1 risk and return intro returns hpr cagr ytm, rcytm apr and apy dy npv, irr average annual return...
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Risk and Return IntroRisk and Return Intro
Returns HPR CAGR YTM, RCYTM APR and APY DY NPV, IRR Average Annual Return Geometric Return
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Holding Period Return (HPR)Holding Period Return (HPR)
Holding Period Return The total return earned from holding an investment for a
specified holding period (usually 1 year or less)
Holding period return
Current incomeduring period
Capital gain (or loss)
during period
Beginning investment value
Capital gain (or loss)during period
Ending
investment value
Beginninginvestment value
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Using HPR Using HPR
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 Inaccurate and irrelevant if time period if longer than one
year
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Using IRR Using IRR
Advantages of Internal Rate of Return Uses the time value of money Allows investments of different investment periods to be
compared with each other If the yield is equal to or greater than the required return, the
investment is acceptable
Disadvantages of Internal Rate of Return Calculation is complex Results may not be unique
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Interest on InterestInterest on Interest
Using YTM and IRR assumes: that all income earned over the investment horizon is reinvested 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.
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RiskRisk
Risk-Return Tradeoff is the relationship between risk and return, in which investments with more risk should provide higher returns, and vice versa
Return, for purposes of planning, is the expected return.
Risk is the chance that the actual return from an investment may differ from what is expected. Measured as the standard deviation of the expected return.
( ) Pr( )E R r r
( ) Pr( )E R r r
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Prices and Coupon RatesPrices and Coupon Rates
Risk
Risk and expected Return Risk and expected Return
r
E(r)
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Sources of RiskSources of Risk
Business Risk
uncertainty associated with an investment’s earnings and ability to pay returns owed investors.
Affects Common stocks Preferred stocks
Examples Decline in company profits or market share Bad management decisions
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Sources of Risk (cont’d)Sources of Risk (cont’d)
Currency Exchange Risk
variation in exchange rates.
Affects International stocks, ADRs International bonds
Examples U.S. dollar appreciates against foreign currency, reducing
value of foreign investment
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Sources of Risk (cont’d)Sources of Risk (cont’d)
Financial Risk
uncertainty attributable to the mix of debt and equity used to finance a business;
more debt, greater this risk.
Affects Common stocks Corporate bonds
Examples Company unable to obtain credit to fund operations Company defaults on bonds
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Sources of Risk (cont’d)Sources of Risk (cont’d)
Purchasing Power Risk
changing price levels (inflation or deflation) that adversely affect investment returns.
Affects Bonds (fixed income) Certificates of deposit
Examples Barrel of oil $66.00 last year is $89.00 this year
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Sources of Risk (cont’d)Sources of Risk (cont’d)
Interest Rate Risk
changes in interest rates that adversely affect a security’s value.
Affects Bonds (fixed income) Preferred stocks
Examples Market values of existing bonds decrease as market interest
rates increase Income from an investment is reinvested at a lower interest
rate than the original rate
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Sources of Risk (cont’d)Sources of Risk (cont’d)
Liquidity Risk
not being able to liquidate an investment conveniently and at a reasonable price.
Affects Some small company stocks Real estate
Examples Selling a low volume stock reduces the price of the stock,
consider blockage discounts
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Sources of Risk (cont’d)Sources of Risk (cont’d)
Tax Risk
Congress may introduce unfavorable tax laws, driving down the after-tax returns and market values of certain investments.
Affects Municipal bonds Real estate
Examples Lower tax rates reduce the tax benefit of municipal bond
interest Limits on deductions from real estate losses
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Sources of Risk (cont’d)Sources of Risk (cont’d)
Market Risk
decline in investment returns because of market factors independent of the given investment.
Affects All types of investments
Examples Stock market decline on bad news Political upheaval Changes in economic conditions
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Sources of Risk (cont’d)Sources of Risk (cont’d)
Event Risk
unexpected events that have significant and immediate effect on the underlying value of an investment.
Affects All types of investments
Examples Decrease in value of insurance company stock after
a major hurricane Decrease in value of real estate after a
major earthquake The BP oil spill
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Measures of Risk: Single AssetMeasures of Risk: Single Asset
Standard deviation is a statistic used to measure the dispersion (variation) of returns around an asset’s average or expected return.
Coefficient of variation is a statistic used to measure the relative dispersion of an asset’s returns; it is useful in comparing the risk of assets with differing average or expected returns.
Higher values for both indicate higher risk
CV
CV
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Historical Returns and RiskHistorical Returns and Risk
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Risk-Return Tradeoffs Risk-Return Tradeoffs
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The Decision Process:Combining Return and Risk
The Decision Process:Combining Return and Risk
Estimate the expected return using present value methods and historical/projected return rates.
Assess the risk of the investment by looking at historical/projected returns using standard deviation or coefficient of variation of returns.
Evaluate the risk-return of each investment alternative to make sure the return is reasonable given the level of risk.
Select the investment vehicles that offer the highest expected returns associated with the level of risk you are willing to accept.
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