Fm 131 Investment and Portfolio Management PDF

FM 131 Investment and Portfolio Management WAEL BENITO ORABI JR. Faculty  CONTENTS What is an Investment Measures of Return and Risk Determinants of Required Rates of Return What Is An Investment Investment is the current commitment of dollars for a period of time i...

FM 131 Investment and Portfolio Management WAEL BENITO ORABI JR. Faculty  CONTENTS What is an Investment Measures of Return and Risk Determinants of Required Rates of Return What Is An Investment Investment is the current commitment of dollars for a period of time in order to derive future payments that will compensate the investor for (1) the time the funds are committed, (2) the expected rate of inflation during this time period, and (3) the uncertainty of the future payments. The “investor” can be an individual, a government, a pension fund, or a corporation. But the central question is, how investors select investments that will give them their required rates of return. Investors need to know how to measure the expected or historical rate of return on an investment and also how to quantify the uncertainty (risk) of expected returns. Measures of Return and Risk Investors need to understand how to choose among alternative investment assets. This selection process requires that you estimate and evaluate the expected risk– return trade-offs for the alternative investments available. Therefore, you must understand how to measure the rate of return and the risk involved in an investment accurately. The following measures are to be used: (1) historical rate of return on an individual investment over the time period the investment is held (that is, its holding period) (2) average historical rate of return for an individual investment over a number of time periods. (3) average rate of return for a portfolio of investments. Traditional measures of risk for a historical time series of returns (that is, the variance and standard deviation of the returns over the time period examined). Measures of Historical Rates of Return When you are evaluating alternative investments for inclusion in your portfolio, you will often be comparing investments with widely different prices or lives. As an example, you might want to compare a $10 stock that pays no dividends to a stock selling for $150 that pays dividends of $5 a year. To properly evaluate these two investments, you must accurately compare their historical rates of returns. When we talk about a return on an investment, we are concerned with the change in wealth resulting from this investment. This change in wealth can be either due to cash inflows, such as interest or dividends, or caused by a change in the price of the asset (positive or negative).  Investors are typically concerned with long-term performance when comparing alternative investments. GM is considered a superior measure of the long-term mean rate of return because it indicates the compound annual rate of return based on the ending value of the investment versus its beginning value. Specifically, using the prior example, if we compounded 3.353 percent for three years, (1.03353)3, we would get an ending wealth value of 1.104. Although the arithmetic average 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. Consider, for example, a security that increases in price from $50 to $100 during year 1 and drops back to $50 during year 2. The annual HPYs would be:  This answer of a 0 percent rate of return accurately measures the fact that there was no change in wealth from this investment over the two-year period. When rates of return are the same for all years, the GM will be equal to the AM. If the rates of return vary over the years, the GM will always be lower than the AM. The difference between the two mean values will depend on the year-to-year changes in the rates of return. Larger annual changes in the rates of return—that is, more volatility— will result in a greater difference between the alternative mean values. An awareness of both methods of computing mean rates of return is important because most published accounts of long-run investment performance or descriptions of financial research will use both the AM and the GM as measures of average historical returns. AM is best used as an expected value for an individual year, while the GM is the best measure of long-term performance since it measures the compound annual rate of return for the asset being measured. Calculating Expected Rates of Return Risk is the uncertainty that an investment will earn its expected rate of return. The investor might say that he or she expects the investment will provide a rate of return of 10 percent, but this is actually the investor’s most likely estimate, also referred to as a point estimate. An investor determines how certain the expected rate of return on an investment is by analyzing estimates of possible returns. To do this, the investor assigns probability values to all possible returns.  In an alternative scenario, suppose an investor believed an investment could provide several different rates of return depending on different possible economic conditions.  The expected rate of return for this investment is the same as the certain return discussed in the first example; but, in this case, the investor is highly uncertain about the actual rate of return. This would be considered a risky investment because of that uncertainty. This expectation is based on the belief that most investors are risk averse, which means that if everything else is the same, they will select the investment that offers greater certainty (that is, less risk). Measuring the Risk of Expected Rates of Return Although the graphs help us visualize the dispersion of possible returns, most investors want to quantify this dispersion using statistical techniques. These statistical measures allow you to compare the return and risk measures for alternative investments directly. Two possible measures of risk (uncertainty) have received support in theoretical work on portfolio theory: the variance and the standard deviation of the estimated distribution of expected returns. Determinants of Required Rates of Return We continue our discussion of factors that you must consider when selecting securities for an investment portfolio. You will recall that this selection process involves finding securities that provide a rate of return that compensates you for (1) the time value of money during the period of investment, (2) the expected rate of inflation during the period, and (3) the risk involved. The summation of these three components is called the required rate of return. This is the minimum rate of return that you should accept from an investment to compensate you for deferring consumption. The Real Risk-Free Rate The real risk-free rate (RRFR) is the basic interest rate, assuming no inflation and no uncertainty about future flows. An investor in an inflation-free economy who knew with certainty what cash flows he or she would receive at what time would demand the RRFR on an investment. Risk Premium Most investors require higher rates of return on investments if they perceive that there is any uncertainty about the expected rate of return. This increase in the required rate of return over the NRFR is the risk premium (RP). Although the required risk premium represents a composite of all uncertainty, it is possible to consider several fundamental sources of uncertainty. In this section, we identify and discuss briefly the major sources of uncertainty, including: (1) business risk, is the uncertainty of income flows caused by the nature of a firm’s business. The less certain the income flows of the firm, the less certain the income flows to the investor. Therefore, the investor will demand a risk premium that is based on the uncertainty caused by the basic business of the firm. As an example, a retail food company would typically experience stable sales and earnings growth over time and would have low business risk compared to a firm in the auto or airline industry, where sales and earnings fluctuate substantially over the business cycle, implying high business risk.  (2) financial risk (leverage), is the uncertainty introduced by the method by which the firm finances its investments. If a firm uses only common stock to finance investments, it incurs only business risk. If a firm borrows money to finance investments, it must pay fixed financing charges (in the form of interest to creditors) prior to providing income to the common stockholders, so the uncertainty of returns to the equity investor increases. (3) liquidity risk, is the uncertainty introduced by the secondary market for an investment. When an investor acquires an asset, he or she expects that the investment will mature (as with a bond) or that it will be salable to someone else. The more difficult it is to make this conversion to cash, the greater the liquidity risk. (4) exchange rate risk, is the uncertainty of returns to an investor who acquires securities denominated in a currency different from his or her own. This risk is becoming greater as investors buy and sell assets from around the world, as opposed to only assets within their own countries. (5) country (political) risk. is the uncertainty of returns caused by the possibility of a major change in the political or economic environment of a country. The United States is acknowledged to have the smallest country risk in the world because its political and economic systems are the most stable. Measures and Sources of Risk THANK YOU