Chapter 4

Return and Risk

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Return and Risks

Learning Goals
1. Review the concept of return, its components, the forces that affect the investors level of return, and historical returns. 2. Discuss the role of time value of money in measuring return and defining a satisfactory investment.
3. Describe real, risk-free, and required returns and the calculation and application of holding period return.

Return and Risks

Learning Goals (contd)

4. Explain the concept and calculation of yield and how to find growth rates.
5. Discuss the key sources of risk that might affect potential investment vehicles. 6. Understand the risk of a single asset, risk assessment, and the steps that combine return and risk.

The Concept of Return

Return
The level of profit from an investment, or The reward for investing

Components of Return
Income: cash or near-cash that is received as a result of owning an investment Capital gains (or losses): the difference between the proceeds from the sale of an investment and its original purchase price

Total Return: the sum of the income and the capital gain (or loss) earned on an investment over a specified period of time

Why Return is Important

Allows comparison of actual or expected gains with the levels of gain needed Allows us to keep score on how our investments are doing compared to our expectations Historical Performance
Provides a basis for future expectations Does not guarantee future performance

Expected Return
Return an investor thinks an investment will earn in the future Determines what an investor is willing to pay for an investment or if they are willing to make an investment

Key Factors in Return

Internal Characteristics
Type or risk of investment Issuers management Issuers financing

External Forces
Political environment Business environment Economic environment Inflation Deflation

Table 4.4 Historical Returns for Popular Security Investments (1926-2005)

The Time Value of Money and Returns

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

Determining a Satisfactory Investment

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

Measuring Return
Required Return
The rate of return an investor must earn on an investment to be fully compensated for its risk
Required return Risk-free Risk premium on investment j rate for investment j
Required return Real rate Expected inflation Risk premium on investment j of return premium for investment j

Measuring Return (contd)

Real Rate of Return
Equals the nominal rate of return minus the inflation rate Measures the change in purchasing power provided by an investment

Expected Inflation Premium

The average rate of inflation expected in the future

Measuring Return (contd)

Risk-free Rate
The rate of return that can be earned on a risk-free investment The most common risk-free investment is considered to be the 3month U.S. Treasury Bill

Real rate Expected inflation Risk-free rate of return premium

RF r * IP

Measuring Return (contd)

Risk Premium
Additional return an investor requires on a risky investment to compensate for risks based upon issue and issuer characteristics Issue characteristics are the type, maturity and features Issuer characteristics are industry and company factors

Holding Period Return (HPR)

Holding Period: the period of time over which an investor wishes to measure the return on an investment vehicle Realized Return: current return actually received by an investor during the given return period Paper Return: return that has been achieved but not yet realized (no sale has taken place)

Holding Period Return (HPR)

Holding Period Return
The total return earned from holding an investment for a specified holding period (usually 1 year or less)
Current income Capital gain (or loss) during period during period Beginning investment value

Holding period return

Capital gain (or loss) Ending Beginning during period investment value investment value

Table 4.6 Key Financial Variables for Four Investment Vehicles

Using HPR in Investment Decisions

Advantages of Holding Period Return

Easy to calculate Easy to understand Considers income and growth

Disadvantages of Holding Period Return

Does not consider time value of money Rate may be inaccurate if time period is longer than one year

Yield: Internal Rate of Return (IRR)

Internal Rate of Return: determines the compound annual rate of return earned on an investment held for longer than one year Yield (IRR) Example: What is the yield (IRR) on an investment costing $1,000 today that you expect will be worth $1,400 at the end of a 5-year holding period?

Calculating an Investments Yield Using an Excel Spreadsheet

Using IRR in Investment Decisions (contd)

Advantages of Internal Rate of Return

Uses the time value of money Allows investments of different investment periods to be compared with each other If the yield is equal to or greater than the required return, the investment is acceptable

Disadvantages of Internal Rate of Return

Calculation is complex

Yield (IRR) for a Stream of Income

Some investments, such as bonds, provide uneven streams of income over the investment period Calculate yield (IRR) by finding the discount rate that equates the PV of the investments income stream to its market price

Table 4.7 Present Value Applied to an Investment

Internal Rate of Return (IRR): Using an Excel Spreadsheet

Interest on Interest: The Critical Assumption

Using yield (IRR) to measure return assumes that all income earned over the investment horizon is reinvested at the same rate as the original investment. Reinvestment Rate is the rate of return earned on interest or other income received from an investment over its investment horizon. Fully compounded rate of return is the rate of return that includes interest earned on interest.

Figure 4.1 Earning Interest on Interest

Finding Growth Rates

Rate of Growth
The compound annual rate of change in the value of a stream of income
Used to see how quickly a stream of income, such as dividends, is growing

Finding Growth Rates

Growth Rate Example: Calculate the rate of growth on the dividend stream in Table 4.3.
Table 4.3 Dividends Per Share

Finding Growth Rates: Using an Excel Spreadsheet

Sources of Risk
Risk-Return Tradeoff is the relationship between risk and return, in which investments with more risk should provide higher returns, and vice versa

Risk is the chance that the actual return from an investment may differ from what is expected

Sources of Risk (contd)

Currency Exchange Risk is the risk caused by the varying exchange rates between the currencies of two countries. (Discussed in Chapter 2) Types of Investments Affected
International stocks or ADRs International bonds

Examples of Currency Exchange Risk

U.S. dollar gets stronger against foreign currency, reducing value of foreign investment

Sources of Risk (contd)

Business Risk is the degree of uncertainty associated with an investments earnings and the investments ability to pay the returns owed to investors. Types of Investments Affected
Common stocks Preferred stocks

Examples of Business Risk

Decline in company profits or market share Bad management decisions

Sources of Risk (contd)

Financial Risk is the degree of uncertainty of payment resulting from a firms mix of debt and equity; the larger the proportion of debt financing, the greater this risk. Types of Investments Affected
Common stocks Corporate bonds

Examples of Financial Risk

Company cant get additional loans for growth or to fund operations Company defaults on bonds

Sources of Risk (contd)

Purchasing Power Risk is the chance that changing price levels (inflation or deflation) will adversely affect investment returns. Types of Investments Affected
Bonds (fixed income) Certificates of deposit

Examples of Purchasing Power Risk

Movie that was $8.00 last year is $9.00 this year

Sources of Risk (contd)

Interest Rate Risk is the chance that changes in interest rates will adversely affect a securitys value.

Types of Investments Affected

Bonds (fixed income) Preferred stocks

Examples of Interest Rate Risk

Market values of existing bonds decrease as market interest rates increase Income from an investment is reinvested at a lower interest rate than the original rate

Sources of Risk (contd)

Liquidity Risk is the risk of not being able to liquidate an investment conveniently and at a reasonable price. Types of Investments Affected
Some small company stocks Real estate

Examples of Liquidity Risk

The price of a house has to be lowered for a quick sale

Sources of Risk (contd)

Tax Risk is the chance that Congress will make unfavorable changes in tax laws, driving down the after-tax returns and market values of certain investments. Types of Investments Affected
Municipal bonds Real estate

Examples of Tax Risk

Lower tax rates reduce the tax benefit of municipal bond interest Limits on deductions from real estate losses

Sources of Risk (contd)

Market Risk is the risk of decline in investment returns because of market factors independent of the given investment. Types of Investments Affected
All types of investments

Examples of Market Risk

Stock market decline on bad news Political upheaval Changes in economic conditions

Sources of Risk (contd)

Event Risk comes from an unexpected event that has a significant and unusually immediate effect on the underlying value of an investment. Types of Investments Affected
All types of investments

Examples of Event Risk

Decrease in value of insurance company stock after a major hurricane Decrease in value of real estate after a major earthquake

Measures of Risk: Single Asset

Standard deviation is a statistic used to measure the dispersion (variation) of returns around an assets average or expected return Coefficient of variation is a 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 values for both indicate higher risk

Table 4.10 Historical Returns and Standard Deviations for Select Asset Classes (19002008)

Figure 4.2 Risk-Return Tradeoffs for Various Investment Vehicles

Acceptable Levels of Risk Depend Upon the Individual Investor

Risk-indifferent describes an investor who does not require a change in return as compensation for greater risk Risk-averse describes an investor who requires greater return in exchange for greater risk Risk-seeking describes an investor who will accept a lower return in exchange for greater risk

Figure 4.3 Risk Preferences

Steps in the Decision Process: Combining Return and Risk

Estimate the expected return using present value methods and historical/projected return rates Assess the risk of the investment by looking at historical/projected returns using standard deviation or coefficient of variation of returns Evaluate the risk-return of each investment alternative to make sure the return is reasonable given the level of risk

Select the investment vehicles that offer the highest expected returns associated with the level of risk you are willing to accept

Chapter 4 Review
Learning Goals
1. Review the concept of return, its components, the forces that affect the investors level of return, and historical returns. 2. Discuss the role of time value of money in measuring return and defining a satisfactory investment. 3. Describe real, risk-free, and required returns and the calculation and application of holding period return.

Chapter 4 Review (contd)

Learning Goals (contd)
4.
5. 6.

Explain the concept and calculation of yield and how to find growth rates.
Discuss the key sources of risk that might affect potential investment vehicles. Understand the risk of a single asset, risk assessment, and the steps that combine return and risk.

Chapter 4

Additional Chapter Art

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Table 4.1 Profiles of Two Investments

Table 4.2 Total Returns of Two Investments

Table 4.3 Historical Investment Data for ExxonMobil Corp. (XOM)

Table 4.5 Present Value Applied to an Investment

Table 4.7 Yield Calculation for an $1,100 Investment

Table 4.8 Historical Returns for ExxonMobil and Panera Bread

Table 4.9 Calculation of Standard Deviations of Returns for ExxonMobil and Panera Bread