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FIN 502 (69)
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Chapter 14

CFIN502- Chapter 14- Principles of Investing-1.docx

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Department
Finance
Course
FIN 502
Professor
Joan Lobo
Semester
Summer

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
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