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Chapter 7 an introduction to risk and return

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Chapter 7 an introduction to risk and return

2. 2. Calculating the Realized Return froman Investment• Realized return or cash return measures the gain or loss on an investment.Copyright © 2011 Pearson Prentice Hall. All rights reserved. 7-2
3. 3. Calculating the Realized Return froman Investment (cont.)• Example 1: You invested in 1 share of Apple (AAPL) for \$95 and sold a year later for \$200. The company did not pay any dividend during that period. What will be the cash return on this investment?Copyright © 2011 Pearson Prentice Hall. All rights reserved. 7-3
4. 4. Calculating the Realized Return froman Investment (cont.)• Cash Return = \$200 + 0 - \$95 = \$105Copyright © 2011 Pearson Prentice Hall. All rights reserved. 7-4
5. 5. Calculating the Realized Return froman Investment (cont.)• We can also calculate the rate of return as a percentage. It is simply the cash return divided by the beginning stock price.Copyright © 2011 Pearson Prentice Hall. All rights reserved. 7-5
6. 6. Calculating the Realized Return froman Investment (cont.)• Example 2: You invested in 1 share of share Apple (AAPL) for \$95 and sold a year later for \$200. The company did not pay any dividend during that period. What will be the rate of return on this investment?Copyright © 2011 Pearson Prentice Hall. All rights reserved. 7-6
7. 7. Calculating the Realized Return froman Investment (cont.)• Rate of Return = (\$200 + 0 - \$95) ÷ 95 = 110.53%• Table 7-1 has additional examples on measuring an investor’s realized rate of return from investing in common stock.Copyright © 2011 Pearson Prentice Hall. All rights reserved. 7-7
9. 9. Calculating the Realized Return froman Investment (cont.)• Table 7-1 indicates that the returns from investing in common stocks can be positive or negative.• Furthermore, past performance is not an indicator of future performance.• However, in general, we expect to receive higher returns for assuming more risk.Copyright © 2011 Pearson Prentice Hall. All rights reserved. 7-9
10. 10. Calculating the Expected Returnfrom an Investment• Expected return is what you expect to earn from an investment in the future.• It is estimated as the average of the possible returns, where each possible return is weighted by the probability that it occurs.Copyright © 2011 Pearson Prentice Hall. All rights reserved. 7-10
13. 13. Calculating the Expected Returnfrom an Investment (cont.)• Expected Return = (-10%×0.2) + (12%×0.3) + (22%×0.5) = 12.6%Copyright © 2011 Pearson Prentice Hall. All rights reserved. 7-13
14. 14. Measuring Risk• In the example on Table 7-2, the expected return is 12.6%; however, the return could range from -10% to +22%.• This variability in returns can be quantified by computing the Variance or Standard Deviation in investment returns.Copyright © 2011 Pearson Prentice Hall. All rights reserved. 7-14
15. 15. Measuring Risk (cont.)• Standard deviation is given by square root of the variance and is more commonly used.Copyright © 2011 Pearson Prentice Hall. All rights reserved. 7-15
16. 16. Calculating the Variance and Standard Deviationof the Rate of Return on an Investment• Let us compare two possible investment alternatives: – (1) U.S. Treasury Bill – Treasury bill is a short- term debt obligation of the U.S. Government. Assume this particular Treasury bill matures in one year and promises to pay an annual return of 5%. U.S. Treasury bill is considered risk- free as there is no risk of default on the promised payments.Copyright © 2011 Pearson Prentice Hall. All rights reserved. 7-16
17. 17. Calculating the Variance and Standard Deviationof the Rate of Return on an Investment (cont.) – (2) Common stock of the Ace Publishing Company – an investment in common stock will be a risky investment.Copyright © 2011 Pearson Prentice Hall. All rights reserved. 7-17
18. 18. Calculating the Variance and Standard Deviationof the Rate of Return on an Investment (cont.) • The probability distribution of an investment’s return contains all possible rates of return from the investment along with the associated probabilities for each outcome. • Figure 7-1 contains a probability distribution for U.S. Treasury bill and Ace Publishing Company common stock.Copyright © 2011 Pearson Prentice Hall. All rights reserved. 7-18
20. 20. Calculating the Variance and Standard Deviationof the Rate of Return on an Investment (cont.)• The probability distribution for Treasury bill is a single spike at 5% rate of return indicating that there is 100% probability that you will earn 5% rate of return.• The probability distribution for Ace Publishing company stock includes returns ranging from -10% to 40% suggesting the stock is a risky investment.Copyright © 2011 Pearson Prentice Hall. All rights reserved. 7-20
21. 21. Calculating the Variance and Standard Deviationof the Rate of Return on an Investment (cont.)• Using equation 7-3, we can calculate the expected return on the stock to be 15% while the expected return on Treasury bill is always 5%.• Does the higher return of stock make it a better investment? Not necessarily, we also need to know the risk in both the investments.Copyright © 2011 Pearson Prentice Hall. All rights reserved. 7-21
22. 22. Calculating the Variance and Standard Deviationof the Rate of Return on an Investment (cont.)• We can measure the risk of an investment by computing the variance as follows:Copyright © 2011 Pearson Prentice Hall. All rights reserved. 7-22
24. 24. Calculating the Variance and Standard Deviationof the Rate of Return on an Investment (cont.) Investment Expected Standard Return Deviation Treasury Bill 5% 0% Common Stock 15% 12.85%• So we observe that the publishing company stock offers a higher expected return but also entails more risk as measured by standard deviation. An investor’s choice of a specific investment will be determined by their attitude toward risk.Copyright © 2011 Pearson Prentice Hall. All rights reserved. 7-24
25. 25. A Brief History of the FinancialMarkets• We can use the tools that we have learned to determine the risk-return tradeoff in the financial markets.Copyright © 2011 Pearson Prentice Hall. All rights reserved. 7-25
26. 26. A Brief History of the FinancialMarkets (cont.)• Investors have historically earned higher rates of return on riskier investments.• However, having a higher expected rate of return simply means that investors “expect” to realize a higher return. Higher return is not guaranteed.Copyright © 2011 Pearson Prentice Hall. All rights reserved. 7-26
27. 27. Geometric vs. Arithmetic AverageRates of Return• Arithmetic average may not always capture the true rate of return realized on an investment. In some cases, geometric or compound average may be a more appropriate measure of return.Copyright © 2011 Pearson Prentice Hall. All rights reserved. 7-27
28. 28. Geometric vs. Arithmetic AverageRates of Return (cont.)• For example, suppose you bought a stock for \$25. After one year, the stock rises to \$30 and in the second year, it falls to \$15. What was the average return on this investment?Copyright © 2011 Pearson Prentice Hall. All rights reserved. 7-28
29. 29. Geometric vs. Arithmetic AverageRates of Return (cont.)• The stock earned +20% in the first year and -50% in the second year.• Simple average = (20%-50%) ÷ 2 = -15%Copyright © 2011 Pearson Prentice Hall. All rights reserved. 7-29
30. 30. Geometric vs. Arithmetic AverageRates of Return (cont.)• However, over the 2 years, the \$25 stock lost the equivalent of 22.54% ({(\$15/\$25)1/2} - 1 = 22.54%).• Here, -15% is the simple arithmetic average while -22.54% is the geometric or compound average rate.• Which one is the correct indicator of return? It depends on the question being asked.Copyright © 2011 Pearson Prentice Hall. All rights reserved. 7-30
31. 31. Geometric vs. Arithmetic AverageRates of Return (cont.)• The geometric average rate of return answers the question, “What was the growth rate of your investment?”• The arithmetic average rate of return answers the question, “what was the average of the yearly rates of return?Copyright © 2011 Pearson Prentice Hall. All rights reserved. 7-31