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
Learning Objectives
•
•
•
•
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.
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 6
Asset Valuation
• 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
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 6
Return Components
• 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
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 6
Risk Sources
• Interest Rate Risk

Affects market value
and resale price
• Market Risk


Purchasing power
variability
• Business Risk
Tied to debt financing
• Liquidity Risk

Overall market
effects
• Inflation Risk

• Financial Risk
Time and price
concession required to
sell security
• Exchange Rate Risk
• Country Risk

Potential change in
degree of political
stability
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 6
Types of Risk
• 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
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 6
Measuring Returns
• 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 CFt +(PE - PB), to the start of period
price, PB
CFt  (PE  PB )
TR 
PB
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 6
Measuring Returns
• 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
CFt  PE
RR 
 1  TR
PB
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 6
Measuring Returns
• 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, CWIn, over n
periods, =
WI (1  TR )(1  TR )...(1  TR )
0
1
2
n
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 6
Measuring International Returns
• International returns include any realized
exchange rate changes

If foreign currency depreciates, returns are
lower in domestic currency terms
• Total Return in domestic currency =
End Val. of For.Curr. 

RR  Begin Val. of For.Curr.   1


Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 6
Summary Statistics for Returns
• 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
X

X
n
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 6
Arithmetic versus Geometric
• 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
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 6
Geometric Mean
• Geometric mean defined as the n-th root of the
product of n return relatives minus one, or G =
(1  TR1)(1  TR2 )...(1  TRn )
1/ n
1
• Difference between Geometric mean and
Arithmetic mean depends on the variability of
returns, s
1  G  1  X   s2
2
2
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 6
Inflation-Adjusted Returns
• 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
TR IA
1  TR 


1
1  CPI
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 6
Measuring Risk
• 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
  X  X
s  
 n1
2



1/ 2
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 6
Risk Premiums
• 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
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 6
Risk Premiums
• Equity Risk Premium, ERP, =


 1  TRCS

1



1  RF 


or,
TRCS  RF
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 6
The Risk-Return Record
• 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%
Cleary Jones/Investments: Analysis and Management, 3rd 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, 3rd Canadian Edition, Chapter 6
Cumulative Wealth Indexes
• On an inflation-adjusted basis
CWI IA
CWI

CI INF
CWI
YI
CWI
YI 
CPC
CPC 
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 6
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