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Returns

Returns. Economics 71a: Spring 2007 Lecture notes 3.2 (extra). Goals. Capital gains and income Inflation and real returns Expected or required returns Returns in other currencies. What is a Return?. Stock held from time t to t+1 Pays dividend during this time of d(t+1)

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Returns

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  1. Returns Economics 71a: Spring 2007 Lecture notes 3.2 (extra)

  2. Goals • Capital gains and income • Inflation and real returns • Expected or required returns • Returns in other currencies

  3. What is a Return? • Stock held from time t to t+1 • Pays dividend during this time of d(t+1) • Why is this sensible? • Increase of 1 dollar after investment t to t+1

  4. Two Parts to a Stock Return = (capital gain) + (dividend yield)

  5. Two Parts of a Bond Return = (capital gain) + (Interest)

  6. Goals • Capital gains and income • Real returns • Expected or required returns • Returns in other currencies

  7. Real Returns • Nominal return • Return before inflation adjustment • Real return • Return after adjusting for inflation

  8. Real Return (example) • $1 in the bank buys how much more bread in the future • Nominal Interest Rate = 10% = RF = “risk free” • Inflation rate = 5% = p • Price of bread = $1 • $1 buys 1 loaf today • In one year • Money = $1.10 • Price of bread = $1.05 • Loaves tomorrow = 1.10/1.05 = 1.048

  9. Finding the Real Return1. Exact

  10. Finding the Real Return(2. Approximate)

  11. Risk Free Return (Interest) • Interest rate = real interest + Inflation premium

  12. Real Interest Rate • Nominal interest rate = 20% per year • Inflation = 15% per year • Real interest rate = 20%-15%=5% • Important • The return on your funds is reduced by inflation • Should always consider the inflation adjusted change for any asset

  13. Goals • Capital gains and income • Real returns • Expected or required returns • Returns in other currencies

  14. Expected or Required Returns

  15. Expected or Required Returns • Amount investors expect to receive on an investment • Three parts • Real risk free return • Inflation premium • Risk premium • Compensation for risk (difficult to estimate)

  16. Goals • Capital gains and income • Real returns • Expected or required returns • Returns in other currencies

  17. Exchange Rates • E($/euro) = U.S. dollars required to purchase 1 euro • Price($) = Price(euro)*E($/euro)

  18. Exchange Rate Risks Price and Dividends in Euros

  19. Exchange Rate Risks(Dividend = 0, stock price 100->110, $/euro 1 -> 0.8)

  20. Returns in US dollars • ($/euro) goes down • Decreases foreign investment values (in dollars) • Price of foreign goods falls (in dollars) • ($/euro) goes up • Increases foreign investment values (in dollars) • Price of foreign goods rises (in dollars)

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