Return and Risks

2

Return and Risks

Learning Goals

1. Review the concept of return, its components, the forces that affect the investor’s level of return, and historical returns.

2. Discuss the role of time value of money in measuring return and defining a satisfactory investment.

3. Describe real, risk-free, and required returns and the calculation and application of holding period return.

3

Return and Risks

Learning Goals (cont’d)

4. Explain the concept and calculation of yield and how to find growth rates.

5. Discuss the key sources of risk that might affect potential investment vehicles.

6. Understand the risk of a single asset, risk assessment, and the steps that combine return and risk.

4

The Concept of Return

Return The level of profit from an investment, or The reward for investing

Components of Return Current income: cash or near-cash that is received as a result of

owning an investment Capital gains (or losses): the difference between the proceeds from

the sale of an investment and its original purchase price

Total Return: the sum of the current income and the capital gain (or loss) earned on an investment over a specified period of time

5

Key Factors in Return

Internal Forces Type of investment Risks of investment

External Forces Political environment Business environment Economic environment Inflation Deflation

6

Table 4.4 Historical Returns for Popular Security Investments (1926-2005)

7

The Time Value of Money and Returns

The sooner you receive a return on a given investment, the better

A dollar received today is worth more than a dollar received in the future

The sooner your money can begin earning interest, the faster it will grow

8

Measuring Return

Required Return The rate of return an investor must earn on an

investment to be fully compensated for its risk

Required returnon investment j

Real rateof return

Expected inflation

premium

Risk premiumfor investment j

Required returnon investment j

Risk-free

rate

Risk premiumfor investment j

9

Measuring Return (cont’d)

Real Rate of Return The rate of return that could be earned in a perfect world

where all outcomes are known and certain—where there was no risk

Historically, this amount has remained relatively stable at 0.5% to 2%

Expected Inflation Premium The average rate of inflation expected in the future

10

Measuring Return (cont’d)

Risk-free Rate The rate of return that can be earned on a

risk-free investment The sum of the real rate of return and the expected

inflation premium The most common “risk-free” investment is considered to

be the 3-month U.S. Treasury Bill

Risk-free rate Real rateof return

Expected inflation

premium

RF r* IP

11

Measuring Return (cont’d)

Risk Premium Additional return an investor requires on an investment to

compensate for higher risks based upon issue and issuer characteristics

Issue characteristics are the type, maturity and features Issuer characteristics are industry and company factors

12

Holding Period Return (HPR)

Holding Period: the period of time over which an investor wishes to measure the return on an investment vehicle

Realized Return: current return actually received by an investor during the given return period

Paper Return: return that has been achieved but not yet realized (no sale has taken place)

13

Holding Period Return (HPR)

Holding Period Return The total return earned from holding an investment for a

specified holding period (usually 1 year or less)

Holding period return

Current incomeduring period

Capital gain (or loss)

during period

Beginning investment value

Capital gain (or loss)during period

Ending

investment value

Beginninginvestment value

14

Table 4.6 Key Financial Variables for Four Investment Vehicles

15

Interest on Interest: The Critical Assumption

Using yield (IRR) to measure return assumes that all income earned over the investment horizon is reinvested at the same rate as the original investment.

Reinvestment Rate is the rate of return earned on interest or other income received from an investment over its investment horizon.

Fully compounded rate of return is the rate of return that includes interest earned on interest.

16

Figure 4.1 Earning Interest on Interest

17

Finding Growth Rates

Rate of Growth The compound annual rate of change in the value

of a stream of income

Used to see how quickly a stream of income, such as dividends, is growing

18

Sources of Risk

Risk-Return Tradeoff is the relationship between risk and return, in which investments with more risk should provide higher returns, and vice versa

Risk is the chance that the actual return from an investment may differ from what is expected

19

Sources of Risk (cont’d)

Currency Exchange Risk is the risk caused by the varying exchange rates between the currencies of two countries. (Discussed in Chapter 2)

Types of Investments Affected International stocks or ADRs International bonds

Examples of Currency Exchange Risk U.S. dollar gets “stronger” against foreign currency,

reducing value of foreign investment

20

Sources of Risk (cont’d)

Business Risk is the degree of uncertainty associated with an investment’s earnings and the investment’s ability to pay the returns owed to investors.

Types of Investments Affected Common stocks Preferred stocks

Examples of Business Risk Decline in company profits or market share Bad management decisions

21

Sources of Risk (cont’d)

Interest Rate Risk is the chance that changes in interest rates will adversely affect a security’s value.

Types of Investments Affected Bonds (fixed income) Preferred stocks

Examples of Interest Rate Risk Market values of existing bonds decrease as market

interest rates increase Income from an investment is reinvested at a lower

interest rate than the original rate

22

Sources of Risk (cont’d)

Tax Risk is the chance that Congress will make unfavorable changes in tax laws, driving down the after-tax returns and market values of certain investments.

Types of Investments Affected Municipal bonds Real estate

Examples of Tax Risk Lower tax rates reduce the tax benefit of municipal bond

interest Limits on deductions from real estate losses

23

Sources of Risk (cont’d)

Market Risk is the risk of decline in investment returns because of market factors independent of the given investment.

Types of Investments Affected All types of investments

Examples of Market Risk Stock market decline on bad news Political upheaval Changes in economic conditions

24

Sources of Risk (cont’d)

Event Risk comes from an unexpected event that has a significant and unusually immediate effect on the underlying value of an investment.

Types of Investments Affected All types of investments

Examples of Event Risk Decrease in value of insurance company stock after

a major hurricane Decrease in value of real estate after a major earthquake

25

Measures of Risk: Single Asset

Standard deviation is a statistic used to measure the dispersion (variation) of returns around an asset’s average or expected return

Coefficient of variation is a statistic used to measure the relative dispersion of an asset’s returns; it is useful in comparing the risk of assets with differing average or expected returns

Higher values for both indicate higher risk

26

Table 4.11 Returns, Standard Deviations, and Coefficients of Variation for Popular Security

Investments (1926–2005)

27

Figure 4.2 Risk-Return Tradeoffs for Various Investment Vehicles

28

Acceptable Levels of Risk Depend Upon the Individual Investor

Risk-indifferent describes an investor who does not require a change in return as compensation for greater risk

Risk-averse describes an investor who requires greater return in exchange for greater risk

Risk-seeking describes an investor who will accept a lower return in exchange for greater risk