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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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Investment Analysis and
Portfolio Management
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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Investment Analysis and
Portfolio Management
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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Investment Analysis and
Portfolio Management
!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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Investment Analysis and
Portfolio Management
● 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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Investment Analysis and
Portfolio Management
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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Investment Analysis and
Portfolio Management
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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Investment Analysis and
Portfolio Management
$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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Investment Analysis and
Portfolio Management
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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Investment Analysis and
Portfolio Management
%olding Period &eturn
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Investment Analysis and
Portfolio Management
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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Investment Analysis and
Portfolio Management
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Investment Analysis and
Portfolio Management
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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Investment Analysis and
Portfolio Management
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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Investment Analysis and
Portfolio Management
$herefore: +*< 0$otal1 ? +*< 0*rice 'ncrease1 @ +*< 0Div1
>5 ? 4>5 @ +*< 0Div1
45 ? +*< 0Dividends1
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Investment Analysis and
Portfolio Management
closing price B opening price
Return ?
pening *rice
88 % 85
Return for anuary ?
85
? 45 or 45
imple &eturn
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Investment Analysis and
Portfolio Management
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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Investment Analysis and
Portfolio Management
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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Investment Analysis and
Portfolio Management
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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Investment Analysis and
Portfolio Management
<ear Actual Return
4 545
54;
7 55
8 55=
$otal 577
Average &eturn ' (.))*+
' (.(,-
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Investment Analysis and
Portfolio Management
$he Ereek letter pi stands for product summation $his means that instead of
adding values in the series, they are multiplied $he rest of the e"uation indicates
that after multiplying the return, we take the nth root of the product, where n is the
number of terms in the series
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Investment Analysis and
Portfolio Management
Calculating the geometric means of a series of a return has a potential problem
because returns are often negative 'f the number of negative returns in a series is
odd, there product will be negative and negative number does not have an even
root
't is easy to eliminate the problem by converting security returns into returnrelatives before calculating the statistics on them
A return relative is simply the return plus 4
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Investment Analysis and
Portfolio Management
During the past five years, you owned two stocks that had the following
annual rates of return:
/ear tock 0 tock 14 549 55>
55> 557
7 B54 B559
8 B557 55
; 54; 558
Compute the geometric mean annual rate of return for each stock
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Investment Analysis and
Portfolio Management
E#$ ? 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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Investment Analysis and
Portfolio Management
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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Investment Analysis and
Portfolio Management
$toc% & is 'ore (esirable beca#se the arith'etic 'ean ann#al rate o) ret#rn
is higher.
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Investment Analysis and
Portfolio Management
"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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Investment Analysis and
Portfolio Management
"xpected &ates of &eturn
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Investment Analysis and
Portfolio Management
S/ *robability *ossible Return
&# ;5 G5
Recession ;5 %5
"xpected &ates of &eturn
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Investment Analysis and
Portfolio Management
S/ *robability *ossibleReturn
/pected Return
&# 5;5 5G5 57;
Recession 5;5 %55 %545
5;
"xpected &eturn
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Investment Analysis and
Portfolio Management
State of /conomy *robability *ossible Return
&oom ; 45
Recession ; 7
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Investment Analysis and
Portfolio Management
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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Investment Analysis and
Portfolio Management
● &isk Free &ate of &eturn 2&F&3
● Market &ate of &eturn 2M&3
● &e#uired &ate of &eturn
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Investment Analysis and
Portfolio Management
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Investment Analysis and
Portfolio Management
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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Investment Analysis and
Portfolio Management
State of /conomy *robability Poss
ible &eturn
Stock A Stock & Stock C
&oom 85 45 4; 5
Recession =5 5> 58 5
'nvestment Criteria
;5 'nvestment in Stock A
; 'nvestment in Stock &
; 'nvestment in Stock C
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Investment Analysis and
Portfolio Management
"xpected Portfolio &eturn
&oom ;5L 45 @;L4;@;L5
5;@57G;@5; ?47G;
Recession ;5L5>@;L58@;L5 ? 5;
State of /conomy *robability &eturn
Stock A Stock & Stock C
&oom 85 45 4; 5
Recession =5 5> 58 5
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Investment Analysis and
Portfolio Management
Probabilit* *ortfolio Return
&oom 85 47G;
Recession =5 5;
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Investment Analysis and
Portfolio Management
/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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Investment Analysis and
Portfolio Management
tock !85L5 ?5>
=5L5 ?55
?5>
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Investment Analysis and
Portfolio Management
"xpected &eturn of Portfolio1ased on Investment !riteria
;5L5>> ? 588
;L5>8 ? 54
;L5> ? 5
? 5>;
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Investment Analysis and
Portfolio Management
Probabilit* *ortfolio Return AverageReturn
&oom 85 47G; 5>;
Recession =5 5; 5>;
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Investment Analysis and
Portfolio Management
Annuali-ed Rate of Return ? Average #onthly Return L 4
Annuali4ed &ate of &eturn
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Investment Analysis and
Portfolio Management
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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Investment Analysis and
Portfolio Management
/0R #&C1? 0751 0%451 @ 0451 05551 @ 0751 0451 @ 0751 0;1
? 0%571 @ 555 @ 57 @ 5G;
? 5G;
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Investment Analysis and
Portfolio Management
!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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Investment Analysis and
Portfolio Management
I A l i d
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Investment Analysis and
Portfolio Management
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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Investment Analysis and
Portfolio Management
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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Investment Analysis and
Portfolio Management
$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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Investment Analysis and
Portfolio Management
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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Investment Analysis and
Portfolio Management
<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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Investment Analysis and
Portfolio Management
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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Investment Analysis and
Portfolio Management
$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