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The Investment Setting (Chapter 1) - Coggle Diagram
The Investment Setting (Chapter 1)
investment
what you do with savings to make them increase over time
reasons for savings: trade-off present consumption for a higher level of future consumption
current commitment of dollars for a period of time in order to derive future payments
compensate the investor for:
expected rate of inflation during this time period
uncertainty of future payments
time the funds are committed
pure rate of interest: rate of exchange between future consumption and current consumption
pure time value of money:
-people's willingness to pay the difference for borrowed funds
-desire to receive a surplus on their savings give rise to an interest rate
uncertainty
demand an interest rate > nominal risk-free interest rate
investor: trading a known dollar amount today for some expected future stream of payments that will be greater than the current dollar amount today
government
pension fund
individual
corporation, etc.
measures of return and risk
average rate of return
portfolio of investments
weighted average of the HPYs for the individual investment
overall % change in the value of the original portfolio
weights used in computing the averages are the relative beginning market values for each investment
traditional measures of risk
variance and standard deviation
variance = sum of (probability) x (possible return - expected return)^2
standard deviation = root variance
coefficient of variation (CV) = standard deviation of returns / expected rate of return
risk of returns = (sum of (HPYi - E(HPY)^2) / n
HPY i = holding period yield during period i
E (HPY) = the expected value of the HPY = arithmetic mean of the series (AM)
n = number of observations
average historical rate of return
individual investment over a number of periods
arithmetic mean return (AM) = (sum of HPY) / n
geometric mean return (GM) = (π HPR)^1/n - 1
expected rate of return
for an investment
expected rates of return = sum of (probability of return) x (possible return)
historical rate of return
individual investment over holding period
annual HPR = HPR^1/n (n = no of years of investment)
annual HPY = annual HPR - 1
holding period yield (HPY) = HPR - 1
holding period return (HPR) = ending value of investment / beginning value of investment
risk-free rate
real risk-free rate (RRFR) = ((1 + NRFR of return) / (1 + rate of inflation)) -1
nominal risk-free rate (NRFR)
conditions in the capital market
expected rate of inflation
NRFR = ((1+RRFR) x (! + expected rate of inflation)) - 1
RRFR = ((1 + NRFR of return) / (1 + rate of inflation)) - 1
real rate of inflation = HPR / (1 + rate of inflation) - 1
expected rate of inflation
common effect
relative ease of tightness in the capital markets
Security Market Line (SML): reflects the combination of risk and return available on alternative investments
changes in SML
changes in the attitudes of investors toward risk
change in the RRFR or the expected rate of inflation (anything that can change in the MRFR)
changes in the perceived risk of the investments
changes in the slope of the SML
compute a risk premium (RP) for an asset
RPi = E(Ri) - NRFR
RPm = E(Rm) - NRFR
changes in expected real growth, capital market conditions or expected inflation
movement along the SML
demonstrates a change in the risk characteristics of a specific investment
risk premium
exchange rate risk
country risk
financial risk
liquidity risk
business risk