Chapter 4
Return
and Risks
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Return and Risks
• Learning Goals
1. Review the concept of return, its components, the
forces that affect the investor’s level of return, and
historical returns.
2. Discuss the role of time value of money in measuring
return and defining a satisfactory investment.
3. Describe real, risk-free, and required returns and the
calculation and application of holding period return.
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Return and Risks
• Learning Goals (cont’d)
4. Explain the concept and calculation of yield and how to
find growth rates.
5. Discuss the key sources of risk that might affect
potential investment vehicles.
6. Understand the risk of a single asset, risk assessment,
and the steps that combine return and risk.
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The Concept of Return
• Return
– The level of profit from an investment, or
– The reward for investing
• Components of Return
– 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
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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
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Key Factors in Return
• Internal Forces
– Type of investment
– Risks of investment
• External Forces
–
–
–
–
–
Political environment
Business environment
Economic environment
Inflation
Deflation
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Table 4.4 Historical Returns for Popular
Security Investments (1926-2005)
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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
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Determining
a Satisfactory Investment
• Satisfactory Investment: one for which the
present value of benefits equals or exceeds
the present value of its costs
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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
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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
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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
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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
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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)
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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)
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Table 4.6 Key Financial Variables
for Four Investment Vehicles
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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?
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Internal Rate of Return (IRR):
Using an Excel Spreadsheet
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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
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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
Table 4.7 Yield Calculation for an $1,1,00 Investment
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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.
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Figure 4.1
Earning Interest on Interest
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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
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Finding Growth Rates
• Growth Rate Example: Calculate the rate of
growth on the dividend stream in Table 4.8.
Table 4.8 Dividends Per Share
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Finding Growth Rates:
Using an Excel Spreadsheet
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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
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Sources of Risk (cont’d)
• Currency Exchange Risk is the risk caused by
the varying exchange rates between the
currencies of two countries. (Discussed in
Chapter 2)
• 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
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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
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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
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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 $8.00 last year is $9.00 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
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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
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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
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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
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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
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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
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Table 4.11 Returns, Standard Deviations,
and Coefficients of Variation for Popular
Security Investments (1926–2005)
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Figure 4.2 Risk-Return Tradeoffs
for Various Investment Vehicles
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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
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Figure 4.3 Risk Preferences
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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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Chapter 4 Review
•
Learning Goals
1. Review the concept of return, its components, the
forces that affect the investor’s level of return, and
historical returns.
2. Discuss the role of time value of money in measuring
return and defining a satisfactory investment.
3. Describe real, risk-free, and required returns and the
calculation and application of holding period return.
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
4-44
Chapter 4 Review (cont’d)
•
Learning Goals (cont’d)
4. Explain the concept and calculation of yield and how
to find growth rates.
5. Discuss the key sources of risk that might affect
potential investment vehicles.
6. Understand the risk of a single asset, risk assessment,
and the steps that combine return and risk.
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4-45
Chapter 4
Additional
Chapter Art
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Table 4.1 Profiles of Two
Investments
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Table 4.2 Total Returns of Two
Investments
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Table 4.3 Historical Investment
Data for a Hypothetical Investment
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Table 4.5 Present Value Applied to
an Investment
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Table 4.7 Yield Calculation for an
$1,100 Investment
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Table 4.9 Returns on Investments
A and B
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Table 4.10 Calculation of Standard
Deviations of Returns for Investments
A and B
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