Chapter 4

Return
and Risk
 Return and Risks

Learning Goals
1. Review the concept of return, its components,
the forces that affect the investors level of
return, and historical returns.
2. Discuss the role of time value of money in
measuring return and defining a satisfactory
investment.
3. Describe real, risk-free, and required returns
and the calculation and application of holding
period return.

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 Return and Risks

Learning Goals (contd)

4. Explain the concept and calculation of yield and
how to find growth rates.
5. Discuss the key sources of risk that might affect
potential investments.
6. Understand the risk of a single asset, risk
assessment, and the steps that combine return
and risk.

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 The Concept of Return

Return
The level of profit from an investment, or
The reward for investing
Components of Return
Income: cash or near-cash that is received as a result of
owning an investment
Capital gains (or losses): the difference between the proceeds
from the sale of an investment and its original purchase price
Total Return: the sum of the income and the capital gain (or
loss) earned on an investment over a specified period of time

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 Why Return is Important

The rate of return indicates how rapidly an investor

can build wealth.
Allows us to keep score on how our investments
are doing compared to our expectations
Historical Performance
Provides a basis for future expectations
Does not guarantee future performance
Expected Return
Return an investor thinks an investment will earn in the
future
Determines what an investor is willing to pay for an
investment or if they are willing to make an investment

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 The Time Value of Money and
Returns

The sooner you receive a return on a given

investment, the better
A dollar received today is worth more than
a dollar received in the future
The sooner your money can begin earning
interest, the faster it will grow

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 Measuring Return

Required Return
The rate of return an investor must earn on an
investment to be fully compensated for its risk

Required return Real rate Expected inflation Risk premium

= + +
on investment j of return premium for investment j

Required return Risk-free Risk premium

= +
on investment j rate for investment j

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 Measuring Return (cont d)

Real Rate of Return

Equals the nominal rate of return minus the inflation rate
Measures the change in purchasing power provided by an
investment
Expected Inflation Premium
The average rate of inflation expected in the future

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 Measuring Return (cont d)

Risk-free Rate
The rate of return that can be earned on a
risk-free investment
The most common risk-free investment is considered to
be the 3-month U.S. Treasury Bill

Real rate Expected inflation

Risk-free rate = +
of return premium

rF r * IP

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 Measuring Return (cont d)

Risk Premium
Additional return an investor requires on a risky
investment to compensate for risks based upon issue and
issuer characteristics
Issue characteristics are the type, maturity and features
Issuer characteristics are industry and company factors

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 Holding Period Return (HPR)

Holding Period: the period of time over which an

investor wishes to measure the return on an
investment vehicle

Realized Return: current return actually received

by an investor during the given return period

Paper Return: return that has been achieved but

not yet realized (no sale has taken place)

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 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)

Income Capital gain (or loss)

during period during period
Holding period return
Beginning investment value

Capital gain (or loss) Ending Beginning

= -
during period investment value investment value

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 Table 4.6 Key Financial Variables for Four
Investments

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 Using HPR in Investment Decisions

Advantages of Holding Period Return

Easy to calculate
Easy to understand
Considers income and growth

Disadvantages of Holding Period Return

Does not consider time value of money
Rate may be inaccurate if time period is longer
than one year

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 Figure 4.1 Earning Interest on
Interest

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 Sources of Risk

Risk-Return Tradeoff is the relationship

between risk and return, in which
investments with more risk should provide
higher returns, and vice versa
Risk is the chance that the actual return
from an investment may differ from what
is expected

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 Sources of Risk (cont d)

Business Risk is the degree of uncertainty

associated with an investments earnings and
the investment s ability to pay the returns
owed to investors.
Types of Investments Affected
Common stocks
Preferred stocks
Examples of Business Risk
Decline in company profits or market share
Bad management decisions

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 Sources of Risk (cont d)

Financial Risk is the degree of uncertainty

of payment resulting from a firms mix of
debt and equity; the larger the proportion
of debt financing, the greater this risk.
Types of Investments Affected
Common stocks
Corporate bonds
Examples of Financial Risk
Company cant get additional loans for growth or
to fund operations
Company defaults on bonds

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 Sources of Risk (cont d)

Purchasing Power Risk is the chance that

changing price levels (inflation or deflation)
will adversely affect investment returns.
Types of Investments Affected
Bonds (fixed income)
Certificates of deposit

Examples of Purchasing Power Risk

Movie that was $8.00 last year is $9.00 this year

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 Sources of Risk (cont d)

Interest Rate Risk is the chance that changes

in interest rates will adversely affect a securitys
value.
Types of Investments Affected
Bonds (fixed income)
Preferred stocks
Examples of Interest Rate Risk
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)

Liquidity Risk is the risk of not being able to

liquidate an investment conveniently and at a
reasonable price.
Types of Investments Affected
Some small company stocks
Real estate

Examples of Liquidity Risk

The price of a house has to be lowered for a quick sale

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 Sources of Risk (cont d)

Event Risk comes from an unexpected event that

has a significant and unusually immediate effect on
the underlying value of an investment.
Types of Investments Affected
All types of investments
Examples of Event Risk
Decrease in value of insurance company stock after
a major hurricane
Decrease in value of real estate after a major earthquake

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 Sources of Risk (cont d)

Market Risk is the risk of decline in

investment returns because of market
factors independent of the given
investment.
Types of Investments Affected
All types of investments

Examples of Market Risk

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

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 Sources of Risk (cont d)

Currency Exchange Risk is the risk

caused by the varying exchange rates
between the currencies of two countries.
(Discussed in Chapter 2)
Types of Investments Affected
International stocks or ADRs
International bonds
Examples of Currency Exchange Risk
U.S. dollar gets stronger against foreign
currency, reducing value of foreign investment

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 Measures of Risk: Single Asset

Standard deviation is a statistic used to measure

the dispersion (variation) of returns around an
assets average or expected return
Coefficient of variation is a statistic used to
measure the relative dispersion of an assets
returns; it is useful in comparing the risk of assets
with differing average or expected returns
Higher values for both indicate higher risk

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 Figure 4.2 Risk-Return Tradeoffs
for Various Investments

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 Acceptable Levels of Risk Depend
Upon the Individual Investor

Risk-indifferent describes an investor who does not

require a change in return as compensation for
greater risk

Risk-averse describes an investor who requires

greater return in exchange for greater risk

Risk-seeking describes an investor who will accept

a lower return in exchange for greater risk

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 Figure 4.3 Risk Preferences

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