Investment Analysis and

Portfolio Management
10th Edition
by

Frank K. Reilly & Keith C. Brown

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 ?
What factors contribute to the rate of return that an
investor requires on an investment?
What macroeconomic and microeconomic factors
contribute to changes in the required rate of return for an
investment?

Why Do Individuals Invest ?

By saving money (instead of spending

it), individuals forego consumption today
in return for a larger consumption
tomorrow.

How Do We Measure The Rate Of

Return On An Investment ?
The real rate of interest is the exchange rate between
future consumption (future dollars) and present
consumption (current dollars). Market forces
determine this rate.
Tomorrow
$104

If you are willing to exchange a

certain payment of $100 today
for a certain payment of $104
tomorrow, then the pure or real
rate of interest is 4%

$100

Today

How Do We Measure The Rate Of

Return On An Investment ?
If the purchasing power of the future payment will
be diminished in value due to inflation, an investor
will demand an inflation premium to compensate
them for the expected loss of purchasing power.
If the future payment from the investment is not
certain, an investor will demand a risk premium to
compensate for the investment risk.

Defining an Investment
Any investment involves a current commitment of
funds for some period of time in order to derive
future payments that will compensate for:
the time the funds are committed (the real rate of return)
the expected rate of inflation (inflation premium)
uncertainty of future flow of funds (risk premium)

Return
The return on an investment (total gain or loss) is the
change in value plus any cash distributions over a
defined time period.
It is expressed as a percent of the beginning-of-theperiod investment.
Income received on an investment plus any change in
market price,
price usually expressed as a percent of the
beginning market price of the investment. Following
formula is used to measure return

Return Example
The stock price for Stock A was $10
per share 1 year ago. The stock is
currently trading at $9.50 per share
and shareholders just received a $1
dividend.
What return was earned
dividend
over the past year?

Example:Calculation of Return

1
H
R
$2.10o-0r%
Measure of
Holding Period Return

Example of Holding Period Return: If you commit $200

to an investment at the beginning of the year and you get
back $220 at the end of the year, what is your return for
the period?
Where:

HPR = Holding period return

P0 = Beginning value
P1 = Ending value

Alternative Formula for Holding Period

Return

EAR1HPR1
1N

Measure of
Equivalent Annual Return

Annualizing the HPR

Where:

EAR = Equivalent Annual Return

HPR = Holding Period Return
N = Number of years

Example: You bought a stock for $10 and sold it for $18 six
years later. What is your HPR & EAR?

1
1
0
H
R

E
A
R

H
P
R

1
1
$1.8-o0r%.8
6
029%
Calculating HPR & EAR

Solution:
Step #1:

Step #2:

Class Exercises
Exc. 1. On February 1, you bought 100 shares of stock
in the Francesca Corporation for $34 a share and a year
later you sold it for $39 a share. During the year, you
received a cash dividend of $1.50 a share. Compute your
HPR and HPY on this Francesca stock investment.
Exc. 2. On August 15, you purchased 100 shares of
stock in the Cara Cotton Company at $65 a share and a
year later you sold it for $61 a share. During the year,
you received dividends of $3 a share. Compute your
HPR and HPY on your investment in Cara Cotton.

Mean of
Historical Rates of Return
Arithmetic Mean(AM) =HPY/n

Where:

R1 R2 ... RN
AM
N

AM = Arithmetic Mean
GM = Geometric Mean
Ri = Annual HPRs
N = Number of years

Geometric Mean (GM), is the

nth root of the product of the
HPRs for n years minus one.

GM 1 R1 1 R2 ... 1 RN

1
N

AM and GM

Although the arithmetic average provides a good indication of the

expected rate of return for an investment during a future individual
year, it is biased upward if you are attempting to measure an assets
long-term performance. This is obvious for a volatile security.
Consider, for example, a security that increases in price from $50 to
$100 during year 1 and drops back to $50 during year 2. The annual
HPYs would be:

AM or GM, which is a better

measure?
Investors are typically concerned with long-term
performance
when
comparing
alternative
investments.
GM is considered a superior measure of the longterm 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.
This is obvious that GM is better measure of Mean
HPR for a volatile security.

Example
You are reviewing an investment with the following price
history as of December 31st each year.

1999 2000 2001 2002 2003 2004 2005 2006

$18.45 $21.15 $16.75 $22.45 $19.85 $24.10 $24.10 $26.50

Calculate:

The HPR for the entire period

The annual HPRs
The Arithmetic mean of the annual HPRs
The Geometric mean of the annual HPRs

A Portfolio of Investments
The mean historical rate of return for a
portfolio of investments is measured as
the weighted average of the HPRs for
the individual investments in the
portfolio, or the overall change in the
value of the original portfolio

Investment Portfolio
Collection of assets or group of assets is called
investment portfolio.
An efficient portfolio is one that maximizes return
for a given risk level or minimizes risk for a given
level of return.
Return of a portfolio is the weighted average of
returns on the individual component assets:

Computation of Holding
Period Return for a Portfolio
#
Stock Shares
A
100,000
B
200,000
C
500,000
Total

Begin
Price
$ 10
$ 20
$ 30

Beginning Ending
Ending
Mkt. Value Price Mkt. Value
$ 1,000,000 $ 12 $ 1,200,000
$ 4,000,000 $ 21 $ 4,200,000
$ 15,000,000 $ 33 $ 16,500,000
$ 20,000,000
$ 21,900,000

HPRPortfolio

HPR
0.20
0.05
0.10

Market
Wt.
0.05
0.20
0.75

P1 P0
P0

21,900, 000 20, 000, 000

20, 000, 000

9.5%

Wtd.
HPR
0.010
0.010
0.075
0.095

Expected Return and Risk

Investors and analysts often look at historical returns as a
starting point for predicting the future.
However, they are much more interested in what
the returns on their investments will be in the future.
For this reason, we need a method for estimating future or
ex-ante returns.
One way of doing this sensitivity analysis where probabilities
are assigned to future states of nature and the returns that
would be realized if a particular state of nature does occur.

E
(R
)
(Pr)obR
ailtyofR
eturn)(PosibleR
turn)
n
ii1ii

Expected Rates of Return

Risk is the uncertainty whether an investment will earn its

expected rate of return
Probability is the likelihood of an outcome

Risk Aversion
Much of modern finance is based on the principle
that investors are risk averse
Risk aversion refers to the assumption that, all else
being equal, most investors will choose the least
risky alternative and that they will not accept
additional risk unless they are compensated in the
form of higher return

Probability Distributions
Risk-free Investment
1.00
0.80
0.60
0.40
0.20
0.00

-5%

0%

5%

10% 15%

Probability Distributions
Risky Investment with 3 Possible Returns

1.00
0.80
0.60
0.40
0.20
0.00

-30%

-10%

10%

30%

Probability Distributions
Risky investment with ten possible rates of return

1.00
0.80
0.60
0.40
0.20
0.00
-40% -20% 0%

20% 40%

HPRNEHPR

n
2
i
i
2i1

Measuring Risk: Historical Returns

Where:

2 = Variance (of the pop)

HPR = Holding Period Return i

E(HPR)i = Expected HPR*
N = Number of years

* The E(HPR) is equal to the arithmetic mean of the series of

returns.

Measuring Risk:
Expected Rates of Return
n

(Pi ) R i E(R)
2

i 1

Where:

2 = Variance
Ri = Return in period i

Note: Because we multiply by

the probability of each return
occurring, we do NOT divide by
N. If each probability is the
same for all returns, then the
variance can be calculated by
either multiplying by the
probability or dividing by N.

E(R) = Expected Return

Pi = Probability of Ri occurring

Measure of Variance

Expected Return and Risk

Measuring Risk: Standard

Deviation
Standard Deviation is the square root of the variance
n

P [R -E(R )]

i 1

2
P
[R
-E(R
)]

i
i
i

i 1

1
2

Standard Deviation is a measure of

dispersion around the mean. The
higher the standard deviation, the
greater the dispersion of returns
around the mean and the greater the
risk.

Standard Deviation

Coefficient of Variation
Coefficient of variation (CV) is a measure of
relative variability
CV indicates risk per unit of return, thus making
comparisons easier among investments with large
differences in mean returns
Standard Deviation of Returns
CV
Expected Rate of Return
i

E(R)

1.9

Why CV is considered more

important?

Example of Expected Return and

Risk

Expected Return and Risk

Expected Return and Risk

Expected Return and Risk

Coefficient of Variation (CV)

One problem with using standard deviation as a
measure of risk is that we cannot easily make risk
comparisons between two assets.
The coefficient of variation overcomes this problem
by measuring the amount of risk per unit of return.
The higher the coefficient of variation, the more
risk per return.
Therefore, if given a choice, an investor would
select the asset with the lower coefficient of
variation

Coefficient of Variation (CV)

Example For Calculation of

Holding Period Return
For example, compute the holding period return
if you purchased a stock for $100, received
a $5 dividend, and sold the stock for $110
Pt - Pt-1 + Ct
kt =

Pt-1

110 - 100 + 5
kt =

100

15
=

100

= 15%

Calculation of Arithmetic Mean of Historical Return

Through Excel

What you type

What you see

Historical Risk
Historical Risk
Variance
Historical risk can be measured by the variability
of an assets returns in relation to its average.
Variance is computed by summing squared deviations
and dividing by the number of observations minus one (n - 1).
Squaring the differences ensures that both positive
and negative deviations are given equal consideration.
The sum of the squared differences is then divided by
the number of observations minus one (n - 1).

Variance of Historical Return on

Investment in Asset - A

Variance of Historical Return on

Investment in Asset - B

What you see

What you type

Variance of Historical Return on Investment

in Assets - A and B Through Excel

Standard deviation of Historical

Returns on Investments
Squaring the deviations makes the variance difficult to
interpret.
In other words, by squaring percentages, the resulting
deviations are in percent squared terms.
The standard deviation simplifies interpretation by taking
the square root of the squared percentages.
In other words, standard deviation is in the same units
as the computed average.
If the average is 10%, the standard deviation might be
20%, whereas the variance would be 20% squared.

What you see

What you type

Standard Deviation of Historical Return on

Investment in Assets - A and B Through Excel

Normal Distribution of Historical Return on

Investment

Class Excercise

Portfolio of Assets
An investment portfolio is any collection or combination

of financial assets.
If we assume all investors are rational and therefore risk averse,

that investor will ALWAYS choose to invest in portfolios rather

than in single assets.
Investors will hold portfolios because he or she will diversify

away a portion of the risk that is inherent in putting all your eggs
in one basket.
If an investor holds a single asset, he or she will fully suffer

the consequences of poor performance.

This is not the case for an investor who owns a diversified

portfolio of assets.

Diversification

Diversification is basically used as a

tool to spread the risk across the
number of assets or investments.

Portfolio and Diversifiaction

Diversification is enhanced depending upon the extent
to which the returns on assets move together.
This movement is typically measured by a statistic
known as correlation as shown in Figure 6.3 below.

Portfolio and Diversification

Even if two assets are not perfectly negatively correlated,
an investor can still realize diversification benefits from
combining them in a portfolio as shown in Figure 6.4 below.

Example
Assume that we wish to determine the expected value and standard deviation
of returns for portfolio XY, created by combining equal portions (50% each) of
assets X and Y. The forecasted returns of assets X and Y for each of the next 5
years (20132017) are given in columns 1 and 2, respectively, in the following
Table.

Comparison of tow Portfolios:

Positive verses negative Correlation among Returns of Assets

Portfolio of Assets A and B

Recall Stocks A and B

Weighted Return of Portfolio of Assets A and B

Weight : Out of available funds, 50% are invested
in A, and 50% are invested in B

Comparison of Return on
Investment

Same portfolio of Assets With Different Weights

20% in A, 80% in B

Comparison of Different Weight

Summarizing Changes in Return and Risk
as the Composition of the Portfolio Changes

Number of Assets in Portfolio and Level of Risk

Determinants of
Required Rates of Return
Three factors influence an investors
required rate of return
Real rate of return
Expected rate of inflation during the period
Risk

The Analysis and Estimation of

the Required Rate of Return
The estimation of RRR is complicated by the
behavior of market rates over time.
First, a wide range of rates is available for
alternative investments at anytime.
Second, the rates of return on specific assets
change dramatically over time.
Third, the difference between the rates available
(that is, the spread) on different assets changes
over time.

Behaviour of Bond Market

Rates over Time

The Real Risk Free Rate

Definition: The real risk-free rate (RRFR) is the basic interest
rate, assuming no inflation and no uncertainty. This is the price
charged for the risk-free exchange between current goods and
future goods. We called this the pure time value of money,
because the only sacrifice the investor made was deferring the use
of the money for a period of time about future flows.
Assumes no inflation.
Assumes no uncertainty about future cash flows.

Exchange price (RRFR) is influenced by two factors.

Subjective Factors: Influenced by the time preference for
consumption of income and
Objective Factors: Investment opportunities in the
economy. Investment opportunities directly depends upon
long run real growth rate of the economy.

Factors Influencing the Nominal Risk-Free Rate

(NRFR)
Nominal rates of interest that prevail in the market are
determined by real rates of interest, plus factors that will
affect the nominal rate of interest, such as the expected
rate of inflation and the monetary environment.
Factors affecting the nominal risk free rate.
Conditions of Capital Market
Monetary Policy
Fiscal Policy
Expected Rate of Inflation
Adjusting for inflation ( Fisher Equation)

Adjusting For Inflation: Fisher Equation

The nominal risk free rate of return is dependent

upon:
Conditions in the Capital Markets
Expected Rate of Inflation

Common Effect
All the factors discussed thus far
regarding the required rate of return affect
all investments equally. Whether the
investment is in stocks, bonds, real estate,
or machine tools, if the expected rate of
inflation increases from 2 percent to 6
percent, the investors required rate of
return for all investments should increase
by 4 percent.

Risk Premium
A risk-free investment was defined as one for which the investor is
certain of the amount and timing of the expected returns. The
returns from most investments do not fit this pattern.
Most investors require higher rates of return on investments if
they perceive that there is any uncertainty about the expected rate
of return.
This increase in the required rate of return over the NRFR is the
risk premium (RP).

Major sources of uncertainty

(1) business risk, (2) financial risk (leverage),
(3) liquidity risk, (4) exchange rate risk, and
(5) country (political) risk.

Components of Fundamental
Risk
Five factors affect the standard deviation of
returns over time.

Business risk:
Financial risk
Liquidity risk
Exchange rate risk
Country risk

Business Risk
Business risk arises due to:
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
Financial risk arises due to:
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
Liquidity risk arises due to the uncertainty
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

Exchange rate risk arises due to the uncertainty
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
Country risk (also called political risk) refers to 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 and Portfolio Theory

An alternative view of risk has been derived from
extensive work in portfolio theory and capital market theory
by Markowitz (1952, 1959) and Sharpe (1964).
When an asset is held in isolation, the appropriate measure
of risk is standard deviation
When an asset is held as part of a well-diversified portfolio,
the appropriate measure of risk is its co-movement with the
market portfolio, as measured by Beta
This is also referred to as
Systematic risk
Non-diversifiable risk

Systematic risk refers to the portion of an individual assets

total variance attributable to the variability of the total
market portfolio

A number of studies have examined the relationship between the market measure of
risk (systematic risk) and accounting variables used to measure the fundamental risk
factors, such as business risk, financial risk, and liquidity risk. The authors of these
studies (especially Thompson, 1976) have generally concluded that a significant
relationship exists between the market measure of risk and the fundamental
measures of risk. Therefore, the two measures of risk can be complementary.

RELATIONSHIP BETWEEN RISK

AND RETURN
The expected relationship between risk and return is
described by Security Market Line (SML).
It shows that investors increase their required rates of
return as perceived risk (uncertainty) increases. The line
that reflects the combination of risk and return available
on alternative investments is referred to as the security
market line (SML). The SML reflects the risk-return
combinations available for all risky assets in the capital
market at a given time. Investors would select investments
that are consistent with their risk preferences; some
would consider only low-risk investments, whereas others
welcome high-risk investments.

SML Relationship Between Risk and

Return
Beginning with an initial SML, three changes in the SML
can occur.
First, individual investments can change positions on the
SML because of changes in the perceived risk of the
investments.
Second, the slope of the SML can change because of a
change in the attitudes of investors toward risk; that is,
investors can change the returns they require per unit of
risk.
Third, the SML can experience a parallel shift due to a
change in the RRFR or the expected rate of inflationi.e.,
anything that can change in the NRFR.

Movements along the SML

Relationship Between
Risk and Return
Rate of
Return

Risk free
Rate

(Expected)
Low

Average

High

Risk

Risk

Risk

Security
Market Line
(SML)

Slope of the SML indicates the

required return per unit of risk
Beta

Changes in the Required Rate of Return

Due to Movements Along the SML
Expected
Rate

Risk free
Rate

Lower
Risk

Higher
Risk

Security
Market Line

Movements along the SML

reflect changes in the market or systematic
risk of the asset

Beta

Changes in the Slope of the SML

The slope of the SML indicates the return per unit
of risk required by all investors
The market risk premium is the yield spread
between the market portfolio and the risk free rate
of return
This changes over time, although the underlying
reasons are not entirely clear
However, a change in the market risk premium will
affect the return required on all risky assets

Change in
Market Risk Premium
Expected
Return

Rm
Rm

Note that as the slope

of the SML increases,
so does the market risk
premium

New
SML

Original
SML

Risk Free
Rate

Beta

Capital Market Conditions,

Expected Inflation, and the SML
Rate of
Return

The SML will shift in a parallel fashion if inflation

expectations, real growth expectations or capital
market conditions change. This will affect the
required return on all assets.

New SML

Original SML
Risk free
Rate

Risk

The Internet
Investments Online
http://www.finpipe.com
http://www.ft.com
http://www.investorguide.com
http://www.fortune.com
http://www.smartmoney.com
http://www.aaii.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