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Investment: Introduction/ P. 1 of 9 ECN4141 Financial Economics

This document introduces some key concepts in financial economics, including: 1) Investment is the postponement of current consumption to have higher future consumption. Investors seek returns to earn from saving and compensate for time, expected inflation, and risk. 2) Returns are measured using holding period return (HPR), holding period yield (HPY), and annual holding period yield (AHPY). Arithmetic and geometric means are used to calculate mean rates of return. 3) Risk is measured using variance, standard deviation, and coefficient of variation. Expected return takes into account probabilities and returns of different economic scenarios. 4) The required rate of return is determined by the real risk-free rate, nominal

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101 views9 pages

Investment: Introduction/ P. 1 of 9 ECN4141 Financial Economics

This document introduces some key concepts in financial economics, including: 1) Investment is the postponement of current consumption to have higher future consumption. Investors seek returns to earn from saving and compensate for time, expected inflation, and risk. 2) Returns are measured using holding period return (HPR), holding period yield (HPY), and annual holding period yield (AHPY). Arithmetic and geometric means are used to calculate mean rates of return. 3) Risk is measured using variance, standard deviation, and coefficient of variation. Expected return takes into account probabilities and returns of different economic scenarios. 4) The required rate of return is determined by the real risk-free rate, nominal

Uploaded by

qadeem
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOC, PDF, TXT or read online on Scribd
You are on page 1/ 9

Introduction/ p.

1 of 9 ECN4141 Financial Economics

INTRODUCTION

INVESTMENT
Postponement of current consumption in order to have
higher future consumption.

WHY INVEST?
To earn return from saving
- Time period
- Expected inflation
- Risk (Uncertain future income)

Required rate of return – return that compensate for time


period, expected inflation and risk.

1
Introduction/ p. 2 of 9 ECN4141 Financial Economics

Return and Risk

Holding Period Return (HPR)

HPR = Ending value / Beginning value

Example:
Invest $200 at the beginning of year and collect 220 at the
end of year.

HPR = 220/200
= 1.10

Holding Period Yield (HPY)

HPY = HPR –1

HPY = 1.10 –1 =0.10


= 10%

2
Introduction/ p. 3 of 9 ECN4141 Financial Economics

Annual HPY (AHPY)

AHPY = AHPR –1 ; AHPR = Annual HPR

AHPR = HPR 1/n ; n = investment period

Example:
Invest $250 and after two year the investment value
increases to $350.

HPR = Ending value/ beginning value


= 350/250
=1.40

AHPR =1.40 1/n


=1.40 ½
=1.1832

AHPY = 1.1832 –1
= 0.1832
=18.32%

3
Introduction/ p. 4 of 9 ECN4141 Financial Economics

Mean Rate of Return

- Arithmetic mean (AM)

- Geometric mean (GM)

a) Single investment
AM =  HPY / n
GM =  (HPR )  1
1/ n

Where  = product of HPR: (HPR1) x (HPR2) x…..


(HPRn)

Example:

Year Beginning value Ending value HPR HPY


1 100 115 1.15 0.15
2 115 138 1.20 0.20
3 138 110.4 0.8 -0.20

AM = [(0.15) +(0.20)+(-0.20)]/n
= 0.15/3
=0.05 = 5%

GM = [(1.15) x (1.20) x (0.80)] 1/3 –1


= (1.104) 1/3 –1
= 1.03353 –1
= 0.03353
= 3.353%

4
Introduction/ p. 5 of 9 ECN4141 Financial Economics

b) Portfolio investment

i) HPY

Investment Begin End HPR HPY Weight Weighted


value value HPY
A 1000 1200 1.20 10% 0.05 0.01
B 4000 4200 1.05 5% 0.20 0.01
C 15,000 16500 1.10 10% 0.75 0.075
Total 20,000 21,900 0.095

21,900
HPR= 20,000 =1.095

HPY = 1.095 – 1 =0.095 = 9.5%

ii) Expected Return (E(R))


n
E (R) =  (return probability x Return)
i 1

E(Ri) = [(P1)(R1) + (P2)(R2) + …….. + (Pn)(Rn)]


n
E(Ri) =  (Pi )(R i )
i 1

Example:

5
Introduction/ p. 6 of 9 ECN4141 Financial Economics

Economic situtation Probalility (Pi) Return(Ri)

Strong, no inflation 0.15 0.20


Weak, above-avg inflation 0.15 -0.20
No major change 0.70 0.10

E(Ri)= [(0.15)(0.20) + (0.15)(-0.20) + (0.70)(0.10)]


= 0.07
= 7%

iii) Variance (  2 ) =
n
2
 Pr obability  (Re turn  Expected Re turn )
i 1
n
 Pi  (R i  E(R i ) 2
i 1

Example:
n
 2
= Pi  (R i  E(R i ) 2
i 1

= [(0.15)(0.20 –0.07)2 + (0.15)(-0.20-0.07)2


+ (0.7)(0.10-0.17) 2
= [0.010935 + 0.002535 + 0.00063]
= 0.0141

6
Introduction/ p. 7 of 9 ECN4141 Financial Economics

iv) Standard deviation

n
 =  Pi (R i  E(R i ) 2
i 1

Example:

 = 0.0141
= 0.11874

v) Coefficient of Variation (CV)

Std Dev of Re turn


CV = Expected Re turn

i
CV = E (R )

Example:
0.11874
CV = 0.0700
= 1.696

DETERMINANT OF REQUIRED RATE OF RETURN

1) Real Risk-Free Rate (RRFR)

7
Introduction/ p. 8 of 9 ECN4141 Financial Economics

 Exchange rate in situation where there is no


inflation and no risk
 time frame
 alternative investments

2) Nominal Risk-Free Rate


 NRFR = (1 + RRFR)(1 + Expected Inflation) - 1
 Ease or tightness of capital market
 Expected rate of inflation

3) Risk Premium (RP)


 Business Risk
- Firm’s cash flows

 Financial Risk
- Firm’s financial resources

 Liquidity Risk
- Ease to buy/sell security

 Exchange Rate Risk


- Foreign security

 Country / Political Risk


- Political stability

RP = f (Business, financial, liquidity, exchange rate


country risks)
RELATIONSHIP BETWEEN RISK AND RETURN

Security Market Line (SML)

8
Introduction/ p. 9 of 9 ECN4141 Financial Economics

 Show the risk-return combination of all risky assets


in capital market at a particular time.

E(R) Low risk Moderate High


risk risk

NRFR

Risk

Risk premium for an asset:

RPi = E(Ri) – NRFR

Market Risk premium:

RPm = E(Rm) - NRFR

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