FINANCIAL ANALYTICS

Unit – II
Syllabus: (a) Time Value of Money: Future Value: Simple, Compound Interest and Annuity, Present
Value: Discounted, Annuity, Equated Loan Amortization, Perpetuity using Spreadsheets.

(b) Risk and Return: Holding Period Returns, Arithmetic Mean vs Geometric Mean, Risk: Standard
Deviation, Coefficient of Variation, Beta, Covariance of Stock.

Course Outcome of Unit2: Learn the relevance of time value money.

Time Value of Money

“Time value of money” is the value of a unit of money at different time intervals. The value of the
money received today is more than its value received at a later date. In other words, the value of
money changes over a period of time. Since a rupee received today has more value, rational
investors would prefer current receipts over future receipts. That is why, this phenomenon is also
referred to as “Time preference of money”. Some important factors contributing to this are:
 Investment opportunities
 Preference for consumption
 Risk

These factors remind us of the famous English saying, “A bird in hand is worth two in the bush”. The
question now is: why should money have time value? Some of the reasons are:

Production

Money can be employed productively to generate real returns. For example, if we spend Rs. 500 on
materials, Rs. 300 on labour and Rs. 200 on other expenses and the finished product is sold for Rs.
1100, we can say that the investment of Rs. 1000 has fetched us a return of 10%.

Inflation

During periods of inflation, a rupee has higher purchasing power than a rupee in the future.

Risk and uncertainty

We all live under conditions of risk and uncertainty. As the future is characterised by uncertainty,
individuals prefer current consumption over future consumption. Most people have subjective
preference for present consumption either because of their current preferences or because of
inflationary pressures.

Future Value

If we are getting a return of 10 % in one year what is the return we are going to get in two years?
20%, right. What about the return on 10 % that you are going to get at the end of one year? If we also
take that into consideration the interest that we get on this 10 % then we get a return of 10 + 1 = 11 %
in the second year making for a total return of 21 %. This is the same as the compound value
calculations that you must have learned earlier

Future Value = (Present Value) x (1 + Interest) No. of time periods

The compound values can be calculated on a yearly basis, or on a half-yearly basis, or on a monthly
basis or on continuous basis or on any other basis you may so desire. This is because the formula
takes into consideration a specific time period and the interest rate for that time period only

To calculate these values would be very tedious and would require scientific calculators. To ease our
jobs there are tables developed which can take care of the interest factor calculations so that our
formulas can be written as:

Future Value = (Present Value) * (Future Value Interest Factor n,i)

where n = no of time periods and i = is the interest rate.

Future Value of an Annuity

Annuity is defined as periodic payment every period for a number of periods. This periodic payment
is the same every year only then it could be called an annuity. The compound value (future value) of
this annuity can be calculated using a different formula:

Future Value= A ( (1+ r )n−1

r )
Here A is the constant periodic cash flow (annuity), i is the rate of return for one period and n is the
number of time periods. The term within the brackets is the compound value factor of an annuity. We
can also use the tables given at the end of the text book to calculate the compound values of the
cash flows and the formula would change to:

Future Value = Annuity * (Future Value Annuity Factor n,i)

Present Value

When we solve for the present value, instead of compounding the cash flows to the future, we
discount the future cash flows to the present value to match with the capital budget that we are
making today. Bringing the values to present serves two purposes:
1. The comparison between the projects become easier as the values of returns of both are as
of today, and
2. We can compare the earnings from the future with the capital budgeting we are making
today to get an idea of whether we are making any profit from the capital budgeting or not.

For calculating the present value, we need two things, one, the discount rate (or the opportunity cost
of capital) and two, the formula.

The present value of a lump sum is just the reverse of the formula of the compound value of the lump
sum:
Future Value
Present value=
( 1+r )n
Or to use the tables the change would be:

Present Value = Future Value * (Present Value Interest Factor n,i)

where n = no of time periods and i is the interest rate.

Present Value of an Annuity

The present value of an annuity can be calculated by:

𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒=A
[ (1+r )n−1
r (1+r )n ]
Or to use the tables the change would be:

Present Value = Annuity *(Present Value Annuity Factor n,i)

SOLVED PROBLEMS

What is the future value of a regular annuity of Re. 1.00 earning a rate
of 12% interest p.a. for 5 years?

SOLUTION:
1*FVIFA (12%, 5y) = 1*6.353 = Rs. 6.353

If a borrower promises to pay Rs. 20000 eight years from now in

return for a loan of Rs. 12550 today, what is the annual interest being
offered?
SOLUTION:
20000*PVIF (k%, 8y) = Rs. 12550 K is approximately 6%

A loan of Rs. 500000 is to be repaid in 10 equal instalments. If the loan

carries 12% interest p.a. what is the value of one instalment?
SOLUTION:
A*PVIFA (12%, 10y) = 500000 So A = 500000/5.650 =Rs. 88492

A person deposits Rs. 25000 in a bank that pays 6% interest half-

yearly. Calculate the amount at the end of 3 years
SOLUTION:
 25000*(1+0.06)3*2 = 25000*1.194 = Rs. 29850

Find the present value of Rs. 100000 receivable after 10 years if 10%
is the time preference for money
SOLUTION:
100000*(0.386) = Rs. 38600
Equated Loan Amortization
Equated Loan Amortization refers to the process of repaying a loan through a series of equal periodic
payments. This type of loan repayment is commonly used for installment loans, such as home
mortgages or car loans. The equated loan amortization schedule outlines the specific details of each
payment, including the amount allocated to interest and principal.

Here's a breakdown of key concepts related to equated loan amortization:

1. Equated Monthly Installment (EMI): This is the fixed amount paid by a borrower to a lender
at a specified date each calendar month. The EMI consists of both principal repayment and
interest payment.

2. Principal Repayment: The portion of the EMI that goes towards repaying the principal
amount of the loan. Over time, the proportion of the EMI allocated to principal increases,
while the interest portion decreases.

3. Interest Payment: The portion of the EMI that covers the interest accrued on the
outstanding loan balance. In the early stages of the loan, a significant portion of the EMI
goes towards paying interest.

4. Amortization Schedule: This is a table that provides a detailed breakdown of each loan
payment, showing the amount applied to interest, principal, and the remaining balance. The
schedule is often presented on a monthly basis.

5. Loan Term: The total duration for which the loan is taken, often expressed in years. The
equated loan amortization schedule covers the entire loan term, detailing each monthly
payment until the loan is fully repaid.

6. Interest Rate: The annual interest rate applied to the outstanding loan balance. The interest
rate determines the cost of borrowing and influences the amount of interest paid over the
life of the loan.

Loan Amortisation Schedule

Principal Recovery Interest Payment
Month EMI (PMT) Loan Balance Amount
(PPMT) (IPMT)
Run =PMT function in Run =PPMT function in Run =IPMT function in
1 =Loan Amount -PPMT
Excel Excel Excel
 Run =PMT function in Run =PPMT function in Run =IPMT function in =1st Year Balance -2nd
2
Excel Excel Excel Year PMT
3

The equated loan amortization process ensures that borrowers make regular, fixed payments over
the loan term, making it easier for them to budget and plan their finances. As the loan progresses, a
larger portion of the EMI goes toward reducing the principal, leading to a decrease in the
outstanding balance and, consequently, a reduction in the interest paid with each installment.
Perpetuity:
A perpetuity is a financial concept that refers to a series of equal payments that continues
indefinitely. In other words, it's a stream of cash flows that never ends. The idea of a perpetuity is
common in finance and valuation, and it is often used in the context of valuing certain types of
investments or securities.

The formula for the present value of a perpetuity is given by:

C
Present Value of Perpetuity =
r
Where:

 C is the cash flow or payment received each period.

 r is the discount rate or interest rate.

The reasoning behind this formula is that the value of each future cash flow is discounted back to its
present value. Since perpetuities continue indefinitely, the sum of all these discounted cash flows
C
converges to a finite value, which is
r
Here are a couple of key points about perpetuities:

1. Constant Cash Flow: Perpetuities assume a constant cash flow or payment received at
regular intervals (e.g., annually) that continues indefinitely.

2. Discount Rate: The discount rate (r) represents the rate of return required by an investor. It
reflects the time value of money and the opportunity cost of not investing in an alternative
opportunity with a similar risk profile.

3. Limitations: While perpetuities are a useful concept for certain financial instruments, in
reality, very few cash flows continue indefinitely. In many cases, cash flows are expected to
have a finite life, and other valuation methods, like discounted cash flow analysis with a
specific time horizon, are used.

4. Examples: Preferred stocks, which pay a fixed dividend, are often considered perpetuities.
Certain types of government bonds or securities may also be considered perpetuities.
It's important to note that perpetuity is more of a theoretical concept and might not perfectly
represent real-world financial instruments. In practical scenarios, time horizons and finite cash flow
periods are more common, and other valuation methods may be applied.

Return:

In the context of investment, the term "return" refers to the financial gain or loss made on an
investment relative to the amount invested. Return is a key metric used by investors to evaluate the
performance of an investment and to assess the profitability of their investment decisions. It is
expressed as a percentage of the original investment or as a monetary value.

Here are some important aspects of return in the context of investment:

1. Types of Returns:

 Total Return: The overall gain or loss on an investment, including both capital
appreciation (or depreciation) and any income generated (e.g., dividends or
interest).

 Nominal Return: The actual percentage increase or decrease in the value of an

investment.

 Real Return: The nominal return adjusted for inflation, providing a more accurate
measure of purchasing power.

2. Calculation of Return:

 The basic formula for calculating return is:

Return = ((Ending Value−Beginning Value)/Beginning Value)×100

 For total return, it includes any additional income earned during the investment
period.

3. Components of Return:

 Capital Gain (or Loss): The change in the market value of an investment over time. If
the ending value is higher than the beginning value, it's a capital gain, and if it's
lower, it's a capital loss.

 Income Return: The income generated by the investment, such as dividends from
stocks or interest from bonds.

The Holding Period Return in Investment Management

The holding period return is a fundamental metric in investment management. The measure
provides a comprehensive view of the financial performance of an asset or investment because it
considers the appreciation of the investment, as well as the income distributions related to the asset
(e.g., dividends paid).

The HPR can be used to compare the performance of different investments or assets. In addition, this
metric is used to identify the appropriate tax rate.

Formula for Calculating the Return

The general formula for calculating the HPR is:

Where:

 Income – the distributions or cash flows from the investment (e.g., dividends)

 Vn – the ending value of the investment

 V0 – the beginning value of the investment

If you need to calculate the annualized HPR, you can use the following formula:

Finally, the returns can be calculated quarterly. Using the formula below, you can translate the
quarterly HPR into the annual HPR:

Where:

 r1, r2, r3, r4 – the quarterly holding period returns

Example of Holding Period Return

Three years ago, Fred invested $10,000 in the shares of ABC Corp. Each year, the company
distributed dividends to its shareholders. Each year, Fred received $100 in dividends. Note that since
Fred received $100 in dividends each year, his total income is $300. Today, Fred sold his shares for
$12,000, and he wants to determine the HPR of his investment.

Using the HPR formula, we can find the following:

Thus, Fred’s investment in the shares of ABC Corp. earned 23% for the entire period of holding the
investment.

Arithmetic Mean vs Geometric Mean

In the context of stock returns, both the arithmetic mean and geometric mean are measures used to
assess the average or central tendency of a set of returns. However, they capture different aspects of
the return distribution and are suited for different purposes.

Arithmetic Mean Geometric Mean

Definition: The arithmetic mean is the average of Definition: The geometric mean is the
a set of values calculated by adding up all the average rate of return of a set of values
values and then dividing by the number of calculated by multiplying all the values and
observations. then taking the nth root, where n is the
number of observations.

Formula: Formula:
 Arithmetic Mean=
∑ of Returns Geometric Mean=∑ ¿ ¿
n

Number of Return i=1

Use in Stock Returns: The arithmetic mean is Use in Stock Returns: The geometric mean is
straightforward and easy to calculate. It gives particularly relevant for assessing the
equal weight to each return in the calculation, compounded average rate of return over
making it suitable for assessing the central multiple periods. It accounts for the
tendency of a set of returns over a specific compounding effect of returns, making it
period. more suitable for measuring investment
performance over time.

Consideration: The arithmetic mean may be Consideration: The geometric mean is less
sensitive to extreme values (outliers) in the sensitive to extreme values compared to the
return distribution. arithmetic mean.

In the context of stock returns, the choice between the arithmetic mean and geometric mean
depends on the specific question being addressed. If you are interested in the average return over a
single period, the arithmetic mean may be appropriate. However, if you are concerned with the
overall performance and want to account for the compounding effect of returns over multiple
periods, the geometric mean is often more relevant, especially in the context of investment analysis
where returns are typically compounded.

In practice, when assessing investment performance, it's common to use both measures to gain a
more comprehensive understanding of the return characteristics.

Risk

Risk, in the context of investment, refers to the uncertainty or variability of returns that an
investment may experience. It is an inherent part of investing and is associated with the possibility of
losing some or all of the invested capital. Investors face various types of risks, and understanding and
managing these risks are crucial for making informed investment decisions. Here are some key types
of risk in the context of investment:

1. Market Risk:

 Definition: Market risk, also known as systematic risk, is the risk that the entire
market or a significant segment of it will decline. It is beyond the control of
individual investors and is associated with factors such as economic conditions,
interest rates, and geopolitical events.

2. Credit Risk:

 Definition: Credit risk, or default risk, is the risk that a borrower (e.g., a company or
government) will fail to meet its debt obligations. It is prevalent in fixed-income
investments such as bonds.

3. Liquidity Risk:

 Definition: Liquidity risk is the risk that an investor may not be able to buy or sell an
investment quickly enough at a desired price. Less liquid assets may have wider bid-
ask spreads and be subject to price fluctuations.

4. Interest Rate Risk:

  Definition: Interest rate risk is associated with changes in interest rates. It affects the
value of fixed-income securities; when interest rates rise, the value of existing bonds
tends to fall.

5. Inflation Risk:

 Definition: Inflation risk is the risk that the purchasing power of money will decline
over time. Inflation erodes the real value of investment returns, particularly for fixed-
income securities.

6. Currency Risk:

 Definition: Currency risk, or exchange rate risk, arises when investments are
denominated in a currency different from the investor's base currency. Fluctuations
in exchange rates can impact the value of the investment.

7. Political and Regulatory Risk:

 Definition: Political and regulatory risk involves the impact of political instability,
changes in government policies, and regulatory developments on investments. These
factors can affect the business environment and investment returns.

8. Business and Financial Risk:

 Definition: Business and financial risk are associated with the specific characteristics
of a company. Business risk relates to the industry and competitive position, while
financial risk pertains to the company's capital structure and financial leverage.

Investors often assess their risk tolerance, which is the level of uncertainty or potential loss they are
willing to accept. Risk tolerance depends on factors such as financial goals, time horizon, and
individual preferences. Diversification, asset allocation, and risk management strategies are
commonly used to mitigate specific risks and create a balanced investment portfolio that aligns with
an investor's objectives. Additionally, understanding the various types of risk is crucial for making
informed investment decisions and managing a well-rounded investment portfolio.

Interpreting variance, standard deviation, coefficient of variation, and beta provides insights into the
risk and volatility associated with a stock. Here's a brief interpretation of each measure:

1. Variance:

 Definition: Variance is a statistical measure that quantifies the degree of dispersion

or variability of a set of data points. In the context of stocks, variance measures how
much the returns of a stock deviate from its average return.

 Calculation: Variance measures the average squared deviation of each data point
(stock return) from the mean return. The formula is given by:

Variance(σ )=
2 ∑ (xi−x )2
n
where Xi represents each individual return, ˉXˉ is the mean return, and n is the
number of returns.
  Interpretation: A higher variance indicates greater volatility or risk. It suggests that
the stock's returns are more spread out, and there is a higher likelihood of
experiencing larger price swings.

2. Standard Deviation:

 Definition: Standard deviation is the square root of variance and is a commonly used
measure of the spread or dispersion of a set of data points.

 Calculation: Standard deviation is the square root of the variance. The formula is:

Standard Deviation ( σ )=√ Variance

 Interpretation: Like variance, a higher standard deviation signifies higher volatility
and risk. It provides a more intuitive measure of how much the returns of a stock are
likely to deviate from the mean (average). Investors often use standard deviation to
assess the risk associated with holding a particular stock.

3. Coefficient of Variation (CV):

 Definition: The coefficient of variation is the ratio of the standard deviation to the
mean, expressed as a percentage. It is a measure of relative risk, providing a
standardized way to compare the risk of different investments, considering their
average returns.

 Calculation: The coefficient of variation is the ratio of the standard deviation to the
mean return, expressed as a percentage. The formula is:

Standard Deviation
CV = × 100
Mean Return
 Interpretation: A higher coefficient of variation indicates higher relative risk
compared to investments with a lower coefficient of variation. It is particularly useful
for comparing the risk-return profile of stocks with different average returns.

4. Beta:

 Definition: Beta is a measure of a stock's systematic risk, representing its sensitivity

to movements in the broader market (usually measured against a market index like
the S&P 500).

 Calculation: Beta measures the sensitivity of a stock's returns to changes in the

broader market. It is often calculated by regressing the stock's returns against the
market returns. The formula is:

Covariance( Rs , Rm)
Beta=
Variance ( Rm)
where Rs is the stock's return and Rm is the market return.

 Interpretation:

 A beta of 1 suggests the stock tends to move in line with the market.
 A beta greater than 1 indicates higher volatility than the market.
 A beta less than 1 suggests lower volatility than the market.
  A negative beta implies an inverse relationship with the market.
 Stocks with higher betas are generally considered riskier because they are
more responsive to market movements.

Investors often consider these measures in conjunction with other financial metrics and qualitative
factors to assess the overall risk and return profile of a stock and to make informed investment
decisions based on their risk tolerance and investment objectives.

Covariance
Covariance is a statistical measure that quantifies the degree to which the returns of two variables,
such as stocks, move in relation to each other. In the context of stocks, covariance measures the joint
variability of their returns. A positive covariance indicates that the returns of the two stocks tend to
move in the same direction, while a negative covariance suggests that they move in opposite
directions.

The formula for the covariance (Cov) between two stocks, denoted as X and Y, is given by:
n

∑ ( Xi−X )(Yi−Y )
Covariance ( X , Y )= i=1
n
Where:
 Xi and Yi are the individual returns for each period.
 ˉXˉ and ˉYˉ are the means (average returns) of X and Y, respectively.
 n is the number of data points or periods.

Interpreting Covariance:

 A positive covariance indicates that the returns of the two stocks tend to move in the same
direction.
 A negative covariance suggests that the returns of the two stocks tend to move in opposite
directions.
 Covariance does not have standardized units, making it challenging to compare the strength
of relationships between different pairs of stocks.