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Summary
The Investment Setting
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 ?
What factors contribute to the rate of
return that an investor requires on an
investment?
What macroeconomic and microeconomic
factors contribute to changes in the
required rate of return for an investment?
Why Do Individuals Invest ?
By saving money (instead of
spending it), individuals forego
consumption today in return
for a larger consumption
tomorrow.
How Do We Measure The Rate Of
Return On An Investment ?
The real rate of interest is the
exchange rate between future
consumption (future dollars) and
present consumption (current
dollars). Market forces determine
this rate.
How Do We Measure The Rate Of
Return On An Investment ?
If the purchasing power of the future
payment will be diminished in value
due to inflation, an investor will
demand an inflation premium to
compensate them for the expected
loss of purchasing power.
If the future payment from the
investment is not certain, an investor
will demand a risk premium to
compensate for the investment risk.
Defining an Investment
Any investment involves a current
commitment of funds for some
period of time in order to derive
future payments that will
compensate for:
– the time the funds are committed (the
real rate of return)
– the expected rate of inflation (inflation
premium)
– uncertainty of future flow of funds (risk
premium)
Determinants of
Required Rates of Return
Three factors influence an
investor’s required rate of
return
– Real rate of return
– Expected rate of inflation during
the period
– Risk
The Real Risk Free Rate
–Assumes no inflation.
–Assumes no uncertainty about
future cash flows.
–Influenced by the time
preference for consumption of
income and investment
opportunities in the economy
Adjusting For Inflation:
Fisher Equation
1  Nominal   1  Real 1  Expected
Inflation
The nominal risk free rate of return
is dependent upon:
– Conditions in the Capital Markets
– Expected Rate of Inflation
Components of Fundamental
Risk
Five factors affect the standard
deviation of returns over time.
– Business risk:
– Financial risk
– Liquidity risk
– Exchange rate risk
– Country risk
Relationship Between
Risk and Return
RT
RELATION
RISQUE-RENDEME
RISK- EXPECTED RETURN RELATIONSHIPS
12
Options/Futures
High
Art objects
10
Coins and stamps
Real estate (commercial)
8
Stocks
Common shares
6
Expected
Return
Rendement
Real estate (residential)
Bonds
Preferred shares
4
Corporate bonds
Government bonds
2
Treasury bills
0
0
Low
2
4
6
Risk
8
10
12
High
Risk-free Rate
The Internet
Investments Online
http://www.finpipe.com http://www.ft.com
http://www.investorguide.com
http://www.fortune.co
m
http://www.aaii.com
http://www.smartmone
http://www.economist.com
y.com
http://www.online.wsj.com
http://www.worth.com
http://www.forbes.com
http://www.money.cnn.
http://www.barrons.com
com
http://fisher.osu.edu/fin/journal/jofsites.htm
Future Topics
Investment Alternatives
non-marketable financial assets
marketable financial assets
money market and capital market
preferred stock, income trusts, and
common stock.
Derivatives