The Investment Setting

Chapter1
Learning Objectives

 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 individual investments and investments in general?
Introduction

 This initial chapter discusses several topics basic to the subsequent chapters.
We begin by defining the term investment and discussing the returns and risks
related to investments. This leads to a presentation of how to measure the
expected and historical rates of returns for an individual asset or a portfolio
of assets. In addition, we consider how to measure risk not only for an
individual investment but also for an investment that is part of a portfolio.
WHAT IS AN INVESTMENT?

 For most of your life, you will be earning and spending money. Rarely,
though, will your current money income exactly balances with your
consumption desires. Sometimes, you may have more money than you want to
spend; at other times, you may want to purchase more than you can afford.
These imbalances will lead you either to borrow or to save to maximize the
long-run benefits from your income.
 When current income exceeds current consumption desires, people tend to
save the excess.
Difference between Savings and
Investment
Investment Defined

(1) the time the funds are committed,

(2) the expected rate of inflation, and
(3) the uncertainty of the future payments. The “investor” can be an individual,
a government, a pension fund, or a corporation.
MEASURES OF RETURN AND RISK

Measures of Historical Rates of Return

 When you are evaluating alternative investments for inclusion in your
portfolio, you will often be comparing investments with widely different
prices or lives. As an example, you might want to compare a $10 stock that
pays no dividends to a stock selling for $150 that pays dividends of $5 a year.
To properly evaluate these two investments, you must accurately compare
their historical rates of returns. A proper measurement of the rates of return
is the purpose of this section.
Holding Period
Return (HPR).
 EX: If you commit $200 to an
investment at the beginning of
HPR= Ending Value of Investment
the year and you get back $220 Beginning Value of Investment
at the end of the year, what is
your return for the period? The HPR= 220
period during which you own an
investment is called its holding
200
period, and the return for that HPR= 1.10
period is the Holding Period
Return (HPR). In this example,
the HPR is 1.10, calculated as
follows:
Holding Period Yield (HPY)

 Although HPR helps us express the change in value of an investment, investors

generally evaluate returns in percentage terms on an annual basis. This
conversion to annual percentage rates makes it easier to directly compare
alternative investments that have markedly different characteristics. The first
step in converting an HPR to an annual percentage rate is to derive a
percentage return, referred to as the holding period yield (HPY). The HPY is
equal to the HPR minus 1.

HPY = HPR – 1
HPY = 1.10 – 1
= 0.10
= 10%
To derive an annual HPY, you
compute an annual HPR and
subtract 1. Annual HPR is found by:
Annual HPR = HPR 1/n
where:
n = number of years the investment
is held
Consider an investment that cost
$250 and is worth $350 after being
held for two years:
Risk

 Risk is the uncertainty that an investment will earn its expected rate of
return.
Factors Influencing the Nominal Risk-
Free Rate (NRFR)
 Conditions in the Capital Market. You will recall from prior courses in
economics and finance that the purpose of capital markets is to bring
together investors who want to invest savings with companies or governments
who need capital to expand or to finance budget deficits.
 Expected Rate of Inflation. Previously, it was noted that if investors
expected the price level to increase during the investment period, they would
require the rate of return to include compensation for the expected rate of
inflation.
Risk Premium

In this section, we identify and briefly discuss the major sources of uncertainty, including:
 Business risk is the uncertainty of income flows caused by the nature of a firm’s
business. The less certain the income flows of the firm, the less certain the income
flows to the investor.
 Financial risk is the uncertainty introduced by the method by which the firm finances
its investments. If a firm uses only common stock to finance investments, it incurs only
business risk.
 Liquidity risk is the uncertainty introduced by the secondary market for an investment.
 Exchange rate risk is the uncertainty of returns to an investor who acquires securities
denominated in a currency different from his or her own.
 Country risk, also called political risk, is the uncertainty of returns caused by the
possibility of a major change in the political or economic environment of a country.
What Is Expected Return?

 The expected return on an investment is the expected value of the

probability distribution of possible returns it can provide to investors. The
return on the investment is an unknown variable that has different values
associated with different probabilities. Expected return is calculated by
multiplying potential outcomes (returns) by the chances of each outcome
occurring, and then calculating the sum of those results (as shown below).
For example,
For example, if an investment has a 50% chance of gaining 20% and a 50% chance
of losing 10%, the expected return would be 5%
= (50% x 20% + 50% x -10% = 5%).
For example, a model might state that an investment has a 10% chance of a 100%
return and a 90% chance of a 50% return. The expected return is calculated as:
Expected Return = 0.1(1) + 0.9(0.5) = 0.55 = 55%.