Chapter 1

1
The Investment
Setting

Chapter 1 The Investment Setting

ZHIQIANG WANG
SCHOOL OF FINANCE
DONGBEI UNIVERSITY OF FINANCE &
ECONOMICS
The Investment Setting 2

 1. What is An Investment?

Chapter 1 The Investment Setting

 2. Measures of Return and Risk
 3. Determinants of Required Rates of Return
 4. Relationship between Risk and Return
 3
1. What is An Investment?
 Why Do Individuals Invest?

Chapter 1 The Investment Setting

 Investment Defined
 Required Rate of Return
 4
Why Do Individuals Invest?
 By saving money (instead of spending it), individuals
tradeoff present consumption for a larger future

Chapter 1 The Investment Setting

consumption.
 There are three factors to be considered
 The time the funds are committed (pure time value of money)
 The expected rate of inflation
 The uncertainty of the future payments (risk premium)
 5
Pure time value of money

 The rate of exchange between future

Chapter 1 The Investment Setting

consumption (future dollars) and current
consumption (current dollars) is the pure
rate of interest
 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.
Expected rate of inflation 6

 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

Chapter 1 The Investment Setting

value of money to also cover the expected inflation expense.
 Risk premium 7

 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

Chapter 1 The Investment Setting

inflation rate to provide a risk premium to cover the investment risk.
 8
Investment Defined
 An investment is the current commitment of dollars for

Chapter 1 The Investment Setting

a period of time to derive future payments that will
compensate the investor for
 The time the funds are committed (pure time value of money)
 The expected rate of inflation
 The uncertainty of the future payments (risk premium)
 The investor is trading a known dollar amount today for
some expected future stream of payments that will be
greater than the current outlay.
 Required Rate of Return 9

 Pure time value of money

 Pure rate of interest

Chapter 1 The Investment Setting

 Nominal risk-free rate
 Risk premium
 Required rate of return, including
 Pure time value of money
 Expected rate of inflation
 Risk premium
 2. Measures of Return and Risk10

Chapter 1 The Investment Setting

 Measures of historical rates of return
 Computing mean historical returns
 Computing expected rates of return
 Measuring the risk of expected rates of return
 Risk measures for historical returns
Measures of historical rates of return 11
 Holding period return (HPR)
 =Ending value of investment / Beginning value of investment

Chapter 1 The Investment Setting

 For example, HPR=$220/$200=1.10
 Annual HPR=HPR1/n
 Holding period yield(HPY)
 HPY=HPR-1
 Annual HPY=annual HPR-1
 For example
 n=2, HPR=$350/$250=1.40, Annual HPR=1.41/2 =1.1832,
Annual HPY=1.1832-1=18.32%
Computing mean historical returns 12
 For a single investment
 Arithmetic mean(AM): AM=ΣHPYi/n
 Geometric mean(GM): GM=(ΠHPRi)1/n -1

Chapter 1 The Investment Setting

 For example
 AM=(15%+20%-20%)/3=5%
 GM=(1.151.20 0.80) 1/3-1=3.353%

Year Beginning Value Ending Value HPRi HPYi

1 100.0 115.0 1.15 0.15
2 115.0 138.0 1.20 0.20
3 138.0 110.4 0.80 -0.20
Computing mean historical returns 13
 The difference between AM and GM
 GM is considered to be a superior measure of the long-term

Chapter 1 The Investment Setting

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.
 GM is also referred to as the time-weighted rate of return (TWRR)
 AM is biased upward if you attempt to measure an asset’s
long-term performance.
 GM will be equal to AM when rates of return are the same
for all years. GM will be lower than AM if the rates of
return vary over the years.
 Computation of Holding 14
Period Yield for a Portfolio Exhibit 1.1

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.

Chapter 1 The Investment Setting

# 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%
Calculating expected rates of return 15
 Uncertainty
 There is uncertainty for rate of return on one investment
 Random variable

Chapter 1 The Investment Setting

 The rate of return on one investment is random
 The expected return from an investment
 Expected Return=ΣPiRi
 For example Economic Conditions Probability Rate of Return
Strong economy, no inflation 0.15 0.20
Weak economy, above AI 0.15 -0.20
No major change in the economy 0.70 0.10

 E(R)= 0.150.20+0.15(-0.20)+0.700.10=7%
Risk Aversion 16

The assumption that most

Chapter 1 The Investment Setting

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
Probability Distributions 17
Exhibit 1.2

Risky Investment with 3 Possible Returns

Chapter 1 The Investment Setting

1.00
0.80
0.60
0.40
0.20
0.00
-30% -10% 10% 30%
Measuring the risk of expected rates of return
18
 Risk is the uncertainty
 Two possible measures of risk (uncertainty)
 Variance: σ2 =ΣPi[Ri-E(R)] 2

Chapter 1 The Investment Setting

 Standard deviation: σ
 For example:σ2 =0.0141, σ =0.11874 (above example)
 A relative measure of risk
 Coefficient of variation (CV)
 CV =Standard Deviation of returns / Expected Rate of Return
 For example
Investment A B
Expected return 0.07 0.12
Standard deviation 0.05 0.07
CV 0.71 0.58
Risk measures for historical returns 19
 To measure the risk for a series of historical rates of returns, we use the
same measures as for expected returns except that we consider the historical
holding period yields as follows:

Chapter 1 The Investment Setting

n
1
 2   [ HPYi  E ( HPY )]2
n i 1
 2  variance of the series
HPYi  holding period yield during period I
E(HPY)  expected value of the HPY that is equal to the
arithmetic mean of the series
n  the number of observations
 3. Determinants of Required Rates of20
Return

Chapter 1 The Investment Setting

 The real risk-free rate
 Factors influencing the nominal risk-free rate
 Risk premium
 Risk premium and portfolio theory
 Fundamental risk versus systematic risk
 Summary of required rate of return
 The real risk-free rate 21
 Real risk-free rate (RFR)
 Pure time value of money

Chapter 1 The Investment Setting

 The basic interest rate, with no inflation and no uncertainty
about future flows, Influenced by time preference for
consumption of income and investment opportunities in the
economy
 Two factors influence this exchange price
 Subjective factor is the time preference of individuals for the
consumption
 Objective factor is the set of investment opportunities available
in the economy
 A positive relationship exists between the real growth rate in
the economy and the real RFR
Factors influencing the nominal risk-22
free rate
 Two other factors influence the nominal RFR

Chapter 1 The Investment Setting

 The relative ease or tightness in the capital markets
 The expected rate of inflation
 Condition in the capital market
 Expected rate of inflation
 Nominal RFR=(1+real RFR)(1+expected rate of inflation)-1
 The common effect
 All the factors discussed thus far regarding the required rate of
return affect all investments equally
 Risk premium 23
 The major fundamental sources
 Business risk is the uncertainty of income flows caused by
the nature of a firm’s business

Chapter 1 The Investment Setting

 Financial risk is the uncertainty introduced by the method
by which the firm finances its investments
 Liquidity risk is the uncertainty introduced by the
secondary market for an investment
 Exchange rate risk is the uncertainty of returns to an
investor who acquires securities in a currency different from
his or her own
 Country risk, also called political risk, is the uncertainty of
returns caused by the possibility of a major change in the
political or economic environment of a country
 Risk premium 24

 Total risk

f (business risk,financial risk,liquidity risk, exchange rate

Chapter 1 The Investment Setting

Risk premium=
risk,country risk)
Risk premium and portfolio theory25
 Systematic risk and unsystematic risk
 systematic risk, measured by an asset’s covariance with the
market portfolio. Beta measures this systematic risk of an

Chapter 1 The Investment Setting

asset.
 unsystematic risk, measured by the non-market (unique)
variance which is not related the market portfolio but is due
to unique features
 Under some assumptions, the risk premium for an
individual earning asset is a function of the asset’s
systematic risk with the aggregate market portfolio of
risky assets
 Risk premium= f (systematic or market risk)
 Fundamental risk versus systematic 26
risk
 There is generally a significant relationship between the market measure of

Chapter 1 The Investment Setting

risk and fundamental measures of risk
 The two measures of risk can be complementary

f
Risk premium= (business risk,financial risk,liquidity risk, exchange rate
risk,country risk)

Risk premium= f (systematic market risk)
Summary required rates of return 27
 The overall required rate of return on alternative
investments is determined by three variables
 The economy’s real RFR, i.e., the long-run real growth rate

Chapter 1 The Investment Setting

 Variables that influence the nominal RFR, which included short-
run ease or tightness in the capital market and the expected rate of
inflation
 The risk premium on the investment

 Measures and sources of risk

 Measures of risk: variance of rates of return, standard deviation of
rates of return, coefficient of variance of rates of return (CV),
covariance of returns with the market portfolio (beta)
 Sources of risk: business risk, financial risk, liquidity risk,
exchange rate risk, country risk
 4. Relationship between Risk and 28
Return

Chapter 1 The Investment Setting

 Movements along the SML
 Changes in the slope of the SML
 Changes in capital market conditions or expected inflation
 Summary of changes in the required rate of return
 Relationship Between
Risk and Return 29
Exhibit 1.3

Ra teof Re turn (Expected)

S e curity
Low Ave ra ge High

Chapter 1 The Investment Setting

Ma rke t Line
Ris k Ris k Ris k

The s lope indica te s the

re quire d re turn pe r unit of ris k
RFR

Ris k
(bus ine s s ris k, e tc., or s ys te ma tic ris k-be ta )
 Movements Along the SML
30

Expe cte d
Exhibit 1.4
Ra te
S e curity

Chapter 1 The Investment Setting

Ma rke t Line

Move me nts a long the curve

tha t re fle ct cha nge s in the
RFR ris k of the a s s e t
Ris k
(bus ine s s ris k, e tc., or s ys te ma tic ris k-be ta )
Changes in the slope of the SML31
 A change in the slope of the SML occurs in response
to a change in the attitudes of investors towards risk

Chapter 1 The Investment Setting

Exhibit 1.5
E(R) Ne w S ML

Rm'
Origina l S ML
Rm

RFR

Ris k
 Changes in capital market conditions32
or expected inflation
 A shift in the SML reflects a change in

Chapter 1 The Investment Setting

 Expected real growth in the economy,
 Capital market conditions,
 The expected rate of inflation.
Capital Market Conditions, 33
Expected Inflation, and the SML
Exhibit 1.6

Chapter 1 The Investment Setting

Ra te of ReReturn
Expected turn
Ne w S ML

Origina l S ML
RFR'
NRFR´

NRFR
RFR

Ris k
Summary of changes in the required 34
rate of return
 The relationship between risk and the required rate of

Chapter 1 The Investment Setting

return for an investment can change in three ways
 A movement along the SML is caused by a change in risk
characteristics of a specific investment. This change affects
only the individual investment
 A change in the slope of the SML occurs in response to a
change in the attitudes of investors towards risk
 A shift in the SML reflects a change in expected real
growth, in market conditions such as ease or tightness of
money, or a change in the rate of inflation. Again, such a
change will affect all investments