Practice investment management pim3 ch02 ch 1 concept of investing

 More on the Relationship between Risk and Return The Direct Relationship  Risk, Return, and Dominance Outline... Holding period = return Ending Beginning value value Income Beginnin

UNDERSTANDING RISK AND RETURN

CHAPTER TWO

 Return

 Holding Period Return

 Yield and Appreciation

 The Time Value of Money

 Compounding

 Compound Annual Return

Outline

 Risk

 Risk vs Uncertainty

 Dispersion and the Chance of Loss

 The Problem with Losses

• Big Losses

• Small Losses

• Risk and the Time Horizon

 Risk Aversion

• Risk Aversion and Rational People

• Risk and Time

Outline

 More on the Relationship between Risk and Return

 The Direct Relationship

 Risk, Return, and Dominance

Outline

aversion Some are more willing to take a chance than others.

Holding

period =

return

Ending Beginning value value Income

Beginning value

_

+

Holding Period Return

holding period return.

 Holding period return is independent of the passage of time.

 When comparing investments, the periods should all be of the same length

corporate actions, care should be taken to ensure that the correct value is used for

calculating the holding period return.

Holding Period Return

Current yield is annual income divided by current price.

Example :

For a stock selling for $40 and expected to pay $1 in dividends over the next year ,

current yield = $1 / $40 = 2.5%

Yield and Appreciation

Dividend yield is used for stocks whose income comes exclusively from dividends.

Appreciation is the increase in value of an investment

independent of its yield.

Yield and Appreciation

It excludes accrued interest, as well as increases in value which are due to additional deposits.

The Time Value of Money

 The time value of money is the notion that

a dollar today is worth more than a dollar tomorrow.

 The current price of any financial asset

should be the present value of its expected future cash flows.

The Time Value of Money

Example :

P × ( 1 + 0.0919 ) 4 = $1,000

 P = $703.50

What is the most that an investor would pay for

a zero coupon bond which matures in 4 years' time, and has a redemption value of $1,000?

The interest rate is 9.19%

 Many securities pay more than one cash flow over their lives In particular, an annuity is a series of equal and evenly spaced payments.

 A convenient expression for the present value

of an annuity is:

The Time Value of Money

where C = coupon or periodic payment

1r

1CP

The Time Value of Money

Insert Figure 2.1 here.

 Compounding refers to the earning of

interest on interest that is earned previously.

where r = annual interest rate

n = number of compounding periods per year and t = investment horizon in years

nt

n

r 1

 The more frequent the compounding, the greater the interest earned.

Compounding

Compound annual return is the annual interest rate that makes the time value of money relationship hold.

Example :

A nondividend-paying stock bought 4.5 years

ago

at $40 and sold today at $78 has a compound

Compound Annual Return

It is also known as the effective annual rate.

 A truly risky situation must involve a chance of loss.

Risk vs Uncertainty

Dispersion and the Chance of Loss

outcome and the scattering of the possible

outcomes about this average.

dispersion is variance The standard

deviation is the square root of the variance.

1

2

i prob x

Dispersion and the Chance of Loss

Insert Figure 2-3 here.

The Problem with Losses

overwhelm a series of gains

occur too often

horizon increases, the probability of losing money decreases but the amount of money that may be lost increases.

Small Losses

Insert Figure 2-4 here.

Risk and the Time Horizon

Risk Aversion and Rational People

risky dollar.

dollar over a risky dollar.

they expect to be rewarded for taking the risks.

aversion Some are more willing to take a chance than others.

Risk Aversion and Rational People

Choice 1 Choice 2 Choice 3 Choice 4 _

Resulting Resulting Resulting Resulting

Number Payoff Number Payoff Number Payoff Number Payoff

1-50 $110 1-50 $200 1-90 $ 50 1-99 $1,000 51-100 $ 90 51-100 $ 0 91-100 $550 100 -$89,000 Avg $100 Avg $100 Avg $100 Avg $ 100

Risk and Time

and how likely, but says nothing about

when.

the length of the forecast period

approaches infinity.

measured over consistent time intervals.

 While the returns over a long horizon may

be more uncertain, history suggests that over long periods of time, the likelihood

that the investment will lose money is less.

Risk and Time

Partitioning Risk

 Undiversifiable risk is risk that must be

borne by virtue of being in the market

It is also known as systematic risk or

market risk , and is measured by beta.

 Diversifiable risk is also known as

unsystematic risk.

 Total risk = undiversifiable risk

+ diversifiable risk

Partitioning Risk

 Business risk - the variability in a firm's

sales, or its ability to sell its product

 Financial risk - associated with the

financial structure of the firm

 Purchasing power risk - the possibility that the rate of return on an investment will be insufficient to offset the rise in the cost of living

Partitioning Risk

 Interest rate risk - the chance of a loss in

portfolio value due to an adverse change in interest rate

 Foreign exchange risk - the possibility of loss due to adverse changes in the relative values of world currencies

Partitioning Risk

 Political risk - the possibility that a

government will interfere with a firm's

preferred manner of conducting business

 Social risk - the potentially adverse impact changing public attitudes can have on a

firm's ability to sell its product

Partitioning Risk

Insert Figure 2-5 here.

Partitioning Risk

Insert Figure 2-6 here.

The Direct Relationship between Risk and Return

Insert Figure 2-7 here.

 Empirical financial research reveals clear

evidence of the direct relationship between systematic risk and expected return, i.e

riskier securities earn higher returns on

average.

The Direct Relationship between Risk and Return

The Direct Relationship between Risk and Return

Insert Figure 2-8 here.

Risk, Return, and Dominance

dominance over another if it offers the

same expected return for less risk, or if the security has a higher expected return than another security of comparable risk.

price.

Risk, Return, and Dominance

Insert Figure 2-9 here.

 Return

 Holding Period Return

 Yield and Appreciation

 The Time Value of Money

 Compounding

 Compound Annual Return

Review

 Risk

 Risk vs Uncertainty

 Dispersion and the Chance of Loss

 The Problem with Losses

• Big Losses

• Small Losses

• Risk and the Time Horizon

 Risk Aversion

• Risk Aversion and Rational People

• Risk and Time

 Partitioning Risk

Review

 More on the Relationship between Risk and Return

 The Direct Relationship

 Risk, Return, and Dominance

Review