Investments Chapter 4/Chapter 5

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.

Applying Beta:

- Beta measures the undiversifiable (or market) risk of a security. - Beta reveals how a security responds to market forces: - If the market is expected to increase 10%, a stock with a beta of 1.5 is expected to increase 15%. - If the market went down 8%, a stock with a beta of 0.50 should only decrease by about 4%. - Stocks with betas greater than 1.0 are more responsive than average to market fluctuations and are more risky than average. - Stocks with betas less than 1.0 are less risky than the average stock.

Limitations of CAPM/Beta

- CAPM generally relies on historical data since the value of beta used in the model is typically based on calculations using historical returns. - Betas estimated from historical data may or may not accurately reflect how the company's stock will perform relative to the overall market in the future.

Costs of International Diversification:

- Investment advisers suggest allocations to foreign investments of 20%-30%: - two-thirds of this allocation in established foreign markets. - other one-third in emerging markets. - Transaction costs of buying securities directly on foreign markets tends to be high. - International mutual funds and American Depository Shares (ADSs) allow you to obtain international diversification with low cost, convenience, transactions in U.S. dollars, and protection under U.S. security laws.

Returns Historical Performance

- Provides a basis for future expectations - Does not guarantee future performance

investment in stock or bonds of foreign companies/gov'ts listed on U.S. exchanges

- Yankee Bonds - American Depository Shares (ADSs)

Deriving Beta:

- derived graphically by plotting the coordinates for the market return and security return of a stock at various points in time and using statistical techniques to fit the "characteristic line" to the data points. - Equation for a straight line takes form: y = mx + b - The slope of the line is beta. - m from the equation y = mx + b

Methods of International Diversification

- direct investment abroad - investment in stock or bonds of foreign companies/gov'ts listed on U.S. exchanges - international mutual fund - portfolio of U.S. based multinational corporations

Direct Investment Abroad

- foreign currency investment brings currency exchange risk - less convenient, more expensive, and riskier than investing in U.S

Level of Return: External Forces

- political environment - business environment - economic environment - general level of price changes: inflation/deflation

Simplicity and Practice Appeal of CAPM

- provides a useful conceptual framework for evaluating and linking risk and return. - Important tool for investors. - Widely used in corporate finance: Many surveys show the primary method that companies use to determine the required rate of return on their stock is the CAPM .

Level of Return: Internal Characteristics

- type of investment - quality of the firm's management - whether the firms finances its operations with debt or equity

What is the beta for the overall market

1.0

Risk Premium

Additional return an investor required on a risky investment to compensate for risks based upon issue and issuer characteristics

risk return tradeoff

An investor must have a portfolio of relatively risky investments to earn a relatively high rate of return. - To earn more return, one must bear more risk.

The Efficient Frontier

Any number of possible portfolios could be constructed from the hundreds of investments available at any point in time.

Sources of Risk:

Business Risk Financial Risk Purchasing Power Risk Interest Rate Risk Liquidity Risk Tax Risk Event Risk Market Risk

Time Value of Money

Generally better to receive cash sooner rather than later

Components of Return

Income Capital Gains (or Losses) Total Return

Why Return is Important?

Indicates how rapidly an investor can build wealth.

Which technique should we use?

Recommended portfolio management policy uses aspects of both approaches: - Determine how much risk you are willing to bear. - Seek diversification among different types of securities and across industry lines. - Pay attention to correlation of return between securities. - Use beta to keep portfolio at acceptable level of risk. - Evaluate alternative portfolios to select highest return for the given level of acceptable risk.

Two approaches used to plan and construct portfolios:

The Traditional Approach Modern Portfolio Theory (MPT)

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

Steps in the Decision Process: Combining Return and Risk

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

What does the positive or negative sign in from to the beta indicate?

Whether the stock's return moves in the same direction as the general market (positive beta) or in the opposite direction (negative beta) - Most stocks have betas that fall between .50 and 1.75

Standard Deviation (risk) of a portfolio's return

a function of the portfolio's individual assets' weights, standard deviations, and correlations with all other assets.

Capital Asset Pricing Model (CAPM)

a model that uses beta to qualify the relation between risk and return for different investments

beta

a number that quantifies undiversifiable risk, indicating how the security's return responds to fluctuations in market returns.

Correlation

a statistical measure of the relationship between two series of numbers

Portfolio return is calculated as...

a weighted average of returns on the assets that make up the portfolio.

Standard Deviation

an indicator of an asset's risk, it measure the dispersion (variation) of returns around an asset's average or expected return

Yankee Bonds

bonds issued in the U.S. bond market by a foreign entity

Income

cash that investors periodically receive as a result of owning an investment

Portfolio

collection of investments assembled to meet one or more investment goals

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

Income-oriented portfolio

designed to produce regular dividends and interest payments

Traditional portfolio management

emphasizes balancing the portfolio by assembling a wide variety of stocks and/or bonds

Security Market Line (SML)

graphically shows the expected return (y-acis) for any security given its beta (x-axis)

Realized Return

income received by the investor during the investment period

Indifference curves

indicate for a given level of utility (satisfaction), the set of risk-return combinations about which an investor would be indifferent.

Issuer Characteristics

industry and company factors

correlation coefficient

measures the degree of correlations, whether positive or negative

Real Rate of Return

measures the increase in purchasing power that the investment provides

Event Risk

occurs when an unexpected event has a significant and unusually immediate effect on the underlying value of an investment

Effectiveness of International Diversification

offers more diverse investment alternatives the U.S. only based investing

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

relevant risk

only relevant risk is that which is undiversifiable given an investor can create a portfolio of assets that will eliminate virtually all diversifiable risk.

Holding Period

period of time over which one wishes to measure the return on an investment

Efficient frontier

portfolios that provide the best tradeoff between risk and return - Portfolios that fall below the frontier are not desirable because portfolios on the frontier offer higher returns for the same risk level - Portfolios that fall to the left are not feasible/available

Growth-oriented portfolio

primary goal is long-term price appreciation

Risk free rate

rate of return that can be earned on a risk-free investment, such as short-term U.S. Treasury Bill

Fully compounded Rate of Return

rate of return that includes interest earned on interest

Risk Diversification

recommend holding 40 or more carefully selected securities to achieve efficient diversification

Diversifiable (unsystematic) risk

results from factors that are firm specific. ex. whether a new product succeeds or fails, the performance of senior managers, or a firms' relationship with its customers and suppliers

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

perfectly positively correlated

series with a correlation coefficient of +1.0

perfectly negatively correlated

series with a correlation coefficient of -1.0

Feasible (attainable) set

set of all possible portfolio combinations if the risk and return of each were plotted on a graph

total risk

sum of undivserifiable and diversifiable risk

The Traditional Approach -

tends to focus on well-known companies - perceived as less risky - stocks are more liquid and available - familiarity provides higher comfort levels for investors - "window dressing"

the portfolio beta (bp)

the beta of a portfolio, calculated as the weighted average of the betas of the individual assets in the portfolio. - interpreted exactly the same way as individual stock betas

Paper Return

the capital gain or loss that has been achieved but not yet realized (no sale has taken place)

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

Interest Rate Risk

the chance that changes in interest rates will adversely affect a security's value

Purchasing Power Risk

the chance that unanticipated changes in price levels (inflation or deflation) will adversely affect investment returns

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

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

Capital Gains (or Losses)

the difference between the proceeds from the sale of an investment and its original purchase price

Internal Rate of Return

the discount rate that equates an investment's cost to the present value of the benefits that it provides for the investor

Financial Risk

the increased uncertainty that results when a firm borrows money

Undiversifiable (systemic) risk

the inescapable portion of an investment's risk that remains even if a portfolio is well diversified. - associated with broad forces such as economic growth, inflation, interest rates, and political views - also called market risk

Return

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

Optimal portfolio

the point at which an investor's highest possible indifference curve is tangent to the efficient frontier represents the highest level of satisfaction the investor can achieve given the available set of portfolios.

Expected inflation premium

the rate of inflation expected over an investment's life

Reinvestment Rate

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

Required Return

the rate of return that fully compensates for an investment's risk

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

Risk-free rate

the return an investor can earn on a risk-free investment such as a U.S. treasury bill or an insured money market deposit account. - As the risk of an investment portfolio increases from 0, the return provided should increase above the risk-free rate.

Nominal Rate of Return

the return that the investment earns expressed in current dollars. It does not take into account the effects of inflation

Liquidity Risk

the risk of not being able to sell an investment quickly without reducing its price

Market Risk

the risk that investment returns will decline because of factors that affect the broader market, not just one company or one investment

Total Return

the sum of the income and the capital gain (loss) earned on an investment over a specified period of time

Risk

the uncertainty surrounding the actual return that an investment will generate

Holding Period Return (HPR)

total return earned from holding an investment for a specified time ( the holding period); usually one year or less. Offers a relative comparison, by dividing the total return by the amount of the investment.

uncorrelated

two series bear no relationship to each other

negatively correlations

two series tend to move in opposite directions

Positively correlated

two series tend to move in the same direction

Issue Characteristics

type, maturity and features

interindustry diversification

typical emphasis uses securities of companies from a broad range of industries to diversify the portfolio.

Efficient portfolio

ultimate goal; one that provides the highest return for a given risk level; requires search for investment alternatives to get the best combinations of risk and return.

Modern Portfolio Theory

uses several basic statistical measures to develop a portfolio plan from: - expected returns - standard deviations - correlations Uses these measures among many combinations of investments to find an optimal portfolio. Maximum benefits of diversification occur when investors find securities that are relatively uncorrelated and combine them in the portfolio.

If PV of the benefits = costs...

you earn a rate equal to the discount rate

If PV of the benefits exceeds costs...

you earn a rate of return greater than the discount rate

If PV of the benefits is less than the costs....

you earn a rate of return less than the discount rate