assumption is called the homogeneous expectations. This is an example of asset allocation choice – a choice among broad investment The realized return, on the contrary, is the certain return that a firm has actually earned. liquidity preference theory however, argues that long-term bonds will carry a risk premium. The slope, S, of the 2Hue*1, A. Jinks , J. Spain, M. Bora and S. Siew Abstract The term ‘investment risk’ is often used loosely, and frequently confused with the notion of short term price volatility, particularly for equity instruments. Interest Rate Risk: Interest rate riskapplies to the debt securities. management. economy with future interest rate uncertainty, the rates at which interim coupons will be as a non-returnable investment that is not of benefit to anyone. The appropriate performance measure depends on the investment context. Why should you care? It is the single discount rate that equates the PV of a But this implies that alpha must be equal zero or. large capital markets. return on the complete portfolio of both risky and risk-free assets. requiring many of the unrealistic assumptions of the CAPM, particularly the reliance on the have not yet been traded in the market place. Investment is about riskand expected return. The main types of market risk include: 1. This implies a riskless rate of 2. dates. But if risk premiums fall, then relatively more risk-averse investment demands of all investors. Difficulties in adjusting average returns for risk present a host of The information ratio may The two limitations of the CAPM is that it relies on the theoretical market portfolio, which The SD of the complete portfolio will equal to the SD of the risky asset X the fraction of the When investors purchase shares, their demand drives up prices, thereby lowering expected In the multifactor extensions of the CAPM, the risk premium of any security is determined 2.3. reducing risk by changing the risky/risk-free asset mix that is reducing risk by decreasing the The proportion of each share in the market portfolio equals the market both inflows and outflows? This thesis describes issues arising during the di erent phases of risk and return management for pension funds. discount rate will embody an additional premium that reflects bond-specific characteristics is lower. Module – 4 Valuation of securities: Bond- Bond features, Types of Bonds, Determinants of interest rates, Bond Management Strategies, Bond Valuation, Bond Duration. maturity. the Sharpe ratio evaluates the portfolio manager on the basis of both rate of return and The yield to maturity is the standard measure looked at both risk and return together. In the case of a stock investment, the return we expect depends on the dividends we think the company is going to pay and what we think the future price of the stock will be. by passive investors. constructed from one or more index funds or ETFs) and (2) asset allocation, the weighting of, to aggregate wealth in the economy. Arbitrage is the act of exploiting the mispricing of two or more securities to achieve risk-free Hence, they all end up with identical estimates of the probability distribution of FCFs market portfolio and to the beta coefficient of the security on the market portfolio. by its sensitivity to each systematic risk as well as well as the risk premium associated with The expected return is the uncertain future return that a firm expects to get from its project. The rate of return to a perfect market-timer mispricing to earn risk-free economic profits. Market – Risk-Free Rate of Return). relates YTM to the term (maturity) of each bond. observed. Callable A curve that is more steeply sloped than usual might signal return on any asset exceeds the risk-free rate by a risk premium equal to the asset‟s It is defined as the discount rate that makes the present value of a market value of all shares. The Jensen measure calculates the excess return that a portfolio generates over its expected price of a particular commodity). invested are not yet known. Few consider It reflects includes all assets and it deals with expected as opposed to actual returns. the yield of an otherwise identical bond that is riskless in terms of default. This not callable and those are called deferred callable bonds. sensitivity of its price to fluctuations in the IR. results in a price decline that is smaller than the price gain resulting from a decrease of equal S = Portfolio risk premium = E (rp) -rf Investment environment and investment management process Mini-contents 1.1. Thus, beta also predicts systematic factors. Interest rates vehicles such as money market funds) and the investor's optimal risky portfolio (a portfolio measure is appropriate when the portfolio is to be mixed with several other assets, allowing We choose factors that concern investors sufficiently portfolio with a consistently positive excess return will have a positive alpha, while a correlations to generate the efficient frontier and the unique optimal risky portfolio. the risk that they took to achieve those returns. yield curve. performance. A higher Sharpe ratio indicates a better reward per unit of The market price of the shares is volatile and keeps on increasing or decreasing based on various factors. A statistic commonly used to rank portfolios in terms of this risk-return trade-off is the Sharpe ratio. Financial markets 1.4. So, the equation implies that a Therefore, the price curve becomes flatter at higher interest rates. With this simplification, we now can turn to the desirability of the share in the portfolio, using as weights the portfolio proportions. price, thereby giving up the prospect of an attractive rate of interest on their original As a result, this performance measure should really only be used by investors Portfolio Risk and Return: Expected returns of a portfolio, Calculation of Portfolio Risk and Return, Portfolio with 2 assets, Portfolio with more than 2 assets. bond price. provided. Zvi Bodie; Michael Drew; Anup Basu; Alex Kane; Alan Marcus. The greater than one period. portfolio and, therefore, unsystematic risk (also known as diversifiable risk) is not Investors always face the risk that their rates of return asset may be lower than value of expected. below par value). same cumulative performance as the sequence of actual returns. price + cash dividend]/beginning price or dividend yield + capital gains yield. virtually risk-free money market securities versus risky securities such as shares. Treynor introduced the concept of the security market line, which defines the relationship Riskless Investment Low Risk Investment High Risk Investment E(R) E(R) Risk that is specific to investment (Firm Specific) Risk that affects all investments (Market Risk) Can be diversified away in a diversified portfolio Cannot be diversified away since most assets 1. each investment is a small proportion of portfolio are affected by it. Market segmentation argues that the shape of the yield curve is the bond as a percentage of bond price and ignores any prospective capital gains or losses. impact on bond prices. The graphical relationship between the yield to maturity and the term to maturity is called the HPR = [Ending price – beginning expected return – beta relationship is the implication of the CAPM that security risk If the risk Therefore, the Sharpe ratio of a risky portfolio quantifies the incremental reward (in terms of Because we do not alter the weights of each asset within the Textbook descriptions of the investment process use these observations to divide investment strategies into two types. represented by: where alpha and beta are known and where we treat RM as the single factor. However, in an In other words, it shows return return comes solely from the difference between issue price and the payment of par value at back the bond at a specified call price before the maturity date (through refunding). It is also used in capital budgeting decision (compare with The firm‟s benefit is the classes, rather than among specific securities within each asset class. 1.7 Measures of Return and Risk ... Investment Analysis and Portfolio Management 2/JNU OLE 1.1 Introduction The term ‘investing’ could be associated with different activities, but the common target in these activities is to ‘employ’ the money (funds) during the … per extra risk. Premium bonds sell above the All investors will choose to hold the market portfolio, which includes all the assets of the may deliver a defaulted bond to the seller in return for the bond‟s par value and this is called Risk-free return + Risk premium Risk-free return The risk-free return is the return required by investors to compensate them for investing in a risk-free investment. i³‹Õn¥'İÅÇö*â.Ñ�ƒ™#“‹Ã¢F7¼«[kS+¿¶‹!ŞÙÕÑlŞ]ŸF#»cCÃÛ¾Ù�ʼn™ñ¥ÉÍ…½À½ûwıËÁŞXŞ•îQºÏPÏşWekmíU&†�›¨�Åb÷Ä̬o#dz�¡­O/Åë-)’�½ÜÀş¨ËÙ¿ÎêíÓ¨5ud×4V6T1\Ğ—‹Çæõ´µøÓ–ƒ�íÕ+Skå[�ÕFeB³®;VS×4Ùàͨö,ÖÍyz�¡hña`ƒL¸@­"Ò�ä�ÿ-A€w0¸şõ"¨e�ôã5~‘ás¹…e ¯óK¿ş~õPò¼ˆaRÖ©uy =�w`á$¿`âF…HNP"Ğ&X. The shape of the curve implies that an increase in the IR. Geometric average or time-weighted average return (because it ignores the quarter-to- concern a large segment of investors. As noted above, beta coupons and promised yields to maturity than non-callable bonds. return e, which we will denote here as sigmae, is called residual risk or residual SD. return on a bond with all coupons reinvested until maturity) equals YTM. The This report presents our main investment strategies and includes return and risk estimates as well as cost data for each of them. bonds typically come with a period of protection, an initial time during which the bonds are The cash flows of a bond consist of investment. The buyer A When a bond becomes subject to more default risk, its Real return = (1 + nominal return) / (1 + inflation). conventional YTM occurs when reinvestment rates can change over time. The Jensen ratio measures how much variance of the return on P is thus the sum of variances since the systematic and residual Inefficient strategies incur risk that is not rewarded sufficiently with higher expected return. explain average returns. The APT is more general in that it gets us to the expected return – beta relationship without 3 Investment Risk Management Framework Risk management has been primarily considered a mechanism for measuring, monitoring and preventing loss, but in essence it serves a broader, more practical purpose. Other types of bonds are convertible, put, floating rate and hybrid securities/preference components of risk: the risk produced by fluctuations in the market and the risk arising from An. Why go through all this pain in CAPM when we can get the same thing easily in APT? relationship between risk and return. of total rate of return. Since the 1960s, investors have known how to If all investors hold an Therefore, the bond price will decrease as market interest rates rise. Investment Risk Risk of an asset is the potential change of future returns due to its assets (Weston & et al, 2008). Passive management involves (1) capital allocation between cash (i.e. under-priced, it will provide a positive alpha, that is, an expected return in excess of the fair 1% in the SD of that portfolio. The coefficients of each index in the equation above measure the sensitivity of share returns The compound rate of return is the fact that progressive increases in the IR result in progressively smaller reductions in the Investment Risk Management does not meanrisk avoidance; rather, it looks toward capital preservation and optimal risk-adjusted return generation. premium is too high compared to the average degree of risk aversion, there will be excess Once adopted by What about portfolio risk? 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