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Chapter 1 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 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 ? Why Do Individuals Invest ? By saving money (instead of spending it), individuals tradeoff present consumption for a future larger consumption. Why Do Individuals Invest ? Which would you rather have: $1 today or $2 tomorrow ? What Is An Investment ? Is hiding money in a mattress or keeping it in a piggy bank an investment ? What Is An Investment ? Is hiding money in a mattress or keeping it in a piggy bank an investment ? No. It does not increase over time. What Is An Investment ? How about baseball cards or Beanie Babies ? Are they an investment? What Is An Investment ? How about baseball cards or Beanie Babies ? Are they an investment? Maybe so, but there are no guarantees of increases. ?? ? What Is An Investment ? Grandpa may be pleased that you are putting your money in CDs… What Is An Investment ? Grandpa may be pleased that you are putting your money in CDs… ... instead of spending it on music. How Do We Measure The Rate Of Return On An Investment ? The pure rate of interest is the exchange rate between future consumption and present consumption. $1.00 4% $1.04 How Do We Measure The Rate Of Return On An Investment ? People’s willingness to pay the difference for borrowing today and their desire to receive a surplus on their savings give rise to an interest rate referred to as the pure time value of money. How Do We Measure The Rate Of Return On An Investment ? 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. How Do We Measure The Rate Of Return On An Investment ? 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. Defining an Investment A current commitment of $ for a period of time to derive future payments that will compensate for: the time the funds are committed the expected rate of inflation uncertainty of future payments. These are the required rate of return. How Do Investors Measure Risk and Return for Alternative Investments ? Historical rates of return Average rates over time Average rate of a portfolio Variance and standard deviation Expected rates of return Measures of uncertainty Measures of Historical Rates of Return Holding Period Return Ending Value of Investment HPR Beginning Value of Investment $220 1.10 $200 1.1 Measures of Historical Rates of Return Holding Period Yield HPY = HPR - 1 1.10 - 1 = 0.10 = 10% 1.2 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 1.3 Measures of Historical Rates of Return Arithmetic Mean where : AM HPY/ n HPY the sum of annual holding period yields 1.4 Measures of Historical Rates of Return 1.5 Geometric Mean GM HPR 1 n 1 where : the product of the annual holding period returns as follows : HPR 1 HPR 2 HPR n Measures of Historical Rates of Return Arithmetic mean return over time Geometric mean will be lower than arithmetic mean if returns vary over time Y Begin R End HPR HPY 1 50 100 2.00 1.00 2 100 50 0.50 -0.50 Arithmetic mean = 0.25 Geometric mean = 0.00 Portfolio of Investments Weighted average of HPYs for the individual investments in the portfolio is the mean historical rate of return (HPY) for a portfolio Computation of Holding Period Yield for a Portfolio # Stock Shares A 100,000 B 200,000 C 500,000 Total HPY = Begin Price $ 10 $ 20 $ 30 Beginning Ending Ending Market Mkt. Value Price Mkt. Value HPR HPY Wt. $ 1,000,000 $ 12 $ 1,200,000 1.20 20% 0.05 $ 4,000,000 $ 21 $ 4,200,000 1.05 5% 0.20 $ 15,000,000 $ 33 $ 16,500,000 1.10 10% 0.75 $ 20,000,000 $ 21,900,000 HPR = $ 21,900,000 $ 20,000,000 = 1.095 1.095 -1 = 0.095 = 9.5% Table 1.1 Wtd. HPY 0.010 0.010 0.075 0.095 Expected Rates of Return Risk is uncertainty of return Point estimates are most likely expected return Range of possible returns Probabilities of various possible returns Risk Premium and Fundamental Risk Business risk Financial risk Liquidity risk Exchange rate risk Country risk Business Risk Uncertainty of income flows caused by the nature of a firm’s business affect income flows to an investor. Investors demand a risk premium based on the uncertainty caused by the basic business of the firm. Financial Risk Uncertainty is introduced by the method by which the firm finances its investments. 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 stock’s risk premium. Liquidity Risk Uncertainty is introduced by the secondary market for an investment. How long will it take to convert an investment into cash? How certain is the price that will be received? Investors increase their required rate of return to compensate for liquidity risk. Exchange Rate Risk Uncertainty of return is introduced by acquiring securities denominated in a currency different from your own. 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 Total Risk Risk Premium is a function of Business Risk, Financial Risk Liquidity Risk Exchange Rate Risk Country Risk Measures of Risk Variance of rates of return Standard deviation of rates of return Coefficient of variation of rates of return (standard deviation/means) Covariation of returns with the market portfolio (beta) Sources of Risk Business Risk Financial Risk Liquidity Risk Exchange Rate Risk Country Risk Relationship Between Risk and Return Figure 1.4 Rateof Return (Expected) Low Risk RFR Average Risk High Risk Security Market Line The slope indicates the required return per unit of risk Risk (business risk, etc., or systematic risk-beta) 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