Risk

Risk and
and Return
Return Intro
Intro
Returns
HPR
CAGR
YTM, RCYTM
APR and APY
DY
NPV, IRR
Average Annual Return
Geometric Return

Holding
Holding Period
Period Return
Return (HPR)
(HPR)
Holding Period Return
The total return earned from holding an investment for a
specified holding period (usually 1 year or less)

Holdingperiodreturn

Currentincome
Capitalgain(orloss)

duringperiod
duringperiod
Beginninginvestmentvalue

Capitalgain(orloss)
Ending
Beginning

duringperiod
investmentvalue
investmentvalue

Using
Using HPR
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

Using
Using IRR
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

Interest
Interest on
on Interest
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.

Risk
Risk
) Pr(
r )gr
Risk-Return Tradeoff isE (Rthe
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.

E ( R ) Pr( r )gr

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.
6

Risk
Prices
andexpected
Coupon Return
Rates
Risk and
and
expected
Return
E(r)

Risk

Sources
Sources of
of Risk
Risk
Business Risk
uncertainty associated with an investments earnings
and ability to pay returns owed investors.
Affects
Common stocks
Preferred stocks

Examples
Decline in company profits or market share
Bad management decisions

Sources
Sources of
of Risk
Risk (contd)
(contd)
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

Sources
Sources of
of Risk
Risk (contd)
(contd)
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
10

Sources
Sources of
of Risk
Risk (contd)
(contd)
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

11

Sources
Sources of
of Risk
Risk (contd)
(contd)
Interest Rate Risk
changes in interest rates that adversely affect a
securitys 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
12

Sources
Sources of
of Risk
Risk (contd)
(contd)
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

13

Sources
Sources of
of Risk
Risk (contd)
(contd)
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
14

Sources
Sources of
of Risk
Risk (contd)
(contd)
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

15

Sources
Sources of
of Risk
Risk (contd)
(contd)
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
16

Measures
Measures of
of Risk:
Risk: Single
Single Asset
Asset
Standard deviation is a statistic
used to measure the

CV

dispersion (variation) of returns

around an assets average
or expected return.
Coefficient of variation is a statistic used to measure the
relative dispersion of an assets returns; it is useful in
comparing the risk of assets with differing average or
expected returns.

CV

Higher values for both indicate higher risk

17

Historical
Historical Returns
Returns and
and Risk
Risk

18

Risk-Return
Risk-Return Tradeoffs
Tradeoffs

19

The
The Decision
Decision Process:
Process:
Combining
Combining Return
Return and
and Risk
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.

20