Lecture01_Rielly_Ch01

7/29/2019 Lecture01_Rielly_Ch01

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Lecture 01

Investment Analysis andPortfolio Management

by

Dr. Kumail Rizvi, CFA, FRM


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Chapter 1

The 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 ?


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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 forinvestments ?


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Why Do Individuals

Invest ?By saving money (instead of

spending it), individuals tradeoffpresent consumption for a larger

future consumption.


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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) andpresent consumption (current

dollars). Market forces determine

this rate.


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Peoples willingness to pay the

difference for borrowing today andtheir desire to receive a surplus on

their savings give rise to an interest

rate referred to as the pure timevalue of money.


Return On An Investment ?


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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.




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If the future payment from theinvestment is not certain, the

investor will demand an interestrate that exceeds the pure timevalue of money plus the inflation

rate to provide a risk premium tocover the investment risk.




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Defining an Investment

A current commitment of $ for aperiod of time in order to derive

future payments that willcompensate for:

the time the funds are committed

the expected rate of inflation

uncertainty of future flow offunds.


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Measures ofHistorical Rates of Return

Holding Period Return

10.1$200

$220

InvestmentofValueBeginning

InvestmentofValueEndingHPR

1.1


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Holding Period Yield

HPY = HPR - 1

1.10 - 1 = 0.10 = 10%

1.2


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Annual Holding Period Return

Annual HPR = HPR1/n

where n = number of years investment is held

Annual Holding Period YieldAnnual HPY = Annual HPR - 1



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Arithmetic Mean1.4

yieldsperiodholdingannualofsumtheHPY

:whereHPY/AM

n


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M f


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Geometric Mean1.5

n

n

HPRHPRHPR

:followsasreturnsperiodholdingannualtheofproductthe

:where 1HPRGM

21

1


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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 statedmeasurement period.

It is not affected by cash withdrawals or additions to

the portfolio.


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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

3 $470 received from selling two shares @$235 each


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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%


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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%


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A Portfolio of Investments

The mean historical rate of returnfor a portfolio of investments is

measured as the weighted averageof the HPYs for the individualinvestments in the portfolio, or theoverall change in the value of theoriginal portfolio


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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 0.010C 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


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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


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n

i 1

i

Return)(PossibleReturn)ofyProbabilit(

)E(RReturnExpected

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

))(RP(1

ii

n

i

1.6


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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 inthe form of higher return


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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


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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


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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


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Measuring the Risk of


2n

1iReturn)Expected-Return(Possibley)Probabilit(

)(Variance

2iii

1

)]E(R)[RP(

n

i

1.7


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Expected Rates of ReturnStandard Deviation is the square

root of the variance

1.8


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Expected Rates of ReturnCoefficient of variation (CV) a measure ofrelative variability that indicates risk per unit

of returnStandard Deviation of Returns

Expected Rate of Returns

E(R)i

1.9

i i f


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Measuring the Risk ofHistorical Rates of Return

variance of the series

holding period yield during period I

expected value of the HPY that is equalto the arithmetic mean of the series

the number of observations

2/nn

1i

i2 HPY)(EHPY[

n

E(HPY)

HPY i

2

1.10

Determinants of


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Determinants ofRequired Rates of Return

Time value of money during the

period of investment

Expected rate of inflation duringthe period

Risk involved


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The Real Risk Free Rate

(RRFR)

Assumes no inflation.

Assumes no uncertainty aboutfuture cash flows.

Influenced by time preference forconsumption of income andinvestment opportunities in the

economy


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Adjusting For Inflation

Real RFR =

1Inflation)ofRate(1

RFR)Nominal1(

1.12


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Nominal Risk-Free Rate

Dependent upon

Conditions in the Capital MarketsExpected Rate of Inflation


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Adjusting For Inflation

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

1.11


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Facets of Fundamental

Risk Business risk

Financial risk Liquidity risk

Exchange rate risk

Country risk


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Business Risk

Uncertainty of income flows caused by

the nature of a firms business

Sales volatility and operating leverage

determine the level of business risk.


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Financial Risk

Uncertainty caused by the use of debtfinancing.

Borrowing requires fixed payments whichmust be paid ahead of payments tostockholders.

The use of debt increases uncertainty ofstockholder income and causes an increasein the stocks risk premium.


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Liquidity Risk

Uncertainty is introduced by the secondary

market for an investment.

How long will it take to convert an investmentinto cash?

How certain is the price that will be received?


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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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Country Risk

Political risk is the uncertainty of returns

caused by the possibility of a major change

in the political or economic environment ina 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


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Risk Premium

f(Business Risk, Financial Risk,

Liquidity Risk, Exchange Rate

Risk, Country Risk)

or

f(Systematic Market Risk)


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Risk Premium

and Portfolio Theory The relevant risk measure for an

individual asset is its co-movementwith the market portfolio

Systematic risk relates the variance ofthe investment to the variance of themarket

Beta measures this systematic risk ofan asset


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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 assets total variance attributableto the variability of the total market portfolio

Relationship Between


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Relationship BetweenRisk and Return Exhibit 1.7

Rateof Return

Riskbusiness risk, etc., or s stematic 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


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Changes in the Required Rate of ReturnDue to Movements Along the SML

Rate

Riskbusiness risk etc. or s stematic risk-beta

RFR

SecurityMarket Line

Expected

Movements along the curvthat reflect changes in therisk of the asset

Exhibit 1.8


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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


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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


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Change inMarket Risk Premium

Exhibit 1.10

Risk

RFR

Original SML

New SML

Rm

Rm'

E(R)

NRFR

Expected Return

Rm

Rm

Capital Market Conditions


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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


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The Internet

Investments Onlinehttp://www.finpipe.comhttp://www.investorguide.com

http://www.aaii.comhttp://www.economist.com

http://www.online.wsj.com

http://www.forbes.comhttp://www.barrons.com

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

http://www.ft.com

http://www.fortune.com

http://www.smartmoney.comhttp://www.worth.com

http://www.money.cnn.com
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.htmhttp://www.ft.com/http://www.fortune.com/http://www.smartmoney.com/http://www.worth.com/http://www.money.cnn.com/http://www.money.cnn.com/http://www.worth.com/http://www.smartmoney.com/http://www.fortune.com/http://www.ft.com/http://fisher.osu.edu/fin/journal/jofsites.htmhttp://www.barrons.com/http://www.forbes.com/http://www.online.wsj.com/http://www.economist.com/http://www.aaii.com/http://www.investorguide.com/http://www.finpipe.com/


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Future Topics

Chapter 2 The asset allocation decision

The individual investor lifecycle

Risk tolerance Portfolio management

Documents

Lecture01_Rielly_Ch01