Risk and Return Intro

1. Returns HPR CAGR YTM, RCYTM APR and APY DY NPV, IRR Average Annual Return Geometric Return Risk and Return Intro

2. 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)

3. 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 year

4. 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

5. 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.

6. Risk • Risk-Return Tradeoff is the relationship between risk and return, in which investments with more risk should provide higher returns, and vice versa • Return, for purposes of planning, is the expected return. • 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.

7. Prices and Coupon Rates Risk and expected Return E(r) r Risk

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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

14. 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 interest • Limits on deductions from real estate losses

15. 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

16. 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

17. 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

18. Historical Returns and Risk

19. Risk-Return Tradeoffs

20. 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.