false

Textbook Notes
(368,652)

Canada
(162,033)

Ryerson University
(11,313)

Finance
(362)

FIN 502
(69)

Joan Lobo
(33)

Chapter 14

Unlock Document

Description

CFIN502- Chapter 14- Principles of Investing
Major developments in the investment world
o Enormous expansion in scholarly knowledge about investments
o Enormous explosion of investment products available even for the small investor
Savings—money you don’t spend
Investing- using the savings that you have and “making it work”
o Putting it in investments to earn a rate of return
BASIC CHARACTERISTICS OF AN INVESTMENT
Important characteristics
o Return, risk, liquidity, marketability, term, management, tax considerations,
divisibility
Return on investment
o Ways to earn a return off investment
Income return- periodic cash flow that the investor receives
Capital gain return- investment is generated when you sell it for a price higher
than what you paid for
o Total return- income return plus the capital gain return
Rate of return
o Rate of return (r) or holding period return (HPR
r (or HPR)= P1-P0+D/ P 0
o Bank account or Canada savings bond the rate of return is simply the rate of interest
o Expected rate E(r) VS realized return
Realized rate of return- rate of return that has actually occurred in a past
period
Can be positive, zero, or negative
Expected rate of return- return that is expected to happen in the future
What we are expecting to earn for buying and holding an investment
E(r)= E(P )-P +E(D)/ P
1 0 0
INVESTMENT RISKS
Risk means probability of a negative rate of return on investment
o Higher the probability of a negative rate or return, higher the risk of the investment
More precise definition and measure of risk
Risk is he uncertainty about the rate of return that you will earn from an investment
Measure variability in investments rate of return
o More variability in their rate of return—riskier than investments with less variability
o Larger the variability, the higher the probability of getting a rate of return lower than
the expected rate of return
Because P 1nd D are random variables r is also random variable
Using the standard deviation as a measure of risk—we see that stocks are the riskiest, long
term bonds are less risky and government treasury bills are the least risky
Bigger the standard deviation he greater risk of the investment
Another measure of risk: Beta
o Beta- measures the co-movement of the stocks return with the stock markets return
o Measures the risk of the investment relative to the risk of the market
o Higher the beta—more sensitive the stock moves in the market
o Defined in such a way that the stock market has a beta of 1
o EG beta 0.5 risk is only half that of
Beta 2 risk is two times that of
Total risk- standard deviation of its rate of return
o Measured he total variability or volatility of an investment
o Ways to formulate a probability distribution of the possible rates of return
Objective probability distribution- formed by measuring objective historical
date
Useful only if the investments rate of return probability distribution
is stationary—doesn’t change over time
Subjective probability distribution- formed by writing down ones perception of
all the possible rates of return of the investment and then assigning
probabilities to them
1 CFIN502- Chapter 14- Principles of Investing
o E(r)= pi i
o SD= [P iriE(r)] ]1/2
The risk-free asset
o Investments whose rates of return are guaranteed
o Rate of return is equal to a certain guaranteed rate f return with a probability of one
o No variability on the rate—standard deviation is zero
o EG treasury bill or T-bill short term note issued by the government
o T-bills are sold in the money market and are prices in such a way that of you hold
them until maturity—rate of return guaranteed
Not really risk free
Depends on inflation—inflation risk
May have to reinvest, horizon is longer than the maturity period—
reinvestment risk
Other factors of risk
o Putting money in a risk-free asset is not necessarily risk-free
o Default risk- risk of losing part or all of the future cash flow that the investor expects to
et them making the investment initially
Other default risks are systematically related to the economy—affect almost
all companies
o Interest rate risk- caused by the charges in the level of market interest rates
Affects value of all assets
Assets values will rise when interest rates fall and they will fall when interest
rates rise
o Liquidity risk- risk of not being able to cash I you investment in time of need
o Reinvestment risk- risk associated with the uncertainty of not knowing at what rates of
return your money can be reinvested in the future
o Inflation risk- risk that the return on your investment will not keep up with inflation
Inflation hedges-investments that are expected to keep pace with inflation
Short-term investments have little inflation risk their rates will change fast
enough to reflect the changing inflation rates
RISK AND RETURN TRADE-OFF
Risk aversion- given 2 investments that are identical in every respect except for risk, people
will choose the investment with lower risk
o Applies to only that people require higher returns for taking greater risks
Return: increasing function of risk
o Given 2 investments—one riskier than the other will be prices in the marketplace so
that the rate of return on the riskier investment will be higher than that of the less
risky one
o First fundamental principle in investment: the expected rate of return on an investment
is an increasing function of its risk
o Higher the risk—the higher the expected rate of return
Dominance
o Given 2 investments A and B—A is always preferred to B for all investors than we say
A dominates B
o We cannot rank all investments by dominance concept
o Important attributes of any investment—risk and return—go hand in hand
o Biggest mistake you can make—fall for stockbrokers’ phone pitches
o Positive relationship between risk and return more risk you take the higher return
that you should expect to get from the investment
DIVERSIFICATION
Diversification- putting ones money into a broad basket of different investment
Investment chosen must not be perfectly correlated
o Stock prices of investments chosen do not always move in the same direction
Second basic principle if investment- avoid putting all of your investment in one kind or type
Risk-adverse approach to investing—involves reducing your risk exposure without necessarily
sacrificing expected return on investment
Portfolio theory
o Portfolio- collection of securities so it is diversified in more than one assets
2 CFIN502- Chapter 14- Principles of Investing
o Portfolio theories- examine various ways of investing and d

More
Less
Related notes for FIN 502

Join OneClass

Access over 10 million pages of study

documents for 1.3 million courses.

Sign up

Join to view

Continue

Continue
OR

By registering, I agree to the
Terms
and
Privacy Policies

Already have an account?
Log in

Just a few more details

So we can recommend you notes for your school.

Reset Password

Please enter below the email address you registered with and we will send you a link to reset your password.