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INVESTMENT ANALYSIS

GSM 5421

By Dr. Chen

“He who does not look ahead remain behind”

– John C. Maxwell

Lecture 3

Return And Risk

Content

Definition of Investment

Element of Risk

Historical return

Measurement of Expected Return and Risk

Risk Aversion and Capital Allocation

Characteristics of Investment

1. Return –

expectation of return – yield + capital appreciation

2. Risk –

proportionate with level of investment . Characteristics:

Longer maturity, larger risk Lower credit worthiness, higher risk

Characteristics of Investment

3. Safety – certainty return of capital without loss of time and money

4. Liquidity – easily saleable or marketable

Objectives 0f Investment:

Maximum return

Minimization of risk

Hedge against inflation

Investment vs Speculation and Gambling

CharacteristiCharacteristi

InvestmentInvestment

SpeculationSpeculation

GamblingGambling

cscs

RiskRisk

lowlow

HighHigh

HighHigh riskrisk highhigh return,return, CanCan loselose allall capital,capital, WithoutWithout knowledgeknowledge ofof riskrisk

TimeTime periodperiod

LongLong--termterm

ShortShort--termterm

VeryVery ShortShort--term.term. UnplannedUnplanned andand nonnon-- scientificscientific

CapitalCapital gaingain

SteadySteady –– capitalcapital gaingain andand dividenddividend

LargeLarge –– mainlymainly forfor capitalcapital gain,gain, buybuy lowlow sellsell highhigh

LargeLarge –– mainlymainly forfor capitalcapital gaingain SurroundedSurrounded byby uncertaintyuncertainty andand basedbased onon tipstips andand rumoursrumours

Eg. CITIBANK BUILDING - IOI

Risk

Investors When expected return not equal to realized return
Investors When expected return not equal to realized return

Investors

Investors When expected return not equal to realized return

When expected return not equal to realized return

Risk

Made

investment

decisions

When expected return not equal to realized return Risk Made investment decisions Based on expected return
When expected return not equal to realized return Risk Made investment decisions Based on expected return

Based on expected return

When expected return not equal to realized return Risk Made investment decisions Based on expected return

Realized

return

Element of Risk

Total risk =

systematic risk + unsystematic risk

Systematic risks

External to companies

Uncontrollable

Eg. Interest rate, market risk, political risk, economic risk and force majeure

Element of Risk (con’t)

Unsystematic risks

- Internal to companies

- Particular or specific to company

- Eg:

- Operating environment (Business)

- Financial pattern adopted by the company (financial)

Interest Rate

Hedge against inflation

Factors Influencing Interest Rates

Supply of funds

Households

Demand of funds

Businesses (finance investments)

Government’s Net Supply and/or Demand

Central Bank Actions

Real and Nominal Rates of Interest

Nominal interest rate

Growth rate of your money

Real interest rate

Growth rate of your purchasing power

If R is the nominal rate and r the real rate and i is the inflation rate:

r =Ri

Correct Procedure

Real Rate (t) =

1 + rt

-

1

 

»

1 + It

Or

1 + rt

= 1 + rrt

 

1

+ It

Where I = inflation in period t rt = nominal rate of return in period t rrt = real rate of interest in period t

Measurement of Historical and Expected Return

Measurement of Risk

Measuring Historical Return

Differences between historical and expected return

Definition of rate of return

r = total dollar income during period

purchase price (or dollar invested)

Calculation of return for various financial instruments

Rates of Return for Bonds

Example: Zero Coupon Bond

r f

( T

)

=

1 0 0

P

(

T

)

1

E.g. Face value = $100

Horizon Price (P(T)) Total Return

= 1 year = $95.52 = (100/95.52) – 1 = 4.69%

Example: Rate of return - stock

r = price change + cash dividends

purchase price

Necessary adjustment in computing rates of return for stocks:

Stock splits

Stock dividends

Right issues

spinoffs

Also define as Holding Period Return

Rates of Return: Single Period

HPR

=

P

1

P

0

+

D

1

P

0

HPR = Holding Period Return P 0 = Beginning price P 1 = Ending price D 1 = Dividend during period one

Example:

Rates of Return: Single Period

Price at beginning of year = RM60 D 1 paid at end of year = RM2.40 Price at end of year = RM69.00

Total return = 2.4 + (69 – 60) = 0.19 or 19%

60

Time Series Analysis of Past Rates of Return – if for a series of total return

Use Arithmetic Average of rates of return

E

(

r

)

=

n

s =

1

p

(

s

)

r

(

s

)

1

n

n

s

=

=

1

rates of return E ( r ) = ∑ n s = 1 p ( s
rates of return E ( r ) = ∑ n s = 1 p ( s

r

(

s

)

Treat as equal prob. if historical return

Example

Year

Stock A: Total return (%)

1

19

2

14

3

22

4

-12

5

5

Arithmetic mean for stock A:

R = (19+14+22-12+5)/5 = 9.6%

Geometric Mean

To know the average compound rate of growth that has actually occurred over multiple period

Geometric (Time-Weighted) Average Return

TV

n

=

(1

+

r

1

)(1

+

r

2

)

x

x

K =

(1

+

r

n

)

TV = Terminal Value of the Investment

g

=

TV

1 / n

1

g= geometric average rate of return

=actual performance

Geometric and Arithmetic Returns

In a period, a stock goes up by 60% and in the second period, the stock drops by 50%

Geometric mean = [(1+0 6)(1-0 5)] ½ - 1

.

.

= -10.56%

Arithmetic mean =(0.6 – 0.5)/2 = 5%

Example: AM vs GM

Year

Stock A: Total return (%)

Relative return

1

19

1.19

2

14

1.14

3

22

1.22

4

-12

0.88

5

5

1.05

Arithmetic mean for stock A: = 9.6%

Geometric return:

[(1.19)(1.14)(1.22)(0.88)(1.05)] 1/5 – 1 = 1.089 – 1 = 8.9%

Stock A has generated a compound rate of return of 8.9% over a period of 5 years GM always < than AM

Normality

In investments, the focus is knowing the central tendency of a series of returns.

Normal distribution is symmetric

Stable

Simplified with mean and standard deviations

Therefore arithmetic mean is preferred

Deviations from Normality

Assess the adequacy of assumptions of normality

Can invalidate the use of standard

deviation as adequate measure of risk

Need to made corrections

Understanding of Econometrics

Figure 5.4 The Normal Distribution

Figure 5.4 The Normal Distribution

Figure 5.5A Normal and Skewed Distributions (mean = 6% SD = 17%)

5.5A Normal and Skewed Distributions (mean = 6% SD = 17%) Eg. positively skewed (>0), std.

Eg. positively skewed (>0), std. dev. overestimates risk, increase estimate of volatility

Figure 5.5B Normal and Fat-Tailed Distributions (mean = .1, SD =.2)

5.5B Normal and Fat-Tailed Distributions (mean = .1, SD =.2) Kurtosis-likelihood of extreme values on either

Kurtosis-likelihood of extreme values on either side of the mean. SD will underestimate the likelihood of extreme events

Real return

The returns discussed are nominal returns. Adjustment must be made for inflation.

Real Rate (t) =

1 + Nominal return

-

1

» 1 + Inflation rate

Example:

Total return for an equity stock during a year was

18.5%

Rate of inflation that year is 5.5%

Real (inflation-adjusted) = ([1.185/1.055] – 1

= 12.3%

Measuring historical risk

Most commonly used measure of risk in finance is variance or standard deviation

σσσσ 2222

==== [[[[ (Ri – R) 2 ]/n-1

Example: returns of a stock over 6 year period

Period

Return Ri

Deviation (Ri – R)

Square of deviation

1

15

5

25

2

12

2

4

3

20

10

100

4

-10

-20

400

5

14

4

16

6

9

-1

1

 

Mean=10

 

Sum Sq dev= 536

σσσσ 2222 v= 536/5 = 107.2 std dev = 10.4

Measurement of Expected Return and Risk

Expectation of future value

Can take various possible values and can vary

Look at likelihood of occurrence

Measurement of Expected Return and Risk

Example:

Investor buy share @RM1.20 per share that expected to give dividend of RM0.05 and share price of RM1.75 at end of year

Expected return =

(Forecast Div. + Forecast end of year stock price) - 1
Initial Investment

= (0.05 + 1.75)/1.2 – 1 = 50%

However, this is only expectation and uncertain.

Assign probability of occurrence

Expected Return

PossiblePossible returnreturn (%)(%) (Xi)(Xi)

ProbabilityProbability ofof occurrenceoccurrence p(Xi)p(Xi)

ExpectedExpected

returnreturn

 

Σ(Xi.p(Xi))Σ(Xi.p(Xi))

3030

0.10.1

33

4040

0.30.3

1212

5050

0.40.4

2020

6060

0.10.1

66

7070

0.10.1

77

   

Mean=48Mean=48

Expected Return and Standard Deviation

Expected returns

E

(

r

)

=

p

s

(

s

)

r

(

s

)

p(s) = probability of a state r(s) = return if a state occurs

s = state

Another Example: Scenario Returns

State

Prob. of State

r in State

1

.1

-.05

2

.2

.05

3

.4

.15

4

2

25

.

.

5

.1

.35

E(r) = (.1)(-.05) + (.2)(.05)… + (.1)(.35) E(r) = .15

Standard Deviation

Standard deviation of the rate of return is a measure of risk

Higher the volatility, higher value of std deviation

Measure uncertainty of outcome

Variance or Dispersion of Returns

Variance:

σ

σ

2

2

=

=

∑ ∑

s s

p

p

(

(

s

s

)

)

[ [

r

r

(

(

s

s

)

)

E r

E r

(

(

)

)

] 2

]

2

Standard deviation = [variance] 1/2

Using 2nd Example:

Var =[(.1)(-.05-.15) 2 +(.2)(.05- .15) 2 …+ .1(.35-.15) 2 ] Var= .01199 S.D.= [ .01199] 1/2 = .1095

Risk Premium and Excess Return

Risk premium = expected HPR minus the risk free rate

Eg. If expected index fund return is 14% and risk free T-Bills is 6%, risk premium would be

8%

Excess return = actual rate of return on a

risky asset and the risk free rate

Rates of Return

Rates of Return

Risk Aversion and Capital Allocation to Risky Assets

Type of Risk

Risk Free

Risk Adverse

Risk Neutral

Risk Seeking (lover)

Risk Tolerance Test

Risk Aversion and Utility Values

These investors are willing to consider only risk-free or speculative prospects with positive risk premiums

Intuitively one would rank those portfolios as more attractive with higher expected returns

Example: Available Risky Portfolios

Example: Available Risky Portfolios Rank each portfolio as more attractive when expected return is higher and

Rank each portfolio as more attractive when expected return is higher and lower when risk is higher. How do investors quantify the rate to trade off return against risk?. Use utility score

Utility Function

Where:

U = utility

(

U = E r

)

1

2

Aσ

2

E ( r ) = expected return on the asset or portfolio

A = coefficient of risk aversion (hi her value – more risk

adverse) σ 2 = variance of returns *Higher utility values with attractive risk-return profile. Higher score =expected return; and lower=higher volatility Risk free portfolios = utility score is rate of return as no penalty for risk

g

Utility Scores of Alternative Portfolios for Investors with Varying Degree of Risk Aversion

for Investors with Varying Degree of Risk Aversion 3 type of investors to choose which of

3 type of investors to choose which of the 3 portfolio i.e. the portfolio L, M and H to invest

The Trade-off Between Risk and Returns of a Potential Investment Portfolio, P

Between Risk and Returns of a Potential Investment Portfolio, P Prefer Quardrant 1 E(ra) > E(rb)

Prefer Quardrant 1 E(ra) > E(rb) SDA < SDb

The Indifference Curve

The Indifference Curve

Estimating Risk Aversion

Observe individuals’ decisions when confronted with risk

Observe how much people are willing to pay to avoid risk

Eg. Insurance against large losses or financial distress

Capital Allocation Across Risky and Risk-Free Portfolios

Have shown that Stocks > risk than LT bonds > than T-Bill

Control risk Asset allocation choice

Fraction of the portfolio invested in Treasury bills or other safe money market securities vs risky assets

The Risky Asset Example

Total portfolio value Risk-free value

Risky (Vanguard & Fidelity)

Vanguard (V) = 54%

Fidelity (F)

= $300,000

90,000

210,000

=

=

= 113,400/210,000

= 46% = 96,600/210,000

The Risky Asset Example Continued

The Risky Asset Example Continued Vanguard 113,400/300,000 = 0.378 Fidelity 96,600/300,000 = 0.322 Portfolio P Risk-Free
The Risky Asset Example Continued Vanguard 113,400/300,000 = 0.378 Fidelity 96,600/300,000 = 0.322 Portfolio P Risk-Free
The Risky Asset Example Continued Vanguard 113,400/300,000 = 0.378 Fidelity 96,600/300,000 = 0.322 Portfolio P Risk-Free

Vanguard

113,400/300,000 = 0.378

Fidelity 96,600/300,000 = 0.322

Portfolio P Risk-Free Assets F

210,000/300,000 =

0.700

90,000/300,000 =

0.300

Portfolio C

300,000/300,000 =

1.000

Risky Portfolio

Suppose reduce risky port. from 0.7 to 0.56

=0.56 x $300,000 = $168,000.

Need to sell $42,000 and buy risk free assets

Sell 0.54 of vanguard and 0.46 of fidelity

Total risk free assets increased = $300,000x(1-0.56) = $132,000 or

90,000+42,000

Risky Portfolio

Proportion remain unchanged in risky assets, 0.54 and 0.46

Need to sell:

0.54x42,000 = 22,680 and

0.46 x 42,000 = 19,320

Treat as a single risky asset

As long as the weight of each risky assets remain unchanged, rate of return remain unchanged

The Risk-Free Asset

Only the government can issue default- free bonds

Guaranteed real rate only if the duration of the bond is identical to the investor’s desire holding period

T-bills viewed as the risk-free asset

Less sensitive to interest rate fluctuations due to short term maturity

Portfolios of One Risky Asset and a Risk-Free Asset

It’s possible to split investment funds between safe and risky assets.

Risk free asset: proxy; T-bills

Risky asset: stock (or a portfolio)

The concern - the proportion of investment budget to allocate

Example: To determine proportion of investment

r f = 7%

E(r p ) = 15%

y = % in p

σσσσ rf = 0%

σσσσ p = 22%

(1-y) = % in r f

Return of complete portfolio = rc = yr p + (1-y) r f

Expected Returns for Combinations

(

E r

c

)

(

= yE r

p

)

+

(1

)

y r

f

r = com lete or combined

c

p

ortfolio

p

For example, y = .75 E(r c ) = .75(.15) + .25(.07) = .13 or 13%

Combinations Without Leverage

If y = .75, then

σσσσσσσσ

c = .75(.22) = .165 or 16.5%

If y = 1

σσσσσσσσ

c = 1(.22) = .22 or 22%

If y = 0

σσσσσσσσ

c

= (.22) = .00 or 0%

Rate of return of complete portf is E(rc) = rf + y[E(rp) – rf]

The Investment Opportunity Set with a Risky Asset and a Risk-free Asset in the Expected Return-Standard Deviation Plane

The Investment Opportunity Set with a Risky Asset and a Risk-free Asset in the Expected Return-Standard

Capital Allocation Line

Slope of line = [E(rp) – rf]/SDp
= (15-7)/22
= 8/22

Extra return per risk is thus 8/22 or 0.36

Or called reward-to-volatility ratio

The CAL = 7 + 8/22 SDc

The Reward-to-Volatility (Sharpe) Ratio

Risk Premium

SD of Excess Return
SD of Excess Return
SD of Excess Return
SD of Excess Return
SD of Excess Return
SD of Excess Return
SD of Excess Return
SD of Excess Return
SD of Excess Return

SD of Excess Return

SD of Excess Return
SD of Excess Return
SD of Excess Return
SD of Excess Return
SD of Excess Return
SD of Excess Return
SD of Excess Return
SD of Excess Return
SD of Excess Return
SD of Excess Return

Sharpe Ratio for Portfolios =

reward

Risk

Use to evaluate the performance of investment manager

Capital Allocation Line with Leverage

Borrow at the Risk-Free Rate and invest in stock. Using 50% Leverage, r c = (-.5) (.07) + (1.5) (.15) = .19

σ c = (1.5) (.22) = .33 If borrowing rate is 9% instead of Rf at 7% Slope = (15-9)/22 = 0.27

The Opportunity Set with Differential Borrowing and Lending Rates

The Opportunity Set with Differential Borrowing and Lending Rates

Risk Tolerance and Asset Allocation

The investor must choose one optimal portfolio, C, from the set of feasible choices

Trade-off between risk and return

Expected return of the complete portfolio is given by:

Variance is:

E

(

r

c

)

= r

f

+ y E

(

r

P

2

C

σ

2

2

P

= y σ

)

r

f

“There are two kinds of people,

those who do work and those who take the credit.

Tr

y

to be in the first

rou ; there is

g less competition there ”

p

THE END Q & A