2. Prerequisite for this course
1. Financial Management
2. Corporate Finance
3. Investment Analysis & Portfolio Management
4. Statistics
3. Book
Analysis of Investment and
Management of Portfolio
tenth Edition
by
Frank K. Reilly & Keith C. Brown
4. 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 ?
5. 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 ?
6. Why Do Individuals Invest ?
• For most of your life, you will be earning and
spending money.
• Rarely, though, will your current money
income exactly balance 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.
7. Why Do Individuals
Invest ?
By saving money (instead of
spending it), individuals tradeoff
present consumption for a larger
future consumption.
8. Definition (Jones)
• Investments is the study of the process of
committing funds to one or more assets
– Emphasis on holding financial assets and marketable
securities
– Concepts also apply to real assets
– Foreign financial assets should not be ignored
• Most individuals make investment decisions
sometime
– Need sound framework for managing and increasing
wealth
• Essential part of a career in the field
– Security analyst, portfolio manager, investment advisor,
financial planner, Chartered Financial Analyst
9. How Do We Measure The Rate Of
Return On An Investment ?
The pure rate of interest is the
exchange rate between future
consumption and present
consumption. Market forces
determine this rate.
$1.00 4% $1.04
10. How Do We Measure The Rate Of
Return On An Investment ?
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.
11. 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.
12. How Do We Measure The Rate Of
Return On An Investment ?
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.
13. 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
Real rate of return +
Inflation premium +
Risk premium
funds.
14. Measures of
Historical Rates of Return
Holding Period Return
HPR Ending Value of Investment
Beginning Value of Investment
1.10
$220
$200
1.1
15. Measures of
Historical Rates of Return
Holding Period Yield
HPY = HPR - 1
1.10 - 1 = 0.10 = 10%
1.2
16. Measures of
Historical Rates of Return
Annual Holding Period Return
–Annual HPR = HPR 1/n
where n = number of years investment is held
Annual Holding Period Yield
–Annual HPY = Annual HPR - 1
(E/B)^(1/n)
HPR Ending Value of Investment
Beginning Value of Investment
=(E/B)^(1/n)-1
17. Consider an investment that cost $250 and is
worth $350 after being held for two years
• HPR?
• HPY?
22. • Note that we made some implicit assumptions
when converting the HPY to an annual basis.
• This annualized holding period yield
computation assumes a constant annual yield
for each year.
• In the two-year investment, we assumed an
18.32 percent rate of return each year,
compounded.
• In the partial year HPR that was annualized,
we assumed that the return is compounded for
the whole year.
23. today investment 250
rate / annum 0.1832
45.8
after year 1 295.8
rate / annum 0.1832
54.19056
After 2-years 349.99056
or
PV 250
rate=i 0.1832
n= 2
FV ?
FV PV*(1+i)^n
349.99056
24. Measures of Historical Rates of Return
( single investment)
1. Arithmetic Mean 1.4
HPY the sum of annual
holding period yields
where :
AM HPY/
n
25. Measures of
Historical Rates of Return
2. Geometric Mean 1.5
GM HPR n
1
where :
the product of the annual
holding period returns as follows :
HPR HPR HPR
1 2
n
1
26. To illustrate these alternatives, consider an
investment with the following data
27. • Investors are typically concerned with long-term
performance when comparing alternative
investments.
• GM is considered a superior measure of the
long-term mean rate of return because it
indicates the compound annual rate of return
based on the ending value of the investment
versus its beginning value
• the arithmetic average provides a good
indication of the expected rate of return for an
investment during a future individual year,
• it is biased upward if you are attempting to
measure an asset’s long-term performance
28. Consider, for example, a security that
increases in price from $50 to $100 during
year 1 and drops back to $50 during year 2.
The annual HPYs would be:
29. • This answer of a 0 percent rate of return
accurately measures the fact that there was
no change
• in wealth from this investment over the two-year
period.
30. 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.
31. Computation of Holding
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
$20,000,000
HPR = = 1.095
HPY = 1.095 - 1 = 0.095
= 9.5%
Exhibit 1.1
32. Expected Rates of Return
• Risk is uncertainty that an investment
will earn its expected rate of return,
or
• Risk: the possibility that the realized
return will be different than the
expected return
• Probability is the likelihood of an
outcome
