INVESTMENT ANALYSIS

GSM 5421 By Dr. Chen

 He who does not look ahead remain behind

John C. Maxwell

Lecture 3

Return And Risk

Content
Definition of Investment Element of Risk Historical return Measurement of Expected Return and Risk Risk Aversion and Capital Allocation

Characteristics of Investment
1. Return expectation of return yield + capital appreciation 2. Risk proportionate with level of investment . Characteristics: Longer maturity, larger risk Lower credit worthiness, higher risk

Characteristics of Investment
3. Safety certainty return of capital without loss of time and money 4. Liquidity easily saleable or marketable

Objectives 0f Investment:
Maximum return Minimization of risk Hedge against inflation

Investment vs Speculation and Gambling

Characteristi cs Risk Investment low Speculation High Gambling High risk high return, Can lose all capital, Without knowledge of risk Very Short-term. ShortUnplanned and nonnonscientific

Time period

LongLong-term

ShortShort-term

Capital gain

Steady capital Large mainly Large mainly for gain and for capital gain, capital gain dividend buy low sell high Surrounded by uncertainty and based on tips and rumours

Eg. CITIBANK BUILDING - IOI

Risk
Made investment decisions Based on expected return

Investors

When expected return not equal to realized return

Risk

Realized return

Element of Risk
Total risk = systematic risk + unsystematic risk
Systematic risks External to companies Uncontrollable Eg. Interest rate, market risk, political risk, economic risk and force majeure

Element of Risk (cont)

Unsystematic risks - Internal to companies - Particular or specific to company - Eg: - Operating environment (Business) - Financial pattern adopted by the company (financial)

Interest Rate
Hedge against inflation

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Factors Influencing Interest Rates

Supply of funds Households Demand of funds Businesses (finance investments) Governments Net Supply and/or Demand Central Bank Actions

Real and Nominal Rates of Interest

Nominal interest rate Growth rate of your money Real interest rate Growth rate of your purchasing power If R is the nominal rate and r the real rate and i is the inflation rate:

r = R i

Correct Procedure
Real Rate (t) = 1 + rt - 1 1 + It Or 1 + rt = 1 + rrt 1 + It Where I = inflation in period t rt = nominal rate of return in period t rrt = real rate of interest in period t

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 Measurement of Historical and Expected Return Measurement of Risk

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Measuring Historical Return

Differences between historical and expected return Definition of rate of return r = total dollar income during period purchase price (or dollar invested)

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Calculation of return for various financial instruments

Rates of Return for Bonds

Example: Zero Coupon Bond

(T ) =

100 1 P (T )

E.g. Face value = $100 Horizon = 1 year Price (P(T)) = $95.52 Total Return = (100/95.52) 1 = 4.69%

Example: Rate of return - stock

r = price change + cash dividends purchase price
Necessary adjustment in computing rates of return for stocks: Stock splits Stock dividends Right issues spinoffs
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Also define as Holding Period Return

Rates of Return: Single Period

P1 P 0 + D1 HPR = P0
HPR = Holding Period Return P0 = Beginning price P1 = Ending price D1 = Dividend during period one

Example:
Rates of Return: Single Period
Price at beginning of year = RM60 D1 paid at end of year = RM2.40 Price at end of year = RM69.00 Total return = 2.4 + (69 60) = 0.19 or 19% 60

Time Series Analysis of Past Rates of Return if for a series of total return
Use Arithmetic Average of rates of return

1 n E ( r ) = s =1 p ( s ) r ( s ) = s =1 r ( s ) n
n
Treat as equal prob. if historical return

Example
Year 1 2 3 4 5 Arithmetic mean for stock A: R = (19+14+22-12+5)/5 = 9.6% Stock A: Total return (%) 19 14 22 -12 5

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Geometric Mean
To know the average compound rate of growth that has actually occurred over multiple period

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Geometric (Time-Weighted) Average Return

TV

(1 + r1 )(1 + r2 ) x K x = (1 + rn )
TV = Terminal Value of the Investment

g = TV

1/ n

g= geometric average rate of return =actual performance

Geometric and Arithmetic Returns

In a period, a stock goes up by 60% and in the second period, the stock drops by 50% Geometric mean = [(1+0.6)(1-0.5)] - 1

= -10.56%

Arithmetic mean =(0.6 0.5)/2 = 5%

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Example: AM vs GM
Year 1 2 3 4 5 Stock A: Total return (%) 19 14 22 -12 5 Relative return 1.19 1.14 1.22 0.88 1.05

Arithmetic mean for stock A: = 9.6% Geometric return: [(1.19)(1.14)(1.22)(0.88)(1.05)] = 1.089 1 = 8.9%

1/5

Stock A has generated a compound rate of return of 8.9% over a period of 5 years GM always < than AM
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Normality
In investments, the focus is knowing the central tendency of a series of returns. Normal distribution is symmetric Stable Simplified with mean and standard deviations Therefore arithmetic mean is preferred

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Deviations from Normality

Assess the adequacy of assumptions of normality Can invalidate the use of standard deviation as adequate measure of risk Need to made corrections Understanding of Econometrics

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Figure 5.4 The Normal Distribution

Figure 5.5A Normal and Skewed Distributions (mean = 6% SD = 17%)

Eg. positively skewed (>0), std. dev. overestimates risk, increase estimate of volatility

Figure 5.5B Normal and Fat-Tailed Distributions (mean = .1, SD =.2)

Kurtosis-likelihood of extreme values on either side of the mean. SD will underestimate the likelihood of extreme events

Real return
The returns discussed are nominal returns. Adjustment must be made for inflation. Real Rate (t) = 1 + Nominal return - 1 1 + Inflation rate Example: Total return for an equity stock during a year was 18.5% Rate of inflation that year is 5.5% Real (inflation-adjusted) = ([1.185/1.055] 1 = 12.3%
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Measuring historical risk

Most commonly used measure of risk in finance is variance or standard deviation

2 = [ (Ri R)2]/n-1
Example: returns of a stock over 6 year period
Period 1 2 3 4 5 6 Return Ri 15 12 20 -10 14 9 Mean=10 2 v= 536/5 = 107.2 std dev = 10.4
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Deviation (Ri R) 5 2 10 -20 4 -1

Square of deviation 25 4 100 400 16 1 Sum Sq dev= 536

Measurement of Expected Return and Risk

Expectation of future value Can take various possible values and can vary Look at likelihood of occurrence

Measurement of Expected Return and Risk Example:

Investor buy share @RM1.20 per share that expected to give dividend of RM0.05 and share price of RM1.75 at end of year Expected return = (Forecast Div. + Forecast end of year stock price) - 1 Initial Investment = (0.05 + 1.75)/1.2 1 = 50% However, this is only expectation and uncertain. Assign probability of occurrence

Expected Return
Possible return Probability of Expected (%) (Xi) occurrence return p(Xi) (Xi.p(Xi)) 30 0.1 3 40 0.3 12 50 0.4 20 60 0.1 6 70 0.1 7 Mean=48

Expected Return and Standard Deviation

Expected returns

E (r ) =

p (s)r (s)

p(s) = probability of a state r(s) = return if a state occurs s = state

Another Example: Scenario Returns

State 1 2 3 4 5 Prob. of State .1 .2 .4 .2 .1 r in State -.05 .05 .15 .25 .35

E(r) = (.1)(-.05) + (.2)(.05) + (.1)(.35) E(r) = .15

Standard Deviation
Standard deviation of the rate of return is a measure of risk Higher the volatility, higher value of std deviation Measure uncertainty of outcome

Variance or Dispersion of Returns

Variance:

= p ( s) [ r ( s ) E (r )]
2 s

Standard deviation = [variance]1/2 Using 2nd Example: Var =[(.1)(-.05-.15)2+(.2)(.05- .15)2+ .1(.35-.15)2] Var= .01199 S.D.= [ .01199] 1/2 = .1095

Risk Premium and Excess Return

Risk premium = expected HPR minus the risk free rate Eg. If expected index fund return is 14% and risk free T-Bills is 6%, risk premium would be 8% Excess return = actual rate of return on a risky asset and the risk free rate

Rates of Return

Risk Aversion and Capital Allocation to Risky Assets

Type of Risk
Risk Free Risk Adverse Risk Neutral Risk Seeking (lover)

 Risk Tolerance Test

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Risk Aversion and Utility Values

These investors are willing to consider only risk-free or speculative prospects with positive risk premiums Intuitively one would rank those portfolios as more attractive with higher expected returns

Example: Available Risky Portfolios

Rank each portfolio as more attractive when expected return is higher and lower when risk is higher. How do investors quantify the rate to trade off return against risk?. Use utility score

Where: U = utility E ( r ) = expected return on the asset or portfolio A = coefficient of risk aversion (higher value more risk adverse) 2 = variance of returns *Higher utility values with attractive risk-return profile. Higher score =expected return; and lower=higher volatility Risk free portfolios = utility score is rate of return as no penalty for risk

Utility Function 1 2 U = E (r ) A 2

Utility Scores of Alternative Portfolios for Investors with Varying Degree of Risk Aversion

3 type of investors to choose which of the 3 portfolio i.e. the portfolio L, M and H to invest

The Trade-off Between Risk and Returns of a Potential Investment Portfolio, P

Prefer Quardrant 1 E(ra) > E(rb) SDA < SDb

The Indifference Curve

Estimating Risk Aversion

Observe individuals decisions when confronted with risk Observe how much people are willing to pay to avoid risk Eg. Insurance against large losses or financial distress

Capital Allocation Across Risky and Risk-Free Portfolios

Have shown that Stocks > risk than LT bonds > than T-Bill Control risk Asset allocation choice Fraction of the portfolio invested in Treasury bills or other safe money market securities vs risky assets

The Risky Asset Example

Total portfolio value = $300,000 Risk-free value = 90,000 Risky (Vanguard & Fidelity) = 210,000 Vanguard (V) = 54% = 113,400/210,000 Fidelity (F) = 46% = 96,600/210,000

The Risky Asset Example Continued

Vanguard Fidelity Portfolio P Risk-Free Assets F Portfolio C

113,400/300,000 = 0.378 96,600/300,000 = 0.322 210,000/300,000 = 0.700 90,000/300,000 = 0.300 300,000/300,000 = 1.000

Risky Portfolio
Suppose reduce risky port. from 0.7 to 0.56 =0.56 x $300,000 = $168,000. Need to sell $42,000 and buy risk free assets Sell 0.54 of vanguard and 0.46 of fidelity Total risk free assets increased = $300,000x(1-0.56) = $132,000 or 90,000+42,000

Risky Portfolio
Proportion remain unchanged in risky assets, 0.54 and 0.46 Need to sell: 0.54x42,000 = 22,680 and 0.46 x 42,000 = 19,320 Treat as a single risky asset
As long as the weight of each risky assets remain unchanged, rate of return remain unchanged
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The Risk-Free Asset

Only the government can issue defaultfree bonds Guaranteed real rate only if the duration of the bond is identical to the investors desire holding period T-bills viewed as the risk-free asset Less sensitive to interest rate fluctuations due to short term maturity

Portfolios of One Risky Asset and a Risk-Free Asset

Its possible to split investment funds between safe and risky assets. Risk free asset: proxy; T-bills Risky asset: stock (or a portfolio) The concern - the proportion of investment budget to allocate

Example: To determine proportion of investment

rf = 7% E(rp) = 15% y = % in p

rf = 0% p = 22%
(1-y) = % in rf

Return of complete portfolio = rc = yrp + (1-y) rf

Expected Returns for Combinations

E (rc ) = yE (rp ) + (1 y )rf

rc = complete or combined portfolio For example, y = .75 E(rc) = .75(.15) + .25(.07) = .13 or 13%

Combinations Without Leverage

If y = .75, then

c = .75(.22) = .165 or 16.5%

If y = 1

c = 1(.22) = .22 or 22%

If y = 0

= (.22) = .00 or 0%
Rate of return of complete portf is E(rc) = rf + y[E(rp) rf]

The Investment Opportunity Set with a Risky Asset and a Risk-free Asset in the Expected Return-Standard Deviation Plane

Capital Allocation Line

Slope of line = [E(rp) rf]/SDp = (15-7)/22 = 8/22 Extra return per risk is thus 8/22 or 0.36 Or called reward-to-volatility ratio The CAL = 7 + 8/22 SDc

The Reward-to-Volatility (Sharpe) Ratio

Risk Premium SD of Excess Return

Sharpe Ratio for Portfolios

reward

Risk

Use to evaluate the performance of investment manager

Capital Allocation Line with Leverage

Borrow at the Risk-Free Rate and invest in stock. Using 50% Leverage, rc = (-.5) (.07) + (1.5) (.15) = .19

c = (1.5) (.22) = .33

If borrowing rate is 9% instead of Rf at 7% Slope = (15-9)/22 = 0.27

The Opportunity Set with Differential Borrowing and Lending Rates

Risk Tolerance and Asset Allocation

The investor must choose one optimal portfolio, C, from the set of feasible choices Trade-off between risk and return Expected return of the complete portfolio is given by:

E (rc ) = rf + y E (rP ) rf
Variance is:

=y

2 C

2 P

 There are two kinds of people, those who do work and those who take the credit. Try to be in the first group; there is less competition there

THE END Q&A

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