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Investment
Compiled by
Kumail Rizvi
PhD from Paris 1 (Panthon sorbonne)
CFA
FRM
MSc Money Banking and Finance
MSc Computer Sciences
MBEcon (Finance)
2011
2010
2010
2007
2003
2001
Experience (Academic)
GIFT University
Hailey College of Commerce, Punjab University
PAK AIMS
IBP (Institute of Bankers Pakistan)
Paris 1 (Panthon Sorbonne)
University of Central Punjab (UCP)
Lahore School of Economics (LSE)
Experience (Corporate)
NATIXIS BANK, France
Sigma Financials, Dubai
Synergistic Financial Advisors (SFA)
SPM Consulting, Dubai
SAS Middle East
IBM (International Business Machines)
GBM (Gulf Business Machines)
Chapter 1
The Investment Setting
Questions to be answered:
Why do individuals invest ?
What is an investment ?
How do we measure the rate of return on
an investment ?
How do investors measure risk related to
alternative investments ?
Chapter 1
The Investment Setting
What factors contribute to the rates of
return that investors require on
alternative investments ?
What macroeconomic and
microeconomic factors contribute to
changes in the required rate of return for
investments ?
Why Do Individuals
Invest ?
By saving money (instead of
spending it), individuals tradeoff
present consumption for a larger
future consumption.
$1.00 4% $1.04
Defining an Investment
A current commitment of $ 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
Holding Period Return
Ending Value of Investment
HPR
Beginning Value of Investment
$220
1.10
$200
1.1
Measures of
Historical Rates of Return
1.2
Measures of
Historical Rates of Return
Annual Holding Period Return
Measures of
Historical Rates of Return
Arithmetic Mean
where :
AM HPY/ n
1.4
Measures of
Historical Rates of Return
1.5
Geometric Mean
GM HPR
where :
Time
Outlay
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, or the
overall change in the value of the
original portfolio
HPY =
Begin
Price
$ 10
$ 20
$ 30
Beginning Ending
Ending
Market
Mkt. Value Price Mkt. Value HPR HPY Wt.
$ 1,000,000
$ 12 $ 1,200,000 1.20 20% 0.05
$ 4,000,000
$ 21 $ 4,200,000 1.05 5% 0.20
$ 15,000,000
$ 33 $ 16,500,000 1.10 10% 0.75
$ 20,000,000
$ 21,900,000
HPR =
$ 21,900,000
$ 20,000,000
1.095
1.095
-1
0.095
9.5%
Wtd.
HPY
0.010
0.010
0.075
0.095
1.6
(
P
)(R
)
i i
i 1
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
-30%
-10%
10%
30%
Probability Distributions
Exhibit 1.4
1.00
0.80
0.60
0.40
0.20
0.00
-40% -20% 0%
20% 40%
2
(
Probabilit
y)
(Possible
Return
Expected
Return)
i 1
(
P
)[R
E(R
)]
i i
i
i 1
1.7
1.8
E(R)
1.9
1.10
[HPYi E(HPY)
2
HPYi
E(HPY)
n
2/n
i 1
variance of the series
holding period yield during period I
expected value of the HPY that is equal
to the arithmetic mean of the series
the number of observations
Determinants of
Required Rates of Return
Time value of money during the
period of investment
Expected rate of inflation during
the period
Risk involved
1.12
Real RFR =
(1 Nominal RFR)
1
(1 Rate of 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 firms 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 stocks 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?
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 assets total variance attributable
to the variability of the total market portfolio
Relationship Between
Risk and Return Exhibit 1.7
Rateof Return (Expected)
Low
Average High
Risk
Risk
Risk
RFR
Security
Market Line
Risk
(business risk, etc., or systematic risk-beta)
Exhibit 1.8
Security
Market Line
RFR
Risk
(business risk, etc., or systematic risk-beta)
1.14
Change in
Market Risk Premium
Exhibit 1.10
Expected
E(R) Return
Rm'
Rm
New SML
Original SML
Rm
Rm
NRFR
RFR
Risk
New SML
Original SML
RFR'
NRFR
NRFR
RFR
Risk
The Internet
Investments Online
http://www.finpipe.com
http://www.ft.com
http://www.investorguide.com http://www.fortune.com
http://www.aaii.com
http://www.smartmoney.com
http://www.economist.com
http://www.worth.com
http://www.online.wsj.com
http://www.money.cnn.com
http://www.forbes.com
http://www.barrons.com
http://fisher.osu.edu/fin/journal/jofsites.htm
Future Topics
Chapter 2
The asset allocation decision
The individual investor life
cycle
Risk tolerance
Portfolio management