This initial chapter discusses several topics basic to the subsequent chapters. We begin by defining the term investment and discussing the returns and risks related to investments. This leads to a presentation of how to measure the expected and historical rates of returns for an indi- vidual asset or a portfolio of assets. In addition, we consider how to measure risk not only for an individual investment but also for an investment that is part of a portfolio.
The third section of the chapter discusses the factors that determine the required rate of return for an individual investment. The factors discussed are those that contribute to an asset’s total risk. Because most investors have a portfolio of investments, it is necessary to consider how to measure the risk of an asset when it is a part of a large portfolio of assets. The risk that prevails when an asset is part of a diversified portfolio is referred to as its systematic risk.
The final section deals with what causes changes in an asset’s required rate of return over time. Changes occur because of both macroeconomic events that affect all investment assets and microeconomic events that affect the specific asset.
For most of your life, you will be earning and spending money. Rarely, though, will your current money income exactly balance with your consumption desires. Sometimes, you may have more money than you want to spend; at other times, you may want to purchase more than you can afford. These imbalances will lead you either to borrow or to save to maximize the long-run ben- efits from your income.
When current income exceeds current consumption desires, people tend to save the excess. They can do any of several things with these savings. One possibility is to put the money under a mattress or bury it in the backyard until some future time when consumption desires exceed current income. When they retrieve their savings from the mattress or backyard, they have the same amount they saved.
The rate of exchange between future consumption (future dollars) and current consumption (current dollars) is the pure rate of interest. Both people’s willingness to pay this difference for borrowed funds and their desire to receive a surplus on their savings give rise to an interest rate referred to as the pure time value of money. This interest rate is established in the capital market by a comparison of the supply of excess income available (savings) to be invested and the demand for excess consumption (borrowing) at a given time. If you can exchange $100 of cer- tain income today for $104 of certain income one year from today, then the pure rate of exchange on a risk-free investment (that is, the time value of money) is said to be 4 percent (104/100 – 1).
The investor who gives up $100 today expects to consume $104 of goods and services in the future. This assumes that the general price level in the economy stays the same. This price sta- bility has rarely been the case during the past several decades when inflation rates have varied from 1.1 percent in 1986 to 13.3 percent in 1979, with an average of about 5.4 percent a year from 1970 to 2001. If investors expect a change in prices, they will require a higher rate of return to compensate for it. For example, if an investor expects a rise in prices (that is, he or she expects inflation) at the rate of 2 percent during the period of investment, he or she will increase the required interest rate by 2 percent. In our example, the investor would require $106 in the future to defer the $100 of consumption during an inflationary period (a 6 percent nominal, risk-free interest rate will be required instead of 4 percent).
Further, if the future payment from the investment is not certain, the investor will demand an interest rate that exceeds the pure time value of money plus the inflation rate. The uncertainty of the payments from an investment is the investment risk. The additional return added to the nom- inal, risk-free interest rate is called a risk premium. In our previous example, the investor would require more than $106 one year from today to compensate for the uncertainty. As an example, if the required amount were $110, $4, or 4 percent, would be considered a risk premium.
