Chapter One: Introduction to investment
1.1 What is an Investment?
An investment is the current commitment of dollars for a period of
time in order to derive future payments that will compensate the
investor.
The “investor” can be an individual, a government, a pension fund, or
a corporation.
Pure rate of interest: The rate of exchange between future
consumption (future dollars) and current consumption (current
dollars).
The pure time value of money: Both people’s willingness to pay
the difference for borrowed funds 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.
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 investors expect a change in prices, they will require a higher
rate of return to compensate for it.
For example, 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. In our example, the investor would require $106 in the
future to defer the $100 of consumption during an inflationary
period (a 6 percent nominal, risk-free interest rate will be required
instead of 4 percent).
Conti---
Further, 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.
The investment risk: is the uncertainty of the payments from
an investment.
A risk premium: is the additional return added to the
nominal, risk-free interest rate. In our previous example, the
investor would require more than $106 one year from today
to compensate for the uncertainty. As an example, if the
required amount were $110, $4, or 4 percent, would be
considered a risk premium.
1.2 Measures of Return and Risk
A return is the ultimate objective for any investor.
But a relationship between return and risk is a key concept in finance.
The concept of return provides investors with a convenient way of expressing the
financial performance of an investment.
Many investments have two components of their measurable return such as a
capital gain or loss and some form of income.
The rate of return is the percentage increase in returns associated with the holding
period.
If you commit $200 to an investment at the beginning of the year and you get back
$220 at the end of the year, what is your return for the period?
The period during which you own an investment is called its holding period, and
The return for that period is the holding period return (HPR).
In this example, the HPR is:
This value will always be zero or greater—that is, it can never
be a negative value.
A value greater than 1.0 reflects an increase in your wealth,
which means that you received a positive rate of return during
the period.
Conti---
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.
To derive an annual HPY, you compute an annual HPR and subtract 1. Annual
HPR is found by:
1.2.2 Computing Mean Historical Returns
Single Investment Given a set of annual rates of return
(HPYs) for an individual investment, there are two summary
measures of return performance.
1. The first is arithmetic means return,
2. The second one is the geometric mean return.
To find the arithmetic mean (AM), the sum of annual HPYs
is divided by the number of years (n) as follows:
An alternative computation is, the geometric mean (GM), is the
nth root of the product of the HPRs for n year minus one
1.2.3 Calculating Expected Rates of Return
Risk is the uncertainty that an investment will earn its expected rate of
return.
The investor might say that he or she expects the investment will provide
a rate of return of 10 percent, but this is actually the investor’s most likely
estimate that referred to as a point estimate.
The annual rate of return on this investment might go as low as −10
percent or as high as 25 percent.
The point is, the specification of a larger range of possible returns from an
investment reflects the investor’s uncertainty regarding what the actual
return will be.
Therefore, a larger range of possible returns implies that the investment is
riskier.
Risk aversion
Expected Return = E(R i ) n (Probability of Return) (Possible Return)
Expected rate of return = r n = Pi ri .
i=1
Most investors are risk averse.
This means that for two alternatives with the same expected rate of
return, investors will choose the one with the lower risk.
No investment will be undertaken unless the expected rate of return
is high enough to compensate the investor for the perceived risk of
the investment.
Illustration- Expected rate of return:
Let us begin our analysis of the effect of risk with an example
of perfect certainty wherein the investor is absolutely certain
of a return of 5 percent.
Perfect certainty allows only one possible return, and the
probability of receiving that return is 1.0.
Few investments provide certain returns and would be
considered risk-free investments.
In the case of perfect certainty, there is only one value for
PiRi:
E(Ri) = (1.0)(0.05) = 0.05 = 5%
1.2.4 Measures the Risk of the Expected Rates of Return
Two possible measures of risk (uncertainty) have received
support in theoretical work on portfolio theory: the variance
and the standard deviation of the estimated distribution of
expected returns.
Question: Compute the variance and Standard deviation for
the three examples above
Answer: 1.The variance for the perfect-certainty example
would be: 0
Conti---
This gives an expected return [E(Ri)] of 7 percent. The
dispersion of this distribution as measured by variance is:
The variance (σ2) is equal to 0.0141.
The standard deviation is equal to the square root of the
variance:
In this example, the standard deviation is approximately 11.87
percent.
Coefficient of Variation
A measure of relative dispersion is the coefficient of variation, which is
defined as: Because lower risk is preferred to higher risk and higher return
is preferred to lower return, an investment with a lower coefficient of
variation, CV, is preferred to an investment with a higher CV
1.3 Determinants of Required Rates of Return:
Recall that the selection process of an investment involves finding
securities that provide a rate of return that compensates you for:
1. the time value of money during the period of investment,
2. the expected rate of inflation during the period, and
3. the risk involved.
The real risk-free rate (RRFR)
This is the basic interest rate, assuming no inflation and no uncertainty
about future flows.
This RRFR of interest is the price charged for the exchange between
current goods and future goods.
Two factors, one subjective and one objective, influence this exchange
price.
The subjective factor is the time preference of individuals for the
consumption of income.
Factors Influencing the Nominal Risk-Free Rate (NRFR)
Nominal rates of interest that prevail in the market are determined by:
real rates of interest, plus
factors that will affect the nominal rate of interest, such as:
the expected rate of inflation and
the monetary environment.
Nominal RFR = (1+Real RFR) x (1+Expected Rate of Inflation) – 1.
Rearranging the formula, you can calculate the RRFR of return on an
investment as follows:
{(1+Nominal RFR/1+Rate of Inflation)-1}
Example: assume that the nominal return on U.S. government T-bills was 9 percent during
a given year, when the rate of inflation was 5 percent. What would be the RRFR of return
on this T-bills ?
RRFR =[(1 +0.09)/(1 +0.05)] – 1
=1.038 – 1
=0.038 =3.8%
Risk Premium
A risk-free investment was defined as one for which the investor is certain of the amount
and timing of the expected returns.
The returns from most investments do not fit this pattern.
Investments can range in uncertainty from basically risk-free securities, such as T-bills, to
highly speculative investments, such as the common stock of small companies engaged in
high-risk enterprises.
The increase in the required rate of return over the NRFR (Nominal Risk Free Rate) is the risk
premium (RP).
Major Sources of Uncertainty:
business risk,
financial risk (leverage),
liquidity risk,
exchange rate risk, and
Country (political) risk.
Conti--
Markowitz and Sharpe: that investors should use an external
market measure of risk.
The co movement, which is measured by an asset’s covariance
with the market portfolio, is referred to as an asset’s systematic
risk
The nonmarket variance is called unsystematic risk, and it is
generally considered unimportant because it is eliminated in a
large, diversified portfolio.
Fundamental Risk versus Systematic Risk
Some might expect a conflict between the market measure of risk
(systematic risk) and the fundamental determinants of risk
(business risk, and so on).
Conti--
A number of studies have examined the relationship between
the market measure of risk (systematic risk) and accounting
variables used to measure the fundamental risk factors, such as
business risk, financial risk, and liquidity risk.
It is possible that a firm that has a high level of fundamental
risk and a large standard deviation of return on stock can have
a lower level of systematic risk.
Therefore, one can specify the risk premium for an asset as:
1.4 Relationship between Risk and Return
Exhibit 1.4 graphs the expected relationship
between risk and return
It shows that investors increase their required rates
of return as perceived risk (uncertainty) increases.
The line that reflects the combination of risk and
return available on alternative investments is
referred to as the security market line (SML).
The SML reflects the risk-return combinations
available for all risky assets in the capital market
at a given time.
Conti--
Beginning with an initial SML, three changes
can occur.
First, individual investments can change positions
on the SML because of changes in the perceived risk
of the investments.
Second, the slope of the SML can change because of
a change in the attitudes of investors toward risk;
that is, investors can change the returns they require
per unit of risk.
Third, the SML can experience a parallel shift due to
a change in the RRFR or the expected rate of
inflation—that is, a change in the NRFR.
Risk Vs Return r/ship
Changes in the Slope of the SML
The slope of the SML indicates the return per unit of risk
required by all investors.
Assuming a straight line, it is possible to select any point on
the SML and compute a risk premium (RP) for an asset
through the equation:
If a point on the SML is identified as the portfolio that contains all the risky
assets in the market (referred to as the market portfolio), it is possible to
compute a market RP as follows:
This market RP is not constant because the slope of the
SML changes over time.
Conti----
we do know that there are changes in the yield differences between assets
with different levels of risk even though the inherent risk differences are
relatively constant.
These differences in yields are referred to as yield spreads, and this yield
spreads change over time.
As an example, if the yield on a portfolio of AAA-rated bonds is 7.50
percent and BAA-rated bonds is 9.00 percent, we would say that the yield
spread is 1.50 percent.
This 1.50 percent is referred to as a credit risk premium because the BAA-
rated bond is considered to have higher credit risk—that is, greater
probability of default.
This Baa–Aaa yield spread is not constant over time.
Exhibit 1.5
Changes in Capital Market Conditions or Expected Inflation
The graph in Exhibit shows what happens to the SML when
there are changes in one of the following factors:
1) Expected real growth in the economy,
2) Capital market conditions, or
3) The expected rate of inflation.
For example, an increase in expected real growth, temporary
tightness in the capital market, or an increase in the expected rate
of inflation will cause the SML to experience a parallel shift
upward.
The parallel shift occurs because changes in expected real
growth or in capital market conditions or a change in the
expected rate of inflation affect all investments, no matter what
their levels of risk are.
Conti--
THE END
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