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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 n1 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.
