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Investment Analysis and Portfolio Management: Frank K. Reilly & Keith C. Brown
Investment Analysis and Portfolio Management: Frank K. Reilly & Keith C. Brown
to accompany
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
investments ?
Why Do Individuals
Invest ?
By saving money (instead of
spending it), individuals tradeoff
present consumption for a larger
future consumption.
$1.04%
$1.04
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.
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Measures of
Historical Rates of Return
Holding Period Return
1.1
Measures of
Historical Rates of Return
Holding Period Yield
HPY = HPR - 1
1.10 - 1 = 0.10 = 10%
1.2
Measures of
Historical Rates of Return
Annual Holding Period Return
Annual HPR = HPR 1/n
where n = number of years investment is held
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Measures of
Historical Rates of Return
Arithmetic Mean
1.4
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Measures of
Historical Rates of Return
Geometric Mean
1.5
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, or the
overall change in the value of the
original portfolio
HPY =
Begin
Price
$ 10
$ 20
$ 30
Beginning Ending
Ending
Market
Mkt. Value Price Mkt. Value HPR HPY Wt.
$ 1,000,000
$ 12 $ 1,200,000 1.20 20% 0.05
$ 4,000,000
$ 21 $ 4,200,000 1.05 5% 0.20
$ 15,000,000
$ 33 $ 16,500,000 1.10 10% 0.75
$ 20,000,000
$ 21,900,000
HPR =
$ 21,900,000
$ 20,000,000
1.095
1.095
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9.5%
Wtd.
HPY
0.010
0.010
0.075
0.095
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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
Risk-free Investment
Exhibit 1.2
1.00
0.80
0.60
0.40
0.20
0.00
-5%
0%
5%
10% 15%
Probability Distributions
Exhibit 1.3
-30%
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10%
30%
Probability Distributions
Exhibit 1.4
1.00
0.80
0.60
0.40
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0.00
-40% -20% 0%
20% 40%
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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 during the
period of investment
Expected rate of inflation during
the period
Risk involved
(1
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Adjusting For Inflation
Real RFR =
1.12
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 firms 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 stocks 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?
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 assets total variance attributable
to the variability of the total market portfolio
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Relationship Between
Risk and Return Exhibit 1.7
(Expected)
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Exhibit 1.8
1.14
Change in
Market Risk Premium
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Expected Return
Rm
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NRFR
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Exhibit 1.10
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Exhibit 1.11
Expected Return
NRFR
NRFR
The Internet
Investments Online
http://www.finpipe.com
http://www.ft.com
http://www.investorguide.com http://www.fortune.com
http://www.aaii.com
http://www.smartmoney.com
http://www.economist.com
http://www.worth.com
http://www.online.wsj.com
http://www.money.cnn.com
http://www.forbes.com
http://www.barrons.com
http://fisher.osu.edu/fin/journal/jofsites.htm
Future Topics
Chapter 2
The asset allocation decision
The individual investor life
cycle
Risk tolerance
Portfolio management