1 1 C h a p t e r A Brief History of Risk and Return second edition Fundamentals of Investments Valuation & Management Charles J. Corrado Bradford D. Jordan McGraw Hill / IrwinSlides by Yee-Tien (Ted) by the McGraw- Hill Companies Inc.All rights reserved.

 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin Who Wants To Be A Millionaire?

 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin A Brief History of Risk and Return Our goal in this chapter is to see what financial market history can tell us about risk and return. Goal  Two key observations emerge.  There is a reward for bearing risk, and at least on average, that reward has been substantial.  Greater rewards are accompanied by greater risks.

 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin Returns Example Total dollar return = Dividend + Capital gain on stock income (or loss) Total dollar return The return on an investment measured in dollars that accounts for all cash flows and capital gains or losses.

 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin Returns Example Percent return = Dividend + Capital gains on stock yield yield or Total dollar return. Beginning stock price Total percent return The return on an investment measured as a % of the originally invested sum that accounts for all cash flows and capital gains or losses. It is the return for each dollar invested.

 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin Returns Example: Calculating Returns  Suppose you invested $1,000 in a stock at $25 per share. After one year, the price increases to $35. For each share, you also received $2 in dividends.  Dividend yield = $2 / $25 = 8%  Capital gains yield = ($35 – $25) / $25 = 40%  Total percentage return = 8% + 40% = 48%  Total dollar return = 48% of $1,000 = $480  At the end of the year, the value of your $1,000 investment is $1,480.

The Historical Record: A First Look McGraw Hill / Irwin

The Historical Record: A Longer Range Look 1 - by the McGraw- Hill Companies Inc.All rights reserved. McGraw Hill / Irwin

 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin Returns A company total market capitalization ( or market cap. For short ) is equal to its stock price multiplied by the number of shares of stocks. In other words, it’s the total value of the company stock. Large companies are called “large cap” stocks and small companies are called “small cap “stocks.

The Historical Record: A Closer Look Figure by the McGraw- Hill Companies Inc.All rights reserved. McGraw Hill / Irwin

The Historical Record: A Closer Look 1 - by the McGraw- Hill Companies Inc.All rights reserved. McGraw Hill / Irwin

The Historical Record: A Closer Look 1 - by the McGraw- Hill Companies Inc.All rights reserved. McGraw Hill / Irwin

The Historical Record: A Closer Look 1 - by the McGraw- Hill Companies Inc.All rights reserved. McGraw Hill / Irwin

The Historical Record: A Closer Look 1 - by the McGraw- Hill Companies Inc.All rights reserved. McGraw Hill / Irwin

 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin Average Returns: The First Lesson  Average annual =  yearly returns return number of years

Average Returns: The First Lesson 1 - by the McGraw- Hill Companies Inc.All rights reserved. McGraw Hill / Irwin

 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin Average Returns: The First Lesson Risk-free rate The rate of return on a riskless investment. Risk premium The extra return on a risky asset over the risk-free rate; the reward for bearing risk.

Average Returns: The First Lesson 1 - by the McGraw- Hill Companies Inc.All rights reserved. McGraw Hill / Irwin

 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin Average Returns: The First Lesson The First Lesson  There is a reward, on average, for bearing risk.

Return Variability: The Second Lesson 1 - by the McGraw- Hill Companies Inc.All rights reserved. McGraw Hill / Irwin

 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin Return Variability: The Second Lesson Variance A common measure of volatility. Standard deviation The square root of the variance. Normal distribution A symmetric, bell-shaped frequency distribution that is completely defined by its average and standard deviation.

 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin Return Variability: The Second Lesson Variance of return where N is the number of returns Standard deviation of return

 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin Return Variability: The Second Lesson Example about variance : Suppose a particular investment had returns of 10% - 12% - 3%- (-9%) Over the last four years The average return is : (10% + 12%+ 3%+ (-9%))/4 = 4 % The deviation from the average is : (10-4 ) ²= 36 (12-4) ²=64 (3-4) ²=1 (-9-4) ²=169 _________________ variance= 270 /3 = 90 S. D. =  90 = 9.487%

 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin Return Variability: The Second Lesson Example about variance : variance= 270 /3 = 90 S. D. =  90 = 9.487% From these two numbers we can say that :  with a normal distribution the probability that we end up with one standard deviation from the average is about 68%.  with a normal distribution the probability that we end up with two standard deviation from the average is about 95%.  with a normal distribution the probability that we end up with three standard deviation from the average is about 1%.

 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin Return Variability: The Second Lesson To let you know : If you know that the standard deviation of returns in the previous ex. Are 7%, and the average return that calculated before are 4%, The probability that the return in a given year is in the range of ( (4+7) to (4-7) )= ( 11% to -3% ) within one standard deviation is about 68%.

Return Variability: The Second Lesson

Return Variability: The Second Lesson 1 - by the McGraw- Hill Companies Inc.All rights reserved. McGraw Hill / Irwin

 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin Return Variability: The Second Lesson The Second Lesson  The greater the potential reward, the greater the risk.

 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin Return Variability: The Second Lesson Source: Dow Jones Top 12 One-Day Percentage Changes in the Dow Jones Industrial Average October 19, %March 14, % October 28, October 26, October 29, July 21, November 6, October 18, December 18, February 1, August 12, October 27, by the McGraw- Hill Companies Inc.All rights reserved.

Risk and Return 1 - by the McGraw- Hill Companies Inc.All rights reserved. McGraw Hill / Irwin

 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin Risk and Return trade off  The risk-free rate represents compensation for just waiting. So, it is often called the time value of money.  If we are willing to bear risk, then we can expect to earn a risk premium, at least on average.  Further, the more risk we are willing to bear, the greater is that risk premium.

 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin Risk and Return trade off  The time value of money is the value of money figuring in a given amount of interest earned over a given amount of time.  For example, 100 dollars of today's money invested for one year and earning 5 percent interest will be worth 105 dollars after one year. Therefore, 100 dollars paid now or 105 dollars paid exactly one year from now both have the same value to the recipient who assumes 5 percent interest; using time value of money terminology, 100 dollars invested for one year at 5 percent interest has a future value of 105 dollars.

 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin Risk and Return trade off  Investment advisers like to say that an investment has a ”wait “ component and a “worry” component.  The time value of money is the compensation for waiting, and the risk premium is the compensation for worrying.  Risky investment do not always pay more than risk free investment, this mean that there are a risk premium on average,but over any particular time interval, there is no guarantee.  Note that not all risk are compensated, as there are some risks which are cheaply and easily avoidable, and there are no expected reward for bearing them.  Those risks that can not be easily avoided that are compensated (on average ).

 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin A Look Ahead  We will learn how to value different assets and make informed, intelligent decisions about the associated risks.  We will also discuss different trading mechanisms and the way different markets function. This text focuses exclusively on financial assets: stocks, bonds, options, and futures.

 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin Chapter Review  Returns  Dollar Returns  Percentage Returns  The Historical Record  A First Look  A Longer Range Look  A Closer Look

 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin Chapter Review  Average Returns: The First Lesson  Calculating Average Returns  Average Returns: The Historical Record  Risk Premiums  The First Lesson

 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin Chapter Review  Return Variability: The Second Lesson  Frequency Distributions and Variability  The Historical Variance and Standard Deviation  The Historical Record  Normal Distribution  The Second Lesson  Risk and Return  The Risk-Return Trade-Off  A Look Ahead