MODULE 2
RISK AND RETURN
Two sides of the Investment Coin
Return
- Is the primary motivating
force that drives
investment
Two components
- Current return
- Capital return
Risk
- Refers to the possibility
that the actual outcome of
an investment will deviate
from its expected outcome.
Three major sources of risk:
- Business risk
- Interest rate risk
- Market risk
It divides total risk as follows:
- Total Risk = Unique risk +
Market risk
Arithmetic Mean
- More appropriate measure
of average performance
over single period
- Rate of return, which, when
compounded over multiple
periods gives the mean of
the prob. Distr'ns of ending
wealth
Geometric Mean
- Is a better measure of
growth in wealth over time
Real Return
= 1 + Nominal Return / 1 +
Inflation Rate - 1
GLOBAL EQUITY RETURNS
What explains larger equity
returns in the second half of the
20th centure compared to the
first half. P. Marsh and M.
Staunton attribute it to the
following factors:
- Unprecedented growth in
productivity and efficiency,
thanks to rapid
technological changes.
- Enhancement in the quality
of management and
corporate governance
- Reduced transaction and
monitoring costs.
- Decline in inflation rates
- Fall in the required rate of
return, thanks to diminished
business and investment
risks.
Critiques
- Variance considers all
deviations, negative as well
as positive
- When the probability
distribution is not
symmetrical around its
expected value, variance
alone does not suffice. In
addition, the skewness of
the distribution should be
considered.
Defence
- If a variable is normally
distributed, u and o capture
all information
- If utility of money ..
quadratic function ..
expected utility .. f(u,o)
- Stanard deviation
analytically more easily
tractable
Risk Premiums
- Equity Risk Premium
- Bond Horizon Premium
- Bond default premium
Summing Up
- For earning returns,
investors must almost
invariably bear some risk.
- While investors like returns
they abhor risk.
- Investment decisions there
involve a tradeoff between
risk and return.
- The cumulative wealth index
captures the cumulative
effect of total returns.
- The arithmetic mean is a
more appropriate measure
of average performance
over a single period.
- The geometric mean is a
better measure of growth in
wealth over time
- The most commonly used
measures of risk in finance
are variance or its square
root the standard
deviation.
- Risk premium may be defined
as the additional return
investors expect to get for
assuming additional risk