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FIN 521 (6)
Chapter 1

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FIN 521
Eric Terry

Chapter 1: The Investment Setting  Pure rate of interest: the rate of exchange between future consumption (future dollars) and current consumption (current dollars)  Pure time value of money: people’s willingness to pay this difference for borrowed funds as well as their desire to receive a surplus on their savings give rise to an interest rate referred to as the time value of money  This interest rate is established in the capital market by a comparison of the supply of excess income available (savings) to the be invested and the demand for excess consumption (borrowing) at a given time  If the future payment from the investment is not certain, the investor will demand a rate higher than the nominal risk-free rate  The uncertainty of the payments from an investment is the investment risk  The additional return added to the nominal, risk-free rate is called a risk premium  Investment: the current commitment of dollars for a period of time in order to derive future payments that compensate the investor for: 1. The time the funds are committed 2. The expected rate of inflation 3. The uncertainty of the future payments - Includes all types of investments, including investments by corporations in plant and equipment and investments by individuals in stocks or shares, bonds, commodities, or real estate - In all cases, the investor is trading a known dollar amount today for some expected future stream of payments that will be greater than the current outlay  1.3 Measures of Risk and Return: - Holding period: the period in which you own the investment - Holding period return (HPR): the return over that period (holding period) - The value will be greater than one (1) if you received a positive return during the period - A value less than one means that wealth declined or you experienced a negative return - A zero HPR indicates that you lost all your money - Although HPR helps express the change in an investment’s value, investors generally evaluate returns in percentage terms on an annual basis so that it is easier to directly compare investments with markedly different characteristics - To convert HPR to an annual percentage rate or the holding period yield (HPY), simply subtract 1 from the HPR (for annual HPR) - When the investment is horizon is not annual, first compute an annual HPR as follows: o Where n= number of years the investment is held - Now that we calculated the HPY for a single investment for a single year, we want to consider mean rates of return for a single investment and for a portfolio of investments - Single Investment: given an individual’s set of annual returns (HPYs), there are two summary measures of return performance 1. Arithmetic mean (AM) return: ∑ o Where ∑ 2. Geometric mean (GM) return: ⁄ o Where ( ) ( ) ( ) o When returns are the same for all years, the GM is equal to the AM o However, if the returns vary over time, the GM will always be lower than the AM o The difference between the two mean values will depend on the year-to-year changes in the returns o Larger annual changes in the returns- that is, more volatility- will result in a greater difference between the mean values - Portfolio of Investments: the mean historic return (HPY) for a portfolio can be measured as the weighted average of the HPYs for the individual investments in the portfolio, or simply the overall change in the value of the original portfolio o The weights used to calculate the averages are the relative beginning market values for each investment; this is referred to as dollar-weighted or value-weighted mean rate of return  Risk: is the uncertainty that an investment will not earn its expected return  Point estimate: the return that you expect ∑ ( ) ( )  Risk averse investors: if everything else is the same, they will select the investment that offers greater certainty (i.e. less risk)  Variance: the larger the variance for an expected return, the greater the dispersion of expected returns and the greater the uncertainty, or risk, of the investment ( ) ∑ (
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