Professional Documents
Culture Documents
+
=
n
r 1 r
1
r
1
C P
South-Western / Thomson Learning 2004
2 - 14
The Time Value of Money
Insert Figure 2.1 here.
South-Western / Thomson Learning 2004
2 - 15
Compounding
Compounding refers to the earning of
interest on interest that is earned previously.
where r = annual interest rate
n = number of compounding periods per year
and t = investment horizon in years
nt
n
r
1 P F
|
.
|
\
|
+ =
South-Western / Thomson Learning 2004
2 - 16
The more frequent the compounding, the
greater the interest earned.
In the limit, compounding occurs
continuously, and F approaches Pe
rt
.
Compounding
South-Western / Thomson Learning 2004
2 - 17
Compound annual return is the
annual interest rate that makes the
time value of money relationship
hold.
Example :
A nondividend-paying stock bought 4.5 years ago
at $40 and sold today at $78 has a compound
annual return of R, where $40(1+R)
4.5
=$78.
Compound Annual Return
It is also known as the effective
annual rate.
South-Western / Thomson Learning 2004
2 - 18
A truly risky situation must
involve a chance of loss.
Risk vs. Uncertainty
South-Western / Thomson Learning 2004
2 - 19
Dispersion and the Chance of Loss
There are 2 aspects to risk - the average
outcome and the scattering of the possible
outcomes about this average.
A common measure of statistical
dispersion is variance. The standard
deviation is the square root of the variance.
( ) ) (
1
2
i prob x x Variance
n
i
i
=
=
South-Western / Thomson Learning 2004
2 - 20
Dispersion and the Chance of Loss
Insert Figure 2-3 here.
South-Western / Thomson Learning 2004
2 - 21
The Problem with Losses
Big losses - a large one-period loss can
overwhelm a series of gains
Small losses - can be a problem too if they
occur too often
Risk and the time horizon - as the time
horizon increases, the probability of losing
money decreases but the amount of money
that may be lost increases.
South-Western / Thomson Learning 2004
2 - 22
Small Losses
Insert Figure 2-4 here.
South-Western / Thomson Learning 2004
2 - 23
Risk and the Time Horizon
South-Western / Thomson Learning 2004
2 - 24
Risk Aversion and Rational People
A safe (certain) dollar is worth more than a
risky dollar.
A rational person will choose a certain
dollar over a risky dollar.
Risk averse persons will take risks, when
they expect to be rewarded for taking the
risks.
People have different degrees of risk
aversion. Some are more willing to take a
chance than others.
South-Western / Thomson Learning 2004
2 - 25
Risk Aversion and Rational People
Table 2.4 Four Risky Alternatives
Choice 1 Choice 2 Choice 3 Choice 4 ___
Resulting Resulting Resulting Resulting
Number Payoff Number Payoff Number Payoff Number Payoff
1-50 $110 1-50 $200 1-90 $ 50 1-99 $1,000
51-100 $ 90 51-100 $ 0 91-100 $550 100 -$89,000
Avg. $100 Avg. $100 Avg. $100 Avg. $ 100
South-Western / Thomson Learning 2004
2 - 26
Risk and Time
Probability theory deals with how much
and how likely, but says nothing about
when.
Forecast variance increases indefinitely as
the length of the forecast period
approaches infinity.
To be comparable, returns must be
measured over consistent time intervals.
South-Western / Thomson Learning 2004
2 - 27
While the returns over a long horizon may
be more uncertain, history suggests that
over long periods of time, the likelihood
that the investment will lose money is less.
Risk and Time
South-Western / Thomson Learning 2004
2 - 28
Partitioning Risk
Undiversifiable risk is risk that must be
borne by virtue of being in the market.
It is also known as systematic risk or
market risk, and is measured by beta.
Diversifiable risk is also known as
unsystematic risk.
Total risk = undiversifiable risk
+ diversifiable risk
South-Western / Thomson Learning 2004
2 - 29
Partitioning Risk
Business risk - the variability in a firm's
sales, or its ability to sell its product
Financial risk - associated with the
financial structure of the firm
Purchasing power risk - the possibility that
the rate of return on an investment will be
insufficient to offset the rise in the cost of
living
South-Western / Thomson Learning 2004
2 - 30
Partitioning Risk
Interest rate risk - the chance of a loss in
portfolio value due to an adverse change in
interest rate
Foreign exchange risk - the possibility of
loss due to adverse changes in the relative
values of world currencies
South-Western / Thomson Learning 2004
2 - 31
Partitioning Risk
Political risk - the possibility that a
government will interfere with a firm's
preferred manner of conducting business
Social risk - the potentially adverse impact
changing public attitudes can have on a
firm's ability to sell its product
South-Western / Thomson Learning 2004
2 - 32
Partitioning Risk
Insert Figure 2-5 here.
South-Western / Thomson Learning 2004
2 - 33
Partitioning Risk
Insert Figure 2-6 here.
South-Western / Thomson Learning 2004
2 - 34
The Direct Relationship between Risk and Return
Insert Figure 2-7 here.
South-Western / Thomson Learning 2004
2 - 35
Empirical financial research reveals clear
evidence of the direct relationship between
systematic risk and expected return, i.e.
riskier securities earn higher returns on
average.
The Direct Relationship between Risk and Return
South-Western / Thomson Learning 2004
2 - 36
The Direct Relationship between Risk and Return
Insert Figure 2-8 here.
South-Western / Thomson Learning 2004
2 - 37
Risk, Return, and Dominance
An investment alternative shows
dominance over another if it offers the
same expected return for less risk, or if the
security has a higher expected return than
another security of comparable risk.
Equivalent assets should sell for the same
price. This is known as the law of one
price.
South-Western / Thomson Learning 2004
2 - 38
Risk, Return, and Dominance
Insert Figure 2-9 here.
South-Western / Thomson Learning 2004
2 - 39
Return
Holding Period Return
Yield and Appreciation
The Time Value of Money
Compounding
Compound Annual Return
Review
South-Western / Thomson Learning 2004
2 - 40
Risk
Risk vs. Uncertainty
Dispersion and the Chance of Loss
The Problem with Losses
Big Losses
Small Losses
Risk and the Time Horizon
Risk Aversion
Risk Aversion and Rational People
Risk and Time
Partitioning Risk
Review
South-Western / Thomson Learning 2004
2 - 41
More on the Relationship between Risk and
Return
The Direct Relationship
Risk, Return, and Dominance
Review