chapter_1_4-1.ppt. X

Analysis of Investments and
Management of Portfolios
The Investment Setting
–What Is An Investment
–Return and Risk Measures
–Determinants of Required Returns
–Relationship between Risk and
Return

1-2
What Is An Investment?
• Defining 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
• Reason for Investing: By investing (saving
money now instead of spending it), individuals
can tradeoff present consumption for a
larger future consumption.

1-3
• Pure Rate of Interest
– It is the exchange rate between future consumption
(future dollars) and present consumption (current
dollars). Market forces determine this rate.
– Example: If you can exchange $100 today for $104
next year, this rate is 4% (104/100-1).
• Pure Time Value of Money
– The fact that people are willing to pay more for the
money borrowed and lenders desire to receive a
surplus on their savings (money invested) gives rise
to the value of time referred to as the pure time
value of money.

1-4
• Other Factors Affecting Investment Value
– Inflation: 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.
– Uncertainty: 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 Pure Time
Value of Money.

1-5
• The Notion of Required Rate of Return
– The minimum rate of return an investor require on
an investment, including the pure rate of interest
and all other risk premiums to compensate the
investor for taking the investment risk.
– Investors may expect to receive a rate of return
different from the required rate of return, which is
called expected rate of return. What would occur if
these two rates of returns are not the same?

1-6
Historical Rates of Return
• Return over A Holding Period
– Holding Period Return (HPR)
– Holding Period Yield (HPY)
HPY=HPR-1
– Annual HPR and HPY
Annual HPR=HPR1/n
Annual HPY= Annual HPR -1=HPR1/n
– 1
where n=number of years of the investment
Investment
of
Value
Beginning
Investment
of
Value
Ending
HPR =

1-7
Example: Assume that you invest $200 at the beginning
of the year and get back $220 at the end of the year.
What are the HPR and the HPY for your investment?
HPR=Ending value / Beginning value
=$220/200
=1.1
HPY=HPR-1=1.1-1=0.1
=10%

1-8
Example: Your investment of $250 in Stock A is worth
$350 in two years while the investment of $100 in
Stock B is worth $120 in six months. What are the
annual HPRs and the HPYs on these two stocks?
• Stock A
– Annual HPR=HPR1/n
= ($350/$250)1/2
=1.1832
– Annual HPY=Annual HPR-1=1.1832-1=18.32%
• Stock B
– Annual HPR=HPR1/n
= ($120/$100)1/0.5
=1.2544
– Annual HPY=Annual HPR-1=1.2544-1=25.44%

1-9
• Computing Mean Historical Returns
Suppose you have a set of annual rates of return
(HPYs or HPRs) for an investment. How do you
measure the mean annual return?
– Arithmetic Mean Return (AM)
AM=  HPY / n
where  HPY=the sum of all the annual HPYs
n=number of years
– Geometric Mean Return (GM)
GM= [ HPY] 1/n
-1
where  HPR=the product of all the annual HPRs
n=number of years

1-10
Suppose you invested $100 three years ago and it is
worth $110.40 today. The information below shows the
annual ending values and HPR and HPY. This
example illustrates the computation of the AM and the
GM over a three-year period for an investment.
Year Beginning Ending HPR HPY
Value Value
1 100 115.0 1.15 0.15
2 115 138.0 1.20 0.20
3 138 110.4 0.80 -0.20

1-11
AM=[(0.15)+(0.20)+(-0.20)] / 3
= 0.15/3=5%
GM=[(1.15) x (1.20) x (0.80)]1/3
– 1
=(1.104)1/3
-1=1.03353 -1 =3.353%
• Comparison of AM and GM
– When rates of return are the same for all years, the
AM and the GM will be equal.
– When rates of return are not the same for all years,
the AM will always be higher than the GM.
– While the AM is best used as an “expected value”
for an individual year, while the GM is the best
measure of an asset’s long-term performance.

1-12
• A Portfolio of Investments
– Portfolio HPY: 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.
– The weights used in the computation are the relative
beginning market values for each investment, which
is often referred to as dollar-weighted or value-
weighted mean rate of return.

1-13
The following exhibit demonstrates how to compute
the rate of return for a portfolio of 3 stocks.

1-14
Expected Rates of Return
• In contrast, an investor would be more
interested in the expected return on a future
risky investment.
• Risk refers to the uncertainty of the future
outcomes of an investment
– There are many possible returns/outcomes from an
investment due to the uncertainty
– Probability is the likelihood of an outcome
– The sum of the probabilities of all the possible
outcomes is equal to 1.0.

1-15
Expected Rates of Return
• Computing Expected Rate of Return
where P i = Probability for possible return i
R i = Possible return i




n
i 1
i Return)
(Possible
Return)
of
y
Probabilit
(
)
E(R
)]
R
(P
....
)
)(R
(P
)
)(R
[(P n
n
2
2
1
1 






n
i
i
i R
P
1
)
)(
(

1-16
Probability Distributions
Exhibit 1.2
Risk-free Investment
0.00
0.20
0.40
0.60
0.80
1.00
-5% 0% 5% 10% 15%

1-17
Exhibit 1.3
Risky Investment with 3 Possible Returns
0.00
0.20
0.40
0.60
0.80
1.00
-30% -10% 10% 30%

1-18
Exhibit 1.4
Risky investment with ten possible returns
0.00
0.20
0.40
0.60
0.80
1.00
-40% -20% 0% 20% 40%

1-19
Risk of Expected Return
• Risk refers to the uncertainty of an investment;
therefore the measure of risk should reflect the
degree of the uncertainty.
• The risk of expected return reflect the degree
of uncertainty that actual return will be different
from the expect return.
• The common measures of risk are based on
the variance of rates of return distribution of an
investment

1-20
å
å
=
=
-
=
-
=
n
i
i
i
i
n
i
R
E
R
P
turn
Expected
turn
Possible
x
obability
Variance
1
2
2
1
)]
(
[
)
Re
Re
(
)
(Pr
)
(s
• Measuring the Risk of Expected Return
– The Variance Measure

1-21
– Standard Deviation (σ): It is the square root of the
variance and measures the total risk
å
=
-
=
n
i
i
i
i R
E
R
P
1
2
)]
(
[
s
– Coefficient of Variation (CV): It measures the risk
per unit of expected return and is a relative
measure of risk.
)
(R
E
Return
of
Rate
Expected
Return
of
Deviation
Standard
CV
s
=
=

1-22
Risk of Historical Rates of Return
where, σ 2
= the variance of the series
HPY i = the holding period yield during period i
E(HPY) = the expected value of the HPY equal
to the arithmetic mean of the series (AM)
n = the number of observations
n
/
HPY)]
(
E
HPY
[ 2
n
1
i
i
2







 


• Given a series of historical returns measured
by HPY, the risk of returns is measured as:

1-23
Determinants of Required Returns
• Three Components of Required Return:
– The time value of money during the time period
– The expected rate of inflation during the period
– The risk involved
• Complications of Estimating Required Return
– A wide range of rates is available for alternative
investments at any time.
– The rates of return on specific assets change
dramatically over time.
– The difference between the rates available on
different assets change over time.

1-24
• The Real Risk Free Rate (RRFR)
– Assumes no inflation.
– Assumes no uncertainty about future cash flows.
– Influenced by time preference for consumption of
income and investment opportunities in the
economy
• Nominal Risk-Free Rate (NRFR)
– Conditions in the capital market
– Expected rate of inflation
NRFR=(1+RRFR) x (1+ Rate of Inflation) - 1
RRFR=[(1+NRFR) / (1+ Rate of Inflation)] - 1

1-25
• 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.

1-26
• Liquidity Risk
– 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.

1-27
• 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.

1-30
• Risk Premium and Portfolio Theory
– From a portfolio theory perspective, 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.
– According to the portfolio theory, the risk premium
depends on the systematic risk.

1-31
• Fundamental Risk versus Systematic Risk
– Fundamental risk comprises business risk, financial
risk, liquidity risk, exchange rate risk, and country
risk.
Risk Premium= f ( Business Risk, Financial Risk,
Liquidity Risk, Exchange Rate
Risk, Country Risk)
– Systematic risk refers to the portion of an
individual asset’s total variance attributable to
the variability of the total market portfolio.
Risk Premium= f (Systematic Market Risk)

1-32
Relationship Between Risk and Return
• The Security Market Line (SML)
– It shows the relationship between risk and return for
all risky assets in the capital market at a given time.
– Investors select investments that are consistent
with their risk preferences.
ExpectedReturn
Risk
(business risk, etc., or systematic risk-beta)
NRFR
Security
Market Line
Low
Risk
Average
Risk
High
Risk
The slope indicates the
required return per unit of risk

1-33
• Movement along the SML
– When the risk of an investment changes due to a
change in one of its risk sources, the expected
return will also change, moving along the SML.
Return
Risk
(business risk, etc., or systematic risk-beta)
NRFR
SML
Expected
Movements along the curve
that reflect changes in the
risk of the asset

1-34
• Changes in the Slope of the SML
– When there is a change in the attitude of investors
toward risk, the slope of the SML will also change.
– If investors become more risk averse, then the SML
will have a steeper slope, indicating a higher risk
premium, RPi, for the same risk level.
Risk
NRFR
Original SML
New SML
R m
R m’
Expected Return

1-35
• Changes in Market Condition or Inflation
– A change in the RRFR or the expected rate of
inflation will cause a parallel shift in the SML.
– When nominal risk-free rate increases, the SML will
shift up, implying a higher rate of return while still
having the same risk premium.
Risk
NRFR
Original SML
New SML
Expected Return
NRFR'

1-36

Steps of the Portfolio Management
Process
1-38
Planning
• Identification of
Objectives and
Constraints
• Investment
Policy Statement
• Capital Market
Expectations
• Asset Allocation
Strategy
• Strategic Asset
Allocation
• Tactical Asset
Allocation
Execution
• Portfolio
Selection
• Portfolio
Implementation
Feedback
• Monitoring and
Rebalancing
• Performance
Evaluation

Types of Investment Strategies
• Portfolios that do not respond to any changes in
expectations
Passive Investment
• These strategies respond much more to changing
expectations.
Active Investment
• An enhanced index, risk-controlled active, and semi-
active strategies, which are hybrids of active and
passive strategies
Hybrids
1-39

Global Investment Strategies
1-41

Global Investment Strategies
1-42

Sector-Based Investment Strategies
• Exposure to innovative products, services, and trends shaping the world
Global Technology Investments
• Exposure to pharmaceuticals, biotechnology, and medical device companies,
benefiting from an aging global population and increasing healthcare
spending.
Global Healthcare Investments
• Transportation, utilities, and communication networks
Global Infrastructure Investments
• Companies engaged in the production, transportation, and distribution of
various energy sources, including fossil fuels, renewables, and nuclear power
Global Energy Investments
• Companies producing and distributing goods and services that cater to the
global consumer market, such as food and beverage, personal care products,
and household items
Global Consumer Goods Investments
1-43

Alternative Global Investment Strategies
• Companies that own, operate or finance income-producing real estate properties. Global
REITs provide investors with exposure to the international real estate market and its potential
for capital appreciation and income generation.
Real Estate Investment Trusts (REITs)
• Commodities are tangible assets like oil, gold, and agricultural products. Global commodity
investments can serve as a hedge against inflation and provide diversification benefits.
Commodities
• Investing in foreign currency can offer diversification and profit opportunities from exchange
rate fluctuations. However, currency investments come with a higher risk due to market
volatility.
Foreign Currency
• Peer-to-peer (P2P) lending platforms connect borrowers and lenders directly, facilitating loans
across international borders. This alternative investment strategy can provide attractive returns
but carries the risk of borrower default.
Peer-to-Peer Lending
• Venture capital (VC) and private equity (PE) investments involve investing in private
companies with growth potential. Global VC and PE investments can provide exposure to
disruptive technologies and innovative business models worldwide.
Venture Capital and Private Equity
1-44

MARKET EFFICIENCY INFORMATION
1-48

MODERN PORTFOLIO THEORY
• MPT is primarily used by investors seeking the
following outcomes:
• Investors who are risk-averse and looking to construct
a diversified portfolio that maximizes returns without
taking on high levels of risk.
• Investors trying to construct the most efficient and
diversified portfolio using ETFs and stocks.
• Investors looking to build a crypto portfolio with the
greatest risk-to-reward ratio that aligns with their risk
appetite.
• Investors whose primary concern is minimizing
downside risk.
1-52

ASSUMPTIONS OF MPT
• Investors are rational and behave in a manner as to
maximise their utility with a given level of income or
money.
• Investors have free access to fair and correct
information on the returns and risk.
• The markets are efficient and absorb the information
quickly and perfectly.
• Investors are risk averse and try to minimise the risk and
maximise return.
• Investors base decisions on expected returns and
variance or standard deviation of these returns from the
mean.
• Investors choose higher returns to lower returns for a
given level of risk.
1-53

CAPITAL ASSET PRICING
MODEL
1-72

CAPM- A SINGLE FACTOR MODEL
1-74

Problems with Capital Asset Pricing
Model
• One of the assumptions used in CAPM is that investors can
borrow as well as lend funds at a risk free rate, which is actually
unreal. Investors are unable to borrow or lend at the GOI bond
rate. Thus, the minimum required rate of return by an investor
might be more than what the model incorporates.
• The yield on GOI bonds is used as a substitute for the risk free
rate. However, this rate keeps on changing on regular basis with
the changing economic circumstances. Thus creating volatility.
• The Beta values are unstable and vary from time to time. Thus,
these may not be reflective of the true risk involved and therefore
are not good estimates of future risk.
1-82

Problems with Capital Asset Pricing
Model
• CAPM assumes that a security’s required rate of
return is based only on one factor, i.e., systematic risk.
However, other factors such as relative sensitivity to
inflation, dividend payout and others may also impact
a security’s return.
• The model focuses on single period time horizon. It
suggests that investors are only concerned with the
wealth their portfolio produces at the end of the current
period. However, this does not hold true in the real
world.
1-83

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