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Chapter 1 The Investment Setting

Chapter 1 The Investment Setting. Questions to be answered: 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 ?. Chapter 1 The Investment Setting.

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Chapter 1 The Investment Setting

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  1. Chapter 1The Investment Setting Questions to be answered: • 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 ?

  2. Chapter 1The Investment Setting • What factors contribute to the rates of return that investors require on alternative investments ? • What macroeconomic and microeconomic factors contribute to changes in the required rate of return for individual investments and investments in general ?

  3. Defining an 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.

  4. Measures of Historical Rates of Return 1.1 Holding Period Return

  5. Measures of Historical Rates of Return 1.2 • Holding Period Yield • HPY = HPR - 1 • 1.10 - 1 = 0.10 = 10%

  6. Measures of Historical Rates of Return Annual Holding Period Return • Annual HPR = HPR 1/n where n = number of years investment is held Annual Holding Period Yield • Annual HPY = Annual HPR - 1

  7. Measures of Historical Rates of Return 1.4 Arithmetic Mean

  8. Measures of Historical Rates of Return 1.5 Geometric Mean

  9. Computation of HoldingPeriod Yield for a Portfolio Exhibit 1.1

  10. Expected Rates of Return • Risk is uncertainty that an investment will earn its expected rate of return • Probability is the likelihood of an outcome

  11. Expected Rates of Return 1.6

  12. 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

  13. Probability Distributions Exhibit 1.2 Risk-free Investment

  14. Probability Distributions Exhibit 1.3 Risky Investment with 3 Possible Returns

  15. Probability Distributions Exhibit 1.4 Risky investment with ten possible rates of return

  16. Measuring the Risk of Expected Rates of Return 1.7

  17. Measuring the Risk of Expected Rates of Return 1.8 Standard Deviation is the square root of the variance

  18. Measuring the Risk of Expected Rates of Return 1.9 Coefficient of variation (CV) a measure of relative variability that indicates risk per unit of return Standard Deviation of Returns Expected Rate of Returns

  19. Measuring the Risk of Historical Rates of Return 1.10 variance of the series holding period yield during period I expected value of the HPY that is equal to the arithmetic mean of the series the number of observations

  20. Determinants of Required Rates of Return • Time value of money • Expected rate of inflation • Risk involved

  21. 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

  22. Adjusting For Inflation 1.12 Real RFR =

  23. Nominal Risk-Free Rate Dependent upon • Conditions in the Capital Markets • Expected Rate of Inflation

  24. Adjusting For Inflation 1.11 Nominal RFR = (1+Real RFR) x (1+Expected Rate of Inflation) - 1

  25. Facets of Fundamental Risk • Business risk • Financial risk • Liquidity risk • Exchange rate risk • Country risk

  26. Risk Premium f (Business Risk, Financial Risk, Liquidity Risk, Exchange Rate Risk, Country Risk) or f (Systematic Market Risk)

  27. Risk Premium and Portfolio Theory • 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

  28. Fundamental Risk versus Systematic Risk • Fundamental risk comprises business risk, financial risk, liquidity risk, exchange rate risk, and country risk • Systematic risk refers to the portion of an individual asset’s total variance attributable to the variability of the total market portfolio

  29. (Expected) Relationship BetweenRisk and Return Exhibit 1.7

  30. Changes in the Required Rate of Return Due to Movements Along the SML Exhibit 1.8

  31. Changes in the Slope of the SML 1.13 RPi = E(Ri) - NRFR where: RPi = risk premium for asset i E(Ri) = the expected return for asset i NRFR = the nominal return on a risk-free asset

  32. Market Portfolio Risk 1.14 The market risk premium for the market portfolio (contains all the risky assets in the market) can be computed: RPm = E(Rm)- NRFR where: RPm = risk premium on the market portfolio E(Rm) = expected return on the market portfolio NRFR = expected return on a risk-free asset

  33. Change in Market Risk Premium Exhibit 1.10 Expected Return Rm´ Rm NRFR

  34. Expected Return NRFR´ NRFR Capital Market Conditions, Expected Inflation, and the SML Exhibit 1.11

  35. www.financecenter.com www.investorama.com www.moneyadvisor.com www.investorguide.com www.finweb.com www.aaii.org www.wsj.com www.cob.ohio-state.edu/dept/fin/osudata.htm www.ft.com www.fortune.com www.money.com www.forbes.com www.worth.com www.barrons.com The InternetInvestments Online

  36. Future TopicsChapter 2 • The asset allocation decision • The individual investor life cycle • Risk tolerance • Portfolio management

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