Chapter 1: The Investment Setting

What Is An Investment?
• Defining Investment: A current commitment of
$ for a period of time in order to derive future
payments that will compensate for:
– The time the funds are committed
– The expected rate of inflation
– Uncertainty of future flow of funds
• Reason for Investing: By investing (saving
money now instead of spending it), individuals
can tradeoff present consumption for a larger
future consumption.

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 What Is An Investment?

• Pure Rate of Interest

– It is the exchange rate between future consumption
(future dollars) and present consumption (current
dollars). Market forces determine this rate.
– The fact that people are willing to pay more for the
money borrowed and lenders desire to receive a
surplus on their savings (money invested) gives rise
to the value of time referred to as the pure time
value of money ( pure rate of interest).

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 What Is An Investment?

– Example: If you can exchange $100 today for $104

next year, this rate is 4% (104/100-1).

– This is the pure rate of exchange on a risk-free

investment (risk-free interest rate).

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 What Is An Investment?

• Other Factors Affecting Investment Value

– Inflation: If the future payment will be diminished in
value because of inflation, then the investor will
demand an interest rate higher than the pure rate of
interest to also cover the expected inflation expense.
– For example, if the previous investor expect an
increase in prices by 2% during the investment period,
then the pure rate of interest should increase by 2% to
cover the inflation. The new rate, 6%, is the nominal
risk-free rate of interest. So in the previous example the
investor should receive 106$ on the 100$ investment,
instead of 104$.
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 What Is An Investment?
• Uncertainty: If the future payment from the investment is
not certain, the investor will demand an interest rate that
exceeds the nominal risk-free rate to provide a risk
premium to cover the investment risk Pure Time Value of
Money. For example, our previous investor will require
110$ on the 100$ investment. The additional 4% added to
the nominal risk-free rate (6%) is the risk premium.

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 What Is An Investment?
• The Notion of Required Rate of Return
– The minimum rate of return an investor require on
an investment, including the pure rate of interest
and all other risk premiums to compensate the
investor for taking the investment risk.
– Investors may expect to receive a rate of return
different from the required rate of return, which is
called expected rate of return. What would occur if
these two rates of returns are not the same?

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 Historical Rates of Return
• Return over A Holding Period
– Holding Period Return (HPR)

= Ending Value of Investment

HPR
Beginning Value of Investment
– Holding Period Yield (HPY)
HPY=HPR-1
– Annual HPR and HPY
Annual HPR=HPR1/n
Annual HPY= Annual HPR -1=HPR1/n – 1
where n=number of years of the investment

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 Historical Rates of Return
Example: Assume that you invest $200 at the beginning
of the year and get back $220 at the end of the year.
What are the HPR and the HPY for your investment?

HPR=Ending value / Beginning value

=$220/200
=1.1
HPY=HPR-1=1.1-1=0.1
=10%
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 Historical Rates of Return
Example: Your investment of $250 in Stock A is worth
$350 in two years while the investment of $100 in
Stock B is worth $120 in six months. What are the
annual HPRs and the HPYs on these two stocks?

• Stock A
– Annual HPR=HPR1/n = ($350/$250)1/2 =1.1832
– Annual HPY=Annual HPR-1=1.1832-1=18.32%
• Stock B
– Annual HPR=HPR1/n = ($120/$100)1/0.5 =1.2544
– Annual HPY=Annual HPR-1=1.2544-1=25.44%

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 Historical Rates of Return
• Computing Mean Historical Returns for a signal
investment
Suppose you have a set of annual rates of return
(HPYs or HPRs) for an investment. How do you
measure the mean annual return?
– Arithmetic Mean Return (AM)
AM=  HPY / n
where  HPY=the sum of all the annual HPYs
n=number of years
– Geometric Mean Return (GM)
GM= [ HPR] 1/n -1
where  HPR=the product of all the annual HPRs
n=number of years
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 Historical Rates of Return
Suppose you invested $100 three years ago and it is
worth $110.40 today. The information below shows the
annual ending values and HPR and HPY. This
example illustrates the computation of the AM and the
GM over a three-year period for an investment.

Year Beginning Ending HPR HPY

Value Value
1 100 115.0 1.15 0.15
2 115 138.0 1.20 0.20
3 138 110.4 0.80 -0.20

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 Historical Rates of Return
AM=[(0.15)+(0.20)+(-0.20)] / 3
= 0.15/3=5%
GM=[(1.15) x (1.20) x (0.80)]1/3 – 1
=(1.104)1/3 -1=1.03353 -1 =3.353%
• Comparison of AM and GM
– When rates of return are the same for all years, the
AM and the GM will be equal.
– When rates of return are not the same for all years,
the AM will always be higher than the GM.
– While the AM is best used as an “expected value”
for an individual year, while the GM is the best
measure of an asset’s long-term performance.
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 Historical Rates of Return
• GM consider the compound annual rate of return
based on the ending value of an investment
versus its beginning value.
• For example, a security that increase in price from
50$ to 100$ during year 1 and drops back to 50$
during year 2. Calculate the AM and GM for that
investment?

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 Historical Rates of Return
Year Beginning Ending HPR HPY
Value Value
1 50 100 2.00 1.00

2 100 50 0.50 - 0.50

AM=[(1.00)+(-0.50)] / 2
= 0.50/2=25%

GM=[(2.00) x (0.50)]1/2 – 1
=(1.00)1/2 -1=1.00 -1 =0%
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 Historical Rates of Return
• A Portfolio of Investments
– Portfolio HPY: 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, or the overall change in
the value of the original portfolio.
– The weights used in the computation are the relative
beginning market values for each investment, which
is often referred to as dollar-weighted or value-
weighted mean rate of return.
– See Exhibit 1.1

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 Expected Rates of Return
• In previous examples, we discussed realized
historical rates of return. In contrast, an investor
would be more interested in the expected return
on a future risky investment.
• Risk refers to the uncertainty of the future
outcomes of an investment
– There are many possible returns/outcomes from an
investment due to the uncertainty
– Probability is the likelihood of an outcome and it’s
estimated based on the historical performance of an
investment or similar investments
– The sum of the probabilities of all the possible
outcomes is equal to ??? 1-18
 Expected Rates of Return
• Computing Expected Rate of Return of a
single investment
n
E(R i )   ( Probabilit y of Return)  (Possible Return)
i 1
 [(P1 )(R 1 )  (P2 )(R 2 )  ....  (Pn R n )]
n
  ( P )( R )
i 1
i i

where P i = Probability for possible return i

R i = Possible return i

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 Probability Distributions

Exhibit 1.2
Risk-free Investment with Absolute Certainty
of the returns
1.00
0.80
0.60
0.40
0.20
0.00
-5% 0% 5% 10% 15% 1-21
 Probability Distributions
Exhibit 1.3
Risky Investment with 3 Possible Returns

1.00
0.80
0.60
0.40
0.20
0.00
-30% -10% 10% 30%
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 Probability Distributions
• In this example the expected rate of return is
calculated as follows:
E(R) = [(0.15)(0.20) + (0.15)(-0.20) + (0.70)(0.10)]

= 0.07 = 7%

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 Probability Distributions

Exhibit 1.4
Risky investment with ten possible returns

1.00
0.80
0.60
0.40
0.20
0.00
-40% -20% 0% 20% 40%
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 Probability Distributions
• In this example the E(R) is equal to 5%

• What investment to choose the first or the third

investment?

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 Risk of Expected Return
• Risk refers to the uncertainty of an investment;
therefore the measure of risk should reflect the
degree of the uncertainty.
• The risk of expected return reflect the degree of
uncertainty that actual return will be different from
the expect return.
• The common measures of risk are based on the
variance of rates of return distribution of an
investment

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 Risk of Expected Return
• Measuring the Risk of Expected Return
– The Variance Measure
Variance (s )
n
Possible Expected 2
= å (Pr obability ) x ( - )
i =1 Re turn Re turn
n
= å Pi [ Ri - E ( Ri )]2
i =1

• The variance of the previous example that has 7%

of expected return, is 0.0141
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 Risk of Expected Return
• The larger the variance, for an expected rate of
return, the greater the dispersion of expected
returns and the greater the uncertainty (risk) of an
investment.
• The variance of a perfect certainty of returns, risk-
free, is …..

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 Risk of Expected Return
– Standard Deviation (σ): It is the square root of the
variance and measures the total risk
n
s= å Pi [ Ri E ( Ri )]
i =1
- 2

- The standard deviation from the previous example is

s= 0.0141
= 0.11874 = 11.87%

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 Risk of Expected Return
– Coefficient of Variation (CV): It measures the risk per
unit of expected return and is a relative measure of
risk.
Standard Deviation of Return
CV =
Expected Rate of Return
=s
E (R )

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 Risk of Expected Return

• The CV from the previous example is

• CV = 0.11874 \ 0.70 = 1.696

- Insome cases the variance or the standard deviation

can be misleading, specifically in the case of two
different investments. In such cases it’s better to use a
measure of relative risk per unit of expected returns

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Risk of Historical Rates of Return
• Given a series of historical returns measured
by HPY, the risk of returns is measured as:
 n 2
 2
   [ HPYi  E ( HPY)]  / n
 i 1 
where, σ 2 = the variance of the series
HPY i = the holding period yield during period i
E(HPY) = the expected value of the HPY equal
to the arithmetic mean of the series (AM)
n = the number of observations

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 Risk of Expected Return
• Computing expected rates of returns on a portfolio
of investments
E(Rp) = Wi * E(Ri)
• The standard deviation of the portfolio

2 2 2 2
s = W1 s 1 + W2 s 2 + 2 W1 W2 s 1 s 2 r12

• Where r12 is the correlation coefficient between

the two investments

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Determinants of Required Returns
• Three Components of Required Return:
– The time value of money during the time period
– The expected rate of inflation during the period
– The risk involved

– These three components are called the RRR. This

is the minimum rate of return that you should
accept from an investment to compensate you for
the deferring consumption.

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Determinants of Required Returns
• The Real Risk Free Rate (RRFR)
– Assumes no inflation.
– Assumes no uncertainty about future cash flows.
– Influenced by time preference for consumption of
income and investment opportunities in the
economy
• Nominal Risk-Free Rate (NRFR)
– Conditions in the capital market
– Expected rate of inflation

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Determinants of Required Returns
• Business Risk
– Uncertainty of income flows caused by the nature of
a firm’s business
– Sales volatility and operating leverage determine the
level of business risk.
• Financial Risk
– Uncertainty caused by the use of debt financing.
– 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.

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Determinants of Required Returns
• Liquidity Risk
– 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.
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Determinants of Required Returns
• 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.

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Determinants of Required Returns
• Risk Premium and Portfolio Theory
– From a portfolio theory perspective, the relevant risk
measure for an individual asset is its co-movement
with the market portfolio.
– Systematic risk relates the variance of the
investment to the variance of the market.
– Beta measures this systematic risk of an asset.
– According to the portfolio theory, the risk premium
depends on the systematic risk.

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Determinants of Required Returns
• Fundamental Risk versus Systematic Risk
– Fundamental risk comprises business risk, financial
risk, liquidity risk, exchange rate risk, and country
risk.
Risk Premium= f ( Business Risk, Financial Risk,
Liquidity Risk, Exchange Rate Risk,
Country Risk)
– Systematic risk refers to the portion of an individual
asset’s total variance attributable to the variability of
the total market portfolio.
Risk Premium= f (Systematic Market Risk)
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 Determinants of Required Returns
• Several studies have generally concluded that a significant
relationship occur between the market measure of risk and
the fundamental measures of risk. For example, you would
expect a firm that has high business risk and financial risk
to have an above average beta.

• But it’s possible that a firm that has a high level of

fundamental risk and a large standard deviation of return
on stock can have a lower level of systematic risk because
its variability of earnings and stock price in not related to
the aggregate economy or the aggregate market.

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Relationship Between Risk and Return
• The Security Market Line (SML)
– It shows the relationship between risk and return for
all risky assets in the capital market at a given time.
– Investors select investments that are consistent
with their risk preferences.

Expected Return
Security
Low Average High
Risk Risk Risk Market Line

The slope indicates the

NRFR required return per unit of risk

Risk
(business risk, etc., or systematic risk-beta) 1-42
Relationship Between Risk and Return
• Movement along the SML
– When the risk changes, the expected return will
also change, moving along the SML.
– Risk premium: RPI = E(Ri) - NRFR

Expected
Return
SML

Movements along the curve

that reflect changes in the
NRFR risk of the asset
Risk
(business risk, etc., or systematic risk-beta)
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 Relationship Between Risk and
Return
• For example, if a company increases its financial
risk by issuing bonds that increases its financial
leverage, investors will perceive its common stock
as riskier and the stock will move up the SML to a
higher risk position.

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Relationship Between Risk and Return
• Changes in the Slope of the SML
– When there is a change in the attitude of investors toward
risk, the slope of the SML will also change.
– If investors become more risk averse, then the SML will have
a steeper slope, indicating a higher market risk premium,
RPm, for the same risk level.
– No matter where an investment is on the SML, its RRR will
increase although its individual risk characteristics remain
unchanged
Expected Return New SML

R m’
Original SML
Rm

NRFR
Risk 1-45
Relationship Between Risk and Return
• Changes in Market Condition or Inflation
– A change in the RRFR or the expected rate of
inflation will cause a parallel shift in the SML.
– When nominal risk-free rate increases, the SML will
shift up, implying a higher rate of return while still
having the same risk premium.

Expected Return
New SML

Original SML
NRFR'

NRFR
Risk 1-46
The Internet Investments Online
• http://www.finpipe.com
• http://www.investorguide.com
• http://www.aaii.com
• http://www.economist.com
• http://online.wsj.com
• http://www.forbes.com
• http://www.barrons.com
• http://fisher.osu.edu/fin/journal/jofsites.htm
• http://www.ft.com
• http://www.fortune.com
• http://www.smartmoney.com
• http://www.worth.com
• http://money.cnn.com

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© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
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© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
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© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
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© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
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