Class I & II

• Why do people invest?

• How do you measure the returns and risks for alternative
investments?
• What factors should you consider when you make asset
allocation decisions?
• What investments are available?
• How do securities markets function?
• How and why are securities markets around the world
changing?
• What are the major uses of security-market indexes?
• How can you evaluate the market behavior of common
stocks and bonds?
Why do individuals invest?
• What is an investment?
• How do investors measure the rate of return on an
investment?
• How do investors measure the risk related to alternative
investments?
• 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 rates of return for
investments?
What is Investment?
 Difference between income and consumption leads to
saving or borrowing.
 Investment is a trade off of present consumption for
future higher consumption
 What you do with the savings to make them increase
over time is “investment”.
 Supply of excess money and demand for borrowed
money determines “ Pure Time value of Money”.
 Inflation gives rise to demand for additional return over
time value of money
 Supply money for uncertain outcome based consumption
requires return over and above time value and inflation. It
is called risk premium.
Who is an investor?
 Individual- Stocks, bonds, Mutual Funds,
commodities, real estate.
 Government- Stocks, bonds, infrastructure
 Pension Fund- Stock, Bonds
 Corporations- Plant, equipment etc.
Measures of Return
 Historical rate of return for individual securities

 Average rate of return for individual securities

 Average rate of return for a portfolio

 Expected rate of returns for portfolio/Stocks

Returns come from cash inflows due to holding of certain asset and
increase in price of the asset.
 HPR and HPY
 Period for which an investor owns certain asset is called
Holding Period.
 Holding period Return is defined by
 HPR = (Ending Value of Investment)/(Beginning Value of Investment)
Example= Calculate HPR on an investment of Rs 200 held for 2 years if
the asset is sold at Rs 220
HPR is never negative.
 HPY (Holding period Yield) gives percentage
return on investment for the holding period:-
HPY = HPR − 1
Calculate HPY in the above example
Annual HPR = (HPR)(1/n)
If the holding period is 2 in the example above calculate Annual HPR
• Annual HPY = Annual HPR -1
 Calculating Mean Historical
Returns
 For Single Investment AM (Arithmetic Mean)
 AM = ΣHPY/n ; ΣHPY = the sum of annual holding period yields
 For Single Value GM (Geometric Mean)
 GM = [πHPR]1/n − 1; π = the product of the annual holding period
returns as follows: (HPR1) × (HPR2) . . . (HPRn)

Year Beginning Value Ending Value HPR HPY

1 100 1.15 1.15 0.15

2 115 1.2 1.2 0.2

3 138 0.8 0.8 -0.2

Based on above data calculate AM and GM

AM or GM; Which one is
superior?
 Take an Example
Beginning Ending
Year Value Value HPR HPY
1 50 100 2 1
2 100 50 0.5 -0.5
 Calculate AM and GM of historical returns and decide which one is
better.
 For long term investment which may face volatility on year by year
basis mean returns which gives compounded rate based on initial
and final value of asset is superior.
 GM<=AM. They are equal only when Annual rate of return are same
for all years.
 GM is best measure of long term historical performance. AM gives
better picture of YoY returns for future expected earning where
outcome is uncertain
Calculation of Holding period
yield for a portfolio

HPY for a period is same whether we calculate returns based on end value and
beginning value or as sum of weighted returns of individual stocks in the
portfolio.
Calculation of Expected
return
 Calculation of historical returns is easier because past
data is always available.
 Expected returns of investor must be modified for future
uncertainties.
 A point estimate of future returns presents most likely
outcome on returns
 Investor’s must understand that there are scenarios when
returns may vary between a range which includes point
estimates somewhere in between.
 Various returns estimates are made and probabilities are
assigned to them to account for uncertainties around it.
 Therefore the expected return is calculated as follows:-
 Expected Return = (Probability of Return× Possible
Return)
 Practice Example
Rate of
Economic Conditions Probability Return

Strong Economy, No inflation 0.15 0.2

Weak economy, above-average
inflation 0.15 -0.2

No major change in economy 0.7 0.1

Calculate Expected return in the above example

Which one would you prefer?
 A certain outcome i.e. 100% probability that an asset
returns 5 % or multiple scenarios throwing multiple
returns and their probabilities based on these
scenarios with expected returns of 5 %. Try this with
returns in the range between -40% to 50 % with a
difference of 10% point between them when each
rate of return has same probability i.e. 10% .
 Most investors are risk averse