Return & Risk Chapter 4

nondiversifiable (systematic risk)

attributable to forces that affect all similar investments and cannot be eliminated through diversification examples: war, inflation, political events -can't get rid of this

expected inflation premium

average rate of inflation expected in the future

rate of return

indicates how rapidly an investor can build wealth and allows us to keep score on how our investments are doing compared to our expectations

risk indifferent

investor who does not require a change in return as compensation for greater risk

risk averse

investor who requires great return in exchange for greater risk

risk seeking

investor who will accept a lower return in exchange for greater risk

negatively correlated

items tend to move in opposite direction

positively correlated

items tend to move in the same direction

correlation coefficient

measure of the degree of correlation btwn two series of numbers representing data -if closer to 0, very weak correlation

Beta

measure of undiversifable risk, indicates how the price of a security responds to market forces, compares historical return of an investment to market return, beta for market is 1.0, stocks may have positive or negative beta, nearly all are postiive, stocks with betas greater than 1 are more risky -higher stock betas result in higher expected returns due to greater risk

capital asset pricing model (CAPM)

model that links the notions of risk and return, helps investors define the required return on investment, as beta increases, the rr for a given investment increases required return on investment=risk free rate+ (beta x (expected market return-risk free rate)) -shown on graph as security market line (SML)

international diversification

offers more diverse investment alternatives than US only based investing, foreign economic cycles may move independently from US economic cycle, foreign markets may not be as efficient as US markets allowing true gains from superior research -advantages:broader investment choices, potentially greater returns than US, reduction of overall portfolio risk -disadvantages: currency exchange risk, less convenient to invest than US stocks, more expensive to invest, riskier than investing in US

satisfactory investment

one for which the present value of benefits equals or exceeds the present value of its costs

external forces

political environment, business environment, economic, inflation and deflation

growth orientated portfolio

primary objective is long term price appreciation

income orientated port

primary objective is to produce regular dividend and interest income

required return

rate of return an investor must earn on an investment to be fully compensated for its risk (=real rate of return + inflation + risk premium)

reinvestment rate

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

risk free rate

rate of return that can be earned on a risk free environment-the most common risk free investment is considered to be the 3 month US treasury bill (=real rate of return + expected inflation premium)

fully compounded rate of return

rate of return that includes interest earned on interest

risk return tradeoff

relationship between risk and return in which investments with more risk should provide higher returns and vice versa

diversifiable (unsystematic risk)

results from uncontrollable or random events that are firm-specific, can be eliminated through diversification -examples: labor strikes, lawsuits -can minimize as much as possible

expected return

return an investor thinks an investment will earn in the future and determines what an investor is willing to pay for an investment or if they are willing to make that investment

paper return

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

currency exchange risk

risk caused by varying exchange rates between the currencies of two countries -international stocks/bonds and ADRS affected -ex:us dollar gets stronger against foreign currency reducing value of foreign investment

market risk

risk of decline in investment returns because of market factors independent of given investment -all investment types affected -ex:stock market decline on bad news

liquidity risk

risk of not being able to liquidate an investment conveniently and at a reasonable price -some small company stocks and real estate affected -ex:price of house has to be lowered for a quick sale

standard deviation

statistic used to measure the dispersion (variation) of returns around an assets average or expected return -lower the sd, lower the risk -this is complicated and is a function of the portfolios individual assets, weights, standard deviations, and correlations with all other assets

coefficient of variation

statistic used to measure the relative dispersion of an assets returns, it is useful in comparing the risk of assets with differing average or expected returns -higher value=higher risk

correlation

statistical measure of relationship btwn two series of numbers representing data

rate of growth

the compound annual rate of change in the value of a stream of income, used to see how quickly stream of income such as dividends are growing

capital gains/losses

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

holding period

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

time value of money and returns

the sooner you receive a return, the better. the dollar received today is worth more than a dollar received in future. the sooner your money can begin earning interest, the faster it will grow

total return

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

holding period return

total return earned from holding an investment for a specified holding period (usually one year or less) (=income during period + capital gain/loss)/beginning investment value) advantages:easy to calculate, easy to understand and considers income and growth disadvantages:does not consider time value of money and rate may be inaccurate if time period is longer than one year

components of risk

total risk=undiversifiable risk + diversifiable risk

internal characteristics

type of risk, issuer's management and issuers financing

efficient portfolio

ultimate goal-portfolio provides the highest return for a given level of risk and requires search for investment alternatives to get the best combinations of risk and return

yield (irr)

use tmv function in calculator

portfolio return

weighted average of individual asset returns in portfolio -portfolios give average returns, standard deviation is NOT an average, variablity

foreign company stocks listed on US stock exchanges

yankee bonds, american depository shares, mutual funds investing in foreign stocks, US multinational companies

risk premium

additional return an investor requires on a risky investment to compensate for risks based upon issue (type, maturity, and features) and issuer (industry and company factors) characteristics

Internal rate of return

advantages: uses the time value of money, allows investments of different investment periods to be compared with, and if the yield is equal to or greater than the required return the investment is acceptable disadvantages: calculation is complex -bonds provide uneven streams of income over investment period so use cash flow function

diversification

assets that are less than perfectly positively correlated tend to offset each others movements, thus reducing the overall risk in portfolio -lower the correlation, the more overall risk in portfolio is reduced -ex: assets with +1 eliminate no risk assets with less than +1 eliminate some risk assets with less than 0 correlation eliminate more risk assets with -1 eliminate all risk

beta of portfolio

-calculated as the weighted average of the betas of individual assets the portfolio includes -to earn more return=one must bear more risk -only nondiversifiable risk (relevant risk) provides a positive risk return relationship -beta of 1 will experience a 10% increase when market increases 10%, beta of .75 will experience a 7.5% increase when market increases 10%, etc -if want to sell stock, sell at lower beta

traditional approach

-emphasizes balancing the portfolio using a wide variety of stocks and bonds -uses a broad range of industries to diversify the portfolio -tends to focus on well-known companies:perceived as less risky, stocks are more liquid and available, higher comfort levels

modern portfolio theory (MPT)

-emphasizes statistical measure to develop a portfolio plan -focus is on: expected returns, standard deviation of returns, and correlation btwn returns -combines securities that have negative correlations btwn each others rates of return

efficient frontier

-leftmost boundary of feasible set of portfolios that include all efficient portfolios those providing the best attainable tradeoff btween risk and return -portfolios that fall to the right of efficient frontier are not desirable because their risk return tradeoffs are inferior -portfolios that fall to left of efficient frontier are not available for investments

Return

Level of profit from an investment or the reward of investment

Income

cash or near-cash that is received as a result of owning an investment

interest rate risk

chance that changes in interest rates will adversely affect a security's value -bonds and preferred stock -ex:market values of existing bonds decrease as market interest rates increase

purchasing power risk

chance that changing price levels (inflation or deflation) will adversely affect investment returns -bonds and certifications affected -ex: movie that was 8 last year is 9 this year

tax risk

chance that congress will make unfavorable changes in tax laws, driving down the after-tax returns and market values of certain investments -municipal bonds and real estate affected -ex:lower tax rates reduce the tax benefit of municipal bond interest, limits on deductions from real estate losses

risk

change that actual return from an investment may differ from what is expected

portfolio

collection of investments assembled to meet one or more investment goals

event risk

comes from an unexpected event that has a significant and unusually immediate effect on the underlying value of an investment -all investment types are affected -ex:decrease in value of insurance company stock after a major hurricane

realized return

current return actually received by an investor during the given return period

business risk

degree of uncertainty associated with an investments earnings and investments ability to pay the returns owed to investors -common and preferred stock that is affected most -a decline in company profits or market share and bad management decisions

financial risk

degree of uncertainty of payment resulting from a firms mix of debt and equity, the larger the proportion of debt financing, the great the risk -common stock and corporate bonds -examples: company cant get addtional loans for growth or to fund operations

perfectly negatively correlated

describes two negative correlated series having a correlation coefficient of -1

perfectly positively correlated

describes two positive correlated series having a correlation coefficient of 1+

uncorrelated

describes two series that lack any relationship and have a correlation coefficient of nearly zero

internal rate of return

determines the compound annual rate of return earned on an investment held for longer than one year

real rate of return

equals the nominal rate of return minus the inflation rate and this measures the change in purchasing power provided by an investment