INVESTMENT DECISIONS AND PORTFOLIO

MANAGEMENT

ACFN 5091
 COURSE OBJECTIVES
After completion of the course, the student should be able
to:
• Develop a sound investment background.
• Understand the function of stock exchange markets
• Understand stock trading system, stock listing requirement
and efficient capital markets
• Construct and analyze security market index.
• Conduct economy, industry and company analysis to
identify potential investment areas
• Analyze the relationship between risk and return
 Chapter One
Investment Process
1.1. Concept of Investment
1.2. Forms of investment
1.3. Objectives of investment
1.4. Characteristics of investment
1.5. Investment verses speculation
1.6. Types of securities
1.7. Major investors in securities
1.8. Investment Process
1.9. Investment income and risk
 Chapter 2
Financial Markets and Capital Market Efficiency
• Financial Markets
• Primary and secondary markets
• Trading in secondary markets
• Stock market indexes
• Capital market efficiency
 Chapter 3
Modern Portfolio Theory and Asset Pricing
Model
➢ Theory for investment portfolio formation
➢ Efficient market hypothesis (EMH)
➢ Portfolio theory
▪ The expected rate of return and risk of
portfolio
▪ Markowitz portfolio theory
➢ Capital Asset Pricing Model(CAPM)
➢ Arbitrage Pricing Theory (APT)
➢ Multifactor pricing models
 CHAPTER 4
Introduction to security valuation Process

1.Introduction to security valuation Process

2.Security valuation approaches
3.Fundamental Analysis(EIC and CIE)
4.The Dow Theory
 Chapter 5

•Analysis and management of common stocks

•Macro analysis and Micro valuation of the Stock
Market.
•Industry Analysis.
•Company Analysis and Stock Valuation.
•Technical Analysis.
•Equity Portfolio Management Strategies.
 Chapter 6

Analysis and management of bonds.

➢Bond Fundamentals

➢The Analysis and Valuation of Bonds.

➢Bond Portfolio Management Strategies.

 Chapter 7
•Derivative security analysis.
•An Introduction to Derivative Markets and
Securities.
•Forward and Futures Contracts
•Option Contracts.
 Chapter 8
Portfolio performance Evaluation and Review
➢ Treynor, Sharpe, Jensen and Information Ratio
Performance Measures.
➢ Application of Portfolio Performance Measures.
➢ Factors affecting the use of Performance Measures.
 Major references:

•Reilly, F. K., Brown, K. C., & Leeds, S.J. (2019).

Investment Analysis and Portfolio Management.
(11th ed) Cengage Learning.
 CHAPTER ONE

OVERVIEW OF INVESTMENT
 Chapter Objectives
Upon completion of this chapter learners should be able to:
Define an investment.
Identify types of investment attributes
Identify the characteristics of investment
Discuss the principal types of investment vehicles.
Discuss the different types of securities
Describe the major steps in the construction of an
investment portfolio.
identify the various investment constraints
measure investment return and risk
 INTRODUCTION
Defining investment

➢Investment: is the current commitment of dollars for a period of

time in order to derive future payments that will compensate the investor for:
• the time the funds are committed,
• the expected rate of inflation, and
• The uncertainty of the future payments.

❖ Generally, investment is undertaken in the expectation of a return which is in

proportion to the risk the investor assumes.
 cont…
Financial and economic meaning of investment
➢ In the financial sense, investment is the employment of
funds to derive future income in the form of interest,
dividend, premiums or appreciation in the value of
investment capital.
➢ Purchase of marketable securities such as shares, bonds
which is regarded as financial investment, is expected to
yield income in the form of interest or dividend along with
appreciation in their value.
Such investment generates financial assets.
 cont…
• Financial assets: are pieces of paper (or electronic)
evidencing claim on some issuer.
• Marketable securities: Financial assets that are easily and
cheaply traded in organized markets.
• In economic sense, investment means the net additions to
the economy’s capital stock which consists of goods and
services that are used in the production of other goods and
services.
Investment in the form of plant and machinery, building,
inventories, etc forms new and productive capital. Such
investment generates physical assets.
 Types of Investors
• Investors can be classified on the bases of their risk
bearing capacity
• Investors in the financial market have different attitudes to
wards risk and hence varying levels of risk bearing
capacity.
• The risk bearing capacity of investor is a function of
personal, economic, environmental and situational factors
such as income, family size, expenditure pattern, and age.
 cont…

•Thus, investor can be classified as risk seekers, risk

avoiders, or risk bearers.

•A risk seeker is capable of assuming a higher risk

while a risk avoider choose instruments that do not
show much variation in returns.

•Risk bearers fall in between these two categories.

They assume moderate levels of risk.

•Investors can also be classified on the basis of

groups as individuals or institutional investors.
 Objectives of Investment
• Savings are invested in assets depending on their risk and
return characteristics. Thus, the objective of the investor is
to minimize risk involved in investment and maximize the
return.
• Saving kept as cash also loses its value to the extent of rise
in prices. Hence, savings are invested to provide a hedge or
protection against inflation.
Thus, the objectives of an investor can be:
1. Maximization of return
2. minimization of risk
3. hedge against inflation
 Characteristics of Investment
Return
All investments are characterized by the expectation of a
return. The return from an investment depends up on the
nature of the investment, the maturity period and other
factors.
Risk
Risk is inherent in any investment. This risk may relate to
loss of capital, delay in repayment of capital, non-payment
of interest, or variability of returns.
 cont…
The risk of investment depends on the following factors:
1. The longer the maturity period, the higher is the risk
2. The lower the credit worthiness of the borrower, the higher is the risk.
3. The risk varies with the nature of investment.

Safety
The safety of an investment implies the certainty of return of capital without
loss of money and time.
Liquidity
An investment which is easily saleable or marketable without loss of money and
without loss of time is said to posses liquidity.
 Investment vs. Speculation
• These two terms are closely related. Both involve
purchase of assets like shares and securities.
• Speculation is the act of buying and selling commodities,
or securities or other properties in the hope of profit from
anticipated changes in price.
Investment differ from speculation with respect to three
factors: risk, return expectation and time period.
Risk
Risk arises from the possibility of variation in returns from
an investment.
 cont…
• An investor generally commits his funds to low risk
investment, whereas a speculator commits his funds to
higher risk investment.
• A speculator is prepared to take higher risks in order to
achieve higher return.

Return expectation
The speculator’s motive is to achieve profits through price
changes, i.e. he is interested in capital gains rather than
income from investment.
Thus, speculation is associated with buying low and selling
high with the hope of making large capital gains.
 cont…
• Investor in most instances expect an income in addition to
the capital gains that may accrue when the securities are
traded in the market.
Time period
• Investment is long term in nature, whereas, speculation is
short term.

• An investor commits his fund for a longer period and waits

for his return. But speculator is interested in short-term
trade gains through buying and selling of investment
instruments.
 Investment Alternatives
➢ Different types of investment avenues are available for
investors.
➢ The best investment opportunity is the one which
promises safety of principal and a reasonable return.
➢ These investment avenues can be broadly categorized as:
1. Real assets
2. Financial assets
 cont…
➢ Real assets
• Real assets are assets used to produce goods and services.
Such as the land, buildings, machines, etc.
➢ Financial assets are claims on real assets or the income
generated by them.
Investment in financial assets differs from investment in
physical assets in those important aspects:
1. Financial assets are divisible, whereas most physical
assets are not. An asset is divisible if investor can buy or
sell small portion of it.
In case of financial assets it means, that investor, for
example, can buy or sell a small fraction of the whole
company as investment object buying or selling a number of
common stocks.
 cont…
2. Marketability (or Liquidity) is a characteristic of financial
assets that is not shared by physical assets, which usually
have low liquidity.

➢ Marketability (or liquidity) reflects the feasibility of

converting of the asset into cash quickly and without
affecting its price significantly.

Most of financial assets are easy to buy or to sell in the

financial markets.
 cont…
3. The planned holding period of financial assets can be
much shorter than the holding period of most physical
assets.
Investors acquiring physical asset usually plan to hold it for
a long period, but investing in financial assets, such as
securities, even for some months or a year can be
reasonable.
Holding period for investing in financial assets vary in very
wide interval and depends on the investor’s goals and
investment strategy.
 cont…
4. Information about financial assets is often more abundant
and less costly to obtain, than information about physical
assets.
➢ Information availability is the real possibility of the
investors to receive the necessary information which could
influence their investment decisions and investment results.
Since a big portion of information important for investors in
such financial assets as stocks, bonds is publicly available,
the impact of many disclosed factors having influence on
value of these securities can be included in the analysis and
the decisions made by investors.
 Financial Investment Alternatives
The main types of financial investment vehicles are:
1. Short-term vehicles
2. Fixed income securities
3. Common stock
4. Derivative instruments
 Types of short-term investment avenues
The main money market/short term investment alternatives
are:
✓ Certificates of deposit
✓ Treasury bills;
✓ Commercial paper;
✓ Bankers’ acceptances;
✓ Repurchase agreements.
❑Certificate of deposit is debt instrument issued by bank
that indicates a specified sum of money has been deposited
at the issuing depository institution.
 cont…
• Treasury bills (also called T-bills) are securities
representing financial obligations of the government.
• Commercial paper: It is a means of short-term borrowing
by large corporations.
• Banker’s acceptance: is a vehicle created to facilitate
commercial trade transactions.
• Repurchase agreement (often referred to as a repo) is
the sale of security with a commitment by the seller to buy
the security back from the purchaser at a specified Price at
a designated future date.
 Fixed-income securities
• Fixed-income securities are those which return is fixed,
up to some redemption date or indefinitely. The fixed
amounts may be stated in money terms or indexed to some
measure of the price level.
• This type of financial investments is presented by two
different groups of securities:
• • Long-term debt securities
• • Preferred stocks.
 cont…
• Long-term debt securities can be described as long-term
debt instruments representing the issuer’s contractual
obligation. Long term securities have maturity longer than
one year.
• Long-term debt securities are traded in the capital markets.
From the investor’s point of view these securities can be
treated as a “safe” asset. But in reality the safety of
investment in fixed –income securities is strongly related
with the default risk of an issuer.
• The major representatives of long-term debt securities are
bonds
 cont…
• Preferred stocks are equity security, which has infinitive
life and pay dividends.
• Preferred stock is attributed to the type of fixed-income
securities, because the dividend for preferred stock is fixed
in amount and known in advance.
• Though, this security provides for the investor the flow of
income very similar to that of the bond.
• The main difference between preferred stocks and bonds is
that for preferred stock the flows are for ever, if the stock is
not callable.
 Common stock
• The common stock is the other type of investment vehicles
which is one of most popular among investors with long-
term horizon of their investments.
• Common stocks, also known as equity securities or
equities, represent ownership shares in a corporation.
• Each share of common stock entitles its owner to one vote
on any matters of corporate management that are put to a
vote at the corporation’s annual meeting and to a share in
the financial benefits of ownership.
• The two most important characteristics of common stock as
an investment are its residual claim and limited liability
features.
 Derivative Securities
Derivative securities
• Derivative contracts do not have their own independent
values; rather they have derived values from the price of
underlying commodities or financial instruments.
• Derivative instruments are used to provide protection
against certain risks that are not insurable by an insurance
company.
• Such risks include risks associated with a rise in the price
of commodity purchased as an input, a decline in a
commodity price of a product the firm sells, a rise in the
cost of borrowing funds, and an adverse exchange rate
movement.
 cont…
Derivative investment vehicles includes:
✓Forward
✓Futures
✓Options
✓Commodities, traded on the exchange
Forward contract is an agreement between two parties to
exchange an asset for cash at a predetermined future date for
a price that is specified today.
• Future contract is a legal agreement between a buyer
(seller) and an established exchange or its clearing house in
which the buyer (seller) agrees to take (make) delivery of
something at a specified price at the end of a designated
period of time.
 cont…
• An option is a contract in which the writer of the option
grants the buyer of the option the right, but not the
obligation, to purchase from or sell to the writer an asset at
a specified price within a specified period of time (or at a
specified date).

• The writer, also referred to as the seller, grants this right to

the buyer in exchange for a certain sum of money, which is
called the option price or option premium.

• The price at which the asset may be bought or sold is called

the exercise price or strike price.
 1.2. The Asset Allocation Decision
• Asset Allocation: It is the process of deciding how to
distribute an investor’s wealth among different countries
and asset classes for investment purposes.
• Asset Class: It refers to the group of securities that have
similar characteristics, attributes, and risk/return
relationships.
• Investor: Depending on the type of investors, investment
objectives and constraints vary
• Individual investors
• Institutional investors
 The Portfolio Management Process
The investment management process describes how an
investor should go about making decisions.
The investment management process involves the following
steps:
➢ Setting of investment policy.
➢ Analysis and evaluation of investment vehicles.
➢ Formation of diversified investment portfolio.
➢ Measurement and evaluation of portfolio performance.
➢ Portfolio revision
 Setting of Investment Policy
Setting objective: deciding on amount of investment in each
asset class
❖ Setting investment policy begins with a thorough analysis
of the investment objectives of the entity whose funds are
being managed.

❖These entities can be classified as individual investors and

institutional investors. Within each of these broad
classification, there are wide range of investment objectives.
 cont…
• The investment policy should have the specific objectives
regarding the investment return requirement and risk
tolerance of the investor.
• The investment policy should also state other important
constrains which could influence the investment
management.
• Constrains can include any liquidity needs for the investor,
projected investment horizon, as well as other unique needs
and preferences of investor.
• The investment horizon is the period of time for
investments.
 cont…
• The investment policy can include the tax status of the
investor.
This stage of investment management concludes with the
identification of the potential categories of financial assets
for inclusion in the investment portfolio.

The identification of the potential categories is based on the

investment objectives, amount of investable funds,
investment horizon and tax status of the investor.
 cont…
• Setting policy begins with the asset allocation decision.
That is, a decision must be made as to how the funds to be
invested should be distributed among the major classes of
assets.
• The asset allocation will take into consideration any
investment constraints or restrictions.
• In the development of an investment policy, the following
factors must be considered:
i. Client constraints
ii. Regulatory constraints
iii. Tax and accounting issues
 cont…
Client-Imposed Constraints
• Client-imposed constraints would be restrictions that
specify the types of securities in which a manager may
invest and concentration limits on how much or little may
be invested in a particular asset class or in a particular
issuer.

Regulatory Constraints
• There are many types of regulatory constraints. These
involve constraints on the asset classes that are permissible
and concentration limits on investments.
 cont…
• Moreover, in making the asset allocation decision,
consideration must be given to any risk-based capital
requirements.
• For depository institutions and insurance companies, the
amount of statutory capital required is related to the quality
of the assets in which the institution has invested.
• There are two types of risk-based capital requirements:
credit risk-based capital requirements and interest rate risk
based capital requirement.
 cont…
• The former relates statutory capital requirements to the
credit-risk associated with the assets in the portfolio.

• The greater the credit risk, the greater the statutory capital
required.

• Interest rate-risk based capital requirements relate the

statutory capital to how sensitive the asset or portfolio is to
changes in interest rates. The greater the sensitivity, the
higher the statutory capital required.
 cont…

Tax and Accounting Issues

• Capital gains or losses: Taxed differently from
income
• Unrealized capital gains: Reflect price appreciation of
currently held assets that have not yet been sold
• Realized capital gains: When the asset has been sold
at a profit
• Trade-off between taxes and diversification: Tax
consequences of selling company stock for
diversification purposes
 Analysis and evaluation of investment
vehicles
• This step is also known as security analysis
• Security analysis involves the valuation and analysis of
individual securities.
• When the investment policy is set up, investor’s objectives
defined and the potential categories of financial assets for
inclusion in the investment portfolio identified, the
available investment types can be analyzed.
• This step involves examining several relevant types of
investment vehicles and the individual vehicles inside
these groups.
 cont…
• For example, if the common stock was identified as investment
vehicle relevant for investor, the analysis will be concentrated
to the common stock as an investment.
• The purpose of such analysis and evaluation is to identify those
investment vehicles that currently appear to be mispriced.
• There are many different approaches how to make such
analysis.
Most frequently two forms of analysis are used: technical
analysis and fundamental analysis.
❖Technical analysis involves the analysis of market prices in an
attempt to predict future price movements for the particular
financial asset traded on the market.
 cont…
• This analysis examines the trends of historical prices and
is based on the assumption that these trends or patterns
repeat themselves in the future.

❖Fundamental analysis in its simplest form is focused

on the evaluation of intrinsic value of the financial asset.

This valuation is based on the assumption that intrinsic

value is the present value of future flows from particular
investment.
 cont…
• By comparison of the intrinsic value and market value of
the financial assets those which are under priced or
overpriced can be identified.

• This step involves identifying those specific financial

assets in which to invest and determining the proportions
of these financial assets in the investment portfolio.
 Formation of diversified
investment portfolio
• This step is also known as portfolio construction
• Investment portfolio is the set of investment vehicles
• In the stage of portfolio formation the issues of selectivity,
timing and diversification need to be addressed by the
investor.
• Selectivity refers to micro forecasting and focuses on
forecasting price movements of individual assets.
• Timing involves macro forecasting of price movements
of particular type of financial asset relative to fixed-income
securities in general.
 cont…
• Diversification involves forming the investor’s portfolio for
decreasing or limiting risk of investment.
Techniques of diversification:
• Random diversification, when several available financial
assets are put to the portfolio at random;
• Objective diversification when financial assets are selected
to the portfolio following investment objectives and using
appropriate techniques for analysis and evaluation of each
financial asset.
• Investment management theory is focused on issues of
objective portfolio diversification and professional investors
follow settled investment objectives then constructing and
managing their portfolios.
 Measurement and evaluation of portfolio
performance
• This is the last step in investment management process
which involves determining periodically how the portfolio
performed, in terms of not only the return earned, but also
the risk of the portfolio.
• For evaluation of portfolio performance appropriate
measures of return and risk and benchmarks are needed.
• A benchmark is the performance of predetermined set of
assets, obtained for comparison purposes. The benchmark
may be a popular index of appropriate assets – stock index,
bond index.
 cont…
• It is important to point out that investment management
process is continuing process influenced by changes in
investment environment and changes in investor’s attitudes
as well.

• Market globalization offers investors new possibilities, but

at the same time investment management become more and
more complicated with growing uncertainty.
 Portfolio revision

• This step of the investment management process concerns

the periodic revision of the three previous stages.

• This is necessary, because over time investor with long-

term investment horizon may change his / her investment
objectives and this, in turn means that currently held
investor’s portfolio may no longer be optimal and even
contradict with the new settled investment objectives.
 cont…
• Investor should form the new portfolio by selling some
assets in his portfolio and buying the others that are not
currently held.

• The other reasons for revising a given portfolio could be :

over time the prices of the assets change, meaning that
some assets that were attractive at one time may be no
longer be so.
 cont…
• For institutional investors portfolio revision is continuing
and very important part of their activity. But individual
investor managing portfolio must perform portfolio revision
periodically as well.

• Periodic re-evaluation of the investment objectives and

portfolios based on them is necessary, because financial
markets change, tax laws and security regulations change,
and other events alter stated investment goals.
 1.3. Investment income and return
❖ Risk and return are the two most important attributes of
an
investment.
❖ Risk and return are linked in the capital markets and that
generally, higher returns can only be achieved by taking on
greater risk.
➢ Risk isn’t just the potential loss of return, it is the potential
loss of the entire investment itself (loss of both principal
and interest).
 Return- An Overview and components

➢Return is a reward and motivating force behind every

investment.
➢In finance, rate of return (ROR), also known as return on
investment (ROI), rate of profit or sometimes just return, is
the ratio of money gained or lost (whether realized or
unrealized) on an investment relative to the amount of
money invested.
➢The amount of money gained or lost may be referred to as
interest, profit/loss, gain/loss, or net income/loss.
 Components of investment return
Return on investment has two components:
1. Regular income in the form of interest or dividend and;
2. Capital appreciation (an increase/decrease) in price).

• Return in the form of income: cash payments, usually

received regularly over the life of the investment; such as
interest payments from bonds, Common and preferred stock
dividend payments.
• Return in the form of capital appreciation: Investors also
experience capital gains or losses as the value of their
investment changes over time.
 cont…
➢For example, a stock may pay a $5 dividend per year
while its value may falls from $100 to $90 or increase to
$110 over the same time period.

➢Return on investment should be adjusted to the following

factors:
1. The Real Risk-Free Interest Rate
It is the rate of return an investor can earn without any risk
in a world with no inflation. That is, it assumes no
inflation and no uncertainty about future cash flows
2. An Inflation Premium
This is the rate that is added to an investment to adjust it for
the market’s expectation of future inflation.
 3. A Liquidity Premium

➢Thinly traded investments such as stocks and bonds require

a liquidity premium.

➢That is, investors are not going to pay the full value of the
asset if there is a very real possibility that they will not be
able to dump the stock or bond in a short period of time
because buyers are scarce.
4. Default risk premium
➢ When signs of trouble appear, a company’s shares or
bonds will collapse as a result of investors demanding a
default risk premium.
➢ If someone were able to acquire assets that were trading
at a huge discount as a result of a default risk premium
that was too large, they could make a great deal of
money.
5. Maturity Premium
➢ The further in the future the maturity of a company’s
bonds, the greater the price will fluctuate when interest
rates change. That’s because of the maturity premium.
 Factors Determining The Return on Investment
The following are the major factors determining a return on
investment:
1. Price of the stock
A return on investment in bond carry fixed rate of interest
which is expressed as a percentage on the face value of
securities.
However, investment in equities do not carry any fixed rate
of dividend, its return depends on the profitability of the
company during the fiscal year.
2. Type of the stock
The return on investment also varies according to the type of
securities.
 cont…
3. Issue price of shares
Shares are issued by the company on different terms.
Shares may be issued at par where the issue price is equal to
the face value of the share.
Shares may also be issued at discount where the issue price
is less than the face value .
Companies also issue shares at premium, where issued price
is higher than the face value of the share.
Thus, the issue price of shares at premium generally
indicates the financial soundness and profitability of the
company.
 cont…
4. Future projects of the company
A company may have several future plans such as
investment, diversification program, production capacity,
technical methods, change in capital structure, etc.
Thus, return on investment varies depending upon the
projects undertaken by the company.
5. Goodwill of the company
Goodwill represents the profitability of the company and its
reputation among the public.
And hence, investors rely on goodwill as it indicates the
regularity with which they can receive their income from
the company by investing in its securities.
 Investment Risk
➢ Risk is the uncertainty associated with the return on an
investment.
➢ Risk is the variability of return .
➢ An investment whose returns are fairly stable is
considered to be a low-risk investment, where as an
investment whose returns fluctuate significantly is
considered risky investments.
➢ Those who do not tolerate risk very well have a relatively
smaller chance of making high earnings than do those
with a higher tolerance for risk.
 Cause of Risk
The cause of risk in investment are price, interest and
internal as well as external forces.
Factors causing internal risks are limited to industry and are
called unsystematic risks.
On the other hand, external risks are beyond the control of
the company and are called systematic risks.
Factors causing internal risks:
✓incorrect decision taken with regard to investment
✓Failure to judge the correct timing of investment
✓Maturity period
✓Amount of investment
✓Nature of business
 Types of Risks
➢There are a number of different types of risk that can
affect investments.
➢While some of these risks can be reduced through a
number of avenues - some of them simply have to be
accepted and planned for in any investment decision.
➢Risks can be broadly classified into two main types,
these are systematic risk and unsystematic risk.
Systematic risk is the risk that cannot be reduced or
predicted in any manner and it is almost impossible to
predict or protect.
 Systematic risk
• When a change occur in economic, political and social
systems is has an influence on the performance of
companies and thereby on their stock prices.
• These changes affect all companies and all securities in
varying degrees.
• Thus, systematic risk is the total variability in security
returns caused by such system wide factors.
• Systematic risks are non-diversifiable
• These risks are further classified into interest rate risk,
market risk and purchasing power risk.
 cont…
Interest rate risk
➢Interest rate risk is the sensitivity of the change in an asset’s value to changes in
market interest rates.
➢ Interest rate risk affects particularly debt securities like bonds.
➢A bond normally has a fixed coupon rate of interest. Subsequent to the issue, the
market interest rate may change but the coupon rate remains constant till the
maturity of the instrument.
Note that market interest rates determine the rate we must use to discount a
future value to a present value.
The value of any investment depends on the rate used to discount its cash flows
to the present. If the discount rate changes, the investment’s value changes.
 cont…
Market risk
• Market risk is the fluctuations or volatility increases and
decreases in price of securities in day-to-day market.
• Market risk arises out of changes in the pattern of demand
and supply in the market which is based on the changing
flow of information or expectation
• The short term volatility in the stock market is caused by
the sweeping changes in investor’s expectations which are
the result of investor reactions.
• the bases of their reaction may be a set of real tangible
events, political, economic or social, such as the fall of the
government, drastic change in monetary policy, etc.
 cont…
• But the reaction is often aggravated by the intangible factor of
emotional instability of investors.
• If the stock market is volatile, it leads to variations in the
returns of investors in shares. Thus, market risk is variation in
returns caused by the volatility of the stock market.
Purchasing power risk

• Is the variation in investor return caused by inflation.

• is the risk that the price level may increase unexpectedly.

• Inflation results in lowering of the purchasing power of money.

 cont…
• When an investor purchases a security, he foregoes the
opportunity to buy some goods or services.
Meanwhile, because of inflation the prices of goods and
services would increase and thereby the investor actually
experiences a decline in the purchasing power of his
investment and the return from the investment.
• The two important source of inflation are rising costs of
production and excess demand for goods and services in
relation to their supply.
• Hence, in an inflationary economy, rational investors
would include an allowance for the purchasing power risk
in estimating the expected rate of return from an
investment. i.e, the expected rate of return would be
adjusted by estimated annual rate of inflation.
 Unsystematic risk
• Unsystematic risk is also called diversifiable risk or non
market risk.
• Unsystematic risk arises out of uncertainty surrounding a
particular firm or industry.
• Unsystematic risk can be minimized or eliminated through
diversification of security holdings.
• It represents the portion of an investment risk that can be
eliminated by holding diversified stocks.
• This risk is due to management changes in the company,
labor problems, strikes etc.
 cont…
• Unsystematic risk arises from three sources: business risk,
financial risk and default or insolvency risk.
I. Business risk
• Business risk arises due to the uncertainty of income
caused by the nature of a company’s business measured by
a ratio of operating earnings (income flows of the firm).
▪It relates to the variability of the business, sales, income,
expenses, and profits.
▪It depends upon the market conditions for the product mix,
input supplies, strength of the competitors etc.
 cont…
II. Financial risk
• Financial risk is the risk that a firm will be unable to meet
its financial obligations.
• It is the risk borne by equity holders (refer Shares section)
due to a firms use of debt.
• This risk is primarily a function of the relative amount of
debt that the firm uses to finance its assets.
• A higher proportion of debt increases the likelihood that at
some point the firm will be unable to make the required
interest and principal payments.
 Cont…
III. Default risk
Default risk or credit risk means the failure of the borrowers
to pay the interest and principal amount within the
stipulated period of time.
It means not only failure to pay, but also delay in payment.
when you invest in a bond, you expect interest to be paid
(usually semiannually) and the principal to be paid at the
maturity date.
However, the more burdened a firm is with debt required
interest and principal payments the more likely it is that
payments promised to bondholders will not be made and
that there will be nothing left for the owners.
 cont…
Other risks
➢ Liquidity Risk –The uncertainty introduced by the
secondary market for a company to meet its future short
term financial obligations.
➢ Political Risk - it is the risk of investing funds in another
country whereby a major change in the political or
economic environment could occur.
➢ Exchange Rate Risk - The uncertainty of returns for
investors that acquire foreign investments and wish to
convert them back to their home currency.
 Measuring Historical Investment Returns
➢There are many ways to measure the historical rate of return
on an investment.
• The simplest measure is the holding period return (HPR):
measures the total return from an investment during a given or
designated time period in which the asset is held by the
investor.
HPR= Ending Value of Investment
Beginning Value of Investment
• However, investors generally evaluate returns in percentage
terms on an annual basis, i.e holding period yield (HPY),
defined as the percentage increase or decrease in the capital
from the beginning of the period to the end of the period.
Total Return = (Ending Capital / Starting Capital) – 1 or
Total Return = [(1+ R1)* (1+ R2)* (1+ R3)*…*(1+ RN)] –1
 Cont..,
➢Holding Period Yield (HPY): Yield is the promised
rate of return on investment under certain
assumptions.
HPY=HPR-1
• Annual HPR and HPY
Annual HPR=HPR1/n
Annual HPY= Annual HPR -1=HPR1/n – 1
where n=number of years of the investment
 Cont..,
• Holding period return is the total return from an
investment , including all sources of income, for a given
period of time.
A value of 1.0 indicates no gain or loss. It is equal to ending
wealth /beginning wealth.
• Holding period yield is the total return from an investment
for a given period of time stated as percentage; equal to
HPR-1.
 Cont…
Example
➢A $1,000 investment portfolio grows to $1,500 at the end
of one year (a 50% increase) and ends up at $1,800 at the
end of the second year (an additional 20% increase over its
$1,500 value at the end of the first year).
➢For the above Example,
Total Return = ($1800 /$1,000) – 1 = 1 = 80%
➢Alternatively, we could use the two annual returns to get
the same result:
Total Return = (1 + 50%) * (1 + 20%) – 1 = 1 = 80%
 Comparing Investment Returns for Periods of Different
Length
Average Annual Return = Sum of Annual Returns / Number
of Years
➢For N years with returns R1, R2, R3, and RN, the average
annual return is:
Average Annual Return = (R + R2 + R3 +...+ RN) / N
Considering the above example,
Average Annual Return = (50% + 20%) / 2 = 70% / 2
= 35%
 Measuring historical risk
➢Risk refers to the possibility that the actual outcome of
the investment will differ from the expected outcome.
Variance and standard deviation
➢The most commonly used measures of risk in finance are
variance or its square root the standard deviation.
➢Standard Deviation - Standard deviation is a measure of
how dispersed the investment’s returns are from its
arithmetic mean.
➢It is derived by calculating the square root of the
difference of the returns of the investment from its
arithmetic mean.
 Cont…
➢ The variance and standard deviation of historical return
series are defined as follows:
σ2=∑n(Ri – E(R) )2
i=1 (n-1)

➢ To illustrate, consider returns from the stock over a six

years period.R1 = 15%, R2 =12%, R3 = 20%, R4 =10% R5
=4%and R6 =9%.
➢ The variance and standard deviation of return are
calculated as below:
Cont…
Period Return Ri Deviation Square of
(Ri-m ) deviation (Ri-
R)
1 15 5 25
2 12 2 4
3 20 10 100
4 -10 -20 400
5 14 4 16
6 9 -1 1
m=10
 Measuring expected (ex ante) return and risk
• In previous examples, we discussed realized historical
rates of return. In contrast, an investor would be more
interested in the expected return on a future risky
investment.
• Risk is the uncertainty that an investment will earn its
expected rate of return.
• Risk refers to the uncertainty of the future outcomes of an
investment
• There are many possible returns/outcomes from an
investment due to the uncertainty
• Probability is the likelihood of an outcome
• The sum of the probabilities of all the possible outcomes
is equal to 1.0.
 Cont..,
Expected return
• It is the weighted average of all possible returns
multiplied by their respective probabilities.
n
E(r) =  PI RI
i=1

• E (r) = Expected return

• Ri = return for the i th possible outcome
• pi = probability associated with Ri
• n = no. of possible outcome
 Cont..,

E r  = P1r1 + P2 r2 + P3r3 + ...Pn rn

n
=  Pi ri
i =1

E r  = 0.333  0.33 + 0.333  0.12 + 0.333  (−0.09) = 0.12 = 12%

 Exercise
• Assume that stock of ABC com. respond to the state of
the economy according to the following table

• What is the expected return of A and B

 Risk

• Risk of security can be analyzed in two ways:

(1) on a stand-alone basis, where the asset is

considered in isolation, and

(2) on a portfolio basis, where the asset is held as one

of a number of assets in a portfolio.

• Thus, an asset’s stand-alone risk is the risk an investor

would face if he/she held only one asset / risk for
individual asset.
 Measuring stand-alone risk
▪ The most popular measure of dispersion or risk is
Variance or standard deviation
▪ Variance -measures the stand-alone risk of an
investment.
o Measures the squared deviations of a security’s return
from its expected return
▪ it may be defined as extent of variability or deviations
(or dispersion) of possible returns from the expected
return
Cont..,

• Variance= 2
✓Risk of single asset is Calculated by

n
σ 2
= 
i =1
pi ( ri − E ( r )) 2
Example

E rs  =  Pi ri = 14.1%
n

i =1

 Pi (ri − E r )2
n
 =
S
i =1

 = 0.4  (0.33 − 0.141) + 0.3  (0.12 − 0.141) + 0.3  ( −0.09 − 0.141) 2

2 2
S

S = 0.0304 = 0.174
Coefficient of Variation
The ratio of the standard deviation of a distribution to
the mean of that distribution.
It is a measure of RELATIVE risk.

CV= 0.0304/0.141 = 21.56%