Chapter Three

OVERVIEW OF INVESTMENT

1
 Contents in this Chapter
– Investment in General
– Investment Decision Process: Important
Considerations
– Investment Alternatives: Money Market,
Fixed Income, Equity, and Derivatives
– Indirect Investment through Different
Types of Investment Companies
– Return and Risks from Investment
– Capital Asset Pricing Models and Analysis
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 3.1. Investment in General
• Investment can be defined as “a sacrifice of current money for future
benefits”.
 Current scarification of money
 Future benefit
• Investment is the commitment of money to purchase financial instruments
or other assets in order to gain profitable returns in the form of interest,
income {dividend}, or appreciation of the value/price of the instrument.

Types of investment
1. Consumer Investment
 Consumer Durable Goods

2. Economic Investment
 Capital Goods

3.Financial investment or security investment

 Security or Financial Instrument 3
 3.2. Investment Decision Process: Important
Considerations (focus on securities investment)
The investment process involves a series of
activities leading to the purchase of securities.
The investment process can be divided into
following stages (6)
1. Determining investment objective and policy
2. Security Analysis
3. Portfolio Construction
4. Portfolio Selection
5. Portfolio Revision
6. Portfolio Evaluation. 4
 Con’t…
1.Determining investment objective and policy
 Ingredients of investment objective and policy
involves considering availability of fund, need of
investor and knowledge of security and financial
market.
2. Security Analysis
 Security that could be identified in investment
policy have to be scrutinized/analized through
security analysis which involves: Fundamental
Analysis (Economic analysis, Industry analysis,
Company analysis) and Technical analysis. 5
 Con’t…
3. Portfolio Construction
 Portfolio means combination of different financial asset that help
to reduce risk in an investment.
 Portfolio construction consists of identifying specific security which
to be bought and determine the proportion of investor’s fund to be
invested in each security.
 It can be done based on the level of diversification.
4. Portfolio Selection
It involve decision which portfolio/security to be bought /hold
5. Portfolio Revision
Portfolio is adjusted according to the change in environment
6.Portfolio Performance Evaluation.
Examine to what extent the objectives have been achieved 6
 3.3. Investment Alternatives: Money Market, Fixed Income,
Equity, and Derivatives
Forms of Financial Investment Alternatives :
1. Long term Fixed Income Security such as
bond.
2. Money Market Security that mature in less
than one year such as TB, Certificate of
Deposits.
3. Variable Income Security –Equity such as
common stock or preferred stock.
4. Derivatives Securities such as futures, option,
swap, etc mainly used to hedge risk and also
they are investment alternatives. 7
 3.4. Indirect Investment through Different
Types of Investment Companies
Types of investing:
1. Direct investing
 Buying and selling of security by investors
themselves.
2 . Indirect investing
The investors let the investment company to do all
the work and make all the decisions for him for
fee.

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3.5. Return and Risks from Investment

• Return is the motivating force and principal reward

in the investment processes
• It include income in the form of interest rate ,
dividend and capital appreciation .

Risk is the potential for variability in return. It arises

where there is a possibility of variation between
expected and realized return from investment.

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 Investment returns
The rate of return on an investment can be calculated as follows:
(Amount received – Amount invested)
Return = ________________________
Amount invested

For example, if Birr 100,000 is invested and Birr 110,000 is returned

after one year, the rate of return for this investment is:
(Birr 110,000 – Birr 100,000) / Birr 100,000 = 10%.
Note that the amount received less amount invested is equal to
income in the form of interest , dividend and/or capital
appreciation. Thus, alternatively rate of return from investment
in securities/financial assets can be computed as follows:
Interest, or dividend ,or capital appreciation

Return = _____________________
Amount invested
Where capital appreciation is the difference between purchase price and selling/current price of the security. And it is
called capital gain. 10
 What is investment risk?
Two types of investment risk
Stand-alone risk – riskiness of an individual asset.
Portfolio risk – risk in the context of portfolio
Investment risk is related to the probability of earning a low
or negative actual return/variability/deviation from the
expected.
The greater the chance of lower than expected or negative
returns, the riskier the investment.
Risk = Dispersion/variability of Returns around
mean/expectation, or expected mean: variance or standard
deviation. The higher the variance/sd the higher the risk.
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 Probability distributions

A listing of all possible outcomes, and the probability

of each occurrence.
Can be shown graphically.

Firm X

Firm Y
Rate of
-70 0 15 100 Return (%)

Expected Rate of Return

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 Investment alternatives

Economy Prob. T-Bill HT Coll USR MKT.

Recession 0.1 5.5% -27.0% 27.0% 6.0% -17.0%

Below avg 0.2 5.5% -7.0% 13.0% -14.0% -3.0%

Average 0.4 5.5% 15.0% 0.0% 3.0% 10.0%

Above avg 0.2 5.5% 30.0% -11.0% 41.0% 25.0%

Boom 0.1 5.5% 45.0% -21.0% 26.0% 38.0%

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 Why is the T-bill return independent of the economy? Do T-bills promise
a completely risk-free return?

T-bills will return the promised 5.5%, regardless of the

economy.
T-bills do not provide a completely risk-free return, as they are
still exposed to inflation. Although, very little unexpected
inflation is likely to occur over such a short period of time.
T-bills are also risky in terms of reinvestment rate risk.

T-bills are risk-free in the default sense of the word.

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How do the returns of HT and Coll. behave
in relation to the market/economy?
• HT – Moves with the economy, and has a
positive correlation. This is typical.

• Coll. – Is countercyclical with the economy,

and has a negative correlation. This is
unusual.

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Calculating the expected return

^
r  expected rate of return

^ N
r 
i 1
ri Pi

^
r HT  (-27%) (0.1)  (-7%) (0.2)
 (15%) (0.4)  (30%) (0.2)
 (45%) (0.1)  12.4%

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 Summary of expected returns
Expected return
HT 12.4%
Market 10.5%
USR 9.8%
T-bill 5.5%
Coll. 1.0%

HT has the highest expected return, and appears to be

the best investment alternative, but is it really? Does
the risk profile also show the same?

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Calculating standard deviation

  Standard deviation

  Variance   2

N
σ  i Pi
(r
i 1
 r̂ ) 2

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Standard deviation for each investment

N ^
  i 1
(ri  r ) 2 Pi
1
(5.5 - 5.5) (0.1)  (5.5 - 5.5) (0.2)
2 2
 2

 
 T  bills   (5.5 - 5.5)2 (0.4)  (5.5 - 5.5)2 (0.2) 
 2 
  (5.5 - 5.5) (0.1) 
 T  bills  0.0%  Coll  13.2%
 HT  20.0%  USR  18.8%
 M  15.2%
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 Comments on standard deviation
as a measure of risk

• Standard deviation (σi) measures total, or

stand-alone, risk.
• The larger σi is, the lower the probability
that actual returns will be closer to
expected returns.
• Larger σi is associated with a wider
probability distribution of returns.

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 Comparing risk and return

Security Expected^ Risk, σ

return, r
T-bills 5.5% 0.0%
HT 12.4% 20.0%
Coll* 1.0% 13.2%
USR* 9.8% 18.8%
Market 10.5% 15.2%

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 Coefficient of Variation (CV)

A standardized measure of dispersion about the

expected value, that shows the risk per unit of
return.

Standard deviation 
CV  
Expected return r̂

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Risk rankings, by coefficient of variation
CV
T-bill 0.0
HT 1.6
Coll. 13.2
USR 1.9
Market 1.4

Coll. has the highest degree of risk per unit of return.

HT, despite having the highest standard deviation of
returns, has a relatively average CV.

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 Illustrating the CV as a measure of
relative risk
Prob.

A B

0 Rate of Return (%)

σA = σB , but A is riskier because of a larger probability of losses. In

other words, the same amount of risk (as measured by σ) for
smaller returns.

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 Investor attitude towards risk

• Risk aversion – assumes investors dislike risk and

require higher rates of return to encourage them to hold
riskier securities.

• Risk premium – the difference between the return on a

risky asset and a riskless asset, which serves as
compensation for investors to hold riskier securities.

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 Portfolio construction: Risk and return

• Assume a two-stock portfolio is created with $50,000

invested in both HT and Collections.

• A portfolio’s expected return is a weighted average of

the returns of the portfolio’s component assets.

• Standard deviation is a little more tricky and requires

that a new probability distribution for the portfolio
returns be devised.

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Calculating portfolio expected return

^
r p is a weighted average :

^ N ^
r p   w i ri
i 1

^
r p  0.5 (12.4%)  0.5 (1.0%)  6.7%

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An alternative method for determining
portfolio expected return
Economy Pro HT Coll Portfolio
b.
Recession 0.1 -27.0% 27.0% 0.0%
Below avg 0.2 -7.0% 13.0% 3.0%
Average 0.4 15.0% 0.0% 7.5%
Above avg 0.2 30.0% -11.0% 9.5%
Boom 0.1 45.0% -21.0% 12.0%

^
r p  0.10 (0.0%)  0.20 (3.0%)  0.40 (7.5%)
 0.20 (9.5%)  0.10 (12.0%)  6.7% 28
Calculating portfolio standard deviation and CV

1
 0.10 (0.0 - 6.7) 
2 2

 2 
 0.20 (3.0 - 6.7) 
 p   0.40 (7.5 - 6.7)2   3.4%
 
 0.20 (9.5 - 6.7)2 
 2

 0.10 (12.0 - 6.7) 

3.4%
CVp   0.51
6.7%
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Comments on portfolio risk measures

σp = 3.4% is much lower than the σi of either stock (σHT

= 20.0%; σColl. = 13.2%).
σp = 3.4% is lower than the weighted average of HT and
Coll.’s σ (16.6%).
Therefore, the portfolio provides the average return of
component stocks, but lower than the average risk.
Why?
 because of Negative correlation between stocks.

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 General comments about risk

• σ  35% for an average stock (in a stock market)

• Most stocks are positively (though not perfectly)

correlated with the market (i.e., ρ between 0 and 1).

• Combining stocks in a portfolio generally lowers risk.

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 Returns distribution for two perfectly
negatively correlated stocks (ρ = -1.0)

Stock W Stock M Portfolio WM

25 25 25

15 15 15

0 0 0

-10 -10 -10

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 Returns distribution for two perfectly
positively correlated stocks (ρ = 1.0)

Stock M Stock M’ Portfolio MM’

25 25 25

15 15 15

0 0 0

-10 -10 -10

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 Creating a portfolio:
Beginning with one stock and adding randomly selected
stocks to portfolio

• σp decreases as stocks added, because they would not

be perfectly correlated with the existing portfolio.
• Expected return/mean/ of the portfolio would remain
relatively constant.
• Eventually the diversification benefits of adding more
stocks dissipates/dissolves(after about 40 stocks), and
for large stock portfolios, σp tends to converge/meet or
join/ to  20%.

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 Illustrating diversification effects of a
stock portfolio

sp (%) Diversifiable Risk

35

Stand-Alone Risk, sp

20
Market Risk

0
10 20 30 40 2,000+
# Stocks in Portfolio
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 Breaking down sources of risk

Stand-alone risk = Market risk + Diversifiable risk

• Market risk – portion of a security’s stand-alone risk that

cannot be eliminated through diversification. Measured
by beta.
• Diversifiable risk – portion of a security’s stand-alone risk
that can be eliminated through proper diversification.

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 Failure to diversify

• If an investor chooses to hold a one-stock portfolio (doesn’t

diversify), would the investor be compensated for the extra
risk s/he bear?
– NO!
– Stand-alone risk is not important to a well-diversified
investor.
– Rational, risk-averse investors are concerned with σp, which
is based upon market risk.
– There can be only one price (the market return) for a given
security.
– No compensation should be earned for holding
unnecessary, diversifiable risk.
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3.6. Capital Asset Pricing Model (CAPM)
Model linking risk and required returns.
CAPM suggests that there is a Security Market Line (SML)
that states that a stock’s required return equals the risk-
free return plus a risk premium that reflects the stock’s risk
after diversification.
ri = rRF + (rM – rRF) bi
Primary conclusion: The relevant riskiness of a stock is its
contribution to the riskiness of a well-diversified portfolio.

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 Beta
• Measures a stock’s market risk, and shows a stock’s volatility/instability
/ relative to the market.

• Indicates how risky a stock is if the stock is held in a well-diversified

portfolio.
Comments on beta
• If beta = 1.0, the security is just as risky as the average stock.
• If beta > 1.0, the security is riskier than average.

• If beta < 1.0, the security is less risky than average.

• Most stocks have betas in the range of 0.5 to 1.5.

• Beta = ΔY/ΔX or Δri /Δrm -slope of the characteristic line in regressing the return on a security on
39
the market return.
 Can the beta of a security be negative?

• Yes, if the correlation between Stock i and the market is

negative (i.e., ρi,m < 0).

• If the correlation is negative, the regression line

would slope downward, and the beta would be
negative.

• However, a negative beta is highly unlikely.

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 Calculating betas
• Well-diversified investors are primarily concerned with
how a stock is expected to move relative to the market in
the future.

• Without a crystal ball to predict the future, analysts are

forced to rely on historical data. A typical approach to
estimate beta is to run a regression of the security’s past
returns against the past returns of the market.

• The slope of the regression line (also called characteristic

line) is defined as the beta coefficient for the security.
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Illustrating the calculation of beta

_
ri

. Year rM ri
20
15
. 1 15%
2 -5 -10
18%

10 3 12 16
5
_
-5 0 5 10 15 20 rM

-5 Regression line:
. -10
^ ^
ri = -2.59 + 1.44 rM
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 Beta coefficients for
HT, Coll, and T-Bills
_
ri HT: b = 1.30
40

20

T-bills: b = 0 _
kM
-20 0 20 40

Coll: b = -0.87

-20
43
Comparing expected returns and
beta coefficients
Security Expected Return Beta
HT 12.4% 1.32
Market 10.5 1.00
USR 9.8 0.88
T-Bills 5.5 0.00
Coll. 1.0 -0.87

Riskier securities have higher returns, so the rank

order is OK.

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 The Security Market Line (SML):
Calculating required rates of return

SML: ri = rRF + (rM – rRF) bi

ri = rRF + (RPM) bi
• RPm =market Risk premium
• Assume the yield curve is flat and that
kM =10.5%, rRF = 5.5% and RPM = 5.0%.

• What is the market risk premium? - The market (or equity) risk
premium is

• RPM = (kM – kRF )= 10.5% – 5.5% = 5%.

• Additional return over the risk-free rate needed to compensate investors
for assuming an average amount of risk.
• Its size depends on the perceived risk of the stock market and investors’
degree of risk aversion.
• Varies from year to year, but most estimates suggest that it ranges between
45
4% and 8% per year.
Calculating required rates of return

• rHT = 5.5% + (5.0%)(1.32) = 12.10%

• rM = 5.5% + (5.0%)(1.00) = 10.50%
• rUSR = 5.5% + (5.0%)(0.88) = 9.90%
• rT-bill = 5.5% + (5.0%)(0.00) = 5.50%
• rColl = 5.5% + (5.0%)(-0.87) = 1.15%

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 Expected vs. Required returns

^
r r
^
HT 12.4% 12.1% Undervalue d (r  r)
^
Market 10.5 10.5 Fairly val ued (r  r)
^
USR 9.8 9.9 Overvalued (r  r)
^
T - bills 5.5 5.5 Fairly val ued (r  r)
^
Coll. 1.0 1.2 Overvalued (r  r)
47
 Illustrating the
Security Market Line

SML: ri = 5.5% + (5.0%) bi

ri (%)
SML

rM = 10.5
HT

.. .
rRF = 5.5
. T-bills
USR

-1
.
Coll. 0 1 2
Risk, bi

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 An example:
Equally-weighted two-stock portfolio
• Create a portfolio with 50% invested in HT and
50% invested in Collections (Coll).
• The beta of a portfolio is the weighted average
of each of the stock’s betas.

bP = wHT bHT + wColl bColl

bP = 0.5 (1.32) + 0.5 (-0.87)
bP = 0.225

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 Calculating portfolio required returns

• The required return of a portfolio is the weighted average of

each of the stock’s required returns.
rP = wHT rHT + wColl rColl
rP = 0.5 (12.10%) + 0.5 (1.15%)
rP = 6.63%
• Or, using the portfolio’s beta, CAPM can be used to solve for
expected return.
rP = rRF + (RPM) bP
rP = 5.5% + (5.0%) (0.225)
rP = 6.63%; but expected rate of return of the portfolio was
6.7%-----what does it implies? 50
 Factors that change the SML

• What if investors raise inflation expectations by

3%, what would happen to the SML?
ri (%)
D I = 3% SML2
SML1
13.5
10.5

8.5
5.5

Risk, bi

0 0.5 1.0 1.5 51

 Factors that change the SML

What if investors’ risk aversion increased, causing the

market risk premium /RPm/ to increase by 3%, what
would happen to the SML?
ri (%)
D RPM = 3% SML2

13.5
SML1
10.5

5.5

Risk, bi

0 0.5 1.0 1.5 52

 Verifying the CAPM empirically
• The CAPM has not been verified completely.

• Statistical tests have problems that make verification

almost impossible.

• Some argue that there are additional risk factors, other

than the market risk premium, that must be
considered. Which results in APT model (Arbitrage
Pricing Model)
53
 More thoughts on the CAPM
• Investors seem to be concerned with both market
risk and total risk. Therefore, the SML may not
produce a correct estimate of ri.
ri = rRF + (rM – rRF) bi + ???
• CAPM/SML concepts are based upon expectations,
but betas are calculated using historical data.
• A company’s historical data may not reflect
investors’ expectations about future riskiness.

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Over and Under Valuation/Pricing of Assets/Security

• A security is undervalued/underpriced if the security’s rate of return

lies above the yield curve, this send a signal to investors: the security
is temporarily underpriced relative to other securities of the same
maturity. Its holders will buy and this will drive the price the security
upward and its yield back down.
• A security is overvalued/overpriced if the security’s rate of return lies
below the yield curve, this send a signal to investors: the security is
temporarily overpriced financial instrument relative to other
securities of the same maturity. This is because the yield curve is
above that of securities bearing the same maturity. Holders of this
security will sell and this will push its price down and its yield back
up.
• Note: Yield curve is curve that represents the return and maturity of
a security.
• Question- how can one know whether a security is under or over
priced/valued using CAPM/SML as an analysis tool? 55
End of Chapter Three

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