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INVESTMENTS:
Analysis and Management
Second Canadian Edition
W. Sean Cleary
Charles P. Jones
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.
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
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
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
Risk Types
• 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
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
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
Measures Describing a Return
Series
• TR and RR 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
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
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
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
Nominal rate – inflation = real rate

Or more accurately:
TR IA
1  TR 


1
1  CPI
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
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
Copyright
Copyright © 2005 John Wiley & Sons Canada, Ltd. All rights
reserved. Reproduction or translation of this work beyond that
permitted by Access Copyright (The Canadian Copyright
Licensing Agency) is unlawful. Requests for further information
should be addressed to the Permissions Department, John Wiley
& Sons Canada, Ltd. The purchaser may make back-up copies
for his or her own use only and not for distribution or resale. The
author and the publisher assume no responsibility for errors,
omissions, or damages caused by the use of these programs or
from the use of the information contained herein.