Chapter 4: Risk and Return

Measuring Return

(CAPM: rs= rf + b (rm-rf) DDM: rs= D1/Po + g only focus on systematic risk because unsystematic risk is diversified) <<< ignore • There are several measures that enable us to compare alternative investments. • To compare returns from different investments, we need to incorporate time value of money concepts that explicitly consider differences in the timing of investment income and capital gains. - Real, Risk−Free, and Required Returns - Holding Period Return - The Internal Rate of Return - Finding Growth Rates

Holding Period Return

- Holding period: the period of time over which one wishes to measure the return on an investment. - Understanding Return Components: Realized Return: income received by the investor during the investment period Paper Return: the capital gain or loss that has been achieved but not yet realized (no sale has taken place) - Computing the Holding Period Return Holding Period Return (HPR): the total return earned from holding an investment for a specified time (the holding period); usually one year or less. FORMULA 3: HPR = (Inc + CG) /Vo and FORMULA 4: CG = Vn - Vo - Using the HPR in Investment Decisions HPR offers a relative comparison, by dividing the total return by the amount of the investment

Components of Return

- Income: cash that investors periodically receive 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 income and the capital gain (loss) earned on an investment over a specified period of time

More about General Level of price changes

- Inflation (Deflation): up (down) - Generally speaking, when investors expect inflation to occur, they demand higher returns. - The way that investment returns respond to unexpected changes in inflation will vary by type of investment, and that response can be influenced by investors' beliefs about how policymakers will react to changing inflation.

Level of Return

- Internal characteristics (3) Type of investment (e.g., stocks or bonds) Quality of the firm's management Whether the firm finances its operations with debt or equity - External Forces (4) Political environment Business environment Economic environment General level of price changes

Historical Returns

- Returns vary over time and by type of investment - Significant differences exist among the average annual rates of return realized on stocks, long−term government bonds, and short−term government bills

Chapter Objectives

- Review the concept of return, its components, the forces that affect the level of return, and historical returns. - Discuss the role of time value of money in measuring return and defining a satisfactory investment. - Describe real, risk−free, and required returns and the calculation and application of holding period return. - Explain the concept and calculation of an internal rate of return and how to find growth rates. - Discuss the key sources of risk that might affect potential investments. - Understand the risk of a single asset, risk assessment, and the steps that combine return and risk.

Why is return important?

- The rate of return indicates how rapidly an investor can build wealth. - Historical Performance Provides a basis for future expectations Does not guarantee future performance - Expected Return Return an investor thinks an investment will earn in the future Determines what an investor is willing to pay for an investment or if they are willing to make an investment

Review of Chapter

1. Review the concept of return, its components, the forces that affect the 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. 4. Explain the concept and calculation of an internal rate of return and how to find growth rates. 5. Discuss the key sources of risk that might affect potential investments. 6. Understand the risk of a single asset, risk assessment, and the steps that combine return and risk.

Assessing Risk

A look at the general risk−return characteristics of alternative investments and at the question of an acceptable level of risk helps show how to evaluate risk. Risk−Return Characteristics of Alternative Investments - A risk−return tradeoff exists such that for a higher risk one expects a higher return, and vice versa. - In general, low−risk/low−return investments include U.S. government securities and deposit accounts. - In general, high−risk/high−return investments include real estate and other tangible investments, common stocks, options, and futures. An Acceptable Level of Risk: Individuals differ in the amount of risk that they are willing to bear and the return they require as compensation for bearing that risk. - Risk−indifferent (risk−neutral): 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.

Risk premium (RP)

Additional return an investor requires on a risky investment to compensate for risks based upon issue and issuer characteristics. - Issue Characteristics: type, maturity and features - Issuer characteristics: industry and company factors rj = r[RF] + RPj

Sources of Risk

Business Risk: the degree of uncertainty associated with an investment's earnings and the investment's ability to pay the returns (interest, principal, dividends) that investors expect. - Tied to a firm's industry - Generally, investments from similar kinds of firms have similar business risk - Differences in management, costs, and location can cause variation Financial Risk: the increased uncertainty that results when a firm borrows money. - The more debt used to finance a firm, the greater its financial risk Purchasing Power Risk: the chance that unanticipated changes in price levels (inflation or deflation) will adversely affect investment returns. Interest Rate Risk: the chance that changes in interest rates will adversely affect a security's value. Liquidity Risk: the risk of not being able to sell (liquidate) an investment quickly without reducing its price. Tax Risk: The chance that Congress will make unfavorable changes in tax laws, driving down the after−tax returns and market values of certain investments Event Risk: occurs when an unexpected event has a significant and unusually immediate effect on the underlying value of an investment. Market Risk: the risk that investment returns will decline because of factors that affect the broader market, not just one company or one investment. - Examples: political, economic, and social events as well as changes in investor tastes and preferences - Actually embodies a number of risks including purchasing power risk, interest rate risk, and tax risk.

IRR: the critical assumption

Interest on Interest: The Critical Assumption - Using 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: 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.

Risk and Returns

Investors are generally risk averse: they do not like risk and will only take risk when they expect compensation for doing so. Required Return: the rate of return that fully compensates for an investment's risk FORMULA 1: rj = r* + IP + RPj Expected inflation premium: the rate of inflation expected over an investment's life Risk−free rate: rate of return that can be earned on a risk−free investment, such as a short−term U.S. Treasury bill. FORMULA 2: r[RF] = r* + IP where r[rf] is risk-free rate, r*= real rate, and IP is inflation premium

Real, Risk−Free, and Required Returns: Inflation and Returns

Nominal Rate of Return: the return that the investment earns expressed in current dollars. It does not take into account the effects of inflation. Real Rate of Return: measures the increase in purchasing power that the investment provides. - Approximately equals the nominal rate of return minus the inflation rate.

Finding Growth Rates

Rate of Growth: The compound annual rate of change in some financial quantity, such as the price of a stock or the size of its dividend. - Can find on financial calculator using Do as PV, Dn as FV, inputting N, and computing I/R, which is equal to the growth rate here.

Determining a Satisfactory Investment

Satisfactory investment: one for which the present value of benefits (discounted at the appropriate discount rate) equals or exceeds the present value of its costs. - If the present value of the benefits equals the cost, you earn a rate equal to the discount rate - If the present value of the benefits exceeds the cost, you earn a rate of return greater than the discount rate. - If the present value of the benefits is less than the cost, you earn a rate of return less than the discount rate.

Risk of a Single Asset

Standard Deviation: An Absolute Measure of Risk - Standard Deviation: An indicator of an asset's risk, it measures the dispersion (variation) of returns around an asset's average or expected return. Historical Returns and Risk - Standard deviation can be used as a measure of risk to assess historical investment return data - General pattern: Investments with higher average returns have higher standard deviations, reflecting greater risk

Internal Rate of Return (IRR)

The discount rate that equates an investment's cost to the present value of the benefits that it provides for the investor. - IRR for a Single Cash Flow E.g., investments such as U.S. savings bonds, stocks paying no dividends, and zero−coupon bonds, that provide no periodic income. EXAMPLE: Finding IRR on an investment costing $1,000 today that you expect will be worth $1,400 at the end of a 5−year holding period. Just use basic TMV calculations on financial calculator (computing I) - IRR for a Stream of Income Investments such as income−oriented stocks and bonds typically provide the investor with an income stream. The IRR on an investment that pays income periodically is the discount rate that equates the present value of the investment's cash flows to its current price. General IRR equates cost with PV of benefits, IRR for periodic payments more specifically equates PV of CFs to its current price.

The Time Value of Money and Returns

Time value of money: It is generally better to receive cash sooner rather than later - Computational Aids for Use in Time Value of Money Calculations Financial calculators Electronic spreadsheet

Steps in the Decision Process: Combining Return and Risk

When deciding among alternative investments, you should take the following steps to combine return and risk: 1) Estimate the expected return using present value methods and historical or projected return data 2) Assess the risk of the investment by looking at historical/projected returns using standard deviation. 3) Evaluate the risk−return characteristics of each investment option to make sure the return is reasonable given the level of risk. 4) Select the investments that offer the highest expected returns associated with the level of risk you are willing to accept.

Return

the level of profit from an investment—that is, the reward for investing

Risk: The Other Side of the Coin

• Risk: the uncertainty surrounding the actual return that an investment will generate. • Risk−Return Tradeoff: the relationship between risk and return in which investors want to obtain the highest possible return for the level of risk that they are willing to take.