Chapter 4 Return and Risks

Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 4-2 Return and Risks Learning Goals 1.Review the concept of return, its components, the forces that affect the investor’s level of return, and historical returns. 2.Discuss the time value of money and the calculations involved in finding future values. 3.Explain the concept of present value, the procedures for calculating present values, and the use of present value in determining whether an investment is satisfactory. 4.Describe real, risk-free, and required returns and the computation and application of holding period return, yield (internal rate of return), and growth rates. 5.Discuss the key sources of risk and how they might affect potential investment vehicles. 6.Understand the risk of a single asset, risk assessment, and the steps that combine return and risk.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 4-3 The Concept of Return Components of Return –Current 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 current income and the capital gain (or loss) earned on an investment over a specified period of time Historical Performance (Example: Table 4.3) –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 © 2005 Pearson Addison-Wesley. All rights reserved. 4-4 Table 4.4 Historical Returns

Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 4-5 The Time Value of Money Time Value of Money: as long as an opportunity exists to earn interest, the value of money is affected by the point in time when the money is received –A dollar received today is worth more than a dollar received in the future. –The sooner you receive money from an investment, the better. –The sooner your money can begin earning interest, faster it will grow.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 4-6 Interest: The Basic Return to Savers Interest: the “rent” paid by a borrower for use of the lender’s money Simple Interest (Example: Table 4.5) –Interest is paid only on the initial deposit Compound Interest (Example: Table 4.6) –Interest is paid on the initial deposit and any interest accumulated from prior periods –Interest is earned on interest –More frequent compounding periods provide higher true rate of interest –Compounding periods range from annually to continuously

Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 4-7 Figure 4.2 Calculating Time Value: Financial Calculators

Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 4-8 Calculating Time Value: Computers and Spreadsheets Built-in routines similar to financial calculators –Values for variables are entered in individual cells on spreadsheet –Cells are linked by equations programmed to calculate time values –Changes in variable values automatically update time values Provides flexibility to investors

Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 4-9 Future Value: An Extension of Compounding Future Value: the amount a current deposit will grow to over a period of time when it is placed in an account paying compound interest Future Value Example: How much will $1,000 deposited into an account earning 8% compounded annually be worth in two years?

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Copyright © 2005 Pearson Addison-Wesley. All rights reserved Future Value of an Annuity Annuity: a stream of equal cash flows that occur at equal intervals over time Ordinary Annuity: an annuity where cash flows occur at the end of each period Future Value of an Annuity Example: What is the future value of $1,000 deposited at the end of each year for 8 years in an account earning 6% compounded annually?

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Copyright © 2005 Pearson Addison-Wesley. All rights reserved Present Value: An Extension of Future Value Present Value: the value today of a sum to be received at some future date Present Value Example: How much would need to be deposited today into an accounting earning 6% compounded annually to grow to $500 in 7 years?

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Copyright © 2005 Pearson Addison-Wesley. All rights reserved Present Value of a Mixed Stream of Returns Mixed Stream of Returns: series of returns that have no special pattern Present Value of an Annuity Example: What is the present value of the following stream of returns discounted at 9%? Example: Table 4.8 and 4.9

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Present Value of an Annuity Annuity: a stream of equal cash flows that occur at equal intervals over time Present Value of an Annuity Example: What is the present value of $50 deposited at the end of each year for 5 years in an account earning 9% compounded annually?

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Copyright © 2005 Pearson Addison-Wesley. All rights reserved Determining a Satisfactory Investment Satisfactory Investment: one for which the present value of benefits equals or exceeds the present value of its costs Example: (Table 4.10) –An investment produces the following cash flows in the next 7 years: $90, 100, 110, 120, 100, 100, –Assuming that the discount rate is 8%, is this a worthy investment?

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Measuring Return Real Rate of Return –It represents the change in purchasing power –It is determined by an equilibrium between the supply of savings and demand of funds –It is affected by economic conditions, tastes and preferences –Historically, this amount has remained relatively stable at 0.5% to 2% Expected Inflation Premium –Inflation rate measures the rate of change on the price of goods (such as CPI) –Inflation has average 3.1% per year since 1925

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Measuring Return (cont’d) Risk-free Rate –The rate of return that can be earned on a risk-free investment –The sum of the real rate of return and the expected inflation premium –The most common “risk-free” investment is considered to be the 3-month U.S. Treasury Bill

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Measuring Return (cont’d) Risk Premium –Additional return an investor requires on an investment to compensate for higher risks based upon issue and issuer characteristics –Issue characteristics are the type, maturity and features –Issuer characteristics are industry and company factors

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Measuring Return (cont’d) Required Return –The rate of return an investor must earn on an investment to be fully compensated for its risk

Copyright © 2005 Pearson Addison-Wesley. All rights reserved 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 © 2005 Pearson Addison-Wesley. All rights reserved 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 © 2005 Pearson Addison-Wesley. All rights reserved Table 4.11 Holding Period Return

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Using HPR in Investment Decisions 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 –Rate may be inaccurate if time period is longer than one year

Copyright © 2005 Pearson Addison-Wesley. All rights reserved 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?

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Internal Rate of Return (IRR): Using an Excel Spreadsheet

Copyright © 2005 Pearson Addison-Wesley. All rights reserved 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 © 2005 Pearson Addison-Wesley. All rights reserved 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 using the IRR function in Excel (Table 4.12) –Example: An investment produces the following cash flows in the next 7 years: $90, 100, 110, 120, 100, 100, –If the initial cost is $1100, what is the yield to this investment?

Copyright © 2005 Pearson Addison-Wesley. All rights reserved 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.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Figure 4.3 Earning Interest on Interest $2,600 = $1,000 + ($80 x 20 years)

Copyright © 2005 Pearson Addison-Wesley. All rights reserved 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 © 2005 Pearson Addison-Wesley. All rights reserved Finding Growth Rates Growth Rate Example: Calculate the rate of growth on the dividend stream in Table 4.13.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved 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 © 2005 Pearson Addison-Wesley. All rights reserved Sources of Risk Business Risk is the degree of uncertainty associated with an investment’s earnings and the investment’s ability to pay the returns owed investors. Types of Investments Affected –Common stocks –Preferred stocks Examples of Business Risk –Decline in company profits or market share –Bad management decisions

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Sources of Risk (cont’d) Currency Exchange Risk is the risk caused by the varying exchange rates between the currencies of two countries. 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 © 2005 Pearson Addison-Wesley. All rights reserved Sources of Risk (cont’d) Financial Risk is the degree of uncertainty attributable to the mix of debt and equity used to finance a business; 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 © 2005 Pearson Addison-Wesley. All rights reserved Sources of Risk (cont’d) Purchasing Power Risk (Inflation risk) is the chance that inflation 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 © 2005 Pearson Addison-Wesley. All rights reserved 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 © 2005 Pearson Addison-Wesley. All rights reserved 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 © 2005 Pearson Addison-Wesley. All rights reserved 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 © 2005 Pearson Addison-Wesley. All rights reserved 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 © 2005 Pearson Addison-Wesley. All rights reserved 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 © 2005 Pearson Addison-Wesley. All rights reserved Historical Returns and Risk

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Measures of Risk Standard Deviation: (Excel: STDEV) Coefficient of Variation: Example: Table 4.15

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Figure 4.4 Risk-Return Tradeoffs for Various Investment Vehicles

Copyright © 2005 Pearson Addison-Wesley. All rights reserved 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 investment vehicles that offer the highest expected returns associated with the level of risk you are willing to accept.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Chapter 4 Homework Exercises (will NOT be collected) –Text Website: Self-assessment quiz –End-of-Chapter CFA questions (Page 172) –End-of-Chapter Odd-numbered Discussion Questions and Problems Homework (will be collected and graded, due date to be announced) –Case Problem 4.1 –Excel with Spreadsheet (Page 183)