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Risk and Return IntroRisk and Return Intro

Returns HPR CAGR YTM, RCYTM APR and APY DY NPV, IRR Average Annual Return Geometric Return

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Holding Period Return (HPR)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)

Holding period return

Current incomeduring period

Capital gain (or loss)

during period

Beginning investment value

Capital gain (or loss)during period

Ending

investment value

Beginninginvestment value

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Using HPR Using HPR

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 Inaccurate and irrelevant if time period if longer than one

year

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Using IRR Using IRR

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 Results may not be unique

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Interest on InterestInterest on Interest

Using YTM and IRR 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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RiskRisk

Risk-Return Tradeoff is the relationship between risk and return, in which investments with more risk should provide higher returns, and vice versa

Return, for purposes of planning, is the expected return.

Risk is the chance that the actual return from an investment may differ from what is expected. Measured as the standard deviation of the expected return.

( ) Pr( )E R r r

( ) Pr( )E R r r

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Prices and Coupon RatesPrices and Coupon Rates

Risk

Risk and expected Return Risk and expected Return

r

E(r)

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Sources of RiskSources of Risk

Business Risk

uncertainty associated with an investment’s earnings and ability to pay returns owed investors.

Affects Common stocks Preferred stocks

Examples Decline in company profits or market share Bad management decisions

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Sources of Risk (cont’d)Sources of Risk (cont’d)

Currency Exchange Risk

variation in exchange rates.

Affects International stocks, ADRs International bonds

Examples U.S. dollar appreciates against foreign currency, reducing

value of foreign investment

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Sources of Risk (cont’d)Sources of Risk (cont’d)

Financial Risk

uncertainty attributable to the mix of debt and equity used to finance a business;

more debt, greater this risk.

Affects Common stocks Corporate bonds

Examples Company unable to obtain credit to fund operations Company defaults on bonds

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Sources of Risk (cont’d)Sources of Risk (cont’d)

Purchasing Power Risk

changing price levels (inflation or deflation) that adversely affect investment returns.

Affects Bonds (fixed income) Certificates of deposit

Examples Barrel of oil $66.00 last year is $89.00 this year

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Sources of Risk (cont’d)Sources of Risk (cont’d)

Interest Rate Risk

changes in interest rates that adversely affect a security’s value.

Affects Bonds (fixed income) Preferred stocks

Examples 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)Sources of Risk (cont’d)

Liquidity Risk

not being able to liquidate an investment conveniently and at a reasonable price.

Affects Some small company stocks Real estate

Examples Selling a low volume stock reduces the price of the stock,

consider blockage discounts

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Sources of Risk (cont’d)Sources of Risk (cont’d)

Tax Risk

Congress may introduce unfavorable tax laws, driving down the after-tax returns and market values of certain investments.

Affects Municipal bonds Real estate

Examples 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)Sources of Risk (cont’d)

Market Risk

decline in investment returns because of market factors independent of the given investment.

Affects All types of investments

Examples Stock market decline on bad news Political upheaval Changes in economic conditions

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Sources of Risk (cont’d)Sources of Risk (cont’d)

Event Risk

unexpected events that have significant and immediate effect on the underlying value of an investment.

Affects All types of investments

Examples Decrease in value of insurance company stock after

a major hurricane Decrease in value of real estate after a

major earthquake The BP oil spill

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Measures of Risk: Single AssetMeasures 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

CV

CV

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Historical Returns and RiskHistorical Returns and Risk

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Risk-Return Tradeoffs Risk-Return Tradeoffs

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The Decision Process:Combining Return and Risk

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.