Chapter 4

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

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 Why Return is Important

• The rate of return indicates how rapidly an investor

can build wealth.
• 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

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 Key Factors in Return

• Internal Characteristics
– Type or risk of investment
– Issuer’s management
– Issuer’s financing
• External Forces
– Political environment
– Business environment
– Economic environment
– Inflation
– Deflation

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 Table 4.4 Historical Returns for Select
Asset Classes (1900-2011)

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 The Time Value of Money and
Returns

• The sooner you receive a positive 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
• Satisfactory Investment: one for which
the present value of benefits equals or
exceeds the present value of its costs

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 Measuring Return

• Required Return
– The rate of return an investor must earn on an
investment to be fully compensated for its risk

Required return Real rate Expected inflation Risk premium

= + +
on investment j of return premium for investment j

Required return Risk-free Risk premium

= +
on investment j rate for investment j

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 Measuring Return (cont’ d)

• 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

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 Measuring Return (cont’ d)

• 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 3-month U.S. Treasury Bill

Real rate Expected inflation

Risk-free rate = +
of return premium

rF  r *  IP

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 Measuring Return (cont’ d)

• 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

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 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)

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 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)

Income Capital gain (or loss)


during period during period
Holding period return 
Beginning investment value

Capital gain (or loss) Ending Beginning

= -
during period investment value investment value

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 Table 4.6 Key Financial Variables for Four
Investments

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 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

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 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?
• This is essentially the annual
compounding return

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 Calculating an Investments Yield
Using an Excel Spreadsheet

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 Using IRR in Investment Decisions
(cont’ d)

• 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

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 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 investment’s income
stream to its market price

Table 4.7 Present Value Applied to an Investment

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

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 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.

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 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

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 Finding Growth Rates

• Growth Rate Example:

Stock paid $0.92 dividend
in 2002 and $1.85 in 2011.
What’s the average annual
growth rate over this period?
• Again an annual compounding
growth rate

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 Finding Growth Rates:
Using an Excel Spreadsheet

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 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

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 Sources of Risk (cont’ d)

• Business Risk is the degree of uncertainty

associated with an investment’s earnings and
the investment’ s 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

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 Sources of Risk (cont’ d)

• Financial Risk is the degree of uncertainty

of payment resulting from a firm’s 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 can’t get additional loans for growth or
to fund operations
– Company defaults on bonds

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 Sources of Risk (cont’ d)

• 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

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 Sources of Risk (cont’ d)

• Interest Rate Risk is the chance that changes

in interest rates will adversely affect a security’s
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

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 Sources of Risk (cont’ d)

• 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

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 Sources of Risk (cont’ d)

• 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

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 Sources of Risk (cont’ d)

• 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

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 Sources of Risk (cont’ d)

• 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

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 Sources of Risk (cont’ d)

• 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

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 Measures of Risk: Single Asset

• Standard deviation is a statistic used to measure

the dispersion (variation) of returns around an
asset’s average or expected return
• Coefficient of variation is a statistic used to
measure the relative dispersion of an asset’s
returns; it is useful in comparing the risk of assets
with differing average or expected returns
• Higher values for both indicate higher risk

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 Table 4.10 Historical Returns and Standard
Deviations for Select Asset Classes (1900–2011)

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 Figure 4.2 Risk-Return Tradeoffs
for Various Investments

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 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

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 Figure 4.3 Risk Preferences

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

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