Download What Is An Investment

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