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Chapter 2
FUNDAMENTALS OF RISK AND
RETURN
• What are the sources of investment returns?
• How are investment returns measured?
• What is investment risk and how is it
measured?
• How are risk and return measured for
portfolios of assets?
• Why does diversification benefit investors?
• What is the relationship between risk and
required return?
Contemporary Investments: Chapter 2
Sources of investment
returns
• Income
• Interest
• Dividends
• Price changes: Capital gains or
Capital losses
• Paper gains and losses
• Ex-ante and ex-post returns
Contemporary Investments: Chapter 2
Measuring investment
returns
• Calculating holding period returns
• Breaking down returns between
income and capital gains
• Calculating expected returns
• Inflation adjusted returns
• International returns
• Total return indexes
Contemporary Investments: Chapter 2
Investment History –The Agony of Bond
Investors: 1965-1981
Contemporary Investments: Chapter 2
Figure 2.1 – Total Return Index for Johnson
& Johnson: 1991-2001
Contemporary Investments: Chapter 2
Summarizing returns
• Arithmetic mean
• Annualizing the arithmetic mean
• Geometric mean
• Comparing the geometric and
arithmetic means
Contemporary Investments: Chapter 2
Investment risk
• A definition of risk: uncertainty of
return
• Types (sources) of risk
• Default, Credit, Tax, Interest Rate,
Market, Event, Liquidity, Foreign
Exchange
• Measuring risk
• Calculating a standard deviation
• Annualizing a standard deviation
Contemporary Investments: Chapter 2
Figure 2.2 – Probability of Possible Return
Contemporary Investments: Chapter 2
Figure 2.3 – Stock and T-Bill Returns:
1982-2001
Contemporary Investments: Chapter 2
Figure 2.4 – Monthly Returns for 3M
and Starbucks
Contemporary Investments: Chapter 2
Risk, return and investment
selection
• Portfolio risk and return
• Finding the mean return of a portfolio
• Finding the standard deviation of a
portfolio
• Correlation coefficient
Contemporary Investments: Chapter 2
Figure 2.5 – Monthly Returns for Dow
Chemical and Verizon Communication
Contemporary Investments: Chapter 2
Diversification
• Naïve versus efficient diversification
• Diversifiable versus non-diversifiable
risk
• Diversifiable or unsystematic risk
• Non-diversifiable or systematic risk
• Beta
• Risk and required return
Contemporary Investments: Chapter 2
Figure 2.6 – Real and Nominal Returns on
T-Bills: 1981-2001
Contemporary Investments: Chapter 2
Figure 2.7 – Yields on T-Bills, T-Bonds, and
Baa Corporate Bonds: 1988-2002
Contemporary Investments: Chapter 2