R-B-Ch.1 Points to Refresh

Why Do Individuals Invest ?

By saving money (instead of spending it), individuals tradeoff present consumption for a larger future consumption.

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.

Measures of Historical Rates of Return

Holding Period Return (HPR)

= Ending value of investment/Beginning value of investment

Holding Period Yield 9HPY)

HPY = HPR - 1

*This difference between return and yield proposed by Reilly is not standard terminology.
Readers have to take a note of it.

Annual Holding Period Return can be calculated from HPR

Annual HPR = HPR^(1/n)
where n = number of years investment is held

Annual Holding Period Yield
Annual HPY = Annual HPR - 1

Arithmetic Mean of Annual HPY can be a measure of past annual average yield

Geometric Mean of past HPYs can also be a measure of average past yield.

For a Portfolio of Investments

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.

Expected Rates of Return (Future orientation - what is likely to happen in future)

Risk is uncertainty that an investment will earn its expected rate of return
Probability is the likelihood of an outcome

Estimates for the future are made based on the past data.

Risk Aversion
The assumption that most investors will choose the least risky alternative, all else being equal and that they will not accept additional risk unless they are compensated in the form of higher return

Measuring the Risk of Expected Rates of Return

Standard Deviation of the data is a measure of the Risk of Expected Rates of Return


Standard Deviation is the square root of the variance

Coefficient of variation (CV) a measure of relative variability that indicates risk per unit of return
= Standard Deviation of Returns/Expected Rate of Returns


Determinants of Required Rates of Return for Individual investments (Different types of assets, and specific securites in an asset category)

Time value of money
Expected rate of inflation
Risk involved

The Real Risk Free Rate (RRFR)

This rate is arrived at on the basis of:
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

Inflation is factored in.

Dependent upon
Conditions in the Capital Markets
Expected Rate of Inflation

Nominal RFR =
(1+Real RFR) x (1+Expected Rate of Inflation) - 1

Return required by investors will NRFR plus risk premium

Facets of Fundamental Risk

Business risk
Financial risk
Liquidity risk
Exchange rate risk
Country risk

Risk Premium is a function of (Business Risk, Financial Risk, Liquidity Risk, Exchange Rate Risk, Country Risk)

From modern portfolio theory based on equilibrium conditions, it was derived that in equilibrium risk premium depends only on systematic risk.

Systematic risk refers to the portion of an individual asset’s total variance attributable to the variability of the total market portfolio

Beta measures this systematic risk of an asset