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Summary The Investment Setting

Summary The Investment Setting. Why do individuals invest ? What is an investment ? How do we measure the rate of return on an investment ? How do investors measure risk related to alternative investments ?

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Summary The Investment Setting

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  1. SummaryThe Investment Setting • Why do individuals invest ? • What is an investment ? • How do we measure the rate of return on an investment ? • How do investors measure risk related to alternative investments ? • What factors contribute to the rate of return that an investor requires on an investment? • What macroeconomic and microeconomic factors contribute to changes in the required rate of return for an investment?

  2. Why Do Individuals Invest ? • By saving money (instead of spending it), individuals forego consumption today in return for a larger consumption tomorrow.

  3. How Do We Measure The Rate Of Return On An Investment ? The real rate of interest is the exchange rate between future consumption (future dollars) and present consumption (current dollars). Market forces determine this rate.

  4. How Do We Measure The Rate Of Return On An Investment ? If the purchasing power of the future payment will be diminished in value due to inflation, an investor will demand an inflation premium to compensate them for the expected loss of purchasing power. If the future payment from the investment is not certain, an investor will demand a risk premium to compensate for the investment risk.

  5. Defining an Investment • Any investment involves a current commitment of funds for some period of time in order to derive future payments that will compensate for: • the time the funds are committed (the real rate of return) • the expected rate of inflation (inflation premium) • uncertainty of future flow of funds (risk premium)

  6. Determinants of Required Rates of Return • Three factors influence an investor’s required rate of return • Real rate of return • Expected rate of inflation during the period • Risk

  7. The Real Risk Free Rate • Assumes no inflation. • Assumes no uncertainty about future cash flows. • Influenced by the time preference for consumption of income and investment opportunities in the economy

  8. Adjusting For Inflation:Fisher Equation The nominal risk free rate of return is dependent upon: • Conditions in the Capital Markets • Expected Rate of Inflation

  9. Components of Fundamental Risk • Five factors affect the standard deviation of returns over time. • Business risk: • Financial risk • Liquidity risk • Exchange rate risk • Country risk

  10. Relationship BetweenRisk and Return Stocks Bonds Risk-free Rate

  11. http://www.finpipe.com http://www.investorguide.com http://www.aaii.com http://www.economist.com http://www.online.wsj.com http://www.forbes.com http://www.barrons.com http://fisher.osu.edu/fin/journal/jofsites.htm http://www.ft.com http://www.fortune.com http://www.smartmoney.com http://www.worth.com http://www.money.cnn.com The InternetInvestments Online

  12. Future TopicsInvestment Alternatives • non-marketable financial assets • marketable financial assets • money market and capital market • preferred stock, income trusts, and common stock. • Derivatives

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