1 ch01-a

AppliedPortfolio and Fund

Management

Presented byMuhammad Khalid Sohail

Prerequisite for this course1. Financial Management2. Corporate Finance3. Investment Analysis & Portfolio Management4. Statistics

BookAnalysis of Investment and

Management of Portfoliotenth Edition

byFrank K. Reilly & Keith C. Brown

Chapter 1The Investment SettingQuestions 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 1The Investment Setting• What factors contribute to the rates of

return that investors require onalternative investments ?

• What macroeconomic andmicroeconomic factors contribute tochanges in the required rate of return forindividual investments and investmentsin general ?

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 yourconsumption desires.

• Sometimes, you may have more money thanyou want to spend; at other times, you maywant to purchase more than you can afford.

• These imbalances will lead you either toborrow or to save to maximize the long-runbenefits from your income.

Why Do IndividualsInvest ?

By saving money (instead ofspending it), individuals tradeoffpresent consumption for a largerfuture consumption.

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 decisionssometime– 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

04.1$%400.1$

How Do We Measure The Rate OfReturn On An Investment ?

The pure rate of interest is theexchange rate between futureconsumption and presentconsumption. Market forcesdetermine this rate.

People’s willingness to pay thedifference for borrowing today andtheir desire to receive a surplus ontheir savings give rise to an interestrate referred to as the pure timevalue of money.

How Do We Measure The Rate OfReturn On An Investment ?

If the future payment will bediminished in value because ofinflation, then the investor willdemand an interest rate higher thanthe pure time value of money toalso cover the expected inflationexpense.

How Do We Measure The Rate OfReturn On An Investment ?

If the future payment from theinvestment is not certain, theinvestor will demand an interestrate that exceeds the pure timevalue of money plus the inflationrate to provide a risk premium tocover the investment risk.

How Do We Measure The Rate OfReturn On An Investment ?

Defining an InvestmentA current commitment of $ for aperiod of time in order to derivefuture payments that willcompensate for:– the time the funds are committed– the expected rate of inflation– uncertainty of future flow of

funds.

Real rate of return +

Inflation premium +

Risk premium

Measures ofHistorical Rates of Return

Holding Period Return

10.1$200$220

InvestmentofValueBeginningInvestmentofValueEndingHPR

1.1

Measures ofHistorical Rates of Return

Holding Period YieldHPY = HPR - 11.10 - 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 ofHistorical Rates of Return

InvestmentofValueBeginningInvestmentofValueEndingHPR

(E/B)^(1/n)

=(E/B)^(1/n)-1

Consider an investment that cost $250 and isworth $350 after being held for two years

• HPR?• HPY?

Consider an investment that cost $250 and isworth $350 after being held for two years

A multiple year loss over twoyears would be

consider an investment of $100 held for onlysix months that earned a return of $12

• HPR?• HPY?

consider an investment of $100 held for onlysix months that earned a return of $12

• Note that we made some implicit assumptionswhen converting the HPY to an annual basis.

• This annualized holding period yieldcomputation assumes a constant annual yieldfor each year.

• In the two-year investment, we assumed an18.32 percent rate of return each year,compounded.

• In the partial year HPR that was annualized,we assumed that the return is compounded forthe whole year.

today investment 250rate / annum 0.1832

45.8after year 1 295.8rate / annum 0.1832

54.19056After 2-years 349.99056orPV 250rate=i 0.1832n= 2FV ?FV PV*(1+i)^n

349.99056

Measures of Historical Rates of Return( single investment)

1. Arithmetic Mean1.4

yieldsperiodholdingannualofsum theHPY

:whereHPY/AM

n

Measures ofHistorical Rates of Return2. Geometric Mean

1.5

n

n

HPRHPRHPR

:followsasreturnsperiodholdingannual theofproduct the

:where1HPRGM

21

1

To illustrate these alternatives, consider aninvestment with the following data

• Investors are typically concerned with long-term performance when comparing alternativeinvestments.

• GM is considered a superior measure of thelong-term mean rate of return because itindicates the compound annual rate of returnbased on the ending value of the investmentversus its beginning value

• the arithmetic average provides a goodindication of the expected rate of return for aninvestment during a future individual year,

• it is biased upward if you are attempting tomeasure an asset’s long-term performance

Consider, for example, a security thatincreases in price from $50 to $100 duringyear 1 and drops back to $50 during year 2.

The annual HPYs would be:

• This answer of a 0 percent rate of returnaccurately measures the fact that there wasno change

• in wealth from this investment over the two-year period.

A Portfolio of InvestmentsThe mean historical rate of returnfor a portfolio of investments ismeasured as the weighted averageof the HPYs for the individualinvestments in the portfolio.

Computation of HoldingPeriod 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 0.010B 200,000 20$ 4,000,000$ 21$ 4,200,000$ 1.05 5% 0.20 0.010C 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,or

• Risk: the possibility that the realizedreturn will be different than theexpected return

• Probability is the likelihood of anoutcome