Chapter No 1

Investment Setting
Money
 Transaction Motive
 Precautionary Motive
 Speculative Motive
What is an Investment?
 Investment
Current commitment of $ for a period
of time in order to derive future
payments that will compensate for:
Timethe funds are committed
Expected rate of inflation
Uncertainty of future flow of funds

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Why Invest?

 By investing (saving money now

instead of spending it), individuals
can tradeoff present consumption for
a larger future consumption.

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Pure Rate of Interest

Exchange rate between future

consumption (future dollars) and present
consumption (current dollars)
 Interface between PV and FV
Marketforces determine rate
Example:
 Ifyou can exchange $100 today for $104
next year, this rate is 4% = (104/100)-1.

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Pure Time Value of Money

 People willing to pay more for the money

borrowed and lenders desire to receive a
surplus on their savings (money invested)

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The Effects of Inflation

 Inflation
‒ 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.

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Uncertainty: Risk by any Other Name

 Uncertainty
 Ifthe 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.

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Required Rate of Return on an
Investment
 Minimum rate of return investors require
on an investment, including the pure rate
of interest and all other risk premiums to
compensate the investor for taking the
investment risk

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Real Assets Versus Financial Assets
 Real Assets
 Determine the productive capacity and net
income of the economy
 Examples: Land, buildings, machines, knowledge
used to produce goods and services

 Financial Assets
 Claims on real assets
Financial Assets

 Three types:
1. Fixed income or debt
2. Common stock or equity
3. Derivative securities
Fixed Income
 Payments fixed or determined by a formula

 Money market debt: short term, highly marketable,

usually low credit risk

 Capital market debt: long term bonds, can be safe

or risky
Common Stock and Derivatives
 Common Stock is equity or ownership in a
corporation.
 Payments to stockholders are not fixed, but depend on
the success of the firm
 Derivatives
 Value derives from prices of other securities, such as
stocks and bonds
 Used to transfer risk
Historical Rates of Return:
What Did We Earn (Gain)?
Example I:

Your investment of $250 in Stock A is worth $350 in two

years while the investment of $100 in Stock B is worth
$120 in six months. What are the annual HPRs and the
HPYs on these two stocks?

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 Your Investments Rise in Value
Example I:
 Stock A
– Annual HPR=HPR1/n = ($350/$250)1/2 =1.1832
– Annual HPY=Annual HPR-1=1.1832-1=18.32%

 Stock B

– Annual HPR=HPR1/n = ($112/$100)1/0.5 =1.2544

– Annual HPY=Annual HPR-1=1.2544-1=25.44%

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Historical Rates of Return:
What Did We Lose?
Your investment of $350 in Stock A is worth
$250 in two years while the investment of $112
in Stock B is worth $100 in six months. What
are the annual HPRs and the HPYs on these
two stocks?

And

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 Your Investments Decline in Value
Example II:
Stock A
– Annual HPR=HPR1/n = ($250/$350)1/2
=.84515
– Annual HPY=Annual HPR-1=.84514 - 1=-
15.48%
 Stock B

– Annual HPR=HPR1/n = ($100/$112)1/0.5

=.79719
– Annual HPY=Annual HPR-1=.79719-1=-
20.28% Copyright © 2010 Nelson Education Ltd. 1-17
Problems
 1. On February 1, you bought 100 shares of a
stock for $34 a share and a year later you sold it
for $39 a share. During the year, you received a
cash dividend of $1.50 a share. Compute your HPR
and HPY on this stock investment.
 2. On August 15, you purchased 100 shares of a
stock at $65 a share and a year later you sold it
for $61 a share. During the year, you received
dividends of $3 a share. Compute your HPR and
HPY on this investment
3)At the beginning of last year, you invested $4,000
in 80 shares of the Chang Corporation. During the
year, Chang paid dividends of $5 per share. At the
end of the year, you sold the 80 shares for $59 a
share. Compute your total HPY on these shares and
indicate how much was due to the price change and
how much was due to the dividend income
Calculating Mean Historical Rates of
Return
Suppose you have a set of annual rates of
return (HPYs or HPRs) for an investment.
How do you measure the mean annual
return?

Do you use the arithmetic average? Or

do you use the geometric average?

It depends!

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Arithmetic Mean Return (AM)
Arithmetic Mean Return (AM)
AM=  HPY / n
where  HPY=the sum of all the annual
Holding Period Yields
n=number of years

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Geometric Mean Return (GM)
 Geometric Mean Return (GM)
 GM= [ HPY] 1/n -1
 where  HPR=the product of all the
annual HPRs
 n=number of years

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 Arithmetic vs. Geometric Averages
When rates of return are the same for all
years, the AM and the GM will be equal.
When rates of return are not the same for all
years, the AM will always be higher than the
GM.
While the AM is best used as an “expected
value” for an individual year,
while the GM is the best measure of an asset’s
long-term performance.

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 Geometric Mean
 Investors are typically concerned with long-term
performance when comparing alternative investments.
GM is considered a superior measure of the long-term
mean rate of return because it indicates the compound
annual rate of return based on the ending value of the
investment versus its beginning value.
Arithmetic mean

 Although the arithmetic average provides

a good indication of the expected rate of
return for an investment during a future
individual year, it is biased upward if you
are attempting to measure an asset’s
long-term performance.
Comparing Arithmetic vs. Geometric
Averages: Example

Suppose you invested $100 three years ago

and it is worth $110.40 today. What are your
arithmetic and geometric average returns?

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Arithmetic Average: An Example
Year Beg. Value Ending Value HPR HPY

1 $100 $115 1.15 .15

2 115 138 1.20 .20
3 138 110.40 .80 -.20
AM=  HPY / n
AM=[(0.15)+(0.20)+(-0.20)] / 3 = 0.15/3=5%

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Geometric Average: An Example
Year Beg. Value Ending Value HPR HPY

1 $100 $115 1.15 .15

2 115 138 1.20 .20
3 138 110.40 .80 -.20
GM= [ HPR] 1/n -1
GM=[(1.15) x (1.20) x (0.80)]1/3 – 1 =(1.104)1/3 -
1=1.03353 -1 =3.353%

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