/n = ($120/$100)1/0.5 =1.2544
Annual HPY=Annual HPR-1=1.2544-1=25.44%
1-10

Computing Mean Historical Returns
Suppose you have a set of annual rates of return
(HPYs or HPRs) for an investment. How do you
measure the mean annual return?
Arithmetic Mean Return (AM)
AM= HPY / n
where HPY=the sum of all the annual HPYs
n=number of years
Geometric Mean Return (GM)

GM= [ HPY] 1/n -1
where HPR=the product of all the annual HPRs
n=number of years
1-11

Suppose you invested $100 three years ago and it is
worth $110.40 today. The information below shows the
annual ending values and HPR and HPY. This
example illustrates the computation of the AM and the
GM over a three-year period for an investment.
Year
1
2
3
Beginning
Ending
Value Value
100
115.0
115
138.0
138
110.4
HPR
HPY
1.15
1.20
0.80
0.15
0.20
-0.20
1-12

AM=[(0.15)+(0.20)+(-0.20)] / 3
= 0.15/3=5%
GM=[(1.15) x (1.20) x (0.80)]1/3 1
=(1.104)1/3 -1=1.03353 -1 =3.353%
Investors are typically concerned with long-term
performance when comparing alternative investments.
GM is considered a superior measure of the long-term
mean rate of return because it indicates the
compaound annual rate of return based on the ending
value of the investment versus its beginning value.
Specifically, using the prior example, if we
compounded 3.353% for 3 years, (1.03353)3 , we
would get an ending wealth value of 1.104.
1-13

Although the arithmetic average provides a good indication of
the expected rate of return for an investment during a future
individual year, it is biased upward if you are attempting to
measure an assets long-term performance. This is obvious for
a volatile security. Consider for a example, a security that
increases in price $ 50 to $ 100 during year 1 and drops back
to $50 during year 2. The annual HPYs would be :
Year
1
2
Beginning
Ending
Value Value
50
100
100
50
HPR
HPY
2.00
1.00
0.50
-0.50
1-14

This would give an AM rate of return of :
[(1.00)+(-0.50)]/2 = 0.50/2
= 0.25 = 25%
This investment brought no change in wealth and
therefore no return, yet the AM rate of the return is
computed to be 25%.
The GM rate of return would be :
(2.00 x 0.50)1/2 - 1 = (1.00) 1/2 - 1
= 1.00 - 1 = 0%
This answer of a 0% rate of return accurately
measures the fact that there was no change in wealth
from this investment over the two-year period
1-15

Comparison of AM and GM :
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.
1-16

A Portfolio of Investments
Portfolio HPY: 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, 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 valueweighted mean rate of return.
See Exhibit 1.1
1-17
Exhibit 1.1
1-18
Expected Rates of Return

In previous examples, we discussed realized
historical rates of return. In contrast, an investor
would be more interested in the expected return
on a future risky investment.
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.
1-19

Computing Expected Rate of Return
n
E(R i ) (Probability of Return) (Possible Return)

i 1
[(P1 )(R 1 ) (P2 )(R 2 ) .... (Pn R n )]

n
( Pi )( Ri )
i 1
where P i = Probability for possible return i

R i = Possible return i
1-20

For example Perfect certainty allows only one
possible return, and the probability of
receiving that return is 1.0. Few investment
provide certain returns and would be
considered risk-free investments. In the case
of perfect certainty, there is only one value for
PiRi :
E(Ri) = (1.0)(0.05) = 0.5 = 5%
Exhibit 1.2 illustrates this situation. Perfect
certainty allows only one possible returns and
would be considered risk-free investments.
1-21
Probability Distributions
Exhibit 1.2
Risk-free Investment
1-22

In an alternative scenario, suppose an investor
believed an investment could provide several
different rates of return depending on different
possible economic condition
As an example, in a strong economic
environment with high corporate profits and little
or no inflation, the investor might expect the rate
of return on common stocks duirng the next year
to reach as high as 20%.
1-23

In contrast, if theres is an economic decline with
higher-than average rate of inflation, the investor
might expect the rate of return on common stocks
during the next year to be -20%.
Finally, with no major change in economic
environment, the rate of return during the next year
would probably approach the long-run average of
10%
This set of potential outcomes can be visualized as
shown in Exhibit 1.3
This investor might estimate probabilities for each of
these economic secarios based on past experience
and current outlook as follows :
1-24

Economic Condition
Probability Rate of return
Strong Economy, no inflation

0.15
Weak Economy, above-average inflation
No major change in economy
0.70
0.20
0.15
0.10
-0.20
The computation of the expected rate of return

E(Ri) = [(0.15)(0.20)] +[(0.15)(-0.20)]+
[(0.70)(0.10)]
E(Ri) = 0.07
Obviously, the investor is less certain about the
expected return from this investment that about
the return from the prior investment with its single
possible return
1-25
Exhibit 1.3
Risky Investment with 3 Possible Returns
1-26

A third example is an investment with 10 possible
outcomes ranging from -40% to 50% with the
same probability for each rate of return.
A graph of this set of ecpectation would appear in
Exhibit 1.4
The expected rate of return computation of the
expected rate of return [E(Ri)] for this investment
would be :
E(Ri) =(0.10)(-0.40) +(0.10)(-0.30)+ (0.10)(-0.20)
+(0.10)(0.10)+(0.10)(0.0)+(0.10)(0.10)+(0.10)
(0.30)+(0.10)(0.40)+(0.10)(0.50)= 0.05
1-27
Exhibit 1.4
Risky investment with ten possible returns
1-28
Risk of Expected Return

Risk refers to the uncertainty of an investment;
therefore the measure of risk should reflect the
degree of the uncertainty.
The risk of expected return reflect the degree of
uncertainty that actual return will be different from
the expect return.
The common measures of risk are based on the
variance of rates of return distribution of an
investment
1-29

Measuring the Risk of Expected Return
The Variance Measure
Variance ( )
n
Possible Expected 2
(Pr obability ) x (
)
Re turn
Re turn
i 1
n
Pi [ Ri E ( Ri )]2
i 1
1-30

The Variance for the perfect-certainty (risk free) example
would be :
n
= Pi [Ri E (Ri)]2
i
= 1.0 (0.05-0.05)2
= 1.0 (0/0) = 0
- Note that in perfect certainty, there is no variance of return
becouse there is no deviation from expectation and,
therefore, no risk or uncertainty The variance for the
second example would be :
n Pi [Ri E (Ri)]2
2 =
=[(0.15)(0.20-0.07)2 + (0.15)(-0.20-0.07)2
+(0/07)(0/10 -0/07) 2 = 0.0141
1-31
[(0.70)(0.10)]

Standard Deviation (): It is the square root of the
variance and measures the total risk
Pi [ Ri E ( Ri )]
i 1
0.0141

1-32

Coefficient of Variation (CV): It measures the risk
per unit of expected return and is a relative
measure of risk.
Standard Deviation of Return
Expected Rate of Return
E (R )
CV
CV
0.11874
0.07000
1-33
Risk of Historical Rates of Return

This measure of relative variability and risk is used
by financial analysts to compare alternative
investments with widely different rates of return and
standard deviation of returns. As an illustration,
consider the following two investments :
1-34

Comparing absolute 5% for measure of risk,
investment B appears to be riskier because it has a
standard deviation of 7% versus 5% for investment A
In contrast, the CV figures show that investment B
has less relative variability or lower risk per unit of
epected return because it has a substantially higher
expected rate of return :
CV A= 0.05 = 0.714
0.07
CV B = 0.07 = 0.583
0.12
1-35

Given a series of historical returns measured
by HPY, the risk of returns is measured as:
[HPY
i 1
E ( HPY)] / n
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
1-36
Determinants of Required Returns

Three Components of Required Return:
The time value of money during the time period

The expected rate of inflation during the period
The risk involved
See Exhibit 1.5
Complications of Estimating Required Return

A wide range of rates is available for alternative
investments at any time.
The rates of return on specific assets change
dramatically over time.
The difference between the rates available on
different assets change over time.
1-37

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
1-38

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.
As an example, a retail food company would
typically experience stable sales and earnings
growth over time and would have how low business
risk compared to a firm in the auto or airlne industry,
where sales and earnings fluctuate substantially
over the business cycle, implying high business risk.
1-39

Financial Risk
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.
1-40

Liquidity Risk
How long will it take to convert an investment into
cash?
How certain is the price that will be received?
A US Government Treasury bill has almost no
liquidity risk becuse it can be bought or sold in
seconds at a price almost identical to the quoted
price.
In contrast, example of illiquid investments include a
work of art, an antique, or a parcel of real estate in a
remote area.
1-41

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.
A US investor who buys Japanese stock
denominated in yen must consider not only the
uncertainty of the return in yen but also any
1-42

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.
When investing globally (which is emphasized
throughout
1-43

Risk Premium 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 Risk versus Systematic Risk
Fundamental risk comprises business risk, financial
risk, liquidity risk, exchange rate risk, and country
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
Relationship Between Risk and Return

The Security Market Line (SML)
It shows the 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.
ExpectedReturn
Low
Average
Risk
Risk
NRFR
High
Risk
Security
Market Line
The slope indicates the

required return per unit of risk
Risk
(business risk, etc., or systematic risk-beta)
1-46

Movement along the SML
When the risk changes, the expected return will
also change, moving along the SML.
Risk premium: RPI = E(Ri) - NRFR
Expected
Return
SML
NRFR
Movements along the curve

that reflect changes in the
risk of the asset
Risk
(business risk, etc., or systematic risk-beta)
1-47
Exhibit 1.9
1-48

Changes in the Slope of the SML
When there is a change in the attitude of investors
toward risk, the slope of the SML will also change.
If investors become more risk averse, then the SML
will have a steeper slope, indicating a higher risk
premium, RPi, for the same risk level.
Expected Return
R
New SML
Original SML
NRFR
Risk
1-49

Changes in Market Condition or Inflation
A change in the RRFR or the expected rate of
inflation will cause a parallel shift in the 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.
Expected Return
New SML
Original SML
NRFR'
NRFR
Risk
1-50
The Internet Investments Online
http://www.finpipe.com
http://www.investorguide.com
http://www.aaii.com
http://www.economist.com
http://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://money.cnn.com
1-51
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Course

: Z1462 Investment Analysis

These slides have been adapted from:

Chapter 1: An Overview of the

Reason for Investing: By investing (saving

Pure Time Value of Money

Historical Rates of Return

Historical Rates of Return

HPR=Ending value / Beginning value

Historical Rates of Return

Historical Rates of Return

Geometric Mean Return (GM)

Historical Rates of Return

Historical Rates of Return

Historical Rates of Return

Historical Rates of Return

Historical Rates of Return

Historical Rates of Return

Expected Rates of Return

Expected Rates of Return

E(R i ) (Probability of Return) (Possible Return)

[(P1 )(R 1 ) (P2 )(R 2 ) .... (Pn R n )]

where P i = Probability for possible return i

Expected Rates of Return

Expected Rates of Return

Expected Rates of Return

Expected Rates of Return

Probability Rate of return

Strong Economy, no inflation

The computation of the expected rate of return

Expected Rates of Return

Risk of Expected Return

Risk of Expected Return

Risk of Expected Return

+(0/07)(0/10 -0/07) 2 = 0.0141

Risk of Expected Return

Risk of Expected Return

Risk of Historical Rates of Return

Risk of Historical Rates of Return

Risk of Historical Rates of Return

where, 2 = the variance of the series

Determinants of Required Returns

The time value of money during the time period

Complications of Estimating Required Return

Determinants of Required Returns

Nominal Risk-Free Rate (NRFR)

Determinants of Required Returns

Determinants of Required Returns

Determinants of Required Returns

Determinants of Required Returns

Determinants of Required Returns

Determinants of Required Returns

Determinants of Required Returns

Relationship Between Risk and Return

The slope indicates the

Relationship Between Risk and Return

Movements along the curve

Relationship Between Risk and Return

Relationship Between Risk and Return

The Internet Investments Online

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