Professional Documents
Culture Documents
Chapter 4
Slide Contents
Learning Objectives
1.
2.
3.
Investment Process
1. Market and Security Analysis
2. Formation of Optimal Portfolio
Return
Income received on an investment plus any change
investment.
sold a year later for $200. The company did not pay any dividend
during that period. What will be the cash return on this
investment?
Cash Return
= $200 + 0 - $95
= $105
and sold a year later for $200. The company did not pay any
dividend during that period. What will be the rate of return on
this investment?
= 110.53%
Table 7-1 has additional examples on measuring an investors realized rate
Expected Return
Measuring Risk
In the example on Table 7-2, the expected return is 12.6%;
Geometric
vs. Arithmetic Average
Rates
of Return
realized on an investment.
In some cases, geometric or compound average may be a more
the stock rises to $30 and in the second year, it falls to $15. What
was the average return on this investment?
year.
Simple average = (20%-50%) 2 = -15%
22.54%
{(1+.20)(1-.50)}1/2 - 1 = -22.54%.
Here, -15% is the simple arithmetic average while -22.54% is the
Year
Annual Rate of
Return
Value of the
stock
$25
40%
$35
-50%
$17.50
Question being
addressed:
Appropriate Average
Calculation:
Checkpoint 7.2
Computing the Arithmetic and Geometric Average Rates of Return
Five years ago Marys grandmother gave her $10,000 worth of stock in the shares of a publicly traded company
founded by Marys grandfather. Mary is now considering whether she should continue to hold the shares, or
perhaps sell some of them. Her first step in analyzing the investment is to evaluate the rate of return she has
earned over the past five years.
The following table contains the beginning value of Marys stock five years ago as well as the values at the end of
each year up until today (the end of year 5):
What rate of return did Mary earn on her investment in the stock given to her by her grandmother?
Checkpoint 7.2
Problem (cont.)
Year
Annual Rate of
Return
-15.0%
$8,500.00
15.0%
$9,775.00
25.0%
$12,218.75
30.0%
$15,884.38
-10.0%
$14,295.94
Step 3: Solve
Calculate the Arithmetic Average
Arithmetic Average
(1+Ryear5) ]1/5 - 1
Step 4: Analyze
The arithmetic average is 9% while the geometric average is
Mary can expect from her investment next year assuming all else
remains the same as in the past?
The geometric average answers the question, what rate of return
Defining Risk
Market Risk
The chance that the value of an investment will affect because
Inflation Risk
Refers to uncertainty of purchasing power of cash flows to be
Business Risk
Variability in the income of the firm and the expected
dividend.
Some Industries have higher business risk than others.
Financial Risk
Degree of debt financing used by the firm in the capital
structure.
Higher the debt financing, the greater the degree of financial
risk.
Debt Financing increases the risk of equity shares by
- Increasing the variability of returns of equity shares
winding up of company.
Types of Risk
Out of the five sources of risk in the investments, the first
Systematic risk
Variability in return due to general factors in the market such
Unsystematic Risk
Fluctuations in return from an investment due to factors that
Measuring Risk
Unique
risk
Market risk
0
5
10
Number of Securities
15
Risk
Illustrated
The range of total possible returns
on the stock runs from -30% to
more than +40%. If the required
return on the stock is 10%, then
those outcomes less than 10%
represent risk to the investor.
Probabilit
y
Outcomes that produce harm
-30% -20%
-10%
0%
10%
20%
30%
40%
Possible Returns on the Stock
Range
The difference between the maximum and minimum values is
8 - 49
Probabilit
y
-30% -20%
-10%
0%
10%
20%
30%
40%
Possible Returns on the Stock
Measuring Risk
Variance - Average value of squared deviations from mean.
A measure of volatility.
Standard Deviation - Average value of squared
deviations from mean. A measure of volatility.
Measuring Risk
Problem 1
Estimate the standard deviation of the historical returns on
investment A that were:
Time
Return
10%
24%
-12%
8%
10%
Measuring Risk
Step 1 Calculate the Historical Average Return
n
r
i 1
10 24 - 12 8 10 40
8.0%
5
5
Ex post
(r r )
i 1
n 1
5 1
2 2 162 202 0 2 22
4 256 400 0 4
664
166 12.88%
4
4
4
Measures of Risk
Given an asset's expected return, its variance can be calculated
= S pi(ri E[r])2
i=1
Where:
N = the number of states
pi = the probability of state i
ri = the return on the stock in state i
E[r] = the expected return on the stock
54
Measures of Risk
The standard deviation is calculated as the positive square root of
the variance:
SD(R) = = 2 = (2)1/2 = (2)0.5
55
Measures of Risk
Probability Distribution:
State
Probability
1
20%
2
30%
3
30%
4
20%
E[r]A = 12.5%
E[r]B = 20%
56
Return On
Stock A
5%
10%
15%
20%
Return On
Stock B
50%
30%
10%
-10%
Expected Return
In this example, the expected return for stock A would be
calculated as follows:
E[r]A = .2(5%) + .3(10%) + .3(15%) + .2(20%) = 12.5%
Now you try calculating the expected return for stock B!
57
Expected Return
Did you get 20%? If so, you are correct.
If not, here is how to get the correct answer:
Stock A.
However, that is only part of the story; we haven't considered
risk.
58
Measures of Risk
The variance and standard deviation for stock A is calculated as follows:
2A = .2(.05 -.125)2 + .3(.1 -.125)2 + .3(.15 -.125)2 + .2(.2 -.125)2 = .002625
59
Measures of Risk
If you didnt get the correct answer, here is how to get it:
riskier since its variance and standard deviation are greater than Stock A's.
This, however, is still only part of the picture because most investors choose
to hold securities as part of a diversified portfolio.
60