Risk and Return

Risk and Return Intro
 APR and APY
 DY
 Average Annual Return
 Geometric Return
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)
Holding period return 
Current income
Capital gain (or loss)
during period
during period
Beginning investment value
Capital gain (or loss)
during period
investment value
investment value
Using HPR
 Advantages of Holding Period Return
 Easy to calculate
 Easy to understand
 Considers current income and growth
 Disadvantages of Holding Period Return
 Does not consider time value of money
 Inaccurate and irrelevant if time period if longer than one
Using IRR
 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
 Results may not be unique
Interest on Interest
 Using YTM and IRR 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.
 Risk-Return Tradeoff Eis(R)the
between risk and
 Pr(relationship
r) r
return, in which investments with more risk should provide
higher returns, and vice versa
 Return, for purposes of planning, is the expected return.
E( R)   Pr(r ) r
 Risk is the chance that the actual return from an investment
may differ from what is expected. Measured as the
standard deviation of the expected return.
Risk and
Coupon Return
Sources of Risk
 Business Risk
uncertainty associated with an investment’s earnings
and ability to pay returns owed investors.
 Affects
 Common stocks
 Preferred stocks
 Examples
 Decline in company profits or market share
 Bad management decisions
Sources of Risk (cont’d)
 Currency Exchange Risk
variation in exchange rates.
 Affects
 International stocks, ADRs
 International bonds
 Examples
 U.S. dollar appreciates against foreign currency, reducing
value of foreign investment
Sources of Risk (cont’d)
 Financial Risk
uncertainty attributable to the mix of debt and equity
used to finance a business;
more debt, greater this risk.
 Affects
 Common stocks
 Corporate bonds
 Examples
 Company unable to obtain credit to fund operations
 Company defaults on bonds
Sources of Risk (cont’d)
 Purchasing Power Risk
changing price levels (inflation or deflation) that
adversely affect investment returns.
 Affects
 Bonds (fixed income)
 Certificates of deposit
 Examples
 Barrel of oil $66.00 last year is $89.00 this year
Sources of Risk (cont’d)
 Interest Rate Risk
changes in interest rates that adversely affect a
security’s value.
 Affects
 Bonds (fixed income)
 Preferred stocks
 Examples
 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 (cont’d)
 Liquidity Risk
not being able to liquidate an investment conveniently
and at a reasonable price.
 Affects
 Some small company stocks
 Real estate
 Examples
 Selling a low volume stock reduces the price of the stock,
consider blockage discounts
Sources of Risk (cont’d)
 Tax Risk
Congress may introduce unfavorable tax laws, driving
down the after-tax returns and market values of
certain investments.
 Affects
 Municipal bonds
 Real estate
 Examples
 Lower tax rates reduce the tax benefit of municipal bond
 Limits on deductions from real estate losses
Sources of Risk (cont’d)
 Market Risk
decline in investment returns because of market factors
independent of the given investment.
 Affects
 All types of investments
 Examples
 Stock market decline on bad news
 Political upheaval
 Changes in economic conditions
Sources of Risk (cont’d)
 Event Risk
unexpected events that have significant and immediate
effect on the underlying value of an investment.
 Affects
 All types of investments
 Examples
 Decrease in value of insurance company stock after
a major hurricane
 Decrease in value of real estate after a
major earthquake
 The BP oil spill
Measures of Risk: Single Asset
 Standard deviation is a statistic
used to measure the
CV 
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.
CV 
 Higher values for both indicate higher risk
Historical Returns and Risk
Risk-Return Tradeoffs
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.

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