Lecture 11 Return and Risk

Taking a Global Perspective When investors buy or sell securities in othe countries, they also take exchange rate risk or currency risk Fluctuation in currency value can be either a source of loss or profit If the foregin currency strengthens, your returns will increase or vice versa

An Example Suppose you purchased 100 shares of IBM at NYSE for $300 each. The dollar-rupee parity was 60 rupees a dollar at the that time. So your total investment in rupees was 100x$300 = $30000 x 60 =Rs.1800,000 At the end of the year, IBM share price was $310, giving you $10 profit per share, your profit is = 100 x 10 = $1000x60 = Rs.60000 But the dollar-rupee parity had jumped to 78 rupee a dollar, now your total investment is =100x310 = $31000 x 78 = Rs.2418000 And your profit is 2,418,000-180,0000 = Rs.618,000 Or in percentage = 618,000/1800,000 = .339 or 33.9%

Equation for calculating returns from foregin stocks = [(P1/Po)x(C1/Co)] – 1 [(310/300)x(78/60)] – 1 [(1.03) x (1.3)] – 1 1.339 – 1 0.339 or 33.9% P1 = Ending share price Po = Beginning share price C1 = Ending value of demestic currency Co = Beginning value of domestic currency

Risk Any investment involves some degree of uncertainty about future returns Risk arises out of variability in returns If an asset has no variability in returns, the assets is considered to be risk free like one year T-bills

Sources of Risk A. Interest rate risk = variability in returns of securities resulting from changes in interest rates Securities prices move inversely with interest rates [why]?

Interest rates and returns 1. Increase in interest rates increases the required rate of return  RRR=  Rf+Risk premium which reduces the prices of the securities (intrinsic value) 2. It increases cost of borrowing and hence cost capital 3. It reduces money supply which lower demand for securities and resultantly prices fall-

Sources of Risk Market risk : variability in returns due to fluctuations in aggregate market Recession, wars etc Inflation risk when purchasing power declines. Inflation also leads to hike in interest rates because lenders demand more to compensate themselves for loss in purchasing power Business risk = the risk of doing business in a particular industry. Like OGDC has a unique risk of falling oil prices

Sources of Risk Financial risk = It is associated with the use of debt financing by companies. The larger the financial leverage, the larger will be the variability in returns Liquidity Risk = Whether a particular security can be sold quickly and without price concession in the secondary market. Exchange risk = for international investors, a source of risk come from exchange rate fluctuation

Sources of Risk Country Risk = For international investors, economic and political stability, law and order situation are important consideration in the investment decision

Measuring Risk The most commonly used measure of risk for securities is standard deviation SD measure the total risk of a security or a portfolio It measure deviations of each observation from the arithmetic mean

Standard Deviation

Interpretation The 5.89 SD means that the security return can fluctuate between +/-5.89 from the mean value of 16% More specifically, the return can fluctuate between 16 - 5.89 = 10.11 or 16 + 5.89 = 21.89 Your return could fall to as low as 10.11% or could rise to 21.89 %

Realized Returns and risk from Investing Class of assets Average SD S&P 500 Composite 9.21% 19.75% S&P Industrial 9.66 21.57 S&P Utility 8.47 20.54 Small Cap Stock (S&P 600) 14.82 37.23 AAA 20-year Corp Bond 3.87 10.05 US 15-year Bond 3.25 10.22 T-Bills 1.569 4.65