Chapter 4
Return
and Risks
The Concept of Return

Return



Components of Return



The level of profit from an investment, or
The reward for investing
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
2
Why Return is Important

Allows comparison of actual or expected gains with
the levels of gain needed

Allows us to “keep score” on how our investments are
doing compared to our expectations

Historical Performance



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
3
Key Factors in Return

Internal Forces



Type of investment
Risks of investment
External Forces


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
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Political environment
Business environment
Economic environment
Inflation
Deflation
4
Historical Returns for Popular Security
Investments (1926-2005)
5
The Time Value of Money and
Returns

The sooner you receive a return on a
given investment, the better

A dollar received today is worth more
than a dollar received in the future

The sooner your money can begin
earning interest, the faster it will grow
6
Determining
a Satisfactory Investment

Satisfactory Investment:
The one that the present value of
benefits equals or exceeds the present
value of its costs
7
Measuring Return

Required Return

The rate of return an investor must earn on
an investment to be fully compensated for
its risk
Required return
Risk-free
Risk premium


on investment j
rate
for investment j
Required return
Real rate
Expected inflation
Risk premium



on investment j
of return
premium
for investment j
8
Measuring Return (cont’d)

Real Rate of Return



The rate of return that could be earned in a perfect
world where all outcomes are known and certain—
where there was no risk
Historically, this amount has remained relatively
stable at 0.5% to 2%
Expected Inflation Premium

The average rate of inflation expected in the future
9
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
Risk-free rate 
Real rate
Expected inflation

of return
premium
RF  r *  IP
10
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
11
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)
12
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)
Holding period return 
Current income
Capital gain (or loss)

during period
during period
Beginning investment value
Capital gain (or loss)
Ending
Beginning


during period
investment value
investment value
13
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

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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 5year holding period?
15
Yield Calculation
Yield for a Single Cash Flow
Cash Flow
Future Value
$2,950.00
Present Value -$1,500.00
No of Years
5
Yield
14.484%
16
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
17
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 calculating the PV of
the different income amounts and adding
together
Yield Calculation for an $1,1,00 Investment
18
Internal Rate of Return (IRR):
Using an Excel Spreadsheet
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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.

Fully compounded rate of return is the rate
of return that includes interest earned on
interest.
20
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
21
Finding Growth Rates

Growth Rate Example: Calculate the rate of
growth on the dividend stream
Dividends Per Share
22
Finding Growth Rates:
Using an Excel Spreadsheet
23
Sources of 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
24
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
25
Sources of Risk (cont’d)

Business Risk is the degree of uncertainty
associated with an investment’s earnings and
the investment’s ability to pay the returns
owed to investors.

Types of Investments Affected



Common stocks
Preferred stocks
Examples of Business Risk


Decline in company profits or market share
Bad management decisions
26
Sources of Risk (cont’d)

Financial Risk is the degree of uncertainty of
payment resulting from a firm’s mix of debt and
equity; 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
27
Sources of Risk (cont’d)

Purchasing Power Risk is the chance that
changing price levels (inflation or deflation) will
adversely affect investment returns.

Types of Investments Affected



Bonds (fixed income)
Certificates of deposit
Examples of Purchasing Power Risk

Movie that was $9.00 last year is $10.50 this year
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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
29
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
30
Sources of Risk (cont’d)

Tax Risk is the chance that Congress will make
unfavorable changes in tax laws, driving down
the after-tax returns and market values of
certain investments.

Types of Investments Affected



Municipal bonds
Real estate
Examples of Tax Risk


Lower tax rates reduce the tax benefit of municipal
bond interest
Limits on deductions from real estate losses
31
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
32
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
33
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
34
Risk-Return Tradeoffs
for Various Investment Vehicles
35
Acceptable Levels of Risk Depend
Upon the Individual Investor

Risk-indifferent describes an investor who
does not require a change in return as
compensation for greater risk

Risk-averse describes an investor who
requires greater return in exchange for greater
risk

Risk-seeking describes an investor who will
accept a lower return in exchange for greater
risk
36
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
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