Risk and Return Intro

Returns  HPR  CAGR   YTM, RCYTM APR and APY   DY NPV, IRR   Average Annual Return Geometric Return 1

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 income during period  Capital gain (or loss) during period Beginning investment value Capital gain (or loss) during period  Ending investment value  Beginning investment value 2

Using HPR

  Advantages of Holding Period Return  Easy to calculate   Easy to understand Considers current income and growth Disadvantages of Holding Period Return  Does not consider time value of money  Inaccurate and irrelevant if time period if longer than one year 3

Using IRR

  Advantages of Internal Rate of Return  Uses the time value of money  Allows investments of different investment periods to be compared with each other  If the yield is equal to or greater than the required return, the investment is acceptable Disadvantages of Internal Rate of Return  Calculation is complex  Results may not be unique 4

Interest on Interest

 Using YTM and IRR 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.

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Risk



Risk-Return Tradeoff

return, in which investments with more risk should provide higher returns, and vice versa 

Return

, for purposes of planning, is the expected return.

 

r



Risk

is the chance that the actual return from an investment may differ from what is expected. Measured as the standard deviation of the expected return.

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E(r)

Risk 

r

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Sources of Risk

  

Business Risk

uncertainty associated with an investment’s earnings and ability to pay returns owed investors.

Affects  Common stocks  Preferred stocks Examples  Decline in company profits or market share  Bad management decisions 8

Sources of Risk (cont’d)

  Affects  International stocks, ADRs  International bonds 

Currency Exchange Risk

variation in exchange rates.

Examples  U.S. dollar appreciates against foreign currency, reducing value of foreign investment 9

Sources of Risk (cont’d)

  

Financial Risk

uncertainty attributable to the mix of debt and equity used to finance a business; more debt, greater this risk.

Affects  Common stocks  Corporate bonds Examples  Company unable to obtain credit to fund operations  Company defaults on bonds 10

Sources of Risk (cont’d)



Purchasing Power Risk

changing price levels (inflation or deflation) that adversely affect investment returns.

 Affects  Bonds (fixed income)  Certificates of deposit  Examples  Barrel of oil $66.00 last year is $89.00 this year 11

Sources of Risk (cont’d)



Interest Rate Risk

  changes in interest rates that adversely affect a security’s value.

Affects  Bonds (fixed income)  Preferred stocks Examples  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 12

Sources of Risk (cont’d)



Liquidity Risk

not being able to liquidate an investment conveniently and at a reasonable price.

 Affects  Some small company stocks  Real estate  Examples  Selling a low volume stock reduces the price of the stock, consider

blockage discounts

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Sources of Risk (cont’d)

  

Tax Risk

Congress may introduce unfavorable tax laws, driving down the after-tax returns and market values of certain investments.

Affects  Municipal bonds  Real estate Examples  Lower tax rates reduce the tax benefit of municipal bond  interest Limits on deductions from real estate losses 14

Sources of Risk (cont’d)

  Affects  All types of investments 

Market Risk

decline in investment returns because of market factors independent of the given investment.

Examples    Stock market decline on bad news Political upheaval Changes in economic conditions 15

Sources of Risk (cont’d)

  

Event Risk

unexpected events that have significant and immediate effect on the underlying value of an investment.

Affects  All types of investments Examples  Decrease in value of insurance company stock after a major hurricane  Decrease in value of real estate after a major earthquake  The BP oil spill 16

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.

CV

    Higher values for both indicate higher risk 17

Historical Returns and Risk

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Risk-Return Tradeoffs

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The Decision Process: Combining Return and Risk

 Estimate the expected return using present value methods and historical/projected return rates.  Assess the risk of the investment by looking at historical/projected returns using standard deviation or coefficient of variation of returns.  Evaluate the risk-return of each investment alternative to make sure the return is reasonable given the level of risk.

 Select the investment vehicles that offer the highest expected returns associated with the level of risk you are willing to accept.

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