Why Do Individuals

Invest ?
By saving money (instead of
spending it), individuals tradeoff
present consumption for a larger
future consumption.
How Do We Measure The Rate Of
Return On An Investment ?
The pure rate of interest is the
exchange rate between future
consumption and present
consumption. Market forces
determine this rate.
$1.00  4%  $1.04
How Do We Measure The Rate Of
Return On An Investment ?
People’s willingness to pay the
difference for borrowing today and
their desire to receive a surplus on
their savings give rise to an interest
rate referred to as the pure time
value of money.
How Do We Measure The Rate Of
Return On An Investment ?
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.
How Do We Measure The Rate Of
Return On An Investment ?
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.
Defining an Investment
A current commitment of Tk. 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.
 Measures of
Historical Rates of Return
1.1

Holding Period Return

Ending Value of Investment
HPR 
Beginning Value of Investment
$220
  1.10
$200
 Measures of
Historical Rates of Return
1.2
Holding Period Yield
HPY = HPR - 1
1.10 - 1 = 0.10 = 10%
 Measures of
Historical Rates of Return
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 of
Historical Rates of Return
Arithmetic Mean
AM   HPY/n
where :

 HPY  the sum of annual

holding period yields
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
# 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 0.010
C 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
HPR = = 1.095
$ 20,000,000

HPY = 1.095 -1 = 0.095

= 9.5%
 Definition of Risk
1. Uncertainty of future outcomes
or
2. Probability of an adverse outcome
 Risk Aversion
Given a choice between two assets with
equal rates of return, most investors
will select the asset with the lower
level of risk.
Not all investors are risk averse
Risk preference may have to do with
amount of money involved - risking small
amounts, but insuring large losses
 Markowitz Portfolio Theory
• Quantifies risk
• Derives the expected rate of return for a
portfolio of assets and an expected risk measure
• Shows that the variance of the rate of return is a
meaningful measure of portfolio risk
• Derives the formula for computing the variance
of a portfolio, showing how to effectively
diversify a portfolio
 Assumptions of
Markowitz Portfolio Theory
1. Investors consider each investment
alternative as being presented by a
probability distribution of expected returns
over some holding period.
 Assumptions of
Markowitz Portfolio Theory
2. Investors minimize one-period expected
utility, and their utility curves demonstrate
diminishing marginal utility of wealth.
 Assumptions of
Markowitz Portfolio Theory
3. Investors estimate the risk of the portfolio
on the basis of the variability of expected
returns.
 Assumptions of
Markowitz Portfolio Theory
4. Investors base decisions solely on expected
return and risk, so their utility curves are a
function of expected return and the
expected variance (or standard deviation) of
returns only.
 Assumptions of
Markowitz Portfolio Theory
5. For a given risk level, investors prefer
higher returns to lower returns. Similarly,
for a given level of expected returns,
investors prefer less risk to more risk.
 Markowitz Portfolio Theory
Using these five assumptions, a single asset
or portfolio of assets is considered to be
efficient if no other asset or portfolio of
assets offers higher expected return with the
same (or lower) risk, or lower risk with the
same (or higher) expected return.
 Alternative Measures of Risk
• Variance or standard deviation of expected
return
• Range of returns
• Returns below expectations
– Semivariance – a measure that only considers
deviations below the mean
– These measures of risk implicitly assume that
investors want to minimize the damage from
returns less than some target rate
 Expected Rates of Return
• For an individual asset - sum of the
potential returns multiplied with the
corresponding probability of the returns
• For a portfolio of assets - weighted average
of the expected rates of return for the
individual investments in the portfolio
 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
 Expected Rates of Return
1.6
Expected Return  E(R i )
n

 (Probability of Return)  (Possible Return)

i 1

[(P1 )(R 1 )  (P2 )(R 2 )  ....  (Pn R n )

n

 (P )(R )
i 1
i i
 Measuring the Risk of
Expected Rates of Return
Variance ( ) 
n

 (Probability)  (Possible Return - Expected Return)

i 1
2

 i i
(P
i 1
)[R  E(R i )] 2
 Measuring the Risk of
Expected Rates of Return
Standard Deviation is the square
root of the variance
Computation of Expected Return for an
Individual Risky Investment
Exhibit 7.1

Possible Rate of Expected Return

Probability Return (Percent) (Percent)
0.25 0.08 0.0200
0.25 0.10 0.0250
0.25 0.12 0.0300
0.25 0.14 0.0350
E(R) = 0.1100
 Variance (Standard Deviation) of
Returns for an Individual Investment
Exhibit 7.3
Possible Rate Expected
2 2
of Return (R i ) Return E(Ri ) R i - E(R i ) [Ri - E(R i )] Pi [Ri - E(Ri )] Pi

0.08 0.11 0.03 0.0009 0.25 0.000225

0.10 0.11 0.01 0.0001 0.25 0.000025
0.12 0.11 0.01 0.0001 0.25 0.000025
0.14 0.11 0.03 0.0009 0.25 0.000225
0.000500

Variance ( 2) = .00050
Standard Deviation ( ) = .02236
 Measuring the Risk of expected Rates of Return

A relative measure of risk, in some cases, an unadjusted

variance or standard deviation can be misleading. If
conditions for two or more investment alternatives are not
similar- that is, if there are major differences in the expected
rates of return- it is necessary to use a measure of relative
variability to indicate risk per unit of expected return. A
widely used relative measure of risk is the coefficient of
variation (CV) calculated in the following slide.
 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
i

E(R)
 Determinants of
Required Rates of Return
• Time value of money
• Expected rate of inflation
• 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 economy
 Adjusting For Inflation
Real RFR =

 (1  Nominal RFR) 
 (1  Rate of Inflation)   1
 
Nominal Risk-Free Rate
Dependent upon
– Conditions in the Capital Markets
– Expected Rate of Inflation
 Adjusting For Inflation
Nominal RFR =
(1+Real RFR) x (1+Expected Rate of Inflation) -
1
 Facets of Fundamental
Risk
• Business risk
• Financial risk
• Liquidity risk
• Exchange rate risk
• Country 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
 Risk Premium
f (Business Risk, Financial Risk,
Liquidity Risk, Exchange Rate
Risk, Country Risk)
or
f (Systematic Market Risk)
 Risk Premium
and Portfolio Theory
• 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
 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 asset’s total variance attributable
to the variability of the total market portfolio
 Relationship Between
Risk and Return
Rate of Return (Expected)
Security
Low Average High
Risk Risk Risk Market Line

The slope indicates the

RFR 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
Rate
Security
Market Line

Movements along the curve

that reflect changes in the
RFR risk of the asset
Risk
(business risk, etc., or systematic risk-beta)
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
 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
 Change in
Market Risk Premium

E(R) Return
Expected
New SML

Rm'
Rm´
Original SML
Rm
Rm

RFR
NRFR

Risk
 Capital Market Conditions,
Expected Inflation, and the SML

Rate of Return
Expected Return
New SML

Original SML
RFR'
NRFR´

RFR
NRFR

Risk
 Variance (Standard Deviation) of
Returns for an Individual Investment
Standard deviation is the square root of the
variance
Variance is a measure of the variation of
possible rates of return Ri, from the expected
rate of return [E(Ri)]
 Covariance of Returns
• A measure of the degree to which two
variables “move together” relative to their
individual mean values over time