Introduction/ p.

1 of 9 ECN4141 Financial Economics

INTRODUCTION

INVESTMENT
Postponement of current consumption in order to have
higher future consumption.

WHY INVEST?
To earn return from saving
- Time period
- Expected inflation
- Risk (Uncertain future income)

Required rate of return – return that compensate for time

period, expected inflation and risk.

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Introduction/ p. 2 of 9 ECN4141 Financial Economics

Return and Risk

Holding Period Return (HPR)

HPR = Ending value / Beginning value

Example:
Invest $200 at the beginning of year and collect 220 at the
end of year.

HPR = 220/200
= 1.10

Holding Period Yield (HPY)

HPY = HPR –1

HPY = 1.10 –1 =0.10

= 10%

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Annual HPY (AHPY)

AHPY = AHPR –1 ; AHPR = Annual HPR

AHPR = HPR 1/n ; n = investment period

Example:
Invest $250 and after two year the investment value
increases to $350.

HPR = Ending value/ beginning value

= 350/250
=1.40

AHPR =1.40 1/n

=1.40 ½
=1.1832

AHPY = 1.1832 –1
= 0.1832
=18.32%

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Introduction/ p. 4 of 9 ECN4141 Financial Economics

Mean Rate of Return

- Arithmetic mean (AM)

- Geometric mean (GM)

a) Single investment
AM =  HPY / n
GM =  (HPR )  1
1/ n

Where  = product of HPR: (HPR1) x (HPR2) x…..

(HPRn)

Example:

Year Beginning value Ending value HPR HPY

1 100 115 1.15 0.15
2 115 138 1.20 0.20
3 138 110.4 0.8 -0.20

AM = [(0.15) +(0.20)+(-0.20)]/n
= 0.15/3
=0.05 = 5%

GM = [(1.15) x (1.20) x (0.80)] 1/3 –1

= (1.104) 1/3 –1
= 1.03353 –1
= 0.03353
= 3.353%

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b) Portfolio investment

i) HPY

Investment Begin End HPR HPY Weight Weighted

value value HPY
A 1000 1200 1.20 10% 0.05 0.01
B 4000 4200 1.05 5% 0.20 0.01
C 15,000 16500 1.10 10% 0.75 0.075
Total 20,000 21,900 0.095

21,900
HPR= 20,000 =1.095

HPY = 1.095 – 1 =0.095 = 9.5%

ii) Expected Return (E(R))

n
E (R) =  (return probability x Return)
i 1

E(Ri) = [(P1)(R1) + (P2)(R2) + …….. + (Pn)(Rn)]

n
E(Ri) =  (Pi )(R i )
i 1

Example:

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Introduction/ p. 6 of 9 ECN4141 Financial Economics

Economic situtation Probalility (Pi) Return(Ri)

Strong, no inflation 0.15 0.20

Weak, above-avg inflation 0.15 -0.20
No major change 0.70 0.10

E(Ri)= [(0.15)(0.20) + (0.15)(-0.20) + (0.70)(0.10)]

= 0.07
= 7%

iii) Variance (  2 ) =
n
2
 Pr obability  (Re turn  Expected Re turn )
i 1
n
 Pi  (R i  E(R i ) 2
i 1

Example:
n
 2
= Pi  (R i  E(R i ) 2
i 1

= [(0.15)(0.20 –0.07)2 + (0.15)(-0.20-0.07)2

+ (0.7)(0.10-0.17) 2
= [0.010935 + 0.002535 + 0.00063]
= 0.0141

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Introduction/ p. 7 of 9 ECN4141 Financial Economics

iv) Standard deviation

n
 =  Pi (R i  E(R i ) 2
i 1

Example:

 = 0.0141
= 0.11874

v) Coefficient of Variation (CV)

Std Dev of Re turn

CV = Expected Re turn

i
CV = E (R )

Example:
0.11874
CV = 0.0700
= 1.696

DETERMINANT OF REQUIRED RATE OF RETURN

1) Real Risk-Free Rate (RRFR)

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 Exchange rate in situation where there is no

inflation and no risk
 time frame
 alternative investments

2) Nominal Risk-Free Rate

 NRFR = (1 + RRFR)(1 + Expected Inflation) - 1
 Ease or tightness of capital market
 Expected rate of inflation

3) Risk Premium (RP)

 Business Risk
- Firm’s cash flows

 Financial Risk
- Firm’s financial resources

 Liquidity Risk
- Ease to buy/sell security

 Exchange Rate Risk

- Foreign security

 Country / Political Risk

- Political stability

RP = f (Business, financial, liquidity, exchange rate

country risks)
RELATIONSHIP BETWEEN RISK AND RETURN

Security Market Line (SML)

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 Show the risk-return combination of all risky assets

in capital market at a particular time.

E(R) Low risk Moderate High

risk risk

NRFR

Risk

Risk premium for an asset:

RPi = E(Ri) – NRFR

Market Risk premium:

RPm = E(Rm) - NRFR