1. © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 1: The Investment Setting

2. What Is An Investment? Defining Investment: A current commitment of $ for a period of time in order to derive future payments that will compensate for: –The time the funds are committed –The expected rate of inflation –Uncertainty of future flow of funds Reason for Investing: By investing (saving money now instead of spending it), individuals can tradeoff present consumption for a larger future consumption. 1-2 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

3. What Is An Investment? Pure Rate of Interest –It is the exchange rate between future consumption (future dollars) and present consumption (current dollars). Market forces determine this rate. –The fact that people are willing to pay more for the money borrowed and lenders desire to receive a surplus on their savings (money invested) gives rise to the value of time referred to as the pure time value of money ( pure rate of interest). 1-3 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

4. What Is An Investment? –Example: If you can exchange $100 today for $104 next year, this rate is 4% (104/100-1). –This is the pure rate of exchange on a risk-free investment (risk-free interest rate). © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 1-4

5. What Is An Investment? Other Factors Affecting Investment Value –Inflation: If the future payment will be diminished in value because of inflation, then the investor will demand an interest rate higher than the pure rate of interest to also cover the expected inflation expense. –For example, if the previous investor expect an increase in prices by 2% during the investment period, then the pure rate of interest should increase by 2% to cover the inflation. The new rate, 6%, is the nominal risk-free rate of interest. So in the previous example the investor should receive 106$ on the 100$ investment, instead of 104$. 1-5 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

6. What Is An Investment? Uncertainty: If the future payment from the investment is not certain, the investor will demand an interest rate that exceeds the nominal risk-free rate to provide a risk premium to cover the investment risk Pure Time Value of Money. For example, our previous investor will require 110$ on the 100$ investment. The additional 4% added to the nominal risk-free rate (6%) is the risk premium. © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 1-6

7. What Is An Investment? The Notion of Required Rate of Return –The minimum rate of return an investor require on an investment, including the pure rate of interest and all other risk premiums to compensate the investor for taking the investment risk. –Investors may expect to receive a rate of return different from the required rate of return, which is called expected rate of return. What would occur if these two rates of returns are not the same? 1-7 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

8. Historical Rates of Return Return over A Holding Period –Holding Period Return (HPR) –Holding Period Yield (HPY) HPY=HPR-1 –Annual HPR and HPY Annual HPR=HPR 1/n Annual HPY= Annual HPR -1=HPR 1/n – 1 where n=number of years of the investment 1-8 Investment of Value Beginning Investment of Value Ending HPR  © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

9. Historical Rates of Return Example: Assume that you invest $200 at the beginning of the year and get back $220 at the end of the year. What are the HPR and the HPY for your investment? 1-9 HPR=Ending value / Beginning value =$220/200 =1.1 HPY=HPR-1=1.1-1=0.1 =10% © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

10. Historical Rates of Return Example: Your investment of $250 in Stock A is worth $350 in two years while the investment of $100 in Stock B is worth $120 in six months. What are the annual HPRs and the HPYs on these two stocks? 1-10 Stock A –Annual HPR=HPR 1/n = ($350/$250) 1/2 =1.1832 –Annual HPY=Annual HPR-1=1.1832-1=18.32% Stock B –Annual HPR=HPR 1/n = ($120/$100) 1/0.5 =1.2544 –Annual HPY=Annual HPR-1=1.2544-1=25.44% © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

11. Historical Rates of Return Computing Mean Historical Returns for a signal investment Suppose you have a set of annual rates of return (HPYs or HPRs) for an investment. How do you measure the mean annual return? –Arithmetic Mean Return (AM) AM=  HPY / n where  HPY=the sum of all the annual HPYs n=number of years –Geometric Mean Return (GM) GM= [  HPR] 1/n -1 where  HPR=the product of all the annual HPRs n=number of years 1-11 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

12. Historical Rates of Return Suppose you invested $100 three years ago and it is worth $110.40 today. The information below shows the annual ending values and HPR and HPY. This example illustrates the computation of the AM and the GM over a three-year period for an investment. 1-12 YearBeginning EndingHPR HPY Value Value 1 100 115.0 1.15 0.15 2 115 138.0 1.20 0.20 3 138 110.4 0.80 -0.20 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

13. Historical Rates of Return AM=[(0.15)+(0.20)+(-0.20)] / 3 = 0.15/3=5% GM=[(1.15) x (1.20) x (0.80)] 1/3 – 1 =(1.104) 1/3 -1=1.03353 -1 =3.353% Comparison of AM and GM –When rates of return are the same for all years, the AM and the GM will be equal. –When rates of return are not the same for all years, the AM will always be higher than the GM. –While the AM is best used as an “expected value” for an individual year, while the GM is the best measure of an asset’s long-term performance. 1-13 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

14. Historical Rates of Return GM consider the compound annual rate of return based on the ending value of an investment versus its beginning value. For example, a security that increase in price from 50$ to 100$ during year 1 and drops back to 50$ during year 2. Calculate the AM and GM for that investment? © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 1-14

15. Historical Rates of Return AM=[(1.00)+(-0.50)] / 2 = 0.50/2=5% GM=[(2.00) x (0.50)] 1/2 – 1 =(1.00) 1/2 -1=1.00 -1 =0% © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 1-15

16. Historical Rates of Return A Portfolio of Investments –Portfolio HPY: 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, or the overall change in the value of the original portfolio. –The weights used in the computation are the relative beginning market values for each investment, which is often referred to as dollar-weighted or value- weighted mean rate of return. –See Exhibit 1.1 1-16 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

17. 1-17 Exhibit 1.1

18. Expected Rates of Return In previous examples, we discussed realized historical rates of return. In contrast, an investor would be more interested in the expected return on a future risky investment. Risk refers to the uncertainty of the future outcomes of an investment –There are many possible returns/outcomes from an investment due to the uncertainty –Probability is the likelihood of an outcome and it’s estimated based on the historical performance of an investment or similar investments –The sum of the probabilities of all the possible outcomes is equal to ??? 1-18 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

19. Expected Rates of Return Computing Expected Rate of Return of a single investment where P i = Probability for possible return i R i = Possible return i 1-19 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

20. Probability Distributions Exhibit 1.2 Risk-free Investment with Absolute Certainty of the returns 1-20 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

21. Probability Distributions Exhibit 1.3 Risky Investment with 3 Possible Returns 1-21 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

22. Probability Distributions In this example the expected rate of return is calculated as follows: E(R) = [(0.15)(0.20) + (0.15)(-0.20) + (0.70)(0.10)] = 0.07 = 7% © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 1-22

23. Probability Distributions Exhibit 1.4 Risky investment with ten possible returns 1-23 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

24. Probability Distributions In this example the E(R) is equal to 5% What investment to choose the first or the third investment? © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 1-24

25. Risk of Expected Return Risk refers to the uncertainty of an investment; therefore the measure of risk should reflect the degree of the uncertainty. The risk of expected return reflect the degree of uncertainty that actual return will be different from the expect return. The common measures of risk are based on the variance of rates of return distribution of an investment 1-25 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

26. Risk of Expected Return Measuring the Risk of Expected Return –The Variance Measure 1-26       n i iii n i RERP turn Expected turn Possible xobability Variance 1 2 2 1 )]([ ) Re ()(Pr )(  © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. The variance of the previous example that has 7% of expected return, is 0.0141

27. Risk of Expected Return The larger the variance, for an expected rate of return, the greater the dispersion of expected returns and the greater the uncertainty (risk) of an investment. The variance of a perfect certainty of returns, risk- free, is ….. © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 1-27

28. Risk of Expected Return –Standard Deviation (σ): It is the square root of the variance and measures the total risk 1-28    n i iii RERP 1 2 )]([  © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. - The standard deviation from the previous example is  0.0141  = 0.11874 = 11.87%

29. Risk of Expected Return –Coefficient of Variation (CV): It measures the risk per unit of expected return and is a relative measure of risk. © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 1-29 )(RE ReturnofRateExpected ReturnofDeviationStandard CV   

30. Risk of Expected Return The CV from the previous example is CV = 0.11874 \ 0.70 = 1.696 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 1-30 - In some cases the variance or the standard deviation can be misleading, specifically in the case of two different investments. In such cases it’s better to use a measure of relative risk per unit of expected returns

31. Risk of Historical Rates of Return where, σ 2 = the variance of the series HPY i = the holding period yield during period i E(HPY) = the expected value of the HPY equal to the arithmetic mean of the series (AM) n = the number of observations 1-31 Given a series of historical returns measured by HPY, the risk of returns is measured as: © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

32. Risk of Expected Return Computing expected rates of returns on a portfolio of investments E(R p ) = W i * E(R i ) The standard deviation of the portfolio Where  is the correlation coefficient between the two investments © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 1-32  W1W1     W2  2 W1 W2    2222

33. Determinants of Required Returns Three Components of Required Return: –The time value of money during the time period –The expected rate of inflation during the period –The risk involved –These three components are called the RRR. This is the minimum rate of return that you should accept from an investment to compensate you for the deferring consumption. 1-33 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

34. Determinants of Required Returns The Real Risk Free Rate (RRFR) –Assumes no inflation. –Assumes no uncertainty about future cash flows. –Influenced by time preference for consumption of income and investment opportunities in the economy Nominal Risk-Free Rate (NRFR) –Conditions in the capital market –Expected rate of inflation 1-34 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

35. Determinants of Required Returns Business Risk –Uncertainty of income flows caused by the nature of a firm’s 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 stock’s risk premium. 1-35 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

36. Determinants of Required Returns Liquidity Risk –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. 1-36 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

37. Determinants of Required Returns 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. 1-37 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

38. Determinants of Required Returns Risk Premium and Portfolio Theory –From a portfolio theory perspective, 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. –According to the portfolio theory, the risk premium depends on the systematic risk. 1-38 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

39. Determinants of Required Returns Fundamental Risk versus Systematic Risk –Fundamental risk comprises business risk, financial risk, liquidity risk, exchange rate risk, and country risk. f Risk Premium= f ( Business Risk, Financial Risk, Liquidity Risk, Exchange Rate Risk, Country Risk) –Systematic risk refers to the portion of an individual asset’s total variance attributable to the variability of the total market portfolio. f Risk Premium= f (Systematic Market Risk) 1-39 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

40. Determinants of Required Returns Several studies have generally concluded that a significant relationship occur between the market measure of risk and the fundamental measures of risk. For example, you would expect a firm that has high business risk and financial risk to have an above average beta. But it’s possible that a firm that has a high level of fundamental risk and a large standard deviation of return on stock can have a lower level of systematic risk because its variability of earnings and stock price in not related to the aggregate economy or the aggregate market. © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 1-40

41. Relationship Between Risk and Return The Security Market Line (SML) –It shows the relationship between risk and return for all risky assets in the capital market at a given time. –Investors select investments that are consistent with their risk preferences. 1-41 ExpectedReturn Risk (business risk, etc., or systematic risk-beta) NRFR Security Market Line Low Risk Average Risk High Risk The slope indicates the required return per unit of risk © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

42. Relationship Between Risk and Return Movement along the SML –When the risk changes, the expected return will also change, moving along the SML. –Risk premium: RP I = E(R i ) - NRFR 1-42 Return Risk (business risk, etc., or systematic risk-beta) NRFR SML Expected Movements along the curve that reflect changes in the risk of the asset © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

43. Relationship Between Risk and Return For example, if a company increases its financial risk by issuing bonds that increases its financial leverage, investors will perceive its common stock as riskier and the stock will move up the SML to a higher risk position. © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 1-43

44. Relationship Between Risk and Return Changes in the Slope of the SML –When there is a change in the attitude of investors toward risk, the slope of the SML will also change. –If investors become more risk averse, then the SML will have a steeper slope, indicating a higher market risk premium, RP m, for the same risk level. –No matter where an investment is on the SML, its RRR will increase although its individual risk characteristics remain unchanged 1-44 Risk NRFR Original SML New SML R m R m’ Expected Return © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

45. Relationship Between Risk and Return Changes in Market Condition or Inflation –A change in the RRFR or the expected rate of inflation will cause a parallel shift in the SML. –When nominal risk-free rate increases, the SML will shift up, implying a higher rate of return while still having the same risk premium. 1-45 Risk NRFR Original SML New SML Expected Return NRFR' © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

46. The Internet Investments Online http://www.finpipe.com http://www.investorguide.com http://www.aaii.com http://www.economist.com http://online.wsj.com http://www.forbes.com http://www.barrons.com http://fisher.osu.edu/fin/journal/jofsites.htm http://www.ft.com http://www.fortune.com http://www.smartmoney.com http://www.worth.com http://money.cnn.com 1-46 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.