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Introduction
Overview of Financial
Markets and Investment
Risk and Return
Investment Management Process
1.
2.
3.
4.
5.
Setting investment Objective
Establishing Investment Policy
Selecting a portfolio strategy
Selecting the assets
Measuring and Evaluating
Performance
Investment Management Process
1.Setting investment Objective

Understand profiles and risk tolerant level
in order to set objective to satisfy the
obligations stipulated in the policy.
 i.e. pension fund, insurance company,
retirement person etc.
2.Establishing Investment Policy

Must be correspond with the objectives
 Make asset allocation decision
Investment Alternatives
Major
Categories
Financial
Assets
Direct
Investing
Real Assets
Indirect
Investing
Mutual
Funds
Non marketable
Money market
-Saving deposit
-T-bill
-CD
-NCD
-Whole Life Insurance
-Commercial Paper i.e.
B/E and P/N
-Foreign Exchange
Real
Estate
Precious
Metals
Fix
Assets
Hedge
Funds
Capital market
-Fixed Income i.e.
Gov.bond, State
Enterprise bond,
Corporate bond, T-note,
Prefer stocks, Mortgage
pass-through
-Common Stock
Derivative Securities
- Options i.e.Calls/Puts
- Corporate created i.e
Convertibles, Warrants
- Forward
- Futures
Investment Alternatives
The Historical Record:
A First Look
McGraw Hill / Irwin
Investment Alternatives
Average Returns: The First Lesson
McGraw Hill / Irwin
Market sizes of developed stock markets
Market coverage of developed stock market
Market capitalization of emerging markets
Size of govy bond market
Investment Management Process
3. Selecting a portfolio strategy

Actives - use information and forecasting
techniques to seek a better performance
 Passives – diversification
 Structured – match the funds received from
contributions to the future liabilities
4.Selecting the assets

Picking securities to build your portfolio
 Efficient portfolio – provides the greatest
expected return at a given level of risk
Investment Management Process
5. Measuring and Evaluating Performance

Benchmark
 Return vs. Risk
 Risk management
Risk and Return

Two key observations emerge
There is a reward for bearing risk, and at least on
average, that reward has been substantial.
Greater rewards are usually accompanied by
greater risks.

In summary, high risk should compensated by high
return
Return Components

Returns consist of two elements:
– Periodic cash flows such as interest or
dividends (income return)
– Price appreciation or depreciation (capital
gain or loss)

Total Return =Yield +Price Change
Measuring Returns

For comparing performance over time or
across different securities

Total Return is a percentage relating all cash
flows received during a given time period,
denoted CFt +(PE - PB), to the start of period
price, PB
CFt  (PE  PB )
TR 
PB
Measuring Returns
Example: Calculating Returns

Suppose you invested $1,000 in a stock at
$25 per share. After one year, the price
increases to $35. For each share, you also
received $2 in dividends.
CFt  (PE  PB ) $2+($35-$25)
TR 
=
 48%
PB
$25

Total dollar return = 48% of $1,000 = $480
 At the end of the year, the value of your
$1,000 investment is $1,480.
Measuring Returns

Total Return can be either positive or
negative
– When cumulating or compounding,
negative returns are problem

A Return Relative solves the problem
because it is always positive
CFt  PE
RR 
 1  TR
PB
Measuring Returns
Example:

What is Relative Return in the previous
example?
RR  1  TR =1+48%=1.48
Measuring Returns

To measure the level of wealth created by
an investment rather than the change in
wealth, need to cumulate returns over time

Cumulative Wealth Index, CWIn, over
n periods, =
WI (1  TR )(1  TR )...(1  TR )
0
1
2
n
Measuring Returns
Example:
 The Return Relatives of a particular stock
investment in two consecutive years are 1.48
and 0.95, assume CW0 is $1000, what is
Cumulative Wealth Index, CWI2, over these 2
years?
CWI  WI (1  TR )(1  TR )  $1000*1.48*0.95  $1406
2
0
1
2
Measures Describing a Return
Series

Arithmetic mean, or simply mean,
X

X
n
Arithmetic Versus Geometric

Arithmetic mean does not measure the
compound growth rate over time
– Does not capture the realized change in
wealth over multiple periods
– Does capture typical return in a single
period

Geometric mean reflects compound,
cumulative returns over more than one period
Geometric Mean

Defined as the n-th root of the product of n
return relatives minus one or G =
(1  TR1)(1  TR2 )...(1  TRn )  1
1/ n

Difference between Geometric mean and
Arithmetic mean depends on the variability of
returns, s
1  G  1  X   s
2
2
2
Adjusting Returns for Inflation

Returns measures are not adjusted for
inflation
– Purchasing power of investment may
change over time
– Consumer Price Index (CPI) is possible
measure of inflation
TRIA
1  TR


1
1  CPI
Measuring Risk

Risk is the chance that the actual outcome is
different than the expected outcome

Standard Deviation measures the deviation of
returns from the mean
   X  X
s  
 n1
2




1/ 2
Risk Sources

Financial Risk
– Tied to debt
financing
Market Risk
– Overall market
effects

Liquidity Risk
– Marketability without sale prices
Inflation Risk
– Purchasing power
variability

Exchange Rate Risk

Country Risk
– Political stability

Interest Rate Risk
– Affects income return



Business Risk
Risk Types

Two general types:
– Systematic (general) risk
• Pervasive, affecting all securities, cannot be
avoided
• Interest rate or market or inflation risks
– Nonsystematic (specific) risk
• Unique characteristics specific to issuer

Total Risk =General Risk +Specific Risk
Risk Premiums

Premium is additional return earned or
expected for taking additional risk

Equity risk premium is the difference between
stock and risk-free returns

Equity Risk Premium, ERP, =


 1  TRCS

1



1  RF


Risk and Return
McGraw Hill / Irwin
The Lesson
The greater the potential reward, the
greater the risk.