Lecture01 PPT-1 Newformat

Lecture 01

Investment Compiled by

Dr. Kumail Rizvi, CFA, FRM

• Kumail Rizvi

PhD from Paris 1 (Panthéon sorbonne) 2011

CFA 2010

FRM 2010

MSc Money Banking and Finance 2007

MSc Computer Sciences 2003

MBEcon (Finance) 2001

Experience (Academic)

GIFT University

Hailey College of Commerce, Punjab University

PAK AIMS

IBP (Institute of Bankers Pakistan)

Paris 1 (Panthéon Sorbonne)

University of Central Punjab (UCP)

Lahore School of Economics (LSE)

Experience (Corporate)

NATIXIS BANK, France

Sigma Financials, Dubai

Synergistic Financial Advisors (SFA)

SPM Consulting, Dubai

SAS Middle East

IBM (International Business Machines)

GBM (Gulf Business Machines)

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 ?

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

investments ?

Why Do Individuals

Invest ?

By saving money (instead of

spending it), individuals tradeoff

present consumption for a larger

future consumption.

04.1$%400.1$

How Do We Measure The Rate Of

Return On An Investment ? The pure rate of interest is the

exchange rate between future

consumption (future dollars) and

present consumption (current

dollars). Market forces determine

this rate.

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.

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.

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.

How Do We Measure The Rate Of

Return On An Investment ?

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 funds.

Measures of Historical Rates of Return

Holding Period Return

10.1 $200

$220

Investment of Value Beginning

Investment of Value EndingHPR

1.1

Measures of Historical Rates of Return

Holding Period Yield

HPY = HPR - 1

1.10 - 1 = 0.10 = 10%

1.2

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

Measures of Historical Rates of Return

Measures of Historical Rates of Return

Arithmetic Mean

1.4

yields period holding

annual of sum the HPY

:where

HPY/AM

n

Measures of Historical Rates of Return

Geometric Mean

1.5

n

n

HPRHPRHPR

:follows as returns period holding annual theofproduct the

:where1HPR GM

21

1

Portfolio Return Measurement

• Money ($) Weighted Rate of Return

– IRR is indeed the money weighted rate of return

because it accounts for the timing and amount of all

dollar flows into and out of the portfolio.

• Time Weighted Rate of Return

– It measures the compound rate of growth of $1

initially invested in the portfolio over a stated

measurement period.

– It is not affected by cash withdrawals or additions to

the portfolio.

Time Outlay

0 $200 to purchase the first share

1 $225 to purchase the second share

Proceeds

1 $5 dividend received from first share (not reinvested)

2 $10 dividend received from two shares

2 $470 received from selling two shares @$235 each

Money Weighted ROR

• PV(outflows) = PV (inflows)

• IRR Function: CF0=-200, CF1=-220,

CF2=480 IRR=9.39%

• Simple Arithmetic Mean of HPY or HPR

• (5+225)/200=1.15 or 15%

• (10+470)/450= 1.06777 or 6.67%

• Average: (15+6.67)/2 =10.84%

Time Weighted ROR

• It is indeed a Geometric Mean of HPRs or

1+HPYs

• TW-ROR = (1.15 x 1.0667)1/2 -1=10.76%

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, or the overall change in the value of the original portfolio

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$

HPY = 1.095 - 1 = 0.095

= 9.5%

HPR = = 1.095

Exhibit 1.1

Expected Rates of Return

• Risk is uncertainty that an

investment will earn its expected

rate of return

• Probability is the likelihood of an

outcome

Expected Rates of Return

n

i 1

i

Return) (Possible Return) ofy Probabilit(

)E(R Return Expected

)R(P....))(R(P))(R[(P nn2211

))(RP(1

ii

n

i

1.6

Risk Aversion

The assumption that most investors

will choose the least risky

alternative, all else being equal and

that they will not accept additional

risk unless they are compensated in

the form of higher return

Probability Distributions

Risk-free Investment

0.00

0.20

0.40

0.60

0.80

1.00

-5% 0% 5% 10% 15%

Exhibit 1.2

Probability Distributions

Risky Investment with 3 Possible Returns

0.00

0.20

0.40

0.60

0.80

1.00

-30% -10% 10% 30%

Exhibit 1.3

Probability Distributions

Risky investment with ten possible rates of return

0.00

0.20

0.40

0.60

0.80

1.00

-40% -20% 0% 20% 40%

Exhibit 1.4

Measuring the Risk of Expected Rates of Return

2n

1i

Return) Expected-Return (Possibley)Probabilit(

)( Variance

2

iii

1

)]E(R)[RP(

n

i

1.7

Measuring the Risk of Expected Rates of Return

Standard Deviation is the square

root of the variance

1.8

Measuring the Risk of Expected Rates of Return

Coefficient of variation (CV) a measure of relative variability that indicates risk per unit of return

Standard Deviation of Returns Expected Rate of Returns

E(R)

i

1.9

Measuring the Risk of Historical Rates of Return

variance of the series

holding period yield during period I

expected value of the HPY that is equal

to the arithmetic mean of the series

the number of observations

2/nn

1i

i

2 HPY)(EHPY[

n

E(HPY)

HPY

i

2

1.10

Determinants of Required Rates of Return

• Time value of money during the

period of investment

• Expected rate of inflation during

the period

• Risk involved

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

Adjusting For Inflation

Real RFR =

1Inflation) of Rate(1

RFR) Nominal1(

1.12

Nominal Risk-Free Rate

Dependent upon

– Conditions in the Capital Markets

– Expected Rate of Inflation

Adjusting For Inflation

Nominal RFR = (1+Real RFR) x (1+Expected Rate of Inflation) - 1

1.11

Facets of Fundamental

Risk

• Business risk

• Financial risk

• Liquidity risk

• Exchange rate risk

• Country risk

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.

Liquidity Risk

• Uncertainty is introduced by the secondary

market for an investment.

– 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.

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

Risk Premium

f (Business Risk, Financial Risk,

Liquidity Risk, Exchange Rate

Risk, Country Risk)

or

f (Systematic Market Risk)

Risk Premium

and Portfolio Theory

• 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

Fundamental Risk

versus Systematic Risk • Fundamental risk comprises business risk,

financial risk, liquidity risk, exchange rate

risk, and country risk

• Systematic risk refers to the portion of an

individual asset’s total variance attributable

to the variability of the total market portfolio

Relationship Between Risk and Return Exhibit 1.7

Rateof Return

Risk(business risk, etc., or systematic risk-beta)

RFR

SecurityMarket Line

LowRisk

AverageRisk

HighRisk

The slope indicates therequired return per unit of risk

(Expected)

Changes in the Required Rate of Return Due to Movements Along the SML

Rate

Risk(business risk, etc., or systematic risk-beta)

RFR

SecurityMarket Line

Expected

Movements along the curvethat reflect changes in therisk of the asset

Exhibit 1.8

Changes in the Slope of the SML

RPi = E(Ri) - NRFR

where:

RPi = risk premium for asset i

E(Ri) = the expected return for asset i

NRFR = the nominal return on a risk-free asset

1.13

Market Portfolio Risk

The market risk premium for the market

portfolio (contains all the risky assets in the

market) can be computed:

RPm = E(Rm)- NRFR where:

RPm = risk premium on the market portfolio

E(Rm) = expected return on the market portfolio

NRFR = expected return on a risk-free asset

1.14

Change in Market Risk Premium

Exhibit 1.10

Risk

RFR

Original SML

New SML

Rm

Rm'

E(R)

NRFR

Expected Return

Rm´

Rm

Capital Market Conditions, Expected Inflation, and the SML

Exhibit 1.11

Risk

RFR

Original SML

New SML

Rate of Return

RFR'

NRFR

NRFR´

Expected Return

The Internet Investments Online

http://www.finpipe.com

http://www.investorguide.com

http://www.aaii.com

http://www.economist.com

http://www.online.wsj.com

http://www.forbes.com

http://www.barrons.com

http://fisher.osu.edu/fin/journal/jofsites.htm

http://www.ft.com

http://www.fortune.com

http://www.smartmoney.com

http://www.worth.com

http://www.money.cnn.com

Future Topics

Chapter 2

• The asset allocation decision

• The individual investor life

cycle

• Risk tolerance

• Portfolio management