Lecture 1s

8/9/2019 Lecture 1s

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Investment Analysis and

Portfolio Management

Investment

A current commitment of funds for a period of time in order to derive future

payments that will compensate for:

●the time the funds are committed

●the expected rate of inflation

●uncertainty of future flow of funds.

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Nonmarketable Financial Assets

Savings accounts , Certificates of Deposit like National

Saving Certificates, Defence Saving CertificatesFeatures

● Commonly owned by individuals

● Represent direct echange of claims between issuer and

investor ● !sually very li"uid or easy to convert to cash without loss

of value

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Money Market ecurities

● #oney market mutual funds, $%&ills, Commercial paper

● #arketable: claims are negotiable or salable in the

marketplace

● Short%term, li"uid, relatively low risk debt instruments

● 'ssued by governments and private firms

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!apital Market ecurities

&onds, Debentures, $erms (inance Certificates

Features● #arketable debt with maturity greater than one year and

ownership shares

● (ied%income securities have a specified payment schedule

●

Dates and amount of interest and principal paymentsknown in advance

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● Common stockholders are residual claimants on income

and assets

● *ar value is face value of a share

● !sually economically insignificant

● &ook value is accounting value of a share

● #arket value is current market price of a share

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Preferred tocks

● +ybrid security because features of both debt and e"uity

●

*referred stockholders paid after debt but before commonstockholders

● Dividend known, fied in advance

● #ay be cumulative if dividend omitted

●

ften convertible into common stock ● #ay carry variable dividend rate

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Derivative Securities

● Securities whose value is derived from another security

●

(utures and options contracts are standardi-ed and performance is guaranteed by a third party

● Risk management tools

● .arrants are options issued by firms

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$ptions

● /change%traded options are created by investors, not

corporations

● Call 0*ut1: &uyer has the right but not the obligation to

purchase 0sell1 a fied "uantity from 0to1 the seller at a

fied price before a certain date

● Right is sold in the market at a price

● 'ncreases return possibilities

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Futures

● (utures contract: A standardi-ed agreement between a

buyer and seller to make future delivery of a fied asset at

a fied price

● A 2good faith deposit,3 called margin, is re"uired of

both the buyer and seller to reduce default risk

● !sed to hedge the risk of price changes

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%olding Period &eturn

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n (ebruary 4, you bought 455 shares of a stock for 678 a share and a year

later you sold it for 679 a share During the year, you received a cash

dividend of 64;5 a share Compute your +*R and +*< on this stock

investment

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n August 4;, you purchased 455 shares of a stock at 6=; a share and a

year later you sold it for 6=4 a share During the year, you received

dividends of 67 a share Compute your +*R and +*< on this investment

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At the beginning of last year, you invested 68,555 in >5 shares of the Chang

Corporation During the year, Chang paid dividends of 6; per share At the end of

the year, you sold the >5 shares for 6;9 a share Compute your total +*< on

these shares and indicate how much was due to the price change and how muchwas due to the dividend income

68,555 used to purchase >5 shares ? 6;5 per share

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$herefore: +*< 0$otal1 ? +*< 0*rice 'ncrease1 @ +*< 0Div1

>5 ? 4>5 @ +*< 0Div1

45 ? +*< 0Dividends1

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closing price B opening price

Return ?

pening *rice

88 % 85

Return for anuary ?

85

? 45 or 45

imple &eturn

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Month Closing Price X

Dec-00 40

Jan-01 44

Feb-01 50.6

Mar-01 51.62

Ar-01 54.!

&eturn

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Month Closing Price X "et#rn X

Dec-00 40

Jan-01 44 .10

Feb-01 50.60 .15

Mar-01 51.62 .02

Ar-01 54.! .06

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Month &eturn

an%54 545

(eb%54 54;

#ar%54 55

Apr%54 55=

$otal 577

Average &eturn or Mean &eturn

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<ear Actual Return

4 545

54;

7 55

8 55=

$otal 577

Average &eturn ' (.))*+

' (.(,-

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$he Ereek letter pi stands for product summation $his means that instead of

adding values in the series, they are multiplied $he rest of the e"uation indicates

that after multiplying the return, we take the nth root of the product, where n is the

number of terms in the series

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Calculating the geometric means of a series of a return has a potential problem

because returns are often negative 'f the number of negative returns in a series is

odd, there product will be negative and negative number does not have an even

root

't is easy to eliminate the problem by converting security returns into returnrelatives before calculating the statistics on them

A return relative is simply the return plus 4

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During the past five years, you owned two stocks that had the following

annual rates of return:

/ear tock 0 tock 14 549 55>

55> 557

7 B54 B559

8 B557 55

; 54; 558

Compute the geometric mean annual rate of return for each stock

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E#$ ? F04491 045>1 0>>1 09G1 044;1H4I; %4

? F4=4=5H 4I; B4 ? 458G;G B4 ? 58G;G

E#& ? F045>1 04571 0941 0451 04581H4I;

%4

? F45G7>7H 4I; B4 ? 45487; B 4 ? 5487;

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During the past five years, you owned two stocks that had the following

annual rates of return:

/ear tock 0 tock 14 549 55>

55> 557

7 B54 B559

8 B557 55

; 54; 558

Compute the arithmetic mean annual rate of return for each stock .hich stock

is most desirable by this measureJ

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$toc% & is 'ore (esirable beca#se the arith'etic 'ean ann#al rate o) ret#rn

is higher.

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"xpected &ates of &eturn

● Risk is uncertainty that an investment will earn its

epected rate of return

● *robability is the likelihood of an outcome

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S/ *robability *ossible Return

&# ;5 G5

Recession ;5 %5


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S/ *robability *ossibleReturn

/pected Return

&# 5;5 5G5 57;

Recession 5;5 %55 %545

5;

"xpected &eturn

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State of /conomy *robability *ossible Return

&oom ; 45

Recession ; 7

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Considering the world economic outlook for the coming year and estimates of salesand earnings for the pharmaceutical industry, you epect the rate of return for Kauren

Kabs common stock to range between B5 percent and @85 percent with the following

probabilities:

Probability Possible &eturns

54 B55

54; B55;

5 545; 54;

5 5

54 58

Compute the epected rate of return F E 0 Ri1H for Kauren Kabs

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● &isk Free &ate of &eturn 2&F&3

● Market &ate of &eturn 2M&3

● &e#uired &ate of &eturn

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State of /conomy *robability Possible &eturn

Stock A Stock & Stock C

&oom 85 45 4; 5

Recession =5 5> 58 5

Portfolio &eturn

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State of /conomy *robability Poss

ible &eturn


&oom 85 45 4; 5


'nvestment Criteria

;5 'nvestment in Stock A

; 'nvestment in Stock &

; 'nvestment in Stock C

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"xpected Portfolio &eturn

&oom ;5L 45 @;L4;@;L5

5;@57G;@5; ?47G;

Recession ;5L5>@;L58@;L5 ? 5;

State of /conomy *robability &eturn


&oom 85 45 4; 5


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Probabilit* *ortfolio Return

&oom 85 47G;

Recession =5 5;

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/pected Return of 'ndividual Stock Stock A

&oom 85L45 ? 58

Recession =5L5> 58>

5>>

Stock &

85L4; ?5==5L58 ?58

5>8

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tock !85L5 ?5>

=5L5 ?55

?5>

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"xpected &eturn of Portfolio1ased on Investment !riteria

;5L5>> ? 588

;L5>8 ? 54

;L5> ? 5

? 5>;

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Probabilit* *ortfolio Return AverageReturn

&oom 85 47G; 5>;

Recession =5 5; 5>;

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Annuali-ed Rate of Return ? Average #onthly Return L 4

Annuali4ed &ate of &eturn

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Possible &ate of &eturn Probability

B545 57

5 54

54 575; 57

<ou are considering ac"uiring shares of common stock in the #adison &eerCorporation <our rate of return epectations are as follows:

Compute the epected return F E 0 Ri1H on your investment in #adison &eer

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/0R #&C1? 0751 0%451 @ 0451 05551 @ 0751 0451 @ 0751 0;1

? 0%571 @ 555 @ 57 @ 5G;

? 5G;

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!S government $%bills ;;5

!S government long%term bonds G;

!S common stocks 44=

During the past year, you had a portfolio that contained !S government $%bills,long%term government bonds, and common stocks $he rates of return on each of

them were as follows:

During the year, the consumer price inde, which measures the rate of inflation, went

from 4=5 to 4G 049>B49>8 ? 4551 Compute the rate of inflation during this yearCompute the real rates of return on each of the investments in your portfolio based on

the inflation rate

A i

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I A l i d

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Assume that the consensus re"uired rate of return on common stocks is 48 percent 'n

addition, you read in Fortune that the epected rate of inflation is ; percent and the

estimated long%term real growth rate of the economy is 7 percent .hat interest rate

would you epect on !S government $%billsJ .hat is the approimate risk premium forcommon stocks implied by these data

I A l i d

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Nominal rate on $%bills 0or risk%free rate1

? 04 @ 571 04 @ 5;1 B 4

?45>4; B 4 ? 5>4; or >4;

$he re"uired rate of return on common stock is e"ual to the risk%free rate plus a risk

premium $herefore the approimate risk premium for common stocks implied by

these data is:

? 48 % 5>4; ? 5;>; or ;>;

I t t A l i d

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$he following are annual rates of return for !S government $%bills and !M

common stocks

Year

5.. 6overnment071ills

5.8. !ommontock

557 55=7 54;5

558 55>4 5587

55; 55G= 57G8

55= 5595 549

55G 55>; 545=

Compute the arithmetic mean rate of return and discuss these two alternative

investments in terms of their arithmetic average rates of return

I t t A l i d

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0b1 $he average return of !S Eovernment $%&ills is lower than the average return

of !nited Mingdom Common Stocks because !S Eovernment $%&ills are riskless,

therefore their risk premium would e"ual 5 $he !M Common Stocks are subect to

the following types of risk: business risk, financial risk, li"uidity risk, echange rate

risk, 0and to a limited etent1 country risk

I t t A l i d

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<ou read in Business Recorder that a panel of economists has estimated that the long%

run real growth rate of the *ak economy over the net five%year period will average 7

percent 'n addition, a bank newsletter estimates that the average annual rate of inflation

during this five%year period will be about 8 percent .hat nominal rate of return would

you epect on *ak government $%bills during this periodJ

NR(R ? 04 @ 571 04 @ 581 B 4 ? 45G4 B 4 ? 5G4

I t t A l i d

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The Wall Street Journal reported that the yield on common stocks is about percent,

whereas a study at the !niversity of Chicago contends that the annual rate of return on

common stocks since 49= has averaged about 4 percent Reconcile these statements

I t t A l i d

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$he difference is because of the definition and measurement of return 'n the case of

the WSJ , they are only referring to the current dividend yield on common stocks

versus the promised yield on bonds 'n the !niversity of Chicago studies, they are

talking about the total rate of return on common stocks, which is the dividend yield

plus the capital gain or loss yield during the period 'n the long run, the dividendyield has been 8%; percent and the capital gain yield has averaged about the same

$herefore, it is important to compare alternative investments based upon total return

Lecture 1s

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