FNCE 625 – Investment Analysis and Management
Skaur12
ch06.pptxInvestments: Analysis and Management
Fourteenth Edition
Gerald R. Jensen and Charles P. Jones
Chapter 6
The Risk and Return from Investing
Asset Valuation
Value is a function of risk and return
At the center of security analysis
Historical risk-return relationships are useful indicators
No guarantee future will be like past
No reason to assume future relative relationships will differ significantly from past
Historical relationships especially useful in the long-run
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Return Components
Return consists of two elements:
Yield
Periodic cash flows such as interest or dividends
Capital gain (loss)
The change in asset price
Total Return = Yield + Percent Price Change
Investors sometimes focus only on one component
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Measuring Returns 1
Return measures allow investors to compare performance over time and across securities
Total return (R) is a percentage relating all cash flows to the start of period price, PB
For a single period:
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Measuring Returns 2
Returns can be either positive or negative
When cumulating or compounding, negative returns are problematic
A return relative (R R) solves this problem because it is always positive
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Measuring Returns 3
To convert returns to wealth and compound over time, use the cumulative wealth index
Cumulative wealth index, C W In, over n periods =
W I0 = Starting wealth
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Measuring International Returns
International investments incur exchange rate risk
Buying foreign assets subjects investors to exchange rate risk
Returns are reduced if foreign currency depreciates
Return in domestic currency equals,
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Measures for a Return Series
How do you summarize returns over several time periods?
Arithmetic mean, or simply mean,
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Arithmetic versus Geometric
Geometric mean captures compound growth rate over time
Reflects realized change in wealth over multiple periods
Reflects compound, cumulative returns over more than one period
Reflects true average compound growth rate over multiple periods
Arithmetic mean reflects typical return in a single period
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Geometric Mean
Defined as the n-th root of the product of n return relatives (1 + R) minus one, or G =
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Adjusting Returns for Inflation
Return measures are nominal, i.e., are not adjusted for inflation
Purchasing power of investment may change over time
Nominal return (R) = [1+ real return (Rr)] × [1+ expected inflation rate (Ir)] − 1
Consumer Price Index (C P I) is a possible measure of inflation
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Risk
Risk and return are opposite sides of the same coin
Risk is the chance that a security’s actual return will differ from its expected return
Investors willing to assume large risks may gain large returns, but they may also lose money
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Risk Sources
Interest Rate Risk
Market rates change
Market Risk
Recession, war, etc.
Inflation Risk
Purchasing power variability
Business Risk
Risk inherent in business
Financial Risk
Tied to debt financing
Liquidity Risk
Marketability of security
Currency Risk
Exchange Rate Risk
Country Risk
Political stability
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Measuring Risk
Risk arises from variability of outcomes
Variance and standard deviation measure variability
Standard deviation is simply the square root of the variance
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Returns for Major Asset Classes
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Risk Premiums
Premium is additional return earned or expected for additional risk
Calculated for any two asset classes
Equity risk premium - difference between stock return and risk-free return
Stocks versus Treasury bills
Stocks versus Treasury bonds
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The Risk-Return Record
From 19 26 to 2018, geometric average annual return was 10.0% for S&P 500
Arithmetic mean was 11.9%
Standard deviation was 19.8%
Smaller common stocks showed greater risk and return than large common stocks
T-bills showed lowest risk and return: 3.3% return and 3.1% standard deviation
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Copyright
Copyright © 2020 John Wiley & Sons, Inc.
All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 19 76 United States Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.
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