Return and risks ppt @ bec doms on finance

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Return and risks ppt @ bec doms on finance

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Return and risks ppt @ bec doms on finance

  1. 1. Return and Risks
  2. 2. Return and Risks <ul><li>Learning Goals </li></ul><ul><ul><li>Review the concept of return, its components, the forces that affect the investor’s level of return, and historical returns. </li></ul></ul><ul><ul><li>Discuss the role of time value of money in measuring return and defining a satisfactory investment. </li></ul></ul><ul><ul><li>Describe real, risk-free, and required returns and the calculation and application of holding period return. </li></ul></ul>
  3. 3. Return and Risks <ul><li>Learning Goals (cont’d) </li></ul><ul><ul><li>Explain the concept and calculation of yield and how to find growth rates. </li></ul></ul><ul><ul><li>Discuss the key sources of risk that might affect potential investment vehicles. </li></ul></ul><ul><ul><li>Understand the risk of a single asset, risk assessment, and the steps that combine return and risk. </li></ul></ul>
  4. 4. The Concept of Return <ul><li>Return </li></ul><ul><ul><li>The level of profit from an investment, or </li></ul></ul><ul><ul><li>The reward for investing </li></ul></ul><ul><li>Components of Return </li></ul><ul><ul><li>Current income : cash or near-cash that is received as a result of owning an investment </li></ul></ul><ul><ul><li>Capital gains (or losses) : the difference between the proceeds from the sale of an investment and its original purchase price </li></ul></ul><ul><li>Total Return: the sum of the current income and the capital gain (or loss) earned on an investment over a specified period of time </li></ul>
  5. 5. Key Factors in Return <ul><li>Internal Forces </li></ul><ul><ul><li>Type of investment </li></ul></ul><ul><ul><li>Risks of investment </li></ul></ul><ul><li>External Forces </li></ul><ul><ul><li>Political environment </li></ul></ul><ul><ul><li>Business environment </li></ul></ul><ul><ul><li>Economic environment </li></ul></ul><ul><ul><li>Inflation </li></ul></ul><ul><ul><li>Deflation </li></ul></ul>
  6. 6. Table 4.4 Historical Returns for Popular Security Investments (1926-2005)
  7. 7. The Time Value of Money and Returns <ul><li>The sooner you receive a return on a given investment, the better </li></ul><ul><li>A dollar received today is worth more than a dollar received in the future </li></ul><ul><li>The sooner your money can begin earning interest, the faster it will grow </li></ul>
  8. 8. Measuring Return <ul><li>Required Return </li></ul><ul><ul><li>The rate of return an investor must earn on an investment to be fully compensated for its risk </li></ul></ul>
  9. 9. Measuring Return (cont’d) <ul><li>Real Rate of Return </li></ul><ul><ul><li>The rate of return that could be earned in a perfect world where all outcomes are known and certain—where there was no risk </li></ul></ul><ul><ul><li>Historically, this amount has remained relatively stable at 0.5% to 2% </li></ul></ul><ul><li>Expected Inflation Premium </li></ul><ul><ul><li>The average rate of inflation expected in the future </li></ul></ul>
  10. 10. Measuring Return (cont’d) <ul><li>Risk-free Rate </li></ul><ul><ul><li>The rate of return that can be earned on a risk-free investment </li></ul></ul><ul><ul><li>The sum of the real rate of return and the expected inflation premium </li></ul></ul><ul><ul><li>The most common “risk-free” investment is considered to be the 3-month U.S. Treasury Bill </li></ul></ul>
  11. 11. Measuring Return (cont’d) <ul><li>Risk Premium </li></ul><ul><ul><li>Additional return an investor requires on an investment to compensate for higher risks based upon issue and issuer characteristics </li></ul></ul><ul><ul><li>Issue characteristics are the type, maturity and features </li></ul></ul><ul><ul><li>Issuer characteristics are industry and company factors </li></ul></ul>
  12. 12. Holding Period Return (HPR) <ul><li>Holding Period : the period of time over which an investor wishes to measure the return on an investment vehicle </li></ul><ul><li>Realized Return : current return actually received by an investor during the given return period </li></ul><ul><li>Paper Return : return that has been achieved but not yet realized (no sale has taken place) </li></ul>
  13. 13. Holding Period Return (HPR) <ul><li>Holding Period Return </li></ul><ul><ul><li>The total return earned from holding an investment for a specified holding period (usually 1 year or less) </li></ul></ul>
  14. 14. Table 4.6 Key Financial Variables for Four Investment Vehicles
  15. 15. Interest on Interest: The Critical Assumption <ul><li>Using yield (IRR) to measure return assumes that all income earned over the investment horizon is reinvested at the same rate as the original investment. </li></ul><ul><li>Reinvestment Rate is the rate of return earned on interest or other income received from an investment over its investment horizon. </li></ul><ul><li>Fully compounded rate of return is the rate of return that includes interest earned on interest. </li></ul>
  16. 16. Figure 4.1 Earning Interest on Interest
  17. 17. Finding Growth Rates <ul><li>Rate of Growth </li></ul><ul><ul><li>The compound annual rate of change in the value of a stream of income </li></ul></ul><ul><ul><li>Used to see how quickly a stream of income, such as dividends, is growing </li></ul></ul>
  18. 18. Sources of Risk <ul><li>Risk-Return Tradeoff is the relationship between risk and return, in which investments with more risk should provide higher returns, and vice versa </li></ul><ul><li>Risk is the chance that the actual return from an investment may differ from what is expected </li></ul>
  19. 19. Sources of Risk (cont’d) <ul><li>Currency Exchange Risk is the risk caused by the varying exchange rates between the currencies of two countries. (Discussed in Chapter 2) </li></ul><ul><li>Types of Investments Affected </li></ul><ul><ul><li>International stocks or ADRs </li></ul></ul><ul><ul><li>International bonds </li></ul></ul><ul><li>Examples of Currency Exchange Risk </li></ul><ul><ul><li>U.S. dollar gets “stronger” against foreign currency, reducing value of foreign investment </li></ul></ul>
  20. 20. Sources of Risk (cont’d) <ul><li>Business Risk is the degree of uncertainty associated with an investment’s earnings and the investment’s ability to pay the returns owed to investors. </li></ul><ul><li>Types of Investments Affected </li></ul><ul><ul><li>Common stocks </li></ul></ul><ul><ul><li>Preferred stocks </li></ul></ul><ul><li>Examples of Business Risk </li></ul><ul><ul><li>Decline in company profits or market share </li></ul></ul><ul><ul><li>Bad management decisions </li></ul></ul>
  21. 21. Sources of Risk (cont’d) <ul><li>Interest Rate Risk is the chance that changes in interest rates will adversely affect a security’s value. </li></ul><ul><li>Types of Investments Affected </li></ul><ul><ul><li>Bonds (fixed income) </li></ul></ul><ul><ul><li>Preferred stocks </li></ul></ul><ul><li>Examples of Interest Rate Risk </li></ul><ul><ul><li>Market values of existing bonds decrease as market interest rates increase </li></ul></ul><ul><ul><li>Income from an investment is reinvested at a lower interest rate than the original rate </li></ul></ul>
  22. 22. Sources of Risk (cont’d) <ul><li>Tax Risk is the chance that Congress will make unfavorable changes in tax laws, driving down the after-tax returns and market values of certain investments. </li></ul><ul><li>Types of Investments Affected </li></ul><ul><ul><li>Municipal bonds </li></ul></ul><ul><ul><li>Real estate </li></ul></ul><ul><li>Examples of Tax Risk </li></ul><ul><ul><li>Lower tax rates reduce the tax benefit of municipal bond interest </li></ul></ul><ul><ul><li>Limits on deductions from real estate losses </li></ul></ul>
  23. 23. Sources of Risk (cont’d) <ul><li>Market Risk is the risk of decline in investment returns because of market factors independent of the given investment. </li></ul><ul><li>Types of Investments Affected </li></ul><ul><ul><li>All types of investments </li></ul></ul><ul><li>Examples of Market Risk </li></ul><ul><ul><li>Stock market decline on bad news </li></ul></ul><ul><ul><li>Political upheaval </li></ul></ul><ul><ul><li>Changes in economic conditions </li></ul></ul>
  24. 24. Sources of Risk (cont’d) <ul><li>Event Risk comes from an unexpected event that has a significant and unusually immediate effect on the underlying value of an investment. </li></ul><ul><li>Types of Investments Affected </li></ul><ul><ul><li>All types of investments </li></ul></ul><ul><li>Examples of Event Risk </li></ul><ul><ul><li>Decrease in value of insurance company stock after a major hurricane </li></ul></ul><ul><ul><li>Decrease in value of real estate after a major earthquake </li></ul></ul>
  25. 25. Measures of Risk: Single Asset <ul><li>Standard deviation is a statistic used to measure the dispersion (variation) of returns around an asset’s average or expected return </li></ul><ul><li>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 </li></ul><ul><li>Higher values for both indicate higher risk </li></ul>
  26. 26. Table 4.11 Returns, Standard Deviations, and Coefficients of Variation for Popular Security Investments (1926–2005)
  27. 27. Figure 4.2 Risk-Return Tradeoffs for Various Investment Vehicles
  28. 28. Acceptable Levels of Risk Depend Upon the Individual Investor <ul><li>Risk-indifferent describes an investor who does not require a change in return as compensation for greater risk </li></ul><ul><li>Risk-averse describes an investor who requires greater return in exchange for greater risk </li></ul><ul><li>Risk-seeking describes an investor who will accept a lower return in exchange for greater risk </li></ul>

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