Investment Analysis and

Portfolio Management
Investment
A current commitment of funds 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.

Investment Analysis and

Portfolio Management
Nonmarketable Financial Assets
Savings accounts , Certificates of Deposit like National
Saving Certificates, Defence Saving Certificates
Features
Commonly owned by individuals
Represent direct exchange of claims between issuer and
investor
Usually very liquid or easy to convert to cash without loss
of value

Investment Analysis and

Portfolio Management
Money Market Securities
Money market mutual funds, T-Bills, Commercial paper

Marketable: claims are negotiable or salable in the

marketplace
Short-term, liquid, relatively low risk debt instruments
Issued by governments and private firms

Investment Analysis and

Portfolio Management
Capital Market Securities
Bonds, Debentures, Terms Finance Certificates
Features
Marketable debt with maturity greater than one year and
ownership shares
Fixed-income securities have a specified payment schedule
Dates and amount of interest and principal payments
known in advance

Investment Analysis and

Portfolio Management
Common Stocks or Equity Securities

Denote an ownership interest in a corporation

Denote control over management, at least in principle

Voting rights important
Denote limited liability
Investor cannot lose more than their
investment should the corporation fail

Investment Analysis and

Portfolio Management

Common stockholders are residual claimants on income

and assets
Par value is face value of a share
Usually economically insignificant
Book value is accounting value of a share
Market value is current market price of a share

Investment Analysis and

Portfolio Management
Preferred Stocks
Hybrid security because features of both debt and equity
Preferred stockholders paid after debt but before common
stockholders
Dividend known, fixed in advance
May be cumulative if dividend omitted
Often convertible into common stock
May carry variable dividend rate

Investment Analysis and

Portfolio Management
Derivative Securities
Securities whose value is derived from another security
Futures and options contracts are standardized and
performance is guaranteed by a third party
Risk management tools
Warrants are options issued by firms

Investment Analysis and

Portfolio Management
Options
Exchange-traded options are created by investors, not
corporations
Call (Put): Buyer has the right but not the obligation to
purchase (sell) a fixed quantity from (to) the seller at a
fixed price before a certain date
Right is sold in the market at a price
Increases return possibilities

Investment Analysis and

Portfolio Management
Futures
Futures contract: A standardized agreement between a
buyer and seller to make future delivery of a fixed asset at
a fixed price
A good faith deposit, called margin, is required of
both the buyer and seller to reduce default risk
Used to hedge the risk of price changes

Investment Analysis and

Portfolio Management
Holding Period Return

Investment Analysis and

Portfolio Management
On February 1, you bought 100 shares of a stock for $34 a share and a year
later you sold it for $39 a share. During the year, you received a cash
dividend of $1.50 a share. Compute your HPR and HPY on this stock
investment.

Investment Analysis and

Portfolio Management

Investment Analysis and

Portfolio Management
On August 15, you purchased 100 shares of a stock at $65 a share and a
year later you sold it for $61 a share. During the year, you received
dividends of $3 a share. Compute your HPR and HPY on this investment.

Investment Analysis and

Portfolio Management
At the beginning of last year, you invested $4,000 in 80 shares of the Chang
Corporation. During the year, Chang paid dividends of $5 per share. At the end of
the year, you sold the 80 shares for $59 a share. Compute your total HPY on
these shares and indicate how much was due to the price change and how much
was due to the dividend income.
$4,000 used to purchase 80 shares = $50 per share

Investment Analysis and

Portfolio Management

Therefore: HPY (Total) = HPY (Price Increase) + HPY (Div)

.280 = .180 + HPY (Div)
.10 = HPY (Dividends)

Investment Analysis and

Portfolio Management
Simple Return

closing price opening price

Return =
Opening Price
44 - 40
Return for January =
40
= .10 or 10%

Investment Analysis and

Portfolio Management
Return

Month

Closing Price X
Dec-00

40

Jan-01

44

Feb-01

50.6

Mar-01

51.62

Apr-01

54.7

Investment Analysis and

Portfolio Management
Month

Closing Price X Return X

Dec-00

40

Jan-01

44

.10

Feb-01

50.60

.15

Mar-01

51.62

.02

Apr-01

54.7

.06

Investment Analysis and

Portfolio Management
Average Return or Mean Return
Month

Return

Jan-01

0.10

Feb-01

0.15

Mar-01

0.02

Apr-01

0.06

Total

0.33

Investment Analysis and

Portfolio Management
Year

Actual Return

0.10

0.15

0.02

0.06

Total

0.33

Average Return
=

=
0.33/4
0.0825

Investment Analysis and

Portfolio Management

The Greek letter pi stands for product summation. This means that instead of
adding values in the series, they are multiplied. The rest of the equation indicates
that after multiplying the return, we take the nth root of the product, where n is the
number of terms in the series

Investment Analysis and

Portfolio Management
.
Calculating the geometric means of a series of a return has a potential problem
because returns are often negative. If the number of negative returns in a series is
odd, there product will be negative and negative number does not have an even
root.
It is easy to eliminate the problem by converting security returns into return
relatives before calculating the statistics on them.
A return relative is simply the return plus 1.

Investment Analysis and

Portfolio Management
During the past five years, you owned two stocks that had the following
annual rates of return:

Year

Stock T

Stock B

0.19

0.08

0.08

0.03

0.12

0.09

0.03

0.02

0.15

0.04

Compute the geometric mean annual rate of return for each stock.

Investment Analysis and

Portfolio Management

GMT

= [(1.19) (1.08) (.88) (.97) (1.15)]1/5 -1

= [1.26160] 1/5 1 = 1.04757 1 = .04757
GMB

= [(1.08) (1.03) (.91) (1.02) (1.04)]1/5 -1

= [1.07383] 1/5 1 = 1.01435 1 = .01435

Investment Analysis and

Portfolio Management
During the past five years, you owned two stocks that had the following
annual rates of return:

Year

Stock T

Stock B

0.19

0.08

0.08

0.03

0.12

0.09

0.03

0.02

0.15

0.04

Compute the arithmetic mean annual rate of return for each stock. Which stock
is most desirable by this measure?

Investment Analysis and

Portfolio Management

Stock T is more desirable because the arithmetic mean annual rate of return
is higher.

Investment Analysis and

Portfolio Management
Expected Rates of Return
Risk is uncertainty that an investment will earn its
expected rate of return
Probability is the likelihood of an outcome

Investment Analysis and

Portfolio Management
Expected Rates of Return

Investment Analysis and

Portfolio Management
Expected Rates of Return

SOE

Probability

Possible Return

BOOM

.50

.70

Recession

.50

-.20

Investment Analysis and

Portfolio Management
Expected Return
SOE

Probability

Possible
Return

Expected Return

BOOM

0.50

0.70

0.35

Recession

0.50

-0.20

-0.10
0.25

Investment Analysis and

Portfolio Management
State of Economy

Probability

Possible Return

Boom

.5

.10

Recession

.5

.3

Investment Analysis and

Portfolio Management
Considering the world economic outlook for the coming year and estimates of sales
and earnings for the pharmaceutical industry, you expect the rate of return for Lauren
Labs common stock to range between 20 percent and +40 percent with the following
probabilities:

Probability

Possible Returns

0.1

0.20

0.15

0.05

0.2

0.1

0.25

0.15

0.2

0.2

0.1

0.4

Compute the expected rate of return [E(Ri)] for Lauren Labs.

Investment Analysis and

Portfolio Management

Risk Free Rate of Return (RFR)

Market Rate of Return (MR)

Required Rate of Return

Investment Analysis and

Portfolio Management

Investment Analysis and

Portfolio Management
Portfolio Return

State of Economy Probability

Possible Return
Stock A

Stock B

Stock C

Boom

.40

.10

.15

.20

Recession

.60

.08

.04

Investment Analysis and

Portfolio Management
State of Economy Probability

Possible Return
Stock A

Stock B

Stock C

Boom

.40

.10

.15

.20

Recession

.60

.08

.04

Investment Criteria
50% Investment in Stock A
25% Investment in Stock B
25% Investment in Stock C

Investment Analysis and

Portfolio Management
State of Economy Probability

Return
Stock A

Stock B

Stock C

Boom

.40

.10

.15

.20

Recession

.60

.08

.04

Expected Portfolio Return

Boom
.50* .10 +.25*.15+.25*.20
.
05+.0375+.05
=.1375
Recession
.50*.08+.25*..04+.25*0
.

= .05

Investment Analysis and

Portfolio Management
Probability

Portfolio Return

Boom

.40

.1375

Recession

.60

.05

Investment Analysis and

Portfolio Management
Expected Return of Individual Stock
Stock A
.Boom
.40*10 =
.04
Recession
.60*.08
.048
.088
Stock B
.40*.15
=.06
.60*.04
=.024
.084

Investment Analysis and

Portfolio Management
Stock C
.40*.20
.60*.0

=.08
=0.0
=.08

Investment Analysis and

Portfolio Management
Expected Return of Portfolio
Based on Investment Criteria
.50*.088 = .044
.25*.084 = .021
.25*.08 = .02
=

.085

Investment Analysis and

Portfolio Management
Probability

Portfolio Return

Average
Return

Boom

.40

.1375

.085

Recession

.60

.05

.085

Investment Analysis and

Portfolio Management
Annualized Rate of Return

Annualized Rate of Return = Average Monthly Return * 12

Investment Analysis and

Portfolio Management
You are considering acquiring shares of common stock in the Madison Beer
Corporation. Your rate of return expectations are as follows:

Possible Rate of Return

Probability

0.10

0.3

0.1

0.1

0.3

0.25

0.3

Compute the expected return [E(Ri)] on your investment in Madison Beer.

Investment Analysis and

Portfolio Management
E(RMBC)= (.30) (-.10) + (.10) (0.00) + (.30) (.10) + (.30) (.25)
= (-.03) + .000 + .03 + .075
= .075

Investment Analysis and

Portfolio Management
During the past year, you had a portfolio that contained U.S. government T-bills,
long-term government bonds, and common stocks. The rates of return on each of
them were as follows:

U.S. government T-bills

U.S. government long-term bonds
U.S. common stocks

5.50%
7.5
11.6

During the year, the consumer price index, which measures the rate of inflation, went
from 160 to 172 (19821984 = 100). Compute the rate of inflation during this year.
Compute the real rates of return on each of the investments in your portfolio based on
the inflation rate.

Investment Analysis and

Portfolio Management

Investment Analysis and

Portfolio Management
Assume that the consensus required rate of return on common stocks is 14 percent. In
addition, you read in Fortune that the expected rate of inflation is 5 percent and the
estimated long-term real growth rate of the economy is 3 percent. What interest rate
would you expect on U.S. government T-bills? What is the approximate risk premium for
common stocks implied by these data

Investment Analysis and

Portfolio Management
Nominal rate on T-bills (or risk-free rate)
= (1 + .03) (1 + .05) 1
=1.0815 1 = .0815 or 8.15%
The required rate of return on common stock is equal to the risk-free rate plus a risk
premium. Therefore the approximate risk premium for common stocks implied by
these data is:
= .14 - .0815 = .0585 or 5.85%.

Investment Analysis and

Portfolio Management
The following are annual rates of return for U.S. government T-bills and U.K.
common stocks.

U.S. Government U.K. Common

T-Bills
Stock
Year
2003

0.063

0.150

2004

0.081

0.043

2005

0.076

0.374

2006

0.090

0.192

2007
0.085
0.106
Compute the arithmetic mean rate of return and discuss these two alternative
investments in terms of their arithmetic average rates of return.

Investment Analysis and

Portfolio Management

(b). The average return of U.S. Government T-Bills is lower than the average return
of United Kingdom Common Stocks because U.S. Government T-Bills are riskless,
therefore their risk premium would equal 0. The U.K. Common Stocks are subject to
the following types of risk: business risk, financial risk, liquidity risk, exchange rate
risk, (and to a limited extent) country risk.

Investment Analysis and

Portfolio Management
You read in Business Recorder that a panel of economists has estimated that the longrun real growth rate of the Pak. economy over the next five-year period will average 3
percent. In addition, a bank newsletter estimates that the average annual rate of inflation
during this five-year period will be about 4 percent. What nominal rate of return would
you expect on Pak government T-bills during this period?
NRFR = (1 + .03) (1 + .04) 1 = 1.0712 1 = .0712

Investment Analysis and

Portfolio Management
The Wall Street Journal reported that the yield on common stocks is about 2 percent,
whereas a study at the University of Chicago contends that the annual rate of return on
common stocks since 1926 has averaged about 12 percent. Reconcile these statements.

Investment Analysis and

Portfolio Management
The difference is because of the definition and measurement of return. In the case of
the WSJ, they are only referring to the current dividend yield on common stocks
versus the promised yield on bonds. In the University of Chicago studies, they are
talking about the total rate of return on common stocks, which is the dividend yield
plus the capital gain or loss yield during the period. In the long run, the dividend
yield has been 4-5 percent and the capital gain yield has averaged about the same.
Therefore, it is important to compare alternative investments based upon total return.