Chapter 4 Return and Risk

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-2 The Concept of Return Return –The level of profit from an investment, or –The reward for investing Components of Return –Income: cash or near-cash that is received as a result of owning an investment –Capital gains (or losses): the difference between the proceeds from the sale of an investment and its original purchase price Total Return: the sum of the income and the capital gain (or loss) earned on an investment over a specified period of time

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-3 Why Return is Important The rate of return indicates how rapidly an investor can build wealth. Allows us to “keep score” on how our investments are doing compared to our expectations Historical Performance –Provides a basis for future expectations –Does not guarantee future performance Expected Return –Return an investor thinks an investment will earn in the future –Determines what an investor is willing to pay for an investment or if they are willing to make an investment

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-4 Key Factors in Return Internal Characteristics – Type or risk of investment – Issuer’s management – Issuer’s financing External Forces – Political environment – Business environment – Economic environment – Inflation – Deflation

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-5 Table 4.4 Historical Returns for Select Asset Classes ( )

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-6 The Time Value of Money and Returns The sooner you receive a positive return on a given investment, the better A dollar received today is worth more than a dollar received in the future The sooner your money can begin earning interest, the faster it will grow Satisfactory Investment: one for which the present value of benefits equals or exceeds the present value of its costs

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-7 Measuring Return Required Return –The rate of return an investor must earn on an investment to be fully compensated for its risk

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-8 Measuring Return (cont’d) Real Rate of Return –Equals the nominal rate of return minus the inflation rate –Measures the change in purchasing power provided by an investment Expected Inflation Premium –The average rate of inflation expected in the future

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-9 Measuring Return (cont’d) Risk-free Rate –The rate of return that can be earned on a risk-free investment –The most common “risk-free” investment is considered to be the 3-month U.S. Treasury Bill

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-10 Measuring Return (cont’d) Risk Premium –Additional return an investor requires on a risky investment to compensate for risks based upon issue and issuer characteristics –Issue characteristics are the type, maturity and features –Issuer characteristics are industry and company factors

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-11 Holding Period Return (HPR) Holding Period: the period of time over which an investor wishes to measure the return on an investment vehicle Realized Return: current return actually received by an investor during the given return period Paper Return: return that has been achieved but not yet realized (no sale has taken place)

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-12 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)

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-13 Table 4.6 Key Financial Variables for Four Investments

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-14 Using HPR in Investment Decisions Advantages of Holding Period Return –Easy to calculate –Easy to understand –Considers income and growth Disadvantages of Holding Period Return –Does not consider time value of money –Rate may be inaccurate if time period is longer than one year

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-15 Yield: Internal Rate of Return (IRR) Internal Rate of Return: determines the compound annual rate of return earned on an investment held for longer than one year Yield (IRR) Example: What is the yield (IRR) on an investment costing $1,000 today that you expect will be worth $1,400 at the end of a 5-year holding period? This is essentially the annual compounding return

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-16 Calculating an Investments Yield Using an Excel Spreadsheet

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-17 Using IRR in Investment Decisions (cont’d) 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

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-18 Yield (IRR) for a Stream of Income Some investments, such as bonds, provide uneven streams of income over the investment period Calculate yield (IRR) by finding the discount rate that equates the PV of the investment’s income stream to its market price Table 4.7 Present Value Applied to an Investment

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-19 Internal Rate of Return (IRR): Using an Excel Spreadsheet

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-20 Interest on Interest: The Critical Assumption Using yield (IRR) to measure return 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.

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-21 Finding Growth Rates Rate of Growth –The compound annual rate of change in the value of a stream of income –Used to see how quickly a stream of income, such as dividends, is growing

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-22 Finding Growth Rates Growth Rate Example: Stock paid $0.92 dividend in 2002 and $1.85 in What’s the average annual growth rate over this period? Again an annual compounding growth rate

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-23 Finding Growth Rates: Using an Excel Spreadsheet

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-24 Sources of Risk Risk-Return Tradeoff is the relationship between risk and return, in which investments with more risk should provide higher returns, and vice versa Risk is the chance that the actual return from an investment may differ from what is expected

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-25 Sources of Risk (cont’d) Business Risk is the degree of uncertainty associated with an investment’s earnings and the investment’s ability to pay the returns owed to investors. Types of Investments Affected –Common stocks –Preferred stocks Examples of Business Risk –Decline in company profits or market share –Bad management decisions

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-26 Sources of Risk (cont’d) Financial Risk is the degree of uncertainty of payment resulting from a firm’s mix of debt and equity; the larger the proportion of debt financing, the greater this risk. Types of Investments Affected –Common stocks –Corporate bonds Examples of Financial Risk –Company can’t get additional loans for growth or to fund operations –Company defaults on bonds

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-27 Sources of Risk (cont’d) Purchasing Power Risk is the chance that changing price levels (inflation or deflation) will adversely affect investment returns. Types of Investments Affected –Bonds (fixed income) –Certificates of deposit Examples of Purchasing Power Risk –Movie that was $8.00 last year is $9.00 this year

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-28 Sources of Risk (cont’d) Interest Rate Risk is the chance that changes in interest rates will adversely affect a security’s value. Types of Investments Affected –Bonds (fixed income) –Preferred stocks Examples of Interest Rate Risk –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

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-29 Sources of Risk (cont’d) Liquidity Risk is the risk of not being able to liquidate an investment conveniently and at a reasonable price. Types of Investments Affected –Some small company stocks –Real estate Examples of Liquidity Risk –The price of a house has to be lowered for a quick sale

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-30 Sources of Risk (cont’d) Tax Risk is the chance that Congress will make unfavorable changes in tax laws, driving down the after-tax returns and market values of certain investments. Types of Investments Affected –Municipal bonds –Real estate Examples of Tax Risk –Lower tax rates reduce the tax benefit of municipal bond interest –Limits on deductions from real estate losses

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-31 Sources of Risk (cont’d) Event Risk comes from an unexpected event that has a significant and unusually immediate effect on the underlying value of an investment. Types of Investments Affected –All types of investments Examples of Event Risk –Decrease in value of insurance company stock after a major hurricane –Decrease in value of real estate after a major earthquake

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-32 Sources of Risk (cont’d) Market Risk is the risk of decline in investment returns because of market factors independent of the given investment. Types of Investments Affected –All types of investments Examples of Market Risk –Stock market decline on bad news –Political upheaval –Changes in economic conditions

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-33 Sources of Risk (cont’d) Currency Exchange Risk is the risk caused by the varying exchange rates between the currencies of two countries. (Discussed in Chapter 2) Types of Investments Affected –International stocks or ADRs –International bonds Examples of Currency Exchange Risk –U.S. dollar gets “stronger” against foreign currency, reducing value of foreign investment

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-34 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

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-35 Table 4.10 Historical Returns and Standard Deviations for Select Asset Classes (1900–2011)

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-36 Figure 4.2 Risk-Return Tradeoffs for Various Investments

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-37 Acceptable Levels of Risk Depend Upon the Individual Investor Risk-indifferent describes an investor who does not require a change in return as compensation for greater risk Risk-averse describes an investor who requires greater return in exchange for greater risk Risk-seeking describes an investor who will accept a lower return in exchange for greater risk

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-38 Figure 4.3 Risk Preferences

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-39 Steps in 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 investments that offer the highest expected returns associated with the level of risk you are willing to accept