Risk and Returns

The storm before the peaceful paradise

By: Group 1
 The Concept of Return-
Components-Importance-Level
By: Vengeline De Leon
What is Return?

The total gains or losses expected on an

investment over a given period of time.

Is the level of profit from an investment.

Concept of Return

Suppose you have P1000 in your savings account

that pays 2% annual interest, and had a classmate
ask you to lend your money to him and pays you
back after 2 months.

Some investments guarantee a return, but most

do not.
Components of Return

Mostcommon source is periodic payments such as

dividends or interest.

Other source:
The change in the investments price.
- Current Income.
- Capital Gains (losses).
Income

May take the form of dividends from stocks

bonds or interest received.

It must be in the form of cash.

Capital Gains (Losses)

Focuses on the change in an investments market

value.
The difference between the proceeds from the
sale of an investment and its original purchase
price.
Use percentage returns.
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.

Important Aspects of Data:

1st we can determine the average level of return.
2nd observe that there was considerable variation
in return.
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.
Level of Return
Achieved or expected from an investment that will depend on a
variety of factors:

Internal Characteristics:
- Type or risk of investment
- Issuers management
- Issuers financing

External Forces:
- Political environment
- Business environment
- Economic environment
- Inflation
- Deflation
REAL, RISK-FREE AND
REQUIRED RETURNS
A genuine heart gives a response without doubt.
By: Rochel Triza Lao
Risk and Return
Rational investors will choose investments that fully compensate
them for the risk involved. The greater the risk, the greater the
return required by investors. The rate of return that fully
compensates for an investments risk is called the required return.

The Required return on any investment j consists of three basic

components; the real rate of return, an expected inflation
premium, and a risk premium.

Equation A

Required return = Real Rate + Expected inflation + Risk premium for

of Return premium investment

Ri = r* + IP + RPi
 The nominal return on an investment is the actual
return that the investment earns expressed in current
dollars. The real rate of return equals the nominal
return minus the inflation rate, and it measures the
increase in purchasing power provided by an
investment.

Equation B

Real Rate of Return = Nominal Return Inflation Rate

 The expected inflation premium represents the average rate
of inflation expected in the future. For instance, most inflation
forecasts for 2010 projected very low inflation due to the
lingering effects of the global recession. By adding the first two
terms from the previous equation, we obtain the risk-free rate.
This is the rate of return that can be earned on a risk-free
investment.

Equation C

Risk Free Rate = Real Rate of Return + Expected Inflation Premium

RF = r* + IP
Holding Period Return
Time spent will waiting for its return
By: Judy Ann Pesquera
Holding Period Return

Isthe period of time over which one wishes to

measure the return on investment.

Compare the holding periods of the same length.

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).
Return components

Income
Capital gains(or losses)
Computing the HPR

Income during period Capital gain(loss) during period

HPR = Beginning investment value

Where:
Capital gain(loss)= Ending Beginning
investment value investment value
 Example:
Investment Vehicle
savings account common stock bond real estate
Cash Received:
1st quarter $15 $10 $0 $0
2nd quarter 15 10 70 0
3rd quarter 15 10 0 0
4th quarter 15 15 70 0
(1) total income $60 $45 $140 $0

Investment Value
End-of-year $1,000 $2,200 $970 $3,300
(2)beginning-of-year 1,000 2,000 1,000 3,000
(3)capital gain(loss) 0 200 (30) 300
(4)total return(1 + 3) 60 245 110 300

(5) Holding period return 6% 12.25% 11% 10%

 Using HPR
in Investment Decisions

Advantages of Holding Period Return

Easy to calculate
Easy to understand
Considers current 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
YIELD: The Internal
Rate of Return
That of which who came back from your investment
By: Liezel Armilla
YIELD: THE INTERNAL RATE OF RETURN

-Alternative way to define a satisfactory investment is in

terms of the compound annual rate of return it earns.

Why do we need an alternative to HPR?

Because the HPR fails to consider the time value of
money, sophisticated investors typically do not use HPR
when the time period is greater than one year.
Yield ( Internal Rate of Return)

- Present-value-based measure
- Use to determine the compound annual rate of return
earned on the investments held for longer than 1 year.
- can also be defined as the discount rate that produces a
present value of benefit just equal to its cost.
- shall be the basis whether an investment is acceptable
if:
Yield >= required return (acceptable)
Yield < required return (unacceptable)
YIELD FOR A SINGLE CASH FLOW

Some investment such as saving bonds, stocks paying no

dividends, and a zero-coupon bonds are purchased by paring a
fixed amount . The investors expects them to provide no
periodic income, but to provide a single- and, the investors
hopes, a largefuture cash flow at a maturity or when the
investment is sold.
Formula:
i= (FV/PV)^1/n 1
 Example:
FV: 1400
PV: 1000
N= 5 years

Solution
i= (FV/PV)^1/n 1
i= (1400/1000)^1/5 1
= (1.4)^0.2 1
=1.069610376 1
= . 069610376 or 6.96%
YIELD FOR A STREAM OF INCOME

Investment such as income-oriented stocks and bonds

typically provide the investors with a stream of income.
The yield for a stream of income(returns) is generally
more difficult to estimate. The most accurate approach is
based on searching for the discount rate that produces a
present value of income just equal to the cost of
investment.
Example:
Consider once more the investment presented from the last slide. That table
illustrates that if the investments cost is P1,175.85 its internal rate of
return is equal to 8% because thats the discount rate that equates the
present value of the investment cash flow to its market price.
End of Year (1) (2) (3) (4) (5)
INCOME Present Value Present Value at 9% Present Value Present Value at
Calculation at 9% Calculation at 10% 10%

1 P90 90/(1+.09)^1 82.57 90/(1+.10)^1 81.82

2 100 100/(1+.09)^2 84.17 100/(1+.10)^2 82.64

3 110 110/(1+.09)^3 84.94 110/(1+.10)^3 82.64

4 120 120/(1+.09)^4 85.01 120/(1+.10)^4 81.96

5 100 100/(1+.09)^5 64.99 100/(1+.10)^5 62.09

6 100 100/(1+.09)^6 69.63 100/(1+.10)^6 56.45

7 1200 1200/(1+.09)^7 656.44 1200/(1+.10)^7 615.79

INTEREST ON THE INTEREST: THE
CRITICAL ASSUMPTION

- The critical assumption underlying the use of yield as a

return measure is an ability to earn a return equal to yield
on all income received during the holding period.
 Example:
Suppose you buys a 1,000 pesos treasury bond
that pays 8% annual interest (80 pesos) over its
20 year maturity. Each year you receive 80 pesos,
and maturity the P1000 in principal is repaid.
However, in order to earn 8% on this investment,
you must be able to reinvest the P80 annual
interest receipts.
 Ifdecided not to reinvest the P80 annual interest
receipts you will end up with:
Principal + annual interest receipt for 20 years
1000 + 80(20 years)
1000 + 1600
2600 which about 5% rate of return.
 butin order to achieve the 8% rate of return, you
must reinvest your P80 annual interest receipts:
FV= PV(1+r)n
=1,000(1+.08)20
=4,661

Thefuture value of the investment would be P2,061

(4,661-2600)greater with interest on interest than
without reinvestment of the interest receipts.
Sources of risk
The thing which make us anxious.
By: Jr Calles
What do mean by risk?

Risk is the chance that the actual return from an

investment may differ from what is expected.

Risk may also be that probability that you might not be

able to achieve something of which you desire.
Firm specific risks

Business
risk The chance that the firm will
be unable to cover its operating cost.

Financial
risk- The chance that the firm will
be unable to cover its financial obligations.
Shareholder- specific risks

Interest rate risk- The chance that changes

in interest rates will adversely affect the
value of an investment.

Liquidity risk- The chance that an

investment cannot be easily liquidates at a
reasonable price.
Shareholder-specific risks

Market risk- The chance that the value of

an investment will decline because of
market factors that are independent of the
investment (such as political, economic,
and social events).
Firm and shareholder risks

Event risk- The chance that a totally

unexpected event will have a significant effect
on the value of the firm or a specific
investment.

Exchange rate risk- The exposure of future

cash flows to fluctuations in the currency
exchange rate.
Firm and shareholder risks

Purchasing-power risk- The chance that

changing price levels caused by inflation or
deflation in the economy will adversely
affect the firms or investments cash flows
and value.

Tax risk- The chance that unfavorable

changes in tax laws will occur.
Expression for calculating the rate of
return earned on any asset over period.

Kt= Ct + Pt Pt-1
Pt-1
Expression for calculating the rate of
return earned on any asset over period.
Where:
Kt = Actual, expected, or required rate of return during
period t.
Ct = Cash(flow) received from the asset investment in the
time period t-1 to t.
Pt = Price(value of asset at time t.
Pt-1 = Price(value) of asset at time t-1.
Expression for calculating the rate of
return earned on any asset over period.
The return kt, reflects the combined effect of
cash flow, Ct, and changes in value, Pt-Pt-1, over
period t.
Sample Problem:

Robins Gameroom, a high-traffic video arcade, wishes to

determine the return on two of its video games,
Conqueror and Demolition. Conqueror was purchased 1
year ago for $ 20,000 and currently has a market value of
$ 21,500. During the year, it generated $ 800 of after tax
cash receipts. Demolition was purchased 4 years ago; its
value in the year just completed declined from $12,000 to
$11,800. During the year, it generated $ 1,700 of after-
tax cash receipts.
Sample Problem:

Althoughthe market value of Demolition declined

during the year, its cash flow caused it to earn a
higher rate of return than Conqueror earned
during the same period. Clearly, the combined
impact of cash flow and changes in value,
measured by the rate of return, is important.
Risk of a Single Asset

The concept of risk can be developed by first

considering a single asset held in isolation. We can
look at expected-return behaviors to assess risk,
and statistics can be used to measure it.
Risk Assessment

Sensitivity
analysis and probability distributions
can be use to assess the general level of risk
embodied in a given asset.
Sensitivity Analysis

This uses several possible-return estimates to

obtain a sense of the variability among outcomes.
One common method involves making pessimistic
(worst), most likely (expected), and optimistic
(best) estimates of the returns associated with a
given asset. In this case the assets risk can be
measured by the range of returns.
Sensitivity Analysis

The range is found by subtracting the pessimistic

outcome from the optimistic outcome. The
greater the range, the more variability, or risk,
the asset is said to have.
Probability Distributions
Probability distributions provide a more quantitative insight into
an assets risk.
The probability of a given outcome is its chance of occurring. An
out come with an 80% probability of occurrence would be
expected to occur 8 out of 10 times.
Probability Distribution
Probability Distribution
Risk Measurement
In addition to considering its range, the risk of an
asset can be measured quantitatively by using
statistics. Here we consider two- the standard
deviation and the coefficient of variation- that
can be used to measure the variability of asset
returns.
Standard Deviation
The most common statistical indicator of an assets risk is
the standard deviation, k, which measures the dispersion
around the expected value. The expected value od a
return, k, is the most likely return on an asset.
Standard Deviation
Standard Deviation
Standard Deviation
Standard Deviation
Standard Deviation
Coefficient of Variation

The coefficient of variation, CV, is a measure of

relative dispersion that is useful in comparing the
risk of assets with differing returns.
Coefficient of Variation

When the standard deviations from the previous

samples along with its respective rate of returns,
now we could compute the coefficient of
variation. Remember that the higher the
coefficient of variation is the riskier it is.
Coefficient of Variation
Coefficient of Variation

Judging solely on the basis of their standard deviations, the

firm would prefer asset X, which has a lower standard
deviation. However, the management would be making a
serious error in choosing asset X, because the dispersion- the
risk- of the asset, as reflected in the coefficient of variation,
is lower for Y than that of X. Clearly using the coefficient of
variation to compare asset risk is effective because it also
considers relative size, or expected return, of the assets.
 Assessing Risk
Determining the chance of losing something
By: Kristin Louise Macaldo
Risk return tradeoffs for various investment vehicles- a
relationship between risk and return, in which investments
with more risk should provide higher returns and vice versa.
Acceptable levels of risk depend upon
the 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.
Risk Preferences
Steps in the Decision Process:
Combining Return and Risk
1. Estimate the expected return using present value methods
and historical/projected return rates
2. Assess the risk of the investment by looking at
historical/projected returns using standard deviation of returns
or more sophisticated measures, such as beta.
3. Evaluate the risk-return of each investment alternative to
make sure the return is reasonable given the level of risk. If
other vehicles with lower levels of risk provide equal or greater
returns, the investment is not acceptable.
4. Select the investment vehicles that offer the highest
expected returns associated with the level of risk you are
willing to accept