Holding Period Return Annual Return

Current Yield + Capital Gains

Current Yield = Cash Received During The Year/Initial Price Capital Gains = (Year-end Price Initial Price)/Initial Price

Arithmetic Average Return = k = 1/n kt Year Return 2005 20 % 2006 22% 2007 18% 2008 26% 2009 21% 2010 16% 2011 17% Sum of Returns = 140 Arithmetic Average = 140/7 = 20

Geometric Return: (1+ it)1/n -1 [1.2x1.22x1.18x1.26x1.21x1.16x1.17]1/7 -1 = 3.574562 1/7 -1 = 1.199587- 1 = .1996 or 19.96%. For positive returns, Geometric Average is always less than arithmetic average

When we are dealing with future, we assign probabilities to future returns. The probability adjusted average is expected return E(k) = kipi

Economic Scenario Recession Normal Boom

Return(ki) -5% 18% 35%

Prob (pi) kipi .25 -1.25 .50 9 .25 8.75

Expected Return = E(k) = kipi = 16.50%

If you want higher return, we must be prepared to take a bigger loss (higher risk) If you want to reduce your risk of loss, you must sacrifice profit

Return
35
30 25 20 15 10 5 RISK 0 0.5 1 1.5 2 2.5

Return

Standard Deviation: Square Root of Sum of Squared Deviations Coefficient of Variation: Standard Deviation per Unit Return

Economic Scenario Recession Normal Boom

Return(ki) -5% 18% 35%

(pi) .25 .50 .25

kipi -1.25 9.00 8.75

ki-E(k) 21.5 1.5 18.5

[ki-E(k)]2 [ki-E(k)]2*pi 462.25 115.5625 2.25 1.125 342.25 85.5625 2 = 202.25 = 14.22

Spreading Out Risk Ancient Sea-Farers Practice of Distribution of Wares among Several Boats Importance of Correlation Portfolio Risk of A Two-Asset Portfolio

Weight

Expected Standard Return Deviation .40 A 18% 20% .60 B 22% 25% Correlation between Returns of A and B, AB = .6. The expected return of this portfolio: E(kAB) = wAkA + wBkB = .40x18 + .60x22 = 20.4%. The general equation for expected return of a portfolio of n assets : E(kA..N) = wAkA + wBkB + . + Wnkn = wiki

Stock

Two Asset Portfolio St. Dev AB = wA2A2+WB2B2+ 2WAWBABAB

.42*202 +.62*252 + 2*.4*.6*20*25*.4 = .16*400 + .36 * 484 + 2*.24*500*.4 = 19.62

Preference for negative, 0, low correlations Dominant Portfolios Efficient Frontier Efficient Portfolio

ACI 0.110195 0.249513 0.460216 -0.20165 0.072723 1.629779 1.875878 -0.11587 -0.13808 0.438079 0.775606

AMCL 0.079549 0.191853 0.430671 -0.25761 -0.022 0.719224 0.692234 0.531855 0.165363 0.281238 0.333596

Apex 0.312197 0.05602 0.566614 -0.32954 0.224587 1.276035 0.814273 0.340039 0.535371 0.421733 0.457373

Bd lmps 0.259559 0.208117 0.870663 -0.2231 -0.14946 0.579072 0.496051 0.705045 0.426668 0.352513 0.367931

Bata 0.104261 0.4154 0.309745 -0.0614 0.013006 1.011791 0.512212 0.688977 0.274142 0.363126 Expected k 0.34141 St Dev Standard Deviation of Portfolios ACI-AMCL
.3597

AMCL

Apex BDlamps Correlation Matrix 0.537449 0.395016 0.495649 0.392674 0.404247

Bata

ACI AMCL Apex BDLamps

0.584783

0.465433 0.380887 0.387296 0.344365

AAA
.3804

AAAB
.3734

AAABB
.3713

Apex Bata
.3924

0.503851

0.437989

0.421085

0.39193

.2983

RISK

Diversifiable Risk Systematic Risk

No. of Assets

Characteristic Line Beta

Higher Beta (Greater Than 1): More Volatile

than the Market. Characteristic Line Steep Low Beta (Less than 1): Less sensitive to market movements. Characteristic line flat Beta meaningful only in a portfolio context
Draw a characteristic line A quiz question

For accepting average risk, investor gets average premium over risk-free rate, RP = (km-krf) Return, k Market Risk Premium= (Km-Krf)

Market Return, km Km Risk-

}
Risk Beta 1

Free Rate Krf

Year 2002 2003 2004 2005 2006

Dividend Yield 0.1096 0.0847 0.0545 0.0906 0.0709

Cap Gain -0.0194 0.1643 0.7576 -0.2548 -0.1257

Total Return % 9.44% 36.11% 81.24% -16.51% -5.42%

2007
2008 2009 2010

0.0421
0.0424 0.0549 0.0468 Average Return

0.7676
-0.0632 0.1223 0.9916

80.98%
-2.08% 18.14% 104.48% 34.04%

Standard Deviation 44.26%

Inflation = 7.5% Real (Lending) Interest Rate = 7-8.6% Real (Deposit) Interest Rate = 3.5% (Suggested) Risk-Free Nominal Rate = About 11% Spread Between Deposit and Lending Rate: About 5% Required Return for Long-term Debt = 15% Market Return = About 30 %

Change in Inflation: Causes a parallel shift in the CML Change in Risk-Premium: The slope of CML Changes.

Portfolio Beta = Bp = wibi Portfolio Required Return = kp = krf + (km krf) Betap

What is required Return? What is expected Return? Which stock is overpriced?

Suppose you can buy a stock for Taka 250 today. You expect to sell it for Taka 310 one year from now. You will earn a dividend of Taka 50 over the year. What is your expected return? Suppose the beta of the stock is 1.2. What is the required return? Is the stock overpriced or underpriced?