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FIN 521 (1)

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Ryerson University
FIN 521
Eric Terry

Chapter 1Investment backround o Pure rate of interestdifference between future consumption and current consumption o Pure time value of moneywillingness to pay the difference for borrowed funds or desire to receive a surplus on their savings giverise to an interest rate Investment current commitment of dollars for a period of time in order to derive future payments o Compensate the investor forTime of the committed fundsExpected rate of inflationUncertainty risk of the future payments Meaures of risk and return Historical rates and returns o Holding period return HPR the return of the period over which you own the investmentoHolding period yield HPYsimply the return in percentages HPR 1 o HPYRETURN RComputing mean historical returns o Single investmentArithmetic mean AM Geometric mean GMo A portfolio of investmentsEither use Arithmetic mean or Geometric mean simple find the average return of your portfolio for each yearCalculating expected rates of return o Risk uncertainty that an investment will not earn its expected returno To calculate risk we must calculate the probability of possible returns Measuring the risk of expected return o We can calculate the risk of an investment by identifying the range of possible returns and assigning each possible return a weight based on the probability that it will occurWhere expected return AndRpossible return o Relative measure of riskCoefficient of variation controls for the size of the mean number determines the level of relative variability or risk per unit of expected return Determinants of required rates of return Real riskfree rate RRFR basic inflation rateassumingno inflation and no uncertainty about future cashflows o If there is greater desire to spend RRFR will decrease to promote saving vice versa o Also a positive relationship between the real growth rate in the economy and the RRFR Nominal riskfree rate NRFR stated in money terms determined by factors such as expected rate of inflation and the monetary environment o The relative ease or tightness in the capital markets affect the risk free rate Risk premiumincrease in the return over the NRFR due to the uncertainty about the returns Sources of uncertainty include o Business riskuncertainty of income flows caused by the nature of a firms business o Financial riskuncertainty resulting from a firms choice of financing investingborrowing o Liquidity risk uncertainty introduced in the secondary market of for an investment o Exchange rate riskuncertainty of returns to an investor who purchases securities denominated in a currency different from his or her own o Country risk political riskuncertainty of returns caused by the possibility of a major change in the politicaleconomic environmentRisk premium and portfolio theory o Relevant risk measure for an individual asset is its movement with the market portfolio also known as an assets systematic risk Unsystematic risk should easily be diversified away o Thereforesystematic riskrisk premium Relationship between risk and return Security market line SML line depicting the increasing in investors RROR as perceived risk increases
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