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.

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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Work the Web

For more information on investments, check out:http://www.investorama.com

For more information on common stocks, check out:http://finance.yahoo.comhttp://www.nyse.comhttp://www.sec.gov

The Historical Record:A First Look

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The Historical Record:A Longer Range Look

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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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The Historical Record: A Closer Look

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The Historical Record: A Closer Look

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Work the Web

To learn more about global market history, visit:http://www.globalfindata.com

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Average Returns: The First Lesson

Average annual = yearly returns return number of years

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.

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.

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

Return Variability: The Second Lesson1 - 24

Return Variability: The Second Lesson

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Work the Web

For an easy-to-read review of basic statistics, see:http://www.robertniles.com/stats/

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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

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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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