01 - Investment Setting

INVESTMENT SETTING
Arief Widijatmoko, SE, MMT, CA, Ak
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 larger
future consumption.
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.
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.
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 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.
Measures of
Historical Rates of Return
1.1
Holding Period Return

Measures of
1.2
Holding Period Yield

HPY = HPR - 1
1.10 - 1 = 0.10 = 10%
Measures of
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
1.4
Arithmetic Mean
Measures of
1.5
Geometric Mean
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 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
Expected Rates of Return
1.6
Risk Aversion
The assumption that most investors
will choose the least risky
alternative, all else being equal and
that they will not accept additional
risk unless they are compensated in
the form of higher return
Probability Distributions
Exhibit 1.2
Risk-free Investment
Exhibit 1.3
Risky Investment with 3 Possible Returns

Exhibit 1.4
Risky investment with ten possible rates of return

Measuring the Risk of
Expected Rates of Return 1.7
Standard Deviation is the square

root of the variance
Coefficient of variation (CV) a measure of

relative variability that indicates risk per unit
of return
Standard Deviation of Returns
Expected Rate of Returns
Historical Rates of Return 1.10
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
Determinants of
Required Rates of Return
Time value of money
Expected rate of inflation
Risk involved
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
Adjusting For Inflation 1.12
Real RFR =
Nominal Risk-Free Rate
Dependent upon
 Conditions in the Capital Markets
 Expected Rate of Inflation
Adjusting For Inflation 1.11
Nominal RFR =
(1+Real RFR) x (1+Expected Rate of Inflation) - 1
Facets of 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
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.
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
Risk Premium
f (Business Risk, Financial Risk,
Liquidity Risk, Exchange Rate Risk,
Country Risk)
or
f (Systematic Market Risk)
Risk Premium
and Portfolio Theory
 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
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
(Expected)
Changes in the Required Rate of Return
Due to Movements Along the SML
Exhibit 1.8
Changes in the Slope of the SML
1.13
RPi = E(Ri) - NRFR

where:
RPi = risk premium for asset i
E(Ri) = the expected return for asset i
NRFR = the nominal return on a risk-free asset
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
Change in
Market Risk Premium
Exhibit 1.10
Expected Return
Rm´
Rm
NRFR
Capital Market Conditions,
Expected Inflation, and the SML
Exhibit 1.11
Expected Return
NRFR´
NRFR
The Internet
Investments Online
www.financecenter.com www.ft.com
www.investorama.com www.fortune.com
www.moneyadvisor.com www.money.com
www.investorguide.com www.forbes.com
www.finweb.com www.worth.com
www.aaii.org www.barrons.com
www.wsj.com
www.cob.ohio-state.edu/dept/fin/osudata.htm
End of Chapter
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INVESTMENT SETTING

Arief Widijatmoko, SE, MMT, CA, Ak

By saving money (instead of

Holding Period Return

Holding Period Yield

Annual Holding Period Return

Annual Holding Period Yield

Risky Investment with 3 Possible Returns

Risky investment with ten possible rates of return

Standard Deviation is the square

Coefficient of variation (CV) a measure of

variance of the series

Uncertainty of income flows caused

 Uncertainty of return is introduced by

 The relevant risk measure for an

 Fundamental risk comprises business risk,

RPi = E(Ri) - NRFR

The market risk premium for the market

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