You are on page 1of 37

1

Chapter

A Brief History of Risk and Return

Fundamentals
& Management
Investments
of Valuation

second edition

Charles J. Corrado Bradford D. Jordan
McGraw Hill / IrwinSlides by Yee-Tien (Ted) Fu

@2002 by the McGraw- Hill Companies Inc.All rights reserved.

1-2

Who Wants To Be A Millionaire?

McGraw Hill / Irwin

2002 by The McGraw-Hill Companies, Inc. All rights reserved.

1-3

A Brief History of Risk and Return
Goal

Our goal in this chapter is to see
what financial market history can tell
us about risk and return.

 Two key observations emerge.
 There

is a reward for bearing risk, and at least on
average, that reward has been substantial.
 Greater rewards are accompanied by
greater risks.
McGraw Hill / Irwin

2002 by The McGraw-Hill Companies, Inc. All rights reserved.

1-4 Returns Total dollar return The return on an investment measured in dollars that accounts for all cash flows and capital gains or losses. All rights reserved. Inc. Example Total dollar return = Dividend + Capital gain on stock income (or loss) McGraw Hill / Irwin  2002 by The McGraw-Hill Companies. .

Example Percent return = Dividend + Capital gains on stock yield yield or Total dollar return Beginning stock price . McGraw Hill / Irwin  2002 by The McGraw-Hill Companies. All rights reserved. Inc. It is the return for each dollar invested.1-5 Returns Total percent return The return on an investment measured as a % of the originally invested sum that accounts for all cash flows and capital gains or losses. .

After one year. McGraw Hill / Irwin  2002 by The McGraw-Hill Companies.000 = $480  At the end of the year. you also received $2 in dividends.000 investment is $1. the value of your $1.000 in a stock at $25 per share.480.1-6 Returns Example: Calculating Returns  Suppose you invested $1. Inc. . For each share. the price increases to $35.  Dividend yield = $2 / $25 = 8%  Capital gains yield = ($35 – $25) / $25 = 40%  Total percentage return = 8% + 40% = 48%  Total dollar return = 48% of $1. All rights reserved.

1-7 The Historical Record: A First Look McGraw Hill / Irwin .

All rights reserved.1-8 The Historical Record: A Longer Range Look McGraw Hill / Irwin @2002 by the McGraw.Hill Companies Inc. .

1-9 Returns A company total market capitalization ( or market cap. In other words . . All rights reserved. For short ) is equal to its stock price multiplied by the number of shares of stocks . it’s the total value of the company stock . Large companies are called “large cap” stocks and small companies are called “small cap “stocks . Inc. McGraw Hill / Irwin  2002 by The McGraw-Hill Companies.

Hill Companies Inc.1 .3 McGraw Hill / Irwin @2002 by the McGraw.All rights reserved.10 The Historical Record: A Closer Look Figure 1. .

Hill Companies Inc.All rights reserved.11 The Historical Record: A Closer Look McGraw Hill / Irwin @2002 by the McGraw. .1 .

Hill Companies Inc.1 .All rights reserved.12 The Historical Record: A Closer Look McGraw Hill / Irwin @2002 by the McGraw. .

All rights reserved.Hill Companies Inc.1 .13 The Historical Record: A Closer Look McGraw Hill / Irwin @2002 by the McGraw. .

All rights reserved.14 The Historical Record: A Closer Look McGraw Hill / Irwin @2002 by the McGraw.1 .Hill Companies Inc. .

15 Average Returns: The First Lesson  Average annual =  yearly returns return number of years McGraw Hill / Irwin  2002 by The McGraw-Hill Companies. All rights reserved. Inc.1 . .

Hill Companies Inc.16 Average Returns: The First Lesson McGraw Hill / Irwin @2002 by the McGraw.All rights reserved. .1 .

All rights reserved. McGraw Hill / Irwin  2002 by The McGraw-Hill Companies. the reward for bearing risk. Inc. . Risk premium The extra return on a risky asset over the risk-free rate.17 Average Returns: The First Lesson Risk-free rate The rate of return on a riskless investment.1 .

.18 Average Returns: The First Lesson McGraw Hill / Irwin @2002 by the McGraw.All rights reserved.Hill Companies Inc.1 .

All rights reserved. on average. .1 . Inc. for bearing risk.19 Average Returns: The First Lesson The First Lesson  There is a reward. McGraw Hill / Irwin  2002 by The McGraw-Hill Companies.

1 .20 Return Variability: The Second Lesson McGraw Hill / Irwin @2002 by the McGraw.Hill Companies Inc.All rights reserved. .

McGraw Hill / Irwin  2002 by The McGraw-Hill Companies. Normal distribution A symmetric.21 Return Variability: The Second Lesson Variance A common measure of volatility. All rights reserved. . Inc. bell-shaped frequency distribution that is completely defined by its average and standard deviation. Standard deviation The square root of the variance.1 .

All rights reserved. .22 Return Variability: The Second Lesson Variance of return R  R  N Var  R   σ  2 i 1 2 i N 1 where N is the number of returns Standard deviation of return SD R   σ  Var  R  McGraw Hill / Irwin  2002 by The McGraw-Hill Companies.1 . Inc.

D. Inc. All rights reserved.487% McGraw Hill / Irwin  2002 by The McGraw-Hill Companies. .23 Return Variability: The Second Lesson Example about variance : Suppose a particular investment had returns of 10% .12% . =90 = 9.1 .3%(-9%) Over the last four years The average return is : (10% + 12%+ 3%+ (-9%))/4 = 4 % The deviation from the average is : (10-4 )²=36 (12-4) ²=64 (3-4) ²=1 (-9-4) ²=169 _________________ variance= 270 /3 = 90 S.

Inc.487% From these two numbers we can say that :  with a normal distribution the probability that we end up with one standard deviation from the average is about 68% . McGraw Hill / Irwin  2002 by The McGraw-Hill Companies. =90 = 9. D.1 .  with a normal distribution the probability that we end up with three standard deviation from the average is about 1% .24 Return Variability: The Second Lesson Example about variance : variance= 270 /3 = 90 S.  with a normal distribution the probability that we end up with two standard deviation from the average is about 95% . . All rights reserved.

. Are 7% . All rights reserved. The probability that the return in a given year is in the range of ( (4+7) to (4-7) )= ( 11% to -3% ) within one standard deviation is about 68%.1 .25 Return Variability: The Second Lesson To let you know : If you know that the standard deviation of returns in the previous ex. McGraw Hill / Irwin  2002 by The McGraw-Hill Companies. Inc. and the average return that calculated before are 4%.

Return Variability: The Second Lesson 1 .26 .

All rights reserved.1 . .Hill Companies Inc.27 Return Variability: The Second Lesson McGraw Hill / Irwin @2002 by the McGraw.

Inc.28 Return Variability: The Second Lesson The Second Lesson  The greater the potential reward. . the greater the risk.1 . McGraw Hill / Irwin  2002 by The McGraw-Hill Companies. All rights reserved.

7 .22.4 March 14.12.7.8 .2 .0 . 1932 Source: Jones McGraw HillDow / Irwin . Allrights rightsreserved. 1929 November 6.29 Return Variability: The Second Lesson Top 12 One-Day Percentage Changes in the Dow Jones Industrial Average October 19.7.7 . by The the McGraw-Hill McGraw. 1899 August 12.8.2  @2002 2002 by Inc.3 % .6 % . 1987 October 28.All . 1929 December 18. 1937 February 1.1 .11. 1933 October 18.7. 1987 July 21.7.HillCompanies. 1997 . 1917 October 27.8.8.9 . Companies Inc. 1907 October 26.7 .9.8 . reserved.8. 1929 October 29.

30 Risk and Return McGraw Hill / Irwin @2002 by the McGraw.Hill Companies Inc.All rights reserved. .1 .

it is often called the time value of money. then we can expect to earn a risk premium. Inc.  Further. So.1 . the more risk we are willing to bear. . the greater is that risk premium.31 Risk and Return trade off  The risk-free rate represents compensation for just waiting. All rights reserved. McGraw Hill / Irwin  2002 by The McGraw-Hill Companies. at least on average.  If we are willing to bear risk.

using time value of money terminology.  For example. Therefore. 100 dollars paid now or 105 dollars paid exactly one year from now both have the same value to the recipient who assumes 5 percent interest.32 Risk and Return trade off  The time value of money is the value of money figuring in a given amount of interest earned over a given amount of time. McGraw Hill / Irwin  2002 by The McGraw-Hill Companies. Inc. All rights reserved.1 . 100 dollars of today's money invested for one year and earning 5 percent interest will be worth 105 dollars after one year. 100 dollars invested for one year at 5 percent interest has a future value of 105 dollars. .

this mean that there are a risk premium on average . McGraw Hill / Irwin  2002 by The McGraw-Hill Companies. All rights reserved. there is no guarantee . and the risk premium is the compensation for worrying . . and there are no expected reward for bearing them .but over any particular time interval .33 Risk and Return trade off  Investment advisers like to say that an investment has a ”wait “ component and a “worry” component .  The time value of money is the compensation for waiting . Inc.  Those risks that can not be easily avoided that are compensated (on average ). as there are some risks which are cheaply and easily avoidable .1 .  Risky investment do not always pay more than risk free investment .  Note that not all risk are compensated .

Inc. bonds. intelligent decisions about the associated risks. All rights reserved.  We will learn how to value different assets and make informed.  We will also discuss different trading mechanisms and the way different markets function. . options.34 A Look Ahead This text focuses exclusively on financial assets: stocks.1 . McGraw Hill / Irwin  2002 by The McGraw-Hill Companies. and futures.

Inc.1 . All rights reserved. .35 Chapter Review  Returns Dollar Returns  Percentage Returns   The Historical Record A First Look  A Longer Range Look  A Closer Look  McGraw Hill / Irwin  2002 by The McGraw-Hill Companies.

All rights reserved. Inc.1 .36 Chapter Review  Average Returns: The First Lesson Calculating Average Returns  Average Returns: The Historical Record  Risk Premiums  The First Lesson  McGraw Hill / Irwin  2002 by The McGraw-Hill Companies. .

1 . All rights reserved.37 Chapter Review  Return Variability: The Second Lesson Frequency Distributions and Variability  The Historical Variance and Standard Deviation  The Historical Record  Normal Distribution  The Second Lesson   Risk and Return The Risk-Return Trade-Off  A Look Ahead  McGraw Hill / Irwin  2002 by The McGraw-Hill Companies. . Inc.