BF 320: Investment & Portfolio Management M.Mukwena
Dec 27, 2015
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Investment Setting Objectives: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?What macroeconomic and
microeconomic factors contribute to changes in the required rate of return for investments?
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Why Do Individuals Invest ?
2 choices with your earnings:Save and tradeoff present consumption for a larger future consumption
Riskier option of investments
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Required Rate Of Return
1. The pure rate of interest is the exchange rate between future consumption and present consumption. Market forces determine this rate.
Ex: if you can exchange K5 of certain income today for K50 tomorrow this rate is 5/50=10%. AKA pure time value of money
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Pure Rate of Interest
0 10 20 30 40 50ZMK 0
ZMK 1
ZMK 2
ZMK 3
ZMK 4
ZMK 5
Consumption Today Versus Tomorrow Trade-Off
Consumption
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Required Rate Of Return
2. 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.
Ex: Investor in Zambia would expect 7% compensation for inflation
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Required Rate Of Return
3. 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.
Ex: A return of 2%
Therefore from above examples an investor would need compensation of 10%+7%+2% =19%
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Defining an Investment
A current commitment of money (K) 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.
These three make up required rate of return
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Measures of Historical Rates of Return
Holding Period Return
K200 worth beginning
period. holding 1after K220
10.1 K200
K220
Investment of Value Beginning
Investment of Value EndingHPR
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Measures of Historical Rates of Return
Holding Period Yield
HPY = HPR - 1
1.10 - 1 = 0.10 = 10%
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Measures of Historical Rates of Return
Investment cost K250 and is worth K350 after 2 years holding period. HPR= = 1.40 Note this is for 2 years
Annual HPR= = 1.1832Annual HPY = Annual HPR-1= 1.1832-1=0.1832
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Measures of Historical Rates of Return
Arithmetic Mean
yields period holding annual of sum the HPY
:whereHPY/AM
n
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Measures of Historical Rates of Return
Geometric Mean
HPR annual
ofproduct the
1 HPR GM 1
n
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Measures of Historical Rates of Return
From given tableAM= =0.05GM= = 0.03353
Year Beginning Value of
Investment
End Value of Investment
HPR HPY
1 100 115.0 1.15 0.15
2 115 138.0 1.20 0.2
3 138 110.4 0.8 -0.2
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Arithmetic Mean versus Geometric Mean
Inv beg
Y1
Y2
HPR HPY AM GM
A 10 20 10 Yr1:20/10=2Yr2:10/20=0.5
Yr1: 2-1=1Yr2: 0.5-1=-0.5
=0.25 [ -1 =0
B 10 8 12 Yr1: 8/10=0.8Yr2: 12/8=1.5
Yr1: 0.8-1=-0.2Yr2:1.5-1=0.5
0.15 -1=0.0954
For A the AM is not true (25%) since investment went from 10 to 20 to 10. Therefore GM is better measure.For B: 10(1.15)(1.15)=13.23 which should be 12. However 10(1.0954)(1.0954)=12. Therefore GM is better measure
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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. Example to follow
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Computation of HoldingPeriod Yield for a Portfolio
*Market Weights based on Beginning Mkt Value
Begin BeginningEndin
g Ending *Market Wtd.Stock Shares Price Mkt. Value Price Mkt. Value HPR HPY Weight HPY
A
100,000 K10 1 000 000 K12 1 200 000 1.2020% 0.05
0.01
0
B
200,000 K20 4 000 000 K21 4 200 000 1.05 5% 0.20
0.01
0
C
500,000 K30 15 000
000 K33 16 500
000 1.1010% 0.75
0.07
5
Total K20 000
000 K21 900
000
0.09
5
HPR =
K21 900 000
= 1.095 K20 000
000
HPY = 1.095- 1 = 0.095
= 9.5%
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Expected Rates of Return
Risk is uncertainty that an investment will earn its expected rate of return
Probability is the likelihood of an outcome
n
i 1
Return) (Possible Return) ofy Probabilit(
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Risk AversionThe 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
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Probability Distributions
Risk-free Investment
-0.05 0 0.05 0.1 0.150.000.200.400.600.801.00
Pro
bability
Return
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Probability Distributions
Risky Investment with 3 Possible Returns
0.00
0.20
0.40
0.60
0.80
1.00
-30% -10% 10% 30%Return
Pro
bability
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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%
Pro
bability
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Measuring the Risk of Expected Rates of Return
2n
1i
Return) Expected-Return (Possibley)Probabilit(
)( Variance
2iii
1
)]E(R)[RP(
n
i
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Measuring the Risk of Expected Rates of Return
Standard Deviation is the square root of the variance
n
i 1
2iii )]E(R-[RP
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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
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Measuring the Risk of Expected Rates of Return
Investment A Investment B
Expected Return 0.07 0.12
Standard Deviation 0.05 0.07
Coefficient of Variation
0.05/0.07 = 0.714 0.07/0.12 = 0.583
B has less risk per unit and is therefore better investment
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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
Take note: RRFR was earlier called pure time value of money as only sacrifice investor made was deferring use of money
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Nominal Risk-Free Rate
Rate of interest stated in money terms
Dependent upon◦Conditions in the Capital Markets
◦Expected Rate of Inflation
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Adjusting For Inflation
Nominal RFR = (1+Real RFR) x (1+Expected Rate of Inflation) – 1
Ex: If you require a real growth in the purchasing power of your investment of 8%, and you expect the rate of inflation over the next year to be 3%, what is the lowest nominal return that you would be satisfied
with? (1+0.08) x (1+0.03) - 1 = 0.1124
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Systematic 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.• AKA leveraging risk• 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.Q: Does a company utilizing only common stock to finance their
investments suffer financial risk?
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Systematic Risk
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.
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Systematic Risk
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
f (Business Risk, Financial Risk, Liquidity Risk, Exchange Rate Risk, Country Risk)
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Systematic Risk
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
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Security Market Lines
Rateof Return
Risk(business risk, etc., or systematic risk-beta)
RFR
SecurityMarket LineLow
RiskAverageRisk
HighRisk
The slope indicates therequired return per unit of risk
(Expected)
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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
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Change in Market Risk Premium
Risk
RFR
Original SML
New SML
Rm
Rm'
E(R)
NRFR
Expected Return
Rm´
Rm