Professional Documents
Culture Documents
Risk and
and Return
Return Intro
Intro
Returns
HPR
CAGR
YTM, RCYTM
APR and APY
DY
NPV, IRR
Average Annual Return
Geometric Return
Holding
Holding Period
Period Return
Return (HPR)
(HPR)
Holding Period Return
The total return earned from holding an investment for a
specified holding period (usually 1 year or less)
Holdingperiodreturn
Currentincome
Capitalgain(orloss)
duringperiod
duringperiod
Beginninginvestmentvalue
Capitalgain(orloss)
Ending
Beginning
duringperiod
investmentvalue
investmentvalue
Using
Using HPR
HPR
Advantages of Holding Period Return
Easy to calculate
Easy to understand
Considers current income and growth
Using
Using IRR
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
Interest
Interest on
on Interest
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.
Risk
Risk
) Pr(
r )gr
Risk-Return Tradeoff isE (Rthe
relationship
between risk and
return, in which investments with more risk should provide
higher returns, and vice versa
Risk
Prices
andexpected
Coupon Return
Rates
Risk and
and
expected
Return
E(r)
Risk
Sources
Sources of
of Risk
Risk
Business Risk
uncertainty associated with an investments earnings
and ability to pay returns owed investors.
Affects
Common stocks
Preferred stocks
Examples
Decline in company profits or market share
Bad management decisions
Sources
Sources of
of Risk
Risk (contd)
(contd)
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
Sources
Sources of
of Risk
Risk (contd)
(contd)
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
Sources
Sources of
of Risk
Risk (contd)
(contd)
Purchasing Power Risk
changing price levels (inflation or deflation) that
adversely affect investment returns.
Affects
Examples
Barrel of oil $66.00 last year is $89.00 this year
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Sources
Sources of
of Risk
Risk (contd)
(contd)
Interest Rate Risk
changes in interest rates that adversely affect a
securitys value.
Affects
Examples
Sources
Sources of
of Risk
Risk (contd)
(contd)
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
Sources of
of Risk
Risk (contd)
(contd)
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
Sources
Sources of
of Risk
Risk (contd)
(contd)
Market Risk
decline in investment returns because of market factors
independent of the given investment.
Affects
Examples
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Sources
Sources of
of Risk
Risk (contd)
(contd)
Event Risk
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
Measures of
of Risk:
Risk: Single
Single Asset
Asset
Standard deviation is a statistic
used to measure the
CV
CV
Historical
Historical Returns
Returns and
and Risk
Risk
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Risk-Return
Risk-Return Tradeoffs
Tradeoffs
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The
The Decision
Decision Process:
Process:
Combining
Combining Return
Return and
and Risk
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.
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