Investment Analysis and

Portfolio Management
by
Frank K. Reilly & Keith C. Brown
 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 ?

 The trade-off of present consumption for a higher level

of future consumption is the essence of investment

 There are mainly three reasons why people invest:

Supplement their income
Earn capital gains
Experience the excitement of the investment
How Do We Measure The Rate Of Return On
An Investment ?

 The pure rate of interest is the rate of exchange

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.
How Do We Measure The Rate Of Return On
An Investment ?

 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.
 Example
 If you can exchange $100 of certain income today for
$104 of certain income one year from today, then the
pure rate of exchange on a risk-free investment (that is,
the time value of money) is said to be 4 percent
(104/100 – 1).

 if an investor expects a rise in prices (that is, he or she

expects inflation) at the rate of 2 percent during the
period of investment, he or she will increase the required
interest rate by 2 percent (i.e. 4% + 2% = 6%: $106
instead of $104).
 Example cont.…
 In case of investment risk (the uncertainty of the
payments from an investment), the investor will ask for
a risk premium (i.e. investor will demand more than
$106).

 Suppose the risk premium is 4% (i.e. $4), then the

required amount would be $110.
 Defining an Investment
 Generally, investment means to invest something in
some where

 In financial terms, it is the commitment of funds in an

attempt to improve your financial wealth
OR
 A current commitment of dollars 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.
 Risk and Return
 In a more formal way: the word “risk” can be used to
describe any situation in which there is an uncertainty about
the outcome
 In the financial world: risk can be defined as “any event or
possibility of an event which can impair corporate earnings
or cash flow over short/medium/long-term horizon”
 In simple words, Risk is…
Uncertainty about future outcomes. OR
Probability of loss. OR
Probability that an investment actual return will be different
than expected return
 The concept of Return
 Risk implies variability in returns, therefore, it is critical to
understand how returns are measured
 Return refers to the money made or lost on an investment over
some period of time
 Returns on any asset are derived in two ways:
– The income flow on the asset
– Capital appreciation (capital gains)
 In bonds, the motivation for investment is the income flow on the
bond
 In equities, the emphasis is on capital appreciation rather than the
regular yield on the equity investment
 Thus a one period return on a stock is
Return = Dividend + Capital gain
 Measures of
Historical Rates of Return

Holding Period Return

Ending Value of Investment

HPR 
Beginning Value of Investment
$220
  1.10
$200
Note: This value will always be zero or greater
 Measures of
Historical Rates of Return

Holding Period Yield

HPY = HPR - 1
1.10 - 1 = 0.10 = 10%
 Quick Exercise

You invested $300 at the beginning of 2019 and get back

$330 at the end of 2019.
Calculate
1). HPR

2). HPY
 Measures of
Annual Historical Rates of Return

Annual Holding Period Return

– Annual HPR = HPR 1/n
where n = number of years the investment is held

Annual Holding Period Yield

– Annual HPY = Annual HPR - 1
 Quick Exercise

You invested $300 at the beginning of 2018 and get back

$330 at the end of 2019.
Calculate
1). Annual HPR

2). Annual HPY

Repeat the exercise for a holding period of 6 months.

 Computing Mean
Historical Rates of Return

Arithmetic Mean
AM   HPY/n
where :

 HPY  the sum of annual

holding period yields
 Computing Mean
Historical Rates of Return

Geometric Mean

GM   HPR 
1
n 1
where :
  the product of the annual
holding period returns as follows :
 HPR 1    HPR 2    HPR n 
Example AM & GM for a Single
Investment
 Mean
Historical Rates of Return for 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 Exhibit 1.1
Period Yield for a Portfolio
# Begin Beginning Ending Ending Market Wtd.
Stock Shares Price Mkt. Value Price Mkt. Value HPR HPY Wt. HPY
A 100,000 $ 10 $ 1,000,000 $ 12 $ 1,200,000 1.20 20% 0.05 0.010
B 200,000 $ 20 $ 4,000,000 $ 21 $ 4,200,000 1.05 5% 0.20 0.010
C 500,000 $ 30 $ 15,000,000 $ 33 $ 16,500,000 1.10 10% 0.75 0.075
Total $ 20,000,000 $ 21,900,000 0.095

$ 21,900,000
HPR = = 1.095
$ 20,000,000

HPY = 1.095 -1 = 0.095

= 9.5%
 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
Expected Return  E(R i )
n

 (Probability of Return)  (Possible Return)

i 1

[(P1 )(R 1 )  (P2 )(R 2 )  ....  (Pn R n )

n

 (P )(R )
i 1
i i
 Probability Distributions
Exhibit 1.2

Risk-free Investment
1.00
0.80
0.60
0.40
0.20
0.00
-5% 0% 5% 10% 15%
3 Different Scenarios
 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%
 Probability Distributions
Exhibit 1.4
Risky investment with ten possible rates of return

1.00
0.80
0.60
0.40
0.20
0.00
-40% -20% 0% 20% 40%
Expected return for an investment
with ten possible rates of return
 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
Note: see the examples of single possible
return and 10 possible returns with the
same rate of return i.e. 5%
 Measuring the Risk of 1.7
Expected Rates of Return

The larger the variance for an expected rate of return, the

greater the dispersion of expected returns and the greater
the uncertainty, or risk, of the investment.
 Measuring the Risk of 1.8
Expected Rates of Return
Standard Deviation is the square
root of the variance
 Examples
1. Perfect certainty
Pi = 1.0 ; Ri = .05 ;
E(Ri ) = .05
2. Uncertainty
Pi = 0.15, 0.15, 0.70 ; Ri = 0.20, -0.20, 0.10 ;
E(Ri ) = .07
 Measuring the Risk of 1.9
Expected Rates of Return
Coefficient of variation (CV) a measure of
relative variability that indicates risk per unit
of return
Standard Deviation of Returns
Expected Rate of Returns
i

E(R)
 CV Example

Usage of CV
Risk Measures for Historical Returns
• To measure the risk for a series of historical rates
of returns, we use the same measures as for
expected returns (variance and standard deviation)
except that we consider the historical holding
period yields (HPYs) as follows:
 Example
• Assume that you are given the following information on
annual rates of return (HPY) for common stocks listed on
the New York Stock Exchange (NYSE):

We can interpret the performance of

NYSE common stocks during this
period of time by saying that the
average rate of return was 4 percent
and the standard deviation of annual
rates of return was 7.56 percent.
Mean Return = = 0.04 (0.20/5).
 Determinants of
Required Rates of Return
• Time value of money
• Expected rate of inflation
• Risk involved
 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
 Systematic risk vs Unsystematic
risk
 Systematic risk refers to the risk inherent to the
entire market or market segment
 Systematic risk is market based… based on
macroeconomic variables
 As no individual business can control it, therefore
it is also called
unavoidable/uncontrollable/undiversifiable risk.
 Systematic risk vs Unsystematic
risk
 Unsystematic risk refers to the risk inherent to a
specific company or industry
 As unsystematic risk can be reduced through
diversification, therefore it is also called
diversifiable/avoidable/controllable risk
 In other words, systematic risk can be thought of
as the probability of a loss that is associated with
the entire market or a segment thereof,
unsystematic risk refers to the probability of a
loss that is associated with a specific industry or
security.