INVESTMENTS: Analysis and Management Third Canadian Edition INVESTMENTS: Analysis and Management Third Canadian Edition W. Sean Cleary Charles P. Jones Prepared by Khalil Torabzadeh University of Lethbridge

Chapter 6 The Returns and Risks from Investing

Define “return” and state its two components. Explain the relationship between return and risk. Identify the sources of risk. Describe the different methods of measuring returns. Describe the different methods of measuring risk. Discuss the returns and risks from investing in major financial assets in the past. Learning Objectives Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 6

Function of both return and risk  At the centre of security analysis How should realized return and risk be measured?  The realized risk-return tradeoff is based on the past  The expected future risk-return tradeoff is uncertain and may not occur Asset Valuation

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 6 Returns consist of two elements:  Yield: Periodic cash flows such as interest or dividends (income return) “Yield” measures relate income return to a price for the security  Capital Gain or Loss: Price appreciation or depreciation The change in price of the asset Total Return = Yield + Price Change Return Components

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 6 Interest Rate Risk  Affects market value and resale price Market Risk  Overall market effects Inflation Risk  Purchasing power variability Business Risk Financial Risk  Tied to debt financing Liquidity Risk  Time and price concession required to sell security Exchange Rate Risk Country Risk  Potential change in degree of political stability Risk Sources

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 6 Two general types:  Systematic (market) risk Pervasive, affecting all securities, cannot be avoided Interest rate or market or inflation risks  Non-systematic (non-market) risk Unique characteristics specific to a security Total Risk = General Risk + Specific Risk = Systematic Risk + Non-Systematic Risk Types of Risk

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 6 Total Return (TR) compares performance over time or across different securities Total Return is a percentage relating all cash flows received during a given time period, denoted CF t +(P E - P B ), to the start of period price, P B Measuring Returns

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 6 Total Return can be either positive or negative  When cumulating or compounding, negative returns are a problem A Return Relative solves the problem because it is always positive Measuring Returns

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 6 To measure the level of wealth created by an investment rather than the change in wealth, returns need to be cumulated over time Cumulative Wealth Index, CWI n, over n periods, = Measuring Returns

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 6 International returns include any realized exchange rate changes  If foreign currency depreciates, returns are lower in domestic currency terms Total Return in domestic currency = Measuring International Returns

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 6 TR, RR, and CWI are useful for a given, single time period What about summarizing returns over several time periods?  Arithmetic mean and geometric mean Arithmetic mean, or simply mean Summary Statistics for Returns

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 6 Arithmetic mean does not measure the compound growth rate over time  Does not capture the realized change in wealth over multiple periods  Does capture typical return in a single period Geometric mean reflects compound, cumulative returns over more than one period Arithmetic versus Geometric

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 6 Geometric mean defined as the n-th root of the product of n return relatives minus one, or G = Difference between Geometric mean and Arithmetic mean depends on the variability of returns, s Geometric Mean

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 6 Returns measures are not adjusted for inflation  Purchasing power of investment may change over time  Consumer Price Index (CPI) is a possible measure of inflation Inflation-Adjusted Returns

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 6 Risk is the chance that the actual outcome will be different than the expected outcome Standard Deviation measures the deviation of returns from the mean Measuring Risk

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 6 Premium is additional return earned or expected for additional risk  Calculated for any two asset classes Equity risk premium is the difference between stock and risk-free returns Bond default premium is the difference between the return on long term corporate bonds and long term government bonds Risk Premiums

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 6 Equity Risk Premium, ERP, = Risk Premiums

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 6 Since 1938, cumulative wealth indexes show stock returns dominate bond returns  Stock standard deviations also exceed bond standard deviations Annual geometric mean return for the time period between 1938 and 2007 for Canadian common stocks is 10.68% with standard deviation of 16.22% The Risk-Return Record

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 6 Table 6-5 Summary Statistics of Annual Total Returns for Major Financial Assets, 1938–2007

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 6 On an inflation-adjusted basis Cumulative Wealth Indexes

Copyright © 2009 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by Access Copyright (The Canadian Copyright Licensing Agency) is unlawful. Requests for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his or her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages caused by the use of these programs or from the use of the information contained herein. Copyright