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C01 Reilly1ce
C01 Reilly1ce
C01 Reilly1ce
Chapter 1
The Investment Setting
What Is An Investment
Return and Risk Measures
Determinants of Required Returns
Relationship between Risk and Return
1-2
What is an Investment?
Investment
Current commitment of $ for a period of
time in order to derive future payments
that will compensate for:
Time the funds are committed
Expected rate of inflation
Uncertainty of future flow of funds
1-3
Why Invest?
By investing (saving money now
instead of spending it), individuals can
tradeoff present consumption for a
larger future consumption.
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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 = ($112/$100)1/0.5 =1.2544
Annual HPY=Annual HPR-1=1.2544-1=25.44%
1-11
1-12
Stock A
Annual HPR=HPR1/n = ($250/$350)1/2 =.84515
Annual HPY=Annual HPR-1=.84514 - 1=-15.48%
Stock B
Annual HPR=HPR1/n = ($100/$112)1/0.5 =.79719
Annual HPY=Annual HPR-1=.79719-1=-20.28%
1-13
It depends!
Copyright 2010 Nelson Education Ltd.
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1-15
1/n
-1
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Beg. Value
Ending
Value
HPR
HPY
$100
$115
1.15
.15
115
138
1.20
.20
138
110.40
.80
-.20
AM= HPY / n
AM=[(0.15)+(0.20)+(-0.20)] / 3 = 0.15/3=5%
1-19
Beg. Value
Ending
Value
HPR
HPY
$100
$115
1.15
.15
115
138
1.20
.20
138
110.40
.80
-.20
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( Pi )( Ri )
i 1
Where:
1-24
Perfect Certainty:
The Risk Free Asset
If you invest in an asset that has an expected return 5%
then it is absolutely certain your expected return will be
5%
E(Ri) = ( 1) (.05) = .05 or 5%
1-25
Probability Distribution
Risk-Free Investment
1-26
Probability
Expected Return
Strong Economy
15%
20%
Weak Economy
15%
-20%
Stable Economy
70%
10%
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Probability Distribution
Risky Investment with 3 Possible
Returns
1-28
E ( Ri ) ( Pi )( Ri )
i 1
1-29
1-30
Possible Expected 2
(Pr obability ) x (
)
Re turn
Re turn
i 1
n
Pi [ Ri E ( Ri )]2
i 1
1-31
Pi [ Ri E ( Ri )]
i 1
1-32
E (R )
CV
1-33
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2
[
HPY
E
(
HPY)]
i
/n
i 1
Where:
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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Three Determinants of
Required Rate of Return
Time value of money during the time period
Expected rate of inflation during the period
Risk involved
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Systematic risk
refers to the portion of an individual assets total
variance attributable to the variability of the total
market portfolio.
Risk Premium= f (Systematic Market Risk)
1-45
NRFR
High
Risk
Security
Market Line
1-46
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1-48