Rationale for Investment
Income streams and spending needs usually differ (surplus = invest, deficit = borrow)
People would be willing to forgo current consumption only if they are confident of achieving greater consumption in the future.
Rate of exchange between future consumption (future $) and present consumption (current $) is the pure rate of interest (determined by market forces).
Investment is the current commitment of dollars for a period of time to obtain future payments that will compensate the investor for the time the funds are committed, for the expected rate of inflation during this period, and for the uncertainty of future payments.
In all cases - the investor is trading a known dollar amount today for some expected future stream of payments that will be greater than the current dollar amount today.
Holding Period Return (HPR)
HPR = EV/BV
The total return from an investment, including all source of income, for a given period of time.
A value of 1.0 indicates no gain or loss.
A value greater than 1.0 indicates an increase in wealth
A value less than 1.0 indicates a decline in wealth
- Avalue of zero indicates that all of the money invested in that asset has been
Holding Period Yield (HPY)
HPY = HPR - 1
The total return from an investment for a given period of time stated as a %.
Mean Rate of Return
The average of an investment's return over time.
Pure Rate of Interest
The rate of exchange between future consumption (future dollars) and current consumption (current dollars)
Current commitment of dollars for a period of time in order to derive future payments that will compensate the investor for...
- the time the funds are committed
- the expected rate of inflation during this time period
- the uncertainty of the future payments.
Portfolio of Investments
- The weighted average of the HPYs for the individual investments in the portfolio, or the overall percent change in value of the original
The weights used in computing the averages are the relative beginning market values for each investment; this is referred to as dollar-weighted or value-weighted mean rate of return.
Geometric Mean (GM)
Indicates the compound annual rate of return based on the ending value of the investment versus its beginning value.
Arithmetic Mean (AM)
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 asset’s long-term performance.)
Measure of Risk
Variance - The larger the variance for an expected rate of return, the greater the dispersion of expected returns and the greater the uncertainty, or risk, of the investment.
Coefficient of variation (SD/means)
Covariance of returns with the market portfolio (Beta)
Real Risk Free Rate (RRFR)
The basic interest rate, assuming no inflation and no uncertainty about future flows.
Factors Influencing the Nominal Risk Free Rate (NRFR)
Conditions in the capital market
Expected rate of inflation
The common effect (inflation should affect all investments equally, i.e., inflation +4%, bonds +4%, stocks +4%)
Sources of Fundamental Risk
Business (uncertainty of income flows caused by the nature of a firm's business)
Financial (uncertainty introduce by the method of financing investments)
Liquidity (uncertainty introduced by the secondary market for an investment)
Exchange Rate (uncertainty of returns to an investor who acquires securities denominated in a foreign currency)
Country/Political (uncertainty of returns caused by possibility of a major change in the political or economic environment of a country)
Required Rate of Return (Variables)
- The economy’s RRFR, which is influenced by the investment opportunities in the economy
- (that is, the long-run real growth rate)
Variables that influence the NRFR (short-run ease or tightness in the capital market and the expected rate of inflation)
The risk premium on the investment
Security Market Line (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.
(Vertical = Er, Horizontal = Risk, line starts at NRFR)
Movement Along the SML
A change in the risk characteristics of a specific investment, such as a change in its business risk, its financial risk, or its systematic risk (its beta).
This change affects only the individual investment.
Change in the Slop of SML
- A change in the attitudes of investors
- toward risk.
- Investors want either higher or lower rates of
- return for the same intrinsic risk.
Also described as a change in the market risk premium (Rm − NRFR) - affects all risky investments.
Shift in the SML
A change in expected real growth, a change in market conditions (such as ease or tightness of money), or a change in the expected rate of inflation.
Affects all investments.