Finance & Financial Management

Risk & Return: Lessons from Market

History
Lecture 4

Lecture slides are based on the textbook and accompanying slides of

Hillier, Ross, Westerfield, Jaffe, and Jordan “Corporate Finance”.
European Edition, 3rd Edition, McGraw-Hill, 2016, (Copyright © The
McGraw-Hill Companies 2016)
Risk & Return: Lessons from Market History
- Understand the relationship between risk and return
and appreciate the differences between equities and
debt.

- Be able to calculate returns on financial investments.

- Be familiar with the concepts and measures of risk and

return, specifically mean, median, & standard deviation.
 Returns

Monetary Percentage
Returns Returns
 Monetary Returns

Dividend
Income

Total
Monetary
Return
Capital
Gains
 Monetary Return

You purchase 100 shares at £37 each:

Total Investment = £3,700
Scenario 1: Scenario 2:
Dividend: £1.85 per share Dividend = £1.85 per share
Share price = £40.33 Share price = £34.78
Total Monetary Return = Total Monetary Return =
(£1.85 + £40.33 - £37) x (£1,85 + £34.78 - £37) x
100 = £518 100 = -£37
Monetary Returns
 Percentage Returns

Dividend
Yield

Percentage
Return

Capital
Gains
Yield
 Percentage Returns

Dividend Capital Gains Percentage

Yield Yield Return
• Divt-1/Pt • (Pt – Pt-1)/Pt-1 • Dividend
Yield +
Capital
Gains Yield
 Percentage Returns
• P0 = £37; Div1 = £1.85; P1 = £40.33
Dividend yield = Divt +1 /Pt Capital gain = (Pt 1  Pt )/Pt
= £1.85/£37 = (£40.33  £37)/£37
= .05 = £3.33/£37
= 5% = .09
= 9%
Divt 1 (Pt 1  Pt )
Rt 1  +
Pt Pt
= 5% + 9%
= 14%
 Example 1:
Calculating Returns
Suppose an equity begins the year with a price of €25 per
share and ends with a price of €35 per share. During the
year it paid a €2 dividend per share. What are its dividend
yield, its capital gain, and its total percentage return for the
year?
Div1 P1  P0
R1  +
P0 P0
€2 €35  25 €12
= + 
€25 €25 €25
= 8% + 40%  48%
Stock Market Performance
of Selected Countries
Annual Stock Market Index
Levels 2005 - 2012
 Annual Stock Market
Returns (%) 2005 - 2012
 Holding Period Returns

Holding Period
Return is the return R = (1 + R1) x (1 +
you earn from R2) x . . . x (1 + Rt) x
holding an asset for . . . x (1 + RT )
many periods
 UK Equity Return
Histogram: 1801 - 2011
 Return Statistics:
Mean Returns

(R1 + · · · + R T )
Mean = R 
T
 Example 2: Calculating
Average Returns
The returns on large French company
shares between 2009 and 2011 were .4278,
.0993, and -.2116, respectively. What was
the average, or arithmetic mean, return over
these three years?

.4278 + .0993 - .2116

R= = .1052 or 10.52%
3
 Average Stock Returns and Risk
Free Returns: Risk Premiums

Risk Premium is the

return on a risky The higher the risk
asset less the return premium, the more
on the risk free risky the investment
security

Government
Treasury bills are
used as the risk-free
asset
 Worldwide Annualized Equity
Risk Premium, 1900-2010

Source: Elroy Dimson, Paul Marsh, and Mike Staunton, Triumph of the Optimists, Princeton University Press, 2002,
and subsequent research. Premiums for Germany are based on 109 years, excluding hyperinflationary 1922–23.
Dimson, E., Marsh, P. and M. Staunton, Equity Premia Around the World, in Rethinking the Equity Risk Premium
(December 2011),CFA Institute.
 Risk Statistics: Variance
and Standard Deviation
The returns on China’s stock market between
2007 and 2011 are .9665, -.6425, .7247, -.1205,
and -.1820, respectively. What is the variance and
standard deviation of China’s returns?
1
Var = [(R1 - R)2 + (R2 - R)2 + (R3 - R)2 + (R4 - R)2 + (R5 - R)2 ]
T -1
1
1.8088 = [(.9665 - .1492) + (-.6426 - .1492) + (.7247 - .1492)
2 2 2
3
+ (-.1206 - .1492) + (-.1821 - .1492) ]
2 2

SD = 1.8088 = 1.3449 or 134.49%

Risk Statistics from
Morningstar
Risk Statistics from
Morningstar
Risk Statistics from
Morningstar
Stock Return Distributions:
The Normal Distribution
 Value at Risk
Definition Example
The potential loss in If the VaR is €100 million with
a one-week holding period and
an asset’s value a 5 per cent probability, you
within a specified would say that there is a 5 per
cent probability that you may
time period with a lose more than €100 million in
specified probability the value of your portfolio.
 Example 4:
VaR Example
We have invested €1 million in the
Allianz RCM Europe Small Cap
Equity Fund. What is the biggest
drop in value that we could expect
over the next month with a 1 per
cent probability?
 Example 4:
VaR Example
Step 1: Find the monthly mean and
standard deviation of the fund’s returns.
Annual
R 19.84%
R Monthly
= = = 1.65%
12 12
s Annual
24.08%
s Monthly
= = = 6.95%
12 12
 Example 4:
VaR Example
Step 2: Calculate the negative return that
will occur 1% of the time. Since we assume
that the Allianz RCM Europe Small Cap
Equity Fund returns are normally distributed,
we can say that a return that is 2.33
standard deviations below the mean will only
occur 1 per cent of the time. In the Allianz
case, this return is:

R1%,Monthly
VaR
= 1.65% - 2.33(6.95%) = -14.54%
 Example 4:
VaR Example
Step 3: Calculate VaR

With a €1 million investment, the

VaR would be (14.54% of €1
million =) €140,540.
 Geometric Average
Returns
Geometric average return
= [(1 + R1) x (1 + R2) x … x (1 + R)]1/  - 1

Arithmetic mean return

(R1 + · · · + R T )
Mean = R 
T
 Example 5: Calculating
Geometric Returns
Calculate the geometric average return for French
stocks for 2007-2011.
Step 1:

Step 2:
Geometric average return = 0.56861/5 - 1 = -
0.10677, or -10.677%
 Worldwide Risk Premiums
Relative to Bonds, 1900-2010
 Arithmetic or Geometric
Returns?
Arithmetic Geometric

• Tells you what • Tells you what

you earn in a you actually
typical year earned per year
on average,
compounded
annually