CHAPTER 14 principles of investment.docx

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21 Apr 2012

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CHAPTER 14 principles of investment
Saving: money that you did not spend; money left over after your consumption
Investing: using the savings that you have and putting it in investments to earn a rate of return
Important characteristics return, risk, liquidity, marketability, term (short term, long term),
management, tax considerations, divisibility
Income return: periodic cash flow that the investor receives
Capital gain return: generated when you sell it for a price higher than what you paid for it
Total return: income return plus the capital gain return
Rate of return (holding period return)
R or (HPR) = P1 P0 + D / P0
P0 = price at the beginning of the holding period
P1 = price at the end of the holding period
D = income return (interest or dividend) during the holding period
Realized rate of return: rate of return that actual occurred in a past period
Expected rate of return: return that is expected to happen in the future
E(r) = E(P1) P0 + E(D) / P0
P0 = price today, or at the beginning of the period
E(D) = expected income during the period
Risk is the uncertainty about the rate of return that you will earn from an investment
Variability: one way of measuring risk in an investment’s rate of return
o Investments with more variability in their rate of return are riskier than investments with less
variability because the larger of the variability, the higher probability of getting a rate of return
lower than the expected rate of return
Beta: measures the co-movement of the stock’s return with the stock market’s return
o Measures the risk of the investment relative to the risk of the market
o The higher the beta, the more sensitive the stock is to moves in the market
Total risk: standard deviation of its rate of return
o Measures the total variability or volatility of an investment
Objective probability distribution: formed by measuring objective historical data to find the rate of
return of a stock (mean and standard deviation)
Subjective probability distribution: formed by writing down one’s perception of all the possible rates of
return of the investment and then assigning probabilities to them
E(r) = Piri
S.D. = [Pi [ri E(r)]2]1/2
Risk-free asset: no variability in the rate and the standard deviation is zero
Inflation risk: does not guarantee the purchasing power of your money
Default risk: risk of losing part or all of the future cash flow that the investor expects to get when making
the investment initially
Interest rate risk: risk that is caused by the changes in the level of market interest rates, which affect the
values of all assets
Liquidity risk: risk of not being able to cash your investment in time of need
Reinvestment risk: risk associated with the uncertainty of not knowing at what rates of return your
money can be reinvested in the future
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