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## Risk and Return Intro

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**Returns**HPR CAGR YTM, RCYTM APR and APY DY NPV, IRR Average Annual Return Geometric Return Risk and Return Intro**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)**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**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**• 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.**Prices and Coupon Rates**Risk and expected Return E(r) r Risk**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 interest • 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 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**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.