Chapter 1 An Overview of The Investment Process

Defining an Investment
An investment is the current

commitment of dollars (Taka) 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
• The uncertainty of future payments
Measures of
Historical Rates of Return
Holding Period Return
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?
Ending Value of
HPR Investment
Beginning Value of

Investment
HPR  $220
$20  1.1
0
1.10
Holding Period Yield
HPY = HPR -1
HPY = 1.10 -1
HPY = 0.10 = 10%
Annual Holding Period Return

Annual HPR =
n = number of years investment is held
Annual Holding Period Yield
Annual HPY = Annual HPR -1
Consider an investment that cost $250 and is
worth $350 after being held for two years,
what is your annual return?
HPR  $350
$25 
0
1.40
Annual HPR 


 1.183
Annual  2
1.1832 -1  0.183
HPY  18.32 2
%
Computing Mean Historical Returns
Arithmetic Mean (AM)   HPY/n

Geometric Mean (GM)  -
where : 1
  the product of the annual
holding period returns as follows :
 HPR    HPR  HPR 
1 2 n
Consider an investment with the following data:
Year Beginning Value Ending Value HPR HPY
1 100 115.0 1.15 0.15
2 115 138.0 1.20 0.20
3 138 110.4 0.80 -0.20
AM  [(0.15) + (0.20) + (-0.20)] / 3

 0.15/3  0.05
 5%

GM  -

1
-1
 1 . 03353 -
10 . 03353
 3 . 353 %
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.
Computation of Holding Period
Yield for a Portfolio
Investment No. of Beginning Beginning Ending Ending HPR HPY Market Weighted
Shares Price Market Price Market Weight* HPY
Value Value
A 100,000 $ 10 $1,000,000 $12 $1,200,000 1.20 20% 0.05 0.01
B 200,000 $ 20 $4,000,000 $21 $4,200,000 1.05 5% 0.20 0.01
C 500,000 $ 30 $ $33 $ 1.10 10% 0.75 0.075
15,000,000 16,500,000
Total $ $ 0.095
20,000,000 21,900,000
$
HPR = = 1.095
21,900,000
$ 20,000,000
HPY 1.095 - 1 = 0.095 = 9.5%

=
Weights are based on beginning values.
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
 (Probability of Return)  (Possible

Expected Returni=1
Return)
Economic Conditions Probability Rate of Return
Strong Economy 0.15 0.20
Weak Economy 0.15 -0.20
No Major Change in Economy 0.70 0.10
[(0.15)(0.20)] + [(0.15)(-0.20)] + [(0.70)(0.10)]

)=
)= 0.03 + (-0.03) + 0.07

)= 0.07

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.
Measuring the Risk of Expected
Rates of Return
n
Variance ()= (Probability)
i=1
2
(Possible Return - Expected Return)
= + +]
=[ 0.002535 + 0.010935 + 0.00063] = 0.0141

Standard Deviation =

SD = SD = 0.11874
SD = 11.874%
Coefficient of Variation
Standard Deviation of Returns
CV= Expected Rate of Returns
Investment A Investment B
Expected Return 0.07 0.12
Standard Deviation 0.05 0.07
=

= 0.714
=
= 0.583
Determinants of
Required Rates of Return
• Time value of money during the
period of investment
• Expected rate of inflation during
the period
• The 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
Nominal Risk-Free Rate
Dependent upon
– The relative ease or tightness in the capital
markets
– The expected Rate of Inflation

Adjusting For Inflation 1.12
𝑁𝑅𝐹𝑅 = [ ( 1+ 𝑅𝑅𝐹𝑅 ) × ( 1+ 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑅𝑎𝑡𝑒 𝑜𝑓 𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 ) ] − 1
RRFR= [ ]

-1
RRFR= [ ]

-1

RRFR=1 . 038− 1
RRFR=0 . 038=3 .8 %
Facets of Fundamental 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
Relationship Between
Risk and Return Exhibit 1.7
Rate of Return (Expected)

Low Average High Security
Market Line
Risk
Risk Risk
The slope indicates the

NRFR required return per unit of risk
Risk
(business risk, etc., or systematic risk-beta)
Changes in the Required Rate of Return
Due to Movements Along the SML
Expected Exhibit 1.8
Rate
Security
Market Line
Movements along the curve

that reflect changes in the
NRFR risk of the asset
Risk
Changes in the Slope of the SML
1.13
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
Market Portfolio Risk 1.14
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
Change in
Market Risk Premium
Exhibit 1.10
Expected Return New SML
Rm̍
Original SML
Rm
NRFR
Risk
Capital Market Conditions,
Expected Inflation, and the SML
Exhibit 1.11
Expected Return
New SML
Original SML
NRFR̍
NRFR
Risk
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Defining an Investment

An investment is the current

Arithmetic Mean (AM)   HPY/n

1 100 115.0 1.15 0.15

2 115 138.0 1.20 0.20

3 138 110.4 0.80 -0.20

AM  [(0.15) + (0.20) + (-0.20)] / 3

HPY 1.095 - 1 = 0.095 = 9.5%

 (Probability of Return)  (Possible

[(0.15)(0.20)] + [(0.15)(-0.20)] + [(0.70)(0.10)]

=[ 0.002535 + 0.010935 + 0.00063] = 0.0141

Standard Deviation 0.05 0.07

– The expected Rate of Inflation

𝑁𝑅𝐹𝑅 = [ ( 1+ 𝑅𝑅𝐹𝑅 ) × ( 1+ 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑅𝑎𝑡𝑒 𝑜𝑓 𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 ) ] − 1

• Changes in exchange rates affect the

Rate of Return (Expected)

The slope indicates the

Movements along the curve

RPi = E(Ri) - NRFR

The market risk premium for the market

Expected Return New SML

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