1、Chapter 4Return and RiskReturn and RisksLearning GoalsReview the concept of return, its components, the forces that affect the investors level of return, and historical returns.Discuss the role of time value of money in measuring return and defining a satisfactory investment.Describe real, risk-free

2、, and required returns and the calculation and application of holding period return.Return and RisksLearning Goals (contd)Explain the concept and calculation of yield and how to find growth rates.Discuss the key sources of risk that might affect potential investments.Understand the risk of a single

3、asset, risk assessment, and the steps that combine return and risk.The Concept of ReturnReturnThe level of profit from an investment, orThe reward for investingComponents of ReturnIncome: cash or near-cash that is received as a result of owning an investmentCapital gains (or losses): the difference

4、between the proceeds from the sale of an investment and its original purchase priceTotal Return: the sum of the income and the capital gain (or loss) earned on an investment over a specified period of timeWhy Return is ImportantThe rate of return indicates how rapidly an investor can build wealth.Al

5、lows us to “keep score on how our investments are doing compared to our expectationsHistorical PerformanceProvides a basis for future expectationsDoes not guarantee future performanceExpected ReturnReturn an investor thinks an investment will earn in the futureDetermines what an investor is willing

6、to pay for an investment or if they are willing to make an investmentKey Factors in ReturnInternal Characteristics Type or risk of investment Issuers management Issuers financingExternal Forces Political environment Business environment Economic environment Inflation DeflationTable 4.4 Historical Re

7、turns for Select Asset Classes (1900-2021)The Time Value of Money and ReturnsThe sooner you receive a return on a given investment, the betterA dollar received today is worth more than a dollar received in the futureThe sooner your money can begin earning interest, the faster it will growDetermining

8、 a Satisfactory InvestmentSatisfactory Investment: one for which the present value of benefits equals or exceeds the present value of its costsMeasuring ReturnRequired ReturnThe rate of return an investor must earn on an investment to be fully compensated for its riskMeasuring Return (contd)Real Rat

9、e of ReturnEquals the nominal rate of return minus the inflation rateMeasures the change in purchasing power provided by an investmentExpected Inflation PremiumThe average rate of inflation expected in the futureMeasuring Return (contd)Risk-free RateThe rate of return that can be earned on a risk-fr

10、ee investmentThe most common “risk-free investment is considered to be the 3-month U.S. Treasury BillMeasuring Return (contd)Risk PremiumAdditional return an investor requires on a risky investment to compensate for risks based upon issue and issuer characteristicsIssue characteristics are the type,

11、 maturity and featuresIssuer characteristics are industry and company factorsHolding Period Return (HPR)Holding Period: the period of time over which an investor wishes to measure the return on an investment vehicleRealized Return: current return actually received by an investor during the given ret

12、urn periodPaper Return: return that has been achieved but not yet realized (no sale has taken place)Holding Period Return (HPR)Holding Period ReturnThe total return earned from holding an investment for a specified holding period (usually 1 year or less)Table 4.6 Key Financial Variables for Four Inv

13、estmentsUsing HPR in Investment DecisionsAdvantages of Holding Period ReturnEasy to calculateEasy to understandConsiders income and growthDisadvantages of Holding Period ReturnDoes not consider time value of moneyRate may be inaccurate if time period is longer than one yearYield: Internal Rate of Re

14、turn (IRR)Internal Rate of Return: determines the compound annual rate of return earned on an investment held for longer than one yearYield (IRR) Example: What is the yield (IRR) on an investment costing $1,000 today that you expect will be worth $1,400 at the end of a 5-year holding period?Calculat

15、ing an Investments Yield Using an Excel Spreadsheet Using IRR in Investment Decisions (contd)Advantages of Internal Rate of ReturnUses the time value of moneyAllows investments of different investment periods to be compared with each otherIf the yield is equal to or greater than the required return,

16、 the investment is acceptableDisadvantages of Internal Rate of ReturnCalculation is complexYield (IRR) for a Stream of IncomeSome investments, such as bonds, provide uneven streams of income over the investment periodCalculate yield (IRR) by finding the discount rate that equates the PV of the inves

17、tments income stream to its market priceTable 4.7 Present Value Applied to an InvestmentInternal Rate of Return (IRR): Using an Excel Spreadsheet Interest on Interest: The Critical AssumptionUsing yield (IRR) to measure return assumes that all income earned over the investment horizon is reinvested

18、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.Figure 4.1 Earning Interest o

19、n InterestFinding Growth RatesRate of GrowthThe compound annual rate of change in the value of a stream of incomeUsed to see how quickly a stream of income, such as dividends, is growingFinding Growth RatesGrowth Rate Example: Stock paid $0.92 dividend in 2002 and $1.85 in 2021. Whats the average an

20、nual growth rate over this period?Finding Growth Rates: Using an Excel Spreadsheet Sources of RiskRisk-Return Tradeoff is the relationship between risk and return, in which investments with more risk should provide higher returns, and vice versaRisk is the chance that the actual return from an inves

21、tment may differ from what is expectedSources of Risk (contd)Business Risk is the degree of uncertainty associated with an investments earnings and the investments ability to pay the returns owed to investors.Types of Investments AffectedCommon stocks Preferred stocksExamples of Business RiskDecline

22、 in company profits or market shareBad management decisionsSources of Risk (contd)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 AffectedCommon stocksCorpora

23、te bondsExamples of Financial RiskCompany cant get additional loans for growth or to fund operationsCompany defaults on bondsSources of Risk (contd)Purchasing Power Risk is the chance that changing price levels (inflation or deflation) will adversely affect investment returns.Types of Investments Af

24、fectedBonds (fixed income)Certificates of depositExamples of Purchasing Power RiskMovie that was $8.00 last year is $9.00 this yearSources of Risk (contd)Interest Rate Risk is the chance that changes in interest rates will adversely affect a securitys value.Types of Investments AffectedBonds (fixed

25、income)Preferred stocksExamples of Interest Rate RiskMarket values of existing bonds decrease as market interest rates increaseIncome from an investment is reinvested at a lower interest rate than the original rateSources of Risk (contd)Liquidity Risk is the risk of not being able to liquidate an in

26、vestment conveniently and at a reasonable price.Types of Investments AffectedSome small company stocksReal estateExamples of Liquidity RiskThe price of a house has to be lowered for a quick saleSources of Risk (contd)Tax Risk is the chance that Congress will make unfavorable changes in tax laws, dri

27、ving down the after-tax returns and market values of certain investments.Types of Investments AffectedMunicipal bondsReal estateExamples of Tax RiskLower tax rates reduce the tax benefit of municipal bond interestLimits on deductions from real estate lossesSources of Risk (contd)Event Risk comes fro

28、m an unexpected event that has a significant and unusually immediate effect on the underlying value of an investment.Types of Investments AffectedAll types of investmentsExamples of Event RiskDecrease in value of insurance company stock after a major hurricaneDecrease in value of real estate after a

29、 major earthquakeSources of Risk (contd)Market Risk is the risk of decline in investment returns because of market factors independent of the given investment.Types of Investments AffectedAll types of investmentsExamples of Market RiskStock market decline on bad newsPolitical upheavalChanges in econ

30、omic conditionsSources of Risk (contd)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 AffectedInternational stocks or ADRsInternational bondsExamples of Currency Exchange RiskU.S. dollar get

31、s “stronger against foreign currency, reducing value of foreign investmentMeasures of Risk: Single AssetStandard deviation is a statistic used to measure the dispersion (variation) of returns around an assets average or expected returnCoefficient of variation is a statistic used to measure the relat

32、ive dispersion of an assets returns; it is useful in comparing the risk of assets with differing average or expected returnsHigher values for both indicate higher riskTable 4.10 Historical Returns and Standard Deviations for Select Asset Classes (19002021)Figure 4.2 Risk-Return Tradeoffs for Various

33、 InvestmentsAcceptable Levels of Risk Depend Upon the Individual InvestorRisk-indifferent describes an investor who does not require a change in return as compensation for greater riskRisk-averse describes an investor who requires greater return in exchange for greater riskRisk-seeking describes an

34、investor who will accept a lower return in exchange for greater riskFigure 4.3 Risk PreferencesSteps in the Decision Process:Combining Return and RiskEstimate the expected return using present value methods and historical/projected return ratesAssess the risk of the investment by looking at historical/projected returns using standard deviation or coefficient of variation of returnsEvaluate the risk-return of each investment alternative to make sure the return is reasonable given the level of riskSelect the