Risk and Rates of Return Chapter 6 Objective 4: Expected Return Thank you Objective 3: The Term Structure of Interest Rates Objectives Objective 5: Risk 1.Describe the relationship between the average returns that investors have earned and riskiness of these returns.

2.Explain the effects of inflation on rates of return.

3.Describe term structure of interest rates.

4.Define and measure the expected rate of return of an individual investment.

5.Define and measure the riskiness of individual investment

6.Explain how diversifying investments affect the riskiness and expected rate of return of a portfolio or combination of assets.

7.Measure the market risk of an individual asset.

8.Calculate the market risk of a portfolio of investment.

9.Explain the relationship between an investor’s required rate of return on an investment and the riskiness of the investment. Principles to be emphasized in this chapter

Principle 9:

All Risk are Not Equal

Some risk can be diversified away, and some cannot.

Principle 3:

Cash-Not Profit-Is King

Principle 1:

The Risk-Return Trade -Off

We won't take an additional risk

unless we expect to be compensated

with additional returns. Objective 1: Rates of Return In

the Financial Markets Risk (uncertainty)

refers to the

variability of

expected returns

associated

with a given

investment. To obtain financing for projects that will benefit a firm's stockholders, a company must offer investors a rate of return that is competitive with the next best investment available to investor.

Opportunity Cost of Funds-

The next best rate of return

available to the investor for a

given level of risk. "The Relationship Between

Risk and Rates of Return"

History can tell us a great deal about the returns that investors earn in the financial

markets.

Historical Perspective of Ibbotson and Sinquefield:

STOCKS, BONDS, BILLS, AND INFLATION

SECURITIES

1.Common stocks of small firms

2.Common stocks of large companies

3.Long-term corporate bonds

4.Long-term U.S government bonds

5.U.S. Treasury bills *Real return equals the nominal return less the average inflation rate from 1926-2002 of 3.1 percent.

*Risk premium equals the nominal return less the average risk-free rate(Treasury Bills)of 3.8 percent. Rates of Return Risk (uncertainty) refers to the variability of expected returns associated with a given investment. Risk, along with the concept of return, is a key consideration in investment and financial decisions. Objective 2: The Effects of Inflation on Rates

Of Return and the Fisher Effect Real Rate of Interest

The Nominal rate of interest less the expected rate of inflation over the maturity of the fixed-income security. This represents the expected increase in actual purchasing power to the investor. If you have $100 today and lend it to someone for a year at a nominal rate of interest of 11.3 percent, you will get back $111.30 in one year. But if during the year prices of goods and services rise by 5%, it will take $105 at year end to purchase the same goods and services that $100 purchased at the beginning of the year.

QUESTION:

What was your increase in purchasing power over the year? Term Structure of Interest Rates (yield to maturity)- Relationship between a debt security’s rate of return and the length of time until the debt matures. The expected return from an investment, either by an individual investor or a company, is determined by the different possible outcomes that could occur from making the investment.

Cash flows, not accounting profits, should be used to measure returns.

This principle holds true regardless of the type of security, whether it is a debt instruments, preferred stock, common stock, or any mixture of these (such as convertible bonds)

Expected Rate of Return – The weighted average of all possible returns where the returns are weighted by the probability that each will occur. X = (.2)($1,000) + (.3)($1,200) + (.5)($1,400)

= $1,260-> Expected cash flow = (.2)(10%) + (.3)(12%) + (.5)(14%) = 12.6% - Expected Rate of return Objective 5: Risk Risk (uncertainty) refers to the variability of expected returns associated with a given investment. Risk, along with the concept of return, is a key consideration in investment and financial decisions.

Standard Deviation – A measure of the spread or dispersion about the mean of a probability distribution. We calculate it by squaring the difference between each outcome and its expected value, weighting each squared difference by its associated probability, summing over all possible outcomes and taking the square root of this sum. 4 Attributes of these returns include:

1. Nominal Average Annual Return

2. Standard Deviation of Returns – measures the volatility or riskiness of the portfolios

3. Real Average Annual Rate of Return- nominal return less inflation rate.

4. Risk Premium- represents the additional return received beyond the risk-free rate (treasury bill rate) for assuming risk. Investment cost of $10,000 NOTE: The PROBABILITY assigned to the 3 possible economic conditions have to be determined subjectively, which requires management to have a thorough understanding of both the investment cash flows and general economy. Types of Risk

1.Business Risk

2.Liquidity Risk

3.Default Risk

4.Market Risk

5.Interest Rate Risk

6.Purchasing Power Risk Standard Deviation – A measure of the spread or dispersion about the mean of a probability distribution. We calculate it by squaring the difference between each outcome and its expected value, weighting each squared difference by its associated probability, summing over all possible outcomes and taking the square root of this sum. RISK AND SINGLE INVESTMENT (two possible investments)

1.The first investment is a U.S. Treasury Bill, which is a government security that matures 90 days and promises to pay an annual return of 6%. If we purchased and hold this security for 90 days, we are virtually assured of receiving no more and no less than 6%. For all practical purposes, the risk of loss is nonexistent.

2.The second investment involves the purchase of the stock of a local publishing company. Looking at the past returns of the firm’s stock, we have made the following estimate of the annual returns from the investment: Percentage Return on average= (.10)(-10%) + (.20)(5%) + (.40)(15%)

+ (.20)(25%) + (.10)(40%)

= 15% What does it mean?

1. "two-third of the time"

an event will fall within plus or minus one standard deviation of the expected value.

(15% + 12.85%) - the actual returns will fall between 2.15% and 27.85%

MEANs- not much certainty with this investment.

2.Compare the investment in the publishing firm against other investment. Publishing firm VS radio company

Expected Return - > 15%

S.D of publishing - 12.85%

S.D of radio c.- 7%

Publishing Firm VS oil-change Franchise

E.R of Publishing - 12.58%

E.R of Oil-change F.- 24%

S.D of publishing- 12.85%

S.D of oil-change F.- 18% Here the final choice is determined by our attitude toward risk, and there is no single right answer.

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# Risk and Rates of Return

Financial Management