risk and return.ppt

INVESTMENTSINVESTMENTS

Chapter 6Chapter 6

The Returns and Risks from The Returns and Risks from InvestingInvesting

• Define “return” and state its two components.• Explain the relationship between return and risk.• Identify the sources of risk.• Describe the different methods of measuring

returns.• Describe the different methods of measuring

risk.• Discuss the returns and risks from investing in

major financial assets in the past.

Learning ObjectivesLearning Objectives

Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 6


• Function of both return and risk At the centre of security analysis

• How should realized return and risk be measured? The realized risk-return tradeoff is based on

the past The expected future risk-return tradeoff is

uncertain and may not occur

Asset ValuationAsset Valuation


• Returns consist of two elements: Yield: Periodic cash flows such as interest or

dividends (income return)• “Yield” measures relate income return to a price

for the security Capital Gain or Loss: Price appreciation or

depreciation• The change in price of the asset

• Total Return = Yield + Price Change

Return ComponentsReturn Components


• Interest Rate Risk Affects market value

and resale price

• Market Risk Overall market

effects• Inflation Risk

Purchasing power variability

• Business Risk

• Financial Risk Tied to debt financing

• Liquidity Risk Time and price

concession required to sell security

• Exchange Rate Risk• Country Risk

Potential change in degree of political stability

Risk SourcesRisk Sources


• Two general types: Systematic (market) risk

• Pervasive, affecting all securities, cannot be avoided

• Interest rate or market or inflation risks Non-systematic (non-market) risk

• Unique characteristics specific to a security• Total Risk = General Risk + Specific Risk =

Systematic Risk + Non-Systematic Risk

Types of RiskTypes of Risk


• Total Return (TR) compares performance over time or across different securities

• Total Return is a percentage relating all cash flows received during a given time period, denoted CFt +(PE - PB), to the start of period price, PB

B

BEtP

)P(PCFTR

Measuring ReturnsMeasuring Returns


• Total Return can be either positive or negative When cumulating or compounding, negative

returns are a problem• A Return Relative solves the problem

because it is always positive

RR CF PPt E

B1 TR



• To measure the level of wealth created by an investment rather than the change in wealth, returns need to be cumulated over time

• Cumulative Wealth Index, CWIn, over n periods, =

)nTR1)...(2TR1)(1TR1(0WI



• International returns include any realized exchange rate changes If foreign currency depreciates, returns are

lower in domestic currency terms• Total Return in domestic currency =

1For.Curr. of Val.Begin

For.Curr. of Val.EndRR

Measuring International ReturnsMeasuring International Returns


• TR, RR, and CWI are useful for a given, single time period

• What about summarizing returns over several time periods? Arithmetic mean and geometric mean

• Arithmetic mean, or simply mean

nXX

Summary Statistics for ReturnsSummary Statistics for Returns


• Arithmetic mean does not measure the compound growth rate over time Does not capture the realized change in

wealth over multiple periods Does capture typical return in a single period

• Geometric mean reflects compound, cumulative returns over more than one period

Arithmetic versus GeometricArithmetic versus Geometric


• Geometric mean defined as the n-th root of the product of n return relatives minus one, or G =

1)TR1)...(TR1)(TR1( n/1n21

sX1G1 222

• Difference between Geometric mean and Arithmetic mean depends on the variability of returns, s

Geometric MeanGeometric Mean


• Returns measures are not adjusted for inflation Purchasing power of investment may change

over time Consumer Price Index (CPI) is a possible

measure of inflation

TR IATRCPI

11 1

Inflation-Adjusted ReturnsInflation-Adjusted Returns


• Risk is the chance that the actual outcome will be different than the expected outcome

• Standard Deviation measures the deviation of returns from the mean

s X Xn 1

2 1/2

Measuring RiskMeasuring Risk


• Premium is additional return earned or expected for additional risk Calculated for any two asset classes

• Equity risk premium is the difference between stock and risk-free returns

• Bond default premium is the difference between the return on long term corporate bonds and long term government bonds

Risk PremiumsRisk Premiums


• Equity Risk Premium, ERP, =

11

1

RF

CSTR

or, RFTRCS

Risk PremiumsRisk Premiums


• Since 1938, cumulative wealth indexes show stock returns dominate bond returns Stock standard deviations also exceed bond

standard deviations• Annual geometric mean return for the time

period between 1938 and 2007 for Canadian common stocks is 10.68% with standard deviation of 16.22%

The Risk-Return RecordThe Risk-Return Record


Table 6-5 Summary Statistics of Annual Total Table 6-5 Summary Statistics of Annual Total Returns for Major Financial Assets, 1938–2007Returns for Major Financial Assets, 1938–2007


• On an inflation-adjusted basis

INFIA CI

CWICWI

CPCCWIYI

YICWICPC

Cumulative Wealth IndexesCumulative Wealth Indexes

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