CORPORATE FINANCE

Chapter 10:​ RISK AND RETURN: LESSONS FROM MARKET HISTORY

I. Returns
- Dollar Return = Dividend + Change in Market Value
dollar return
- Percentage Return = beginning market value
dividend+change in market value
= beginning market value
= dividend yield + capital gain yield
II. Holding period returns:
- The holding period return is the return that an investor would get when holding an
investment over a period of ​T ​years, when the return during year ​i​ is given as ​R​i:​
- HPR = (1+R​1​) x (1+R​2​) … -1
III. Return statistics:
- The history of capital market returns can be summarized by describing the:
● average return
R +…+ R
R= 1 T T

● the standard deviation of those returns

√
2 2
(R1 −R) +…+(RT −R)
S D = √V AR = T −1

● the frequency distribution of the returns

→​ Important lesson from historical financial market:
+ Investors require a risk premium when investing in risky assets instead of risk free
assets.
+ The riskier assets, the higher expected return
IV. Average stock returns and risk – free returns:
- The ​Risk Premium is the added return (over and above the risk-free rate)
resulting from bearing risk:
- Risk premium = R​i​ - R​f
- Market risk premium​ (MRP)
​ = R​M​ - R​f
- US Treasury Bill is used as Risk free rate (R​f​)

Default risk Inflation risk Interest rate risk

Large Company Stocks ✓ ✓ ✓
Small Company Stocks ✓ ✓ ✓
Long-term Corporate Bonds ✓ ✓ ✓
 Long-term Government Bonds ✗ ✓ ✓
. Treasury Bills (Risk free asset) ✗ ✗ ✗

V. Risk statistics:
- Total risk is measured by variance or standard deviation.
● The standard deviation is the standard statistical measure of the spread of a
sample, and it will be the measure we use most of this time.
● Its interpretation is facilitated by a discussion of the normal distribution.
VI. More on average returns:
- Arithmetic average – return earned in an average period over multiple periods
R +…+ R
R= 1 T T

- Geometric average – average compound return per period over multiple periods
Rg = √
T
(1 + R1 ) + (1 + R2 ) + … -1
- The geometric average will be less than the arithmetic average unless all the
returns are equal.
- Which is better?
● The arithmetic average is overly optimistic for long horizons.
● The geometric average is overly pessimistic for short horizons.