CH.1 a Brief History of Risk and Return

37
1 C h a p t e r A Brief History of Risk and Return second edition Fundamentals of Investments Valuation & Management Charles J. Corrado Bradford D. Jordan McGraw Hill / Irwin Slides by Yee-Tien (Ted) Fu @2002 by the McGraw- Hill Companies Inc.All rights reserved

Transcript of CH.1 a Brief History of Risk and Return

Page 1: CH.1 a Brief History of Risk and Return

11C h a p t e r

A Brief History of Risk and ReturnA Brief History of Risk and Return

second edition

Fundamentals

of InvestmentsValuation & Management

Charles J. Corrado Bradford D. Jordan

McGraw Hill / IrwinSlides by Yee-Tien (Ted) Fu @2002 by the McGraw- Hill Companies Inc.All rights reserved.

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2002 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Who Wants To Be A Millionaire?

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A Brief History of Risk and Return

Our goal in this chapter is to see what financial market history can tell us about risk and return.

Goal

Two key observations emerge.There is a reward for bearing risk, and at least on

average, that reward has been substantial.Greater rewards are accompanied by

greater risks.

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Returns

Example

Total dollar return = Dividend + Capital gain on stock income (or loss)

Total dollar return

The return on an investment measured in dollars that accounts for all cash flows and capital gains or losses.

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Returns

ExamplePercent return = Dividend + Capital gains

on stock yield yield or Total dollar return .

Beginning stock price

Total percent returnThe return on an investment measured as a % of the originally invested sum that accounts for all cash flows and capital gains or losses. It is the return for each dollar invested.

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Returns

Example: Calculating Returns Suppose you invested $1,000 in a stock at $25 per

share. After one year, the price increases to $35. For each share, you also received $2 in dividends.

Dividend yield = $2 / $25 = 8% Capital gains yield = ($35 – $25) / $25 = 40% Total percentage return = 8% + 40% = 48% Total dollar return = 48% of $1,000 = $480 At the end of the year, the value of your $1,000

investment is $1,480.

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The Historical Record:A First Look

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McGraw Hill / Irwin

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The Historical Record:A Longer Range Look

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Returns

A company total market capitalization ( or market cap. For short ) is equal to its stock price multiplied by the number of shares of stocks . In other words , it’s the total value of the company stock .

Large companies are called “large cap” stocks and small companies are called “small cap “stocks .

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The Historical Record: A Closer Look

Figure 1.3

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The Historical Record: A Closer Look

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The Historical Record: A Closer Look

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@2002 by the McGraw- Hill Companies Inc.All rights reserved.McGraw Hill / Irwin

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The Historical Record: A Closer Look

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The Historical Record: A Closer Look

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Average Returns: The First Lesson

Average annual = yearly returns return number of years

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Average Returns: The First Lesson

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Average Returns: The First Lesson

Risk-free rateThe rate of return on a riskless investment.

Risk premiumThe extra return on a risky asset over the risk-free rate; the reward for bearing risk.

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Average Returns: The First Lesson

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Average Returns: The First Lesson

The First Lesson There is a reward, on average, for bearing risk.

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Return Variability: The Second Lesson

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Return Variability: The Second Lesson

VarianceA common measure of volatility.

Standard deviationThe square root of the variance.

Normal distributionA symmetric, bell-shaped frequency distribution that is completely defined by its average and standard deviation.

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Return Variability: The Second Lesson

Variance of return

1σ 1

2

2

N

RRRVar

N

ii

where N is the number of returns

Standard deviation of return

RVarRSD σ

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Return Variability: The Second Lesson

Example about variance :Suppose a particular investment had returns of 10% - 12% - 3%-

(-9%) Over the last four years The average return is :(10% + 12%+ 3%+ (-9%))/4 = 4 %The deviation from the average is :(10-4 )²=36 (12-4) ²=64(3-4) ²=1(-9-4) ²=169_________________ variance= 270 /3 = 90 S. D. =90 = 9.487%

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Return Variability: The Second Lesson

Example about variance :variance= 270 /3 = 90 S. D. =90 = 9.487%From these two numbers we can say that : with a normal distribution the probability that we

end up with one standard deviation from the average is about 68% .

with a normal distribution the probability that we end up with two standard deviation from the average is about 95% .

with a normal distribution the probability that we end up with three standard deviation from the average is about 1% .

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Return Variability: The Second Lesson

To let you know :If you know that the standard deviation of returns in

the previous ex. Are 7% , and the average return that calculated before are 4%,

The probability that the return in a given year is in the range of ( (4+7) to (4-7) )= ( 11% to -3% ) within one standard deviation is about 68%.

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Return Variability: The Second Lesson1 - 26

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Return Variability: The Second Lesson

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Return Variability: The Second Lesson

The Second Lesson The greater the potential reward, the greater

the risk.

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Return Variability: The Second Lesson

Source: Dow Jones

Top 12 One-Day Percentage Changes in the Dow Jones Industrial Average

October 19, 1987 - 22.6 % March 14, 1907 - 8.3 %

October 28, 1929 - 12.8 October 26, 1987 - 8.0

October 29, 1929 - 11.7 July 21, 1933 - 7.8

November 6, 1929 - 9.9 October 18, 1937 - 7.7

December 18, 1899 - 8.7 February 1, 1917 - 7.2

August 12, 1932 - 8.4 October 27, 1997 - 7.2

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Risk and Return

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Risk and Return trade off

The risk-free rate represents compensation for just waiting. So, it is often called the time value of money.

If we are willing to bear risk, then we can expect to earn a risk premium, at least on average.

Further, the more risk we are willing to bear, the greater is that risk premium.

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Risk and Return trade off The time value of money is the value of money

figuring in a given amount of interest earned over a given amount of time.

For example, 100 dollars of today's money invested for one year and earning 5 percent interest will be worth 105 dollars after one year. Therefore, 100 dollars paid now or 105 dollars paid exactly one year from now both have the same value to the recipient who assumes 5 percent interest; using time value of money terminology, 100 dollars invested for one year at 5 percent interest has a future value of 105 dollars.

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Risk and Return trade off Investment advisers like to say that an investment has a ”wait

“ component and a “worry” component . The time value of money is the compensation for waiting , and

the risk premium is the compensation for worrying . Risky investment do not always pay more than risk free

investment , this mean that there are a risk premium on average ,but over any particular time interval , there is no guarantee .

Note that not all risk are compensated , as there are some risks which are cheaply and easily avoidable , and there are no expected reward for bearing them .

Those risks that can not be easily avoided that are compensated (on average ).

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A Look Ahead

We will learn how to value different assets and make informed, intelligent decisions about the associated risks.

We will also discuss different trading mechanisms and the way different markets function.

This text focuses exclusively on financial assets: stocks, bonds, options, and futures.

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Chapter Review

Returns Dollar Returns Percentage Returns

The Historical Record A First Look A Longer Range Look A Closer Look

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Chapter Review

Average Returns: The First Lesson Calculating Average Returns Average Returns: The Historical Record Risk Premiums The First Lesson

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Chapter Review

Return Variability: The Second Lesson Frequency Distributions and Variability The Historical Variance and Standard Deviation The Historical Record Normal Distribution The Second Lesson

Risk and Return The Risk-Return Trade-Off A Look Ahead


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