Lecture 1 - Investments PDF

LCAST LECTURE #1 INVESTMENTS  LCAST LEARNING OBJECTIVES INVESTMENTS Learning Objectives Define an investment Learn why people invest Compute the rate of return of an investment Me...

LCAST LECTURE #1 INVESTMENTS  LCAST LEARNING OBJECTIVES INVESTMENTS Learning Objectives Define an investment Learn why people invest Compute the rate of return of an investment Measure the risk related to alternative investments Identify factors that contribute to the rates of return that investors require Identify macro & microeconomic factors that contribute to changes in the required return for investments  WHAT IS AN INVESTMENT? Definition A current commitment of money for a period of time in order to derive future payments that will compensate for: The time the funds are committed 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 The expected rate of 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 time value of money to also cover the expected inflation expense. Uncertainty of future flow of funds If the future payment from the investment is not certain, the investor will demand an interest rate that exceeds the pure time value of money plus the inflation rate to provide a risk premium to cover the investment risk. The Notion of Required Rate of Return The minimum rate of return an investor require on an investment, 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?  REASONS WHY PEOPLE INVEST 1 LARGER FUTURE CONSUMPTION By investing (saving money now instead of spending it), individuals can tradeoff present consumption for a larger future consumption. It can be either long-term (ie. retirement) or short- term (ie. buy a car) 2 THRILL OF INVESTING Risk-taking. Challenge of being right.  HISTORICAL RATES OF RETURN Return over A Holding Period Holding Period Return (HPR) Annual HPR and HPY HPR = Ending value/Beginning value Annual HPR=HPR1/n Holding Period Yield (HPY) Annual HPY= Annual HPR -1=HPR1/n – 1 HPY=HPR-1 where n=number of years of the investment Examples Your investment of $250 in Stock A is worth $350 in two Assume that you invest $200 at the beginning of the years while the investment of $100 in Stock B is worth $120 year and get back $220 at the end of the year. What in six months. What are the annual HPRs and the HPYs on are the HPR and the HPY for your investment? these two stocks? HPR=Ending value / Beginning value Stock A =$220/200 Annual HPR=HPR1/n = ($350/$250)1/2 =1.1832 =1.1 Annual HPY=Annual HPR-1=1.1832-1=18.32% HPY=HPR-1 Stock B =1.1-1=0.1=10% Annual HPR=HPR1/n = ($120/$100)1/0.5 =1.2544 Annual HPY=Annual HPR-1=1.2544-1=25.44%  HISTORICAL RATES OF RETURN Computing Mean Historical Returns Examples Suppose you have a set of annual rates of return (HPYs Suppose you invested $100 three years ago and it is or HPRs) for an investment. How do you measure the mean annual return? worth $110.40 today. The information below shows Arithmetic Mean Return (AM) the annual ending values and HPR and HPY. This example illustrates the computation of the AM and AM=  HPY / n the GM over a three-year period for an investment where  HPY=the sum of all the annual HPYs and n=number of years Year Beginning Ending HPR HPY Geometric Mean Return (GM) Value Value GM= [ HPR] 1/n -1 1 100 115.0 1.15 0.15 where  HPR=the product of all the annual HPRs and n=number of years 2 115 138.0 1.20 0.20 3 138 110.4 0.80 -0.20 Comparison of AM and GM When rates of return are the same for all years, the AM=[(0.15)+(0.20)+(-0.20)] / 3 AM = GM. When rates of return are not the same = 0.15/3=5% for all years, the AM > GM. GM=[(1.15) x (1.20) x (0.80)]1/3 – 1 While the AM is best used as an “expected value” =(1.104)1/3 -1=1.03353 -1 =3.353% for an individual year, while the GM is the best measure of an asset’s long-term performance.  POP QUIZ On Jan. 10, you bought 100 shares of ALI for P 34/share and a year later you sold it for P39/share. During the year you received a cash dividend of P1.50/share. What is your HPR and HPY on your ALI stock investment? a. HPR: 1.15 HPY: 15% b. HPR: 1.19 HPY: 19% c. HPR: 1.10 HPY: 10% d. None of the above Answer: B HPR = (39 +1.50)/34 = 1.19 HPY = 1.19 – 1 = 19%  POP QUIZ During the past three years, you owned two stocks that had the following annual rates of return: Year Stock A Stock B 1 0.19 0.08 2 0.08 0.03 3 -0.12 -0.09 What is the arithmetic and geometric mean of both stocks? Answer: Arithmetic Mean: Stock A: 5% Stock B: 0.67% Geometric Mean: Stock A: 4.2% Stock B: 0.41%  HISTORICAL RATES OF RETURN Return over A Holding Period 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  EXPECTED RATES OF RETURN Expected Return & Risk Formula Expected Rate of Return In previous examples, we discussed realized historical rates of return. In contrast, an E(Ri) = ∑ (Probability of return) x (Possible return) investor would be more interested in the where P i = Probability for possible return i expected return on a future risky investment. R i = Possible return i Risk-free Investment Risky Investment w/ Risk refers to the uncertainty of the future outcomes of an investment 3 Possible Returns There are many possible returns/outcomes from an investment due to the uncertainty Probability is the likelihood of an outcome The sum of the probabilities of all the possible outcomes is equal to 1.0. Risky Investment w/ 10 Possible Returns  RISK OF EXPECTED RETURN Definition Measuring Risk of Expected Return Risk refers to the uncertainty of Standard deviation an investment; therefore the measure of risk should reflect the degree of the uncertainty. The risk of expected return Coefficient of Variation (CV): It measures the risk per unit of reflect the degree of expected return and is a relative measure of risk uncertainty that actual return will be different from the expect return.  LCAST STANDARD DEVIATION  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 Complications of Estimating Required Return A wide range of rates is available for alternative investments at any time. The rates of return on specific assets change dramatically over time. The difference between the rates available on different assets change over time Risk Free Rates 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 NRFR=(1+RRFR) x (1+ Rate of Inflation) - 1 RRFR=[(1+NRFR) / (1+ Rate of Inflation)] - 1  RISK-FREE RATES BSP O/N = 6.0/7.0% INFLATION = 4.4% Tenor BVAL Rate Today BVAL Rate Previous Day 1M - 5.8391 3M - 5.9425 6M - 6.0829 1Y - 6.1263 2Y - 6.0279 3Y - 6.0394 4Y - 6.0587 5Y - 6.0805 7Y - 6.1144 10Y - 6.1385 20Y - 6.3012 25Y - 6.3019  POP QUIZ The risk free rate is based on: a. Interest rate of government securities b. Interest rate of a basket of AAA corporate bonds c. Interest rate of a basket of municipal bonds d. None of the above Answer: A  COMMON TYPES OF INVESTMENT RISKS Financial risk Business risk Uncertainty caused by Uncertainty of income flows caused by the use of debt financing. the nature of a firm’s business Borrowing requires fixed Sales volatility and operating leverage payments which must be determine the level of business risk. paid ahead of payments to stockholders. BUSINESS The use of debt increases Liquidity risk is asset illiquidity. RISK This is the inability to easily exit a uncertainty of FINANCIAL position or the inability to sell stockholder income and RISK causes an increase in the assets quickly enough without a stock’s risk premium. loss of capital or a reduction in price LIQUIDITY EXCHANGE RATE RISK RISK Country risk is the uncertainty Exchange rate risk of returns caused by the Uncertainty of return is introduced by acquiring securities possibility of a major change in denominated in a currency different from that of the investor. the political or economic Changes in exchange rates affect the investors return when COUNTRY environment in a country. RISK converting an investment back into the “home” currency.  POP QUIZ Which of the following risks is affected by the depth, activity and number of participants of the financial markets? a. Business risk b. Financial risk c. Liquidity risk d. None of the above Answer: C  UNSYSTEMATIC & SYSTEMATIC RISK Unsystematic Risk Unsystematic risk, or company-specific risk, is a risk associated with a particular investment. Examples: business risk, financial risk, liquidity risk, exchange rate risk, etc. Unsystematic risk can be mitigated through diversification, and so is also known as diversifiable risk Systematic Risk Systematic risk is inherent to the market as a whole, reflecting the impact of economic, geopolitical, and financial factors. Systematic risk is largely unpredictable and generally viewed as being difficult to avoid. From a portfolio theory perspective, the relevant risk measure for an individual asset is its co- movement with the market portfolio. Beta measures this systematic risk of an asset.  RELATIONSHIP BETWEEN RISK & 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. Expected Return Security Low Average High Market Line Risk Risk Risk The slope indicates the required return per unit NRFR of risk Risk (Business risk, etc., or systematic risk-beta)  RELATIONSHIP BETWEEN RISK & RETURN Movement along the SML When the risk changes, the expected return will also change, moving along the SML. Risk premium: RPI = E(Ri) - NRFR Expected Return SML Examples: The credit risk of a corporate bond changes over time PH has a credit rating upgrade NRFR Movements along the curve that reflect changes in the risk of the asset Risk (Business risk, etc., or systematic risk-beta)  RELATIONSHIP BETWEEN RISK & 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 risk premium, RPi, for the same risk level. Expected Return New SML Examples: 2008 Sub-prime Crisis R m’ 1997 Asian Financial Crisis Original SML Rm NRFR Risk  RELATIONSHIP BETWEEN RISK & 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. Examples: Expected Return Contractionary monetary policy by the Central Bank either to New SML manage inflation or overheating of economy Original SML NRFR' NRFR Risk