Académique Documents
Professionnel Documents
Culture Documents
to accompany
fhe
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Historical Rates of Return
Geometric Mean
u
lsPow
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fR
1.5
s:
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
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Expected Rates of Return
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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%
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Measuring the Risk of
Expected Rates of Return
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Measuring the Risk of
Expected Rates of Return
Standard Deviation is the square
root of the variance
1.8
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Measuring the Risk of
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
1.9
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Measuring the Risk of
Historical Rates of Return
1
Adjusting For Inflation 1.12
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 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?
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 assets total variance attributable
to the variability of the total market portfolio
R
ate
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Relationship Between
R ow Avera ge Hi
Risk and Return
iskR iskR gh
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e
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kr
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Exhibit 1.7
(Expected)
R
FR re
qT
uh
e
i
rdsl
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p
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i
p
ec
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ut
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(bu
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stema Ri
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ticr-b
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ta
)
E
xp
ec
t
e
d
Changes in the Required Rate of Return
R
a S
ecur
it
y
Due to Movements Along the SML
Ma
rkeLin
e
Exhibit 1.8
R
FR M
t
h
r
io
a
sv
e
t
r
k
o m
en
t
fl
f
t
hc
es
ac
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en
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sh
e
inc
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t
her
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e
(b
u
sin
e
srisk
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tc.,o
rsy
ste
ma Ri
sk
ticr-b
eta)
Changes in the Slope of the SML
1.13
R
mE
(
'R) N
e
w S M
L
Exhibit 1.10
O
rig in
a
lS
M
L
Expected Return
R
m
Rm
R
FR R isk
Rm
NRFR
Capital Market Conditions,
Expected Inflation, and the SML
Ra
teo
fR
e
tu
rn N
e w
SML
Exhibit 1.11
O
r
i
g i
n
alS
ML
Expected Return
R
F
RR
'
FR R
isk
NRFR
NRFR
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.finweb.com
www.forbes.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