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Portfolio Management
Eighth Edition
by
Chapter 1
The Investment Setting
Questions to be answered:
$100
Today
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)
Measures of
Historical Rates of Return
1.1
Where:
HPR = Holding period return
P0 = Beginning value
P1 = Ending value
Measures of
Historical Rates of Return
Annualizing the HPR
EAR 1 HPR
1
N
Where:
Example: You bought a stock for $10 and sold it for $18 six
years later. What is your HPR & EAR?
P1 P0
HPR
P0
$18 - 10
$10
0.80 or 80%
Step #2:
EAR 1 HPR
1
6
1
N
1.80 1
10.29%
Measures of
Historical Rates of Return
Arithmetic Mean
Where:
R1 R2 ... RN
AM
N
AM = Arithmetic Mean
GM = Geometric Mean
Ri = Annual HPRs
N = Number of years
Geometric Mean
GM 1 R1 1 R2 ... 1 RN
1
N
Example
You are reviewing an investment with the following price
history as of December 31st each year.
Calculate:
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
Computation of Holding
Period Return for a Portfolio
HPRPortfolio
P1 P0
P0
(Pi )(R i )
i 1
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%
HPR
i 1
E HPRi
N
Where:
Measuring Risk:
Expected Rates of Return
n
(Pi ) R i E(R)
2
i 1
Where:
2 = Variance
Ri = Return in period i
P [R -E(R )]
i 1
2
P
[R
-E(R
)]
i
i
i
i 1
1
2
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
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
Inflation
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?
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
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
Nondiversifiable risk
Relationship Between
Risk and Return
Rate of
Return
Risk free
Rate
(Expected)
Low
Average
High
Risk
Risk
Risk
Security
Market Line
(SML)
Risk free
Rate
Lower
Risk
Higher
Risk
Security
Market Line
Beta
Change in
Market Risk Premium
Expected
Return
Rm
Rm
New
SML
Original
SML
Risk Free
Rate
Beta
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