Investment management and portfolios, Slides of Investment Management and Portfolio Theory

Download Investment management and portfolios and more Slides Investment Management and Portfolio Theory in PDF only on Docsity! Lecture Presentation Software to accompany Investment Analysis and Portfolio Management Seventh Edition by Frank K. Reilly & Keith C. Brown 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 ? 04.1$%400.1$  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. Market forces determine this rate. 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 ? Measures of Historical Rates of Return Holding Period Return 10.1 $200 $220 Investment of Value Beginning Investment of Value Ending HPR   1.1 Measures of Historical Rates of Return Holding Period Yield HPY = HPR - 1 1.10 - 1 = 0.10 = 10% 1.2 Annual Holding Period Return –Annual HPR = HPR 1/n where n = number of years investment is held Annual Holding Period Yield –Annual HPY = Annual HPR - 1 Measures of Historical Rates of Return A Portfolio of Investments The mean historical rate of return for a portfolio of investments is measured as the weighted average of the HPYs for the individual investments in the portfolio. Computation of Holding Period Yield for a Portfolio # Begin Beginning Ending Ending Market Wtd. Stock Shares Price Mkt. Value Price Mkt. Value HPR HPY Wt. HPY A 100,000 10$ 1,000,000$ 12$ 1,200,000$ 1.20 20% 0.05 0.010 B 200,000 20$ 4,000,000$ 21$ 4,200,000$ 1.05 5% 0.20 0.010 C 500,000 30$ 15,000,000$ 33$ 16,500,000$ 1.10 10% 0.75 0.075 Total 20,000,000$ 21,900,000$ 0.095 21,900,000$ 20,000,000$ HPY = 1.095 - 1 = 0.095 = 9.5% HPR = = 1.095 Exhibit 1.1 Expected Rates of Return • Risk is uncertainty that an investment will earn its expected rate of return • Probability is the likelihood of an outcome Probability Distributions Risk-free Investment 0.00 0.20 0.40 0.60 0.80 1.00 -5% 0% 5% 10% 15% Exhibit 1.2 Probability Distributions Risky Investment with 3 Possible Returns 0.00 0.20 0.40 0.60 0.80 1.00 -30% -10% 10% 30% Exhibit 1.3 Probability Distributions Risky investment with ten possible rates of return 0.00 0.20 0.40 0.60 0.80 1.00 -40% -20% 0% 20% 40% Exhibit 1.4 Measuring the Risk of Expected Rates of Return Coefficient of variation (CV) a measure of relative variability that indicates risk per unit of return Standard Deviation of Returns Expected Rate of Returns E(R) i 1.9 Measuring the Risk of Historical Rates of Return 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 2/n n 1i i 2 HPY)(EHPY[       n E(HPY) HPY i 2 1.10 Determinants of Required Rates of Return • Time value of money • Expected rate of inflation • Risk involved Nominal Risk-Free Rate Dependent upon –Conditions in the Capital Markets –Expected Rate of Inflation Adjusting For Inflation Nominal RFR = (1+Real RFR) x (1+Expected Rate of Inflation) - 1 1.11 Facets of Fundamental Risk • Business risk • Financial risk • Liquidity risk • Exchange rate risk • Country risk 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? Exchange Rate Risk • Uncertainty of return is introduced by acquiring securities denominated in a currency different from that of the investor. • 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 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 Relationship Between Risk and Return Exhibit 1.7 Rateof Return Risk (business risk, etc., or systematic risk-beta) RFR Security Market LineLowRisk Average Risk High Risk The slope indicates the required return per unit of risk (Expected) Changes in the Required Rate of Return Due to Movements Along the SML Rate Risk (business risk, etc., or systematic risk-beta) RFR Security Market Line Expected Movements along the curve that reflect changes in the risk of the asset Exhibit 1.8 Change in Market Risk Premium Exhibit 1.10 Risk RFR Original SML New SML Rm Rm' E(R) N FR Expected Return Rm´ Rm Capital Market Conditions, Expected Inflation, and the SML Exhibit 1.11 Risk RFR Original SML New SML Rate of Return RFR' N N FR´ Expected Ret The Internet Investments Online 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