Investment Analysis and Portfolio Management: Frank K. Reilly & Keith C. Brown
Investment Analysis and Portfolio Management: Frank K. Reilly & Keith C. Brown
to accompany
Arithmetic Mean
AM HPY/n
where :
Geometric Mean
GM HPR
1
n 1
where :
the product of the annual
holding period returns as follows :
HPR 1 HPR 2 HPR n
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 Exhibit 1.1
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
= 9.5%
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
1.6
Expected Return E(R i )
n
(P )(R )
i 1
i i
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
Probability Distributions
Exhibit 1.2
Risk-free Investment
1.00
0.80
0.60
0.40
0.20
0.00
-5% 0% 5% 10% 15%
Probability Distributions
Exhibit 1.3
1.00
0.80
0.60
0.40
0.20
0.00
-40% -20% 0% 20% 40%
Measuring the Risk of 1.7
Expected Rates of Return
Variance ( )
n
i i
(P
i 1
)[R E(R i )] 2
Measuring the Risk of 1.8
Expected Rates of Return
Standard Deviation is the square
root of the variance
Measuring the Risk of 1.9
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)
Measuring the Risk of
Historical Rates of Return 1.10
n
[HPYi E(HPY)
2 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
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 1.12
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 1.11
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 Exhibit 1.7
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
E(R) Return
Expected
New SML
Rm'
Rm´
Original SML
Rm
Rm
RFR
NRFR
Risk
Capital Market Conditions,
Expected Inflation, and the SML
Exhibit 1.11
Rate of Return
Expected Return
New SML
Original SML
RFR'
NRFR´
RFR
NRFR
Risk
The Internet
Investments Online
www.financecenter.com www.ft.com
www.investorama.com www.fortune.com
www.moneyadvisor.com
www.money.com
www.investorguide.com
www.forbes.com
www.finweb.com
www.aaii.org www.worth.com
www.wsj.com www.barrons.com
www.cob.ohio-state.edu/dept/fin/osudata.htm
Future Topics
Chapter 2
• The asset allocation decision
• The individual investor life
cycle
• Risk tolerance
• Portfolio management