1. Returns Economics 71a: Spring 2007 Lecture notes 3.2 (extra)

2. Goals  Capital gains and income  Inflation and real returns  Expected or required returns  Returns in other currencies

3. What is a Return?  Stock held from time t to t+1  Pays dividend during this time of d(t+1)  Why is this sensible? Increase of 1 dollar after investment t to t+1

4. Two Parts to a Stock Return = (capital gain) + (dividend yield)

5. Two Parts of a Bond Return = (capital gain) + (Interest)

6. Goals  Capital gains and income  Real returns  Expected or required returns  Returns in other currencies

7. Real Returns  Nominal return Return before inflation adjustment  Real return Return after adjusting for inflation

8. Real Return (example)  $1 in the bank buys how much more bread in the future Nominal Interest Rate = 10% = R F = “risk free” Inflation rate = 5% =  Price of bread = $1 $1 buys 1 loaf today  In one year Money = $1.10 Price of bread = $1.05 Loaves tomorrow = 1.10/1.05 = 1.048

9. Finding the Real Return 1. Exact

10. Finding the Real Return (2. Approximate)

11. Risk Free Return (Interest)  Interest rate = real interest + Inflation premium

12. Real Interest Rate  Nominal interest rate = 20% per year  Inflation = 15% per year  Real interest rate = 20%-15%=5%  Important The return on your funds is reduced by inflation Should always consider the inflation adjusted change for any asset

13. Goals  Capital gains and income  Real returns  Expected or required returns  Returns in other currencies

14. Expected or Required Returns

15.  Amount investors expect to receive on an investment  Three parts Real risk free return Inflation premium Risk premium  Compensation for risk (difficult to estimate)

16. Goals  Capital gains and income  Real returns  Expected or required returns  Returns in other currencies

17. Exchange Rates  E($/euro) = U.S. dollars required to purchase 1 euro  Price($) = Price(euro)*E($/euro)

18. Exchange Rate Risks Price and Dividends in Euros

19. Exchange Rate Risks (Dividend = 0, stock price 100->110, $/euro 1 -> 0.8)

20. Returns in US dollars  ($/euro) goes down Decreases foreign investment values (in dollars) Price of foreign goods falls (in dollars)  ($/euro) goes up Increases foreign investment values (in dollars) Price of foreign goods rises (in dollars)