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Applied

Portfolio and Fund


Management

Presented by

Muhammad Khalid Sohail

Prerequisite for this course


1. Financial Management
2. Corporate Finance
3. Investment Analysis & Portfolio Management
4. Statistics

Book
Analysis of Investment and
Management of Portfolio
tenth Edition
by

Frank K. Reilly & Keith C. Brown

Chapter 1
The Investment Setting

Questions to be answered:
Why do individuals invest ?
What is an investment ?
How do we measure the rate of return on
an investment ?
How do investors measure risk related to
alternative investments ?

Chapter 1
The Investment Setting

What factors contribute to the rates of


return that investors require on
alternative investments ?
What macroeconomic and
microeconomic factors contribute to
changes in the required rate of return for
individual investments and investments
in general ?

Why Do Individuals Invest ?

For most of your life, you will be earning and


spending money.
Rarely, though, will your current money
income exactly balance with your
consumption desires.
Sometimes, you may have more money than
you want to spend; at other times, you may
want to purchase more than you can afford.
These imbalances will lead you either to
borrow or to save to maximize the long-run
benefits from your income.

Why Do Individuals
Invest ?
By saving money (instead of
spending it), individuals tradeoff
present consumption for a larger
future consumption.

Definition (Jones)

Investments is the study of the process of


committing funds to one or more assets
Emphasis on holding financial assets and marketable
securities
Concepts also apply to real assets
Foreign financial assets should not be ignored

Most individuals make investment decisions


sometime
Need sound framework for managing and increasing
wealth

Essential part of a career in the field


Security analyst, portfolio manager, investment advisor,
financial planner, Chartered Financial Analyst

How Do We Measure The Rate Of


Return On An Investment ?
The pure rate of interest is the
exchange rate between future
consumption and present
consumption. Market forces
determine this rate.

$1.00 4% $1.04

How Do We Measure The Rate Of


Return On An Investment ?
Peoples willingness to pay the
difference for borrowing today and
their desire to receive a surplus on
their savings give rise to an interest
rate referred to as the pure time
value of money.

How Do We Measure The Rate Of


Return On An Investment ?
If the future payment will be
diminished in value because of
inflation, then the investor will
demand an interest rate higher than
the pure time value of money to
also cover the expected inflation
expense.

How Do We Measure The Rate Of


Return On An Investment ?
If the future payment from the
investment is not certain, the
investor will demand an interest
rate that exceeds the pure time
value of money plus the inflation
rate to provide a risk premium to
cover the investment risk.

Defining an Investment
A current commitment of $ for a
period of time in order to derive
future payments that will
compensate for:

Real rate of return +

the
time
the
funds
are
committed
Inflation premium +

the
expected
rate
of
inflation
Risk premium
uncertainty of future flow of
funds.

Measures of
Historical Rates of Return
Holding Period Return

Ending Value of Investment


HPR
Beginning Value of Investment
$220

1.10
$200

1.1

Measures of
Historical Rates of Return
Holding Period Yield
HPY = HPR - 1
1.10 - 1 = 0.10 = 10%

1.2

Measures of
Historical Rates of Return
Annual Holding Period Return
Annual HPR = HPR 1/n

(E/B)^(1/n)

where n = number of years investment is held


HPR

Ending Value of Investment


Beginning Value of Investment

Annual Holding Period Yield


Annual HPY = Annual HPR - 1
=(E/B)^(1/n)-1

Consider an investment that cost $250 and is


worth $350 after being held for two years
HPR?
HPY?

Consider an investment that cost $250 and is


worth $350 after being held for two years

A multiple year loss over two


years would be

consider an investment of $100 held for only


six months that earned a return of $12
HPR?
HPY?

consider an investment of $100 held for only


six months that earned a return of $12

Note that we made some implicit assumptions


when converting the HPY to an annual basis.
This annualized holding period yield
computation assumes a constant annual yield
for each year.
In the two-year investment, we assumed an
18.32 percent rate of return each year,
compounded.
In the partial year HPR that was annualized,
we assumed that the return is compounded for
the whole year.

today investment
rate / annum
after year 1
rate / annum
After 2-years
or
PV
rate=i
n=
FV
FV

250
0.1832
45.8
295.8
0.1832
54.19056
349.99056
250
0.1832
2

?
PV*(1+i)^n
349.99056

Measures of Historical Rates of Return


( single investment)

1. Arithmetic Mean
where :

AM HPY/ n

HPY the sum of annual

holding period yields

1.4

Measures of
Historical Rates of Return
1.5

2. Geometric Mean
where :

GM HPR

the product of the annual

holding period returns as follows :

HPR 1 HPR 2 HPR n

To illustrate these alternatives, consider an


investment with the following data

Investors are typically concerned with longterm performance when comparing alternative
investments.
GM is considered a superior measure of the
long-term mean rate of return because it
indicates the compound annual rate of return
based on the ending value of the investment
versus its beginning value
the arithmetic average provides a good
indication of the expected rate of return for an
investment during a future individual year,
it is biased upward if you are attempting to
measure an assets long-term performance

Consider, for example, a security that


increases in price from $50 to $100 during
year 1 and drops back to $50 during year 2.
The annual HPYs would be:

This answer of a 0 percent rate of return


accurately measures the fact that there was
no change
in wealth from this investment over the twoyear period.

A Portfolio of Investments
The mean historical rate of return
for a portfolio of investments is
measured as the weighted average
of the HPYs for the individual
investments in the portfolio.

Computation of Holding Exhibit 1.1


Period Yield for a Portfolio
#
Stock Shares
A
100,000
B
200,000
C
500,000
Total

HPY =

Begin
Price
$ 10
$ 20
$ 30

Beginning Ending
Ending
Market
Mkt. Value Price Mkt. Value HPR HPY Wt.
$ 1,000,000
$ 12 $ 1,200,000 1.20 20% 0.05
$ 4,000,000
$ 21 $ 4,200,000 1.05 5% 0.20
$ 15,000,000
$ 33 $ 16,500,000 1.10 10% 0.75
$ 20,000,000
$ 21,900,000

HPR =

$ 21,900,000
$ 20,000,000

1.095

1.095

-1

0.095

9.5%

Wtd.
HPY
0.010
0.010
0.075
0.095

Expected Rates of Return

Risk is uncertainty that an investment


will earn its expected rate of return,
or
Risk: the possibility that the realized
return will be different than the
expected return
Probability is the likelihood of an
outcome

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