Investment Analysis and
Portfolio Management
Eighth Edition
by
Frank K. Reilly & Keith C. Brown
Chapter 1
The Investment Setting
Questions to be answered:




Why do individuals invest ?
What is an investment ?
How do we measure the rate of return on an investment ?
How do investors measure risk related to alternative
investments ?
 What factors contribute to the rate of return that an
investor requires on an investment?
 What macroeconomic and microeconomic factors
contribute to changes in the required rate of return for an
investment?
Why Do Individuals Invest ?

By saving money (instead of spending
it), individuals forego consumption
today in return for a larger consumption
tomorrow.
How Do We Measure The Rate Of
Return On An Investment ?
The real rate of interest is the exchange rate between
future consumption (future dollars) and present
consumption (current dollars). Market forces
determine this rate.
Tomorrow
$104
If you are willing to exchange a
certain payment of $100 today
for a certain payment of $104
tomorrow, then the pure or real
rate of interest is 4%
$100
Today
How Do We Measure The Rate Of
Return On An Investment ?
 If the purchasing power of the future payment will
be diminished in value due to inflation, an investor
will demand an inflation premium to compensate
them for the expected loss of purchasing power.
 If the future payment from the investment is not
certain, an investor will demand a risk premium to
compensate for the investment risk.
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
 Holding Period Return
P1  P0
HPR 
P0
$220 - 200
$200
 0.10 or 10%

Where:
HPR = Holding period return
P0 = Beginning value
P1 = Ending value
Measures of
Historical Rates of Return
 Annualizing the HPR
EAR  1  HPR   1
1
N
Where:
EAR = Equivalent Annual Return
HPR = Holding Period Return
N = Number of years
Example: You bought a stock for $10 and sold it for $18 six years
later. What is your HPR & EAR?
Calculating HPR & EAR
 Solution:
Step #1:
Step #2:
P1  P0
HPR 
P0
EAR  1  HPR   1
$18 - 10

$10
 0.80 or 80%
1
N
 1.80  1
 10.29%
1
6
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
1
N
GM  1  R1 1  R2  ... 1  RN    1
Example
 You are reviewing an investment with the following
price history as of December 31st each year.
1999 2000 2001 2002 2003 2004 2005 2006
$18.45 $21.15 $16.75 $22.45 $19.85 $24.10 $24.10 $26.50
 Calculate:




The HPR for the entire period
The annual HPRs
The Arithmetic mean of the annual HPRs
The Geometric mean of the annual HPRs
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
#
Stock Shares
A
100,000
B
200,000
C
500,000
Total
Begin
Price
$ 10
$ 20
$ 30
Beginning Ending
Ending
Market Wtd.
Mkt. Value Price Mkt. Value HPR Wt.
HPR
$ 1,000,000
$ 12 $ 1,200,000 0.20 0.05 0.010
$ 4,000,000
$ 21 $ 4,200,000 0.05 0.20 0.010
$ 15,000,000
$ 33 $ 16,500,000 0.10 0.75 0.075
$ 20,000,000
$ 21,900,000
0.095
HPRPortfolio 
P1  P0
P0
21,900, 000  20, 000, 000

20, 000, 000
 9.5%
Expected Rates of Return
 Risk is the uncertainty whether an investment will earn its
expected rate of return
 Probability is the likelihood of an outcome
n
E(R i )   (Probabilit y of Return)  (Possible Return)
i 1
n
  (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%
Measuring Risk: Historical Returns
n
2 
 HPR
i 1
i
 E HPRi 
N
2
Where:
 2 = Variance (of the pop)
HPR = Holding Period Return i
E(HPR)i = Expected HPR*
N = Number of years
* The E(HPR) is equal to the arithmetic mean of the series of
returns.
Measuring Risk:
Expected Rates of Return
n
   (Pi )  R i  E(R) 
2
2
i 1
Where:
 2 = Variance
Ri = Return in period i
Note: Because we multiply by
the probability of each return
occurring, we do NOT divide by
N. If each probability is the
same for all returns, then the
variance can be calculated by
either multiplying by the
probability or dividing by N.
E(R) = Expected Return
Pi = Probability of Ri occurring
Measuring Risk: Standard
Deviation
 Standard Deviation is the square root of the variance

n
 P [R -E(R )]
2
i 1
i
i
i


   Pi [R i -E(R i )]2 
 i 1

n
1
2
Standard Deviation is a measure of
dispersion around the mean. The
higher the standard deviation, the
greater the dispersion of returns
around the mean and the greater the
risk.
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 investor’s
required rate of return
 Real rate of return
 Expected rate of inflation during the period
 Risk
The Real Risk Free Rate
 Assumes no inflation.
 Assumes no uncertainty about future cash
flows.
 Influenced by the time preference for
consumption of income and investment
opportunities in the economy
Adjusting For Inflation:
Fisher Equation
1  Nominal   1  Real 1  Expected
Inflation 
The nominal risk free rate of return is dependent
upon:
 Conditions in the Capital Markets
 Expected Rate of 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
firm’s 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 stock’s 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?
Exchange Rate Risk
 Exchange rate risk arises due to the uncertainty
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.
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 comovement with the market portfolio, as measured by Beta
 This is also referred to as
 Systematic risk
 Nondiversifiable risk
• Systematic risk refers to the portion of an individual asset’s
total variance attributable to the variability of the total
market portfolio
Relationship Between
Risk and Return
(Expected)
Rate of
Return
Risk free
Rate
Low
Average
High
Risk
Risk
Risk
Security
Market Line
(SML)
Slope of the SML indicates the
required return per unit of risk
Beta
Changes in the Required Rate of Return
Due to Movements Along the SML
Expected
Rate
Risk free
Rate
Lower
Risk
Higher
Risk
Security
Market Line
Movements along the SML
reflect changes in the market or systematic
risk of the asset
Beta
Changes in the Slope of the SML
 The slope of the SML indicates the return per unit
of risk required by all investors
 The market risk premium is the yield spread
between the market portfolio and the risk free rate
of return
 This changes over time, although the underlying
reasons are not entirely clear
 However, a change in the market risk premium will
affect the return required on all risky assets
Change in
Market Risk Premium
Expected
Return
Rm´
Rm
Note that as the slope
of the SML increases,
so does the market risk
premium
New
SML
Original
SML
Risk Free
Rate
Beta
Capital Market Conditions,
Expected Inflation, and the SML
The SML will shift in a parallel fashion if inflation
expectations, real growth expectations or capital
market conditions change. This will affect the required
return on all assets.
Rate of
Return
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.aaii.com
http://www.smartmoney.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