Three key components of an investor’s required rate of return on an investment.
Risk Free Rate - pure time value of money and is the compensation an individual demands for deferring consumption. Can be measured in terms of the long-run real growth rate in the economy since the investment opportunities available in the economy influence the RFR.
The inflation premium - conveniently measured in terms of the Consumer Price Index, is the additional protection an individual requires to compensate for the erosion in purchasing power resulting from increasing prices.
Risk Premium - the return on all investments is not certain as it is with T-bills, the investor requires a premium for taking on additional risk. Examined in terms of business risk, financial risk, liquidity risk, exchange rate risk and country risk.
“Young investors have little savings and therefore they should not invest their savings
One assumes that the young person has a steady job, adequate insurance coverage, and sufficient cash reserves.
Accumulation phase of the investment life cycle.
Should consider moderately high-risk investments, such as common stocks, because he/she has a long investment horizon and much earnings ability over time.
Role of a policy statement for a particular investment plan.
Important for both the investor and the investment advisor.
Assists the investor in establishing realistic investment goals, as well as providing a benchmark by which a portfolio manager’s performance may be measured.
Various types of information needed for the construction of an investment policy statement.
Client’s investment objectives must be clarified (e.g. capital preservation, capital appreciation, current income or total return) and constraints (e.g. liquidity needs, time horizon, tax factors, legal and regulatory constraints, and unique needs and preferences).
Data on current investments, portfolio returns, and savings plans (future additions to the portfolio) are helpful, too.
Capital Market Line (CML) and
the Security Market Line (SML)
Same - both measure the relationship between risk and expected return.
- CML measures risk by the standard deviation (i.e., total risk) of the investment.
- CML can only be applied to portfolio holdings that are already fully diversified.
- CML the lowest risk portfolio is 100 percent invested in the risk-free asset with a standard deviation of zero.
- SML explicitly considers only the systematic component of an investment’s volatility. SML can be applied to any individual asset or collection of assets.
- SML deals primarily with security or asset risk. Security risk is measured by the asset’s systematic risk, or beta. Beta can be negative (if the asset’s returns and market returns are negatively correlated) so the SML extends to the left of the vertical (expected return) axis.
Vertical = Expected return
Horizontal = Beta
Market = Rm, Beta 1.0
Intersect = Rf, Beta 0.0
Under = estimated return exceeding expected return.
The return on equity increases (Earnings Multiplier)
An increase in the ROE with no other changes should cause an increase in the multiple because it would imply a higher growth rate.
If it was due to operating factors (higher asset turnover or profit margin) it is positive.
If it was due to an increase in financial leverage, there could be some offset due to an increase in the required rate of return (k).
The aggregate debt-equity ratio declines (Earnings Multiplier)
- Decrease, because this will decrease earnings growth by reducing equity turnover as the
- firm will be less leveraged.
It could also cause the P/E ratio to increase because it will lower the financial risk and, thus, may increase the required k.
Overall production of capital increases (Earnings Multiplier)
Decrease, because this will increase growth and therefore raise the real RFR.
This raises the required return, k.
Should higher capital productivity reduce inflation, the net effect may decrease the nominal RFR, causing the multiplier to rise.
The dividend payoff ratio declines
- The P/E equals dividend payout / (k – g). A lower dividend payout ratio lowers the
- numerator but should cause the denominator to fall, too. A lower dividend payout ratio
- means more earnings are retained and the growth rate (retention rate x ROE) should
- rise. The final effect depends on the relative changes of the numerator and denominator.
A company retains 80% of its earnings and all earnings are growing at a rate of 8% per
year, versus an average growth rate of 6% for all firms. Discuss whether one would
consider this a growth company.
Above average earnings growth is a characteristic of a growth company. Additionally, a rather high retention rate of 80 percent implies that the firm will have the resources to take advantage of high return investment opportunities. These factors lend support to classifying the firm as a growth company. However, as a result of the high retention rate, investors will continue to require a high return on investment. Only if the firm can continue to achieve returns above its cost of capital will the firm continue to be classified as a growth company.
Discuss the underlying reasoning for the contention that in a completely competitive economy, there would never be a true growth company
- In a perfectly competitive economy, if other companies see a particular firm achieving returns consistently above risk based expectations, it is expected that these
- other companies will enter that particular industry or market and eventually drive
- prices down until the returns are consistent with the inherent risk. In other words,
- the competition would not allow the continuing existence of excess return investments and so competition would negate such growth. The computer industry is a good example of increased competition resulting in lower profit margins. The theory implies that in truly competitive environments, a true growth company is a temporary classification.
Price momentum strategy
- Based on the assumption that a stock’s recent price behavior will continue to hold. Thus an investor would buy a stock whose price has
- recently been rising, and sell (or short) a stock whose price has been falling.
Earnings Momentum Strategy
- Rests on the idea that a firm’s stock price will
- ultimately follow its earnings. The measurement of earnings momentum is usually based on a comparison to expected earnings. Thus an investor would buy a stock that has accelerating earnings relative to expectations and sell (or short) a stock whose earnings fall below expectations.
Explain the trade-offs involved when constructing a portfolio using a full replication versus a sampling method.
Fully replicating an index is more difficult to manage and has higher trading commission costs, when compared to the sampling method.
Tracking error occurs from sampling, which should not be the case in the full replication of the index.
Explain how each of these measures adjusts a portfolio’s return for the level of that risk
Treynor ratio and Jensen’s alpha measure risk by systematic risk, beta.
The Sharp ratio measure uses total risk (SD)
The information ratio uses the SD of excess returns where excess return is the difference between the return on a portfolio and its benchmark.
The Sortino ratio uses a semi-deviation measure, including only those returns that fall below a specified minimum acceptable return.
Treynor (1965) divided a fund’s excess return (return less risk-free rate) by its beta. For a fund not completely diversified, Treynor’s “T” value will understate risk and overstate performance. Sharpe (1966) divided a fund’s excess return by its standard deviation. Sharpe’s “S” value will produce evaluations very similar to Treynor’s for funds that are well diversified. Jensen (1968) measures performance as the difference between a fund’s actual and required returns. Since the latter return is based on the CAPM and a fund’s beta, Jensen makes the same implicit assumptions as Treynor - namely, that funds are completely diversified. The information ratio (IR) measures a portfolio’s average return in excess of that of a benchmark, divided by the standard deviation of this excess return. Like Sharpe, it can be used when the fund is not necessarily well-diversified. The Sortino Ratio defines excess return as the difference between the portfolio return and a minimum acceptable return defined by the investor; this is divided by a semi-deviation measure that is computed using only returns less than the minimum acceptable return.
Earnings Multiplier (Price/Earnings)
= Current Market Price / Expected 12-month Earnings
Model implies that the P/E ratio is determined by
- - The expected dividend payout ratio
- - The estimated required rate of return
- - The expected growth rate of dividends for the stock