CHAPTER TWO UNDERSTANDING RISK AND RETURN Practical Investment Management Robert A Strong
UNDERSTANDING RISK AND RETURN CHAPTER TWO Practical Investment Management Robert A. Strong
Introduction a dollar today is worth more than a dollar tomorrow a safe dollar is worth more than a risky dollar. People have different degrees of risk aversion. Some are more willing to take a chance than others A tradeoff exists between risk and return Strong C2-Understanding Risk and Return 2-2
2 - 2 Strong C2 – Understanding Risk and Return Introduction A dollar today is worth more than a dollar tomorrow. A safe dollar is worth more than a risky dollar. People have different degrees of risk aversion. Some are more willing to take a chance than others. A tradeoff exists between risk and return
Holding Period Return The simplest measure of return is the holding period return Ending Beginning Holding value value Income period return Beginning value Strong C2-Understanding Risk and Return 2-3
2 - 3 Strong C2 – Understanding Risk and Return Holding period = return Ending Beginning value value Income Beginning value _ + Holding Period Return The simplest measure of return is the holding period return
Holding period return Example: Buy 100 shares Dividend of Sell the shares at $25 per share $0.10 per share at $30 per share Time $30$25+$0.10 Holding period return =20.4% $25 Strong C2-Understanding Risk and Return 2-4
2 - 4 Strong C2 – Understanding Risk and Return Buy 100 shares at $25 per share Time Sell the shares at $30 per share Dividend of $0.10 per share Example : Holding period return = = 20.4% $30 - $25 + $0.10 $25 Holding Period Return
Holding period return Holding period return is independent of the passage of time When comparing investments, the periods should all be of the same length When there are stock splits or other corporate actions, care should be taken to ensure that the correct value is used for calculating the holding period return Strong C2-Understanding Risk and Return 2-5
2 - 5 Strong C2 – Understanding Risk and Return Holding period return is independent of the passage of time. When comparing investments, the periods should all be of the same length. When there are stock splits or other corporate actions, care should be taken to ensure that the correct value is used for calculating the holding period return. Holding Period Return
Yield and Appreciation Current yield is annual income divided by current price Dividend yield is used for stocks whose income comes exclusively from dividends Example For a stock selling for $40 and expected to pay $1 in dividends over the next year current yield = $1/$40=2.5% Strong C2-Understanding Risk and Return 2-6
2 - 6 Strong C2 – Understanding Risk and Return Current yield is annual income divided by current price. Example : For a stock selling for $40 and expected to pay $1 in dividends over the next year , current yield = $1 / $40 = 2.5% . Yield and Appreciation Dividend yield is used for stocks whose income comes exclusively from dividends
Yield and Appreciation Appreciation is the increase in value of an investment independent of its yield It excludes accrued interest as well as increases in value which are due to additional deposits EXample When a stock bought at $95 rises to $97. 50, it has appreciated by $2.50, or $250/$95=26% Strong C2-Understanding Risk and Return 2-7
2 - 7 Strong C2 – Understanding Risk and Return Appreciation is the increase in value of an investment independent of its yield. Example : When a stock bought at $95 rises to $97.50, it has appreciated by $2.50, or $2.50 / $95 = 2.6% . Yield and Appreciation It excludes accrued interest, as well as increases in value which are due to additional deposits
The Time Value of Money The time value of money is the notion that a dollar today is worth more than a dollar tomorrow P×(1+r)=F where P= present value (i.e. price today) F= future value r= interest rate per period and n number of periods Strong C2-Understanding Risk and Return 2-8
2 - 8 Strong C2 – Understanding Risk and Return P × ( 1 + r )n = F where P = present value (i.e. price today) F = future value r = interest rate per period and n = number of periods The Time Value of Money The time value of money is the notion that a dollar today is worth more than a dollar tomorrow
The Time Value of Money The current price of any financial asset should be the present value of its expected future cash flows Example What is the most that an investor would pay for a zero coupon bond which matures in 4 years time, and has a redemption value of $1,000? The interest rate is 9.19% P×(1+00919)4=$1,000 今P=$70350 Strong C2-Understanding Risk and Return 2-9
2 - 9 Strong C2 – Understanding Risk and Return The current price of any financial asset should be the present value of its expected future cash flows. The Time Value of Money Example : P × ( 1 + 0.0919 )4 = $1,000 P = $703.50 What is the most that an investor would pay for a zero coupon bond which matures in 4 years' time, and has a redemption value of $1,000? The interest rate is 9.19%
The Time Value of Money Many securities pay more than one cash flow over their lives. In particular, an annuity is a series of equal and evenly spaced payments A convenient expression for the present value of an annuity is P=C rr(1+ n where C= coupon or periodic payment Strong C2-Understanding Risk and Return 2-10
2 - 10 Strong C2 – Understanding Risk and Return Many securities pay more than one cash flow over their lives. In particular, an annuity is a series of equal and evenly spaced payments. A convenient expression for the present value of an annuity is: The Time Value of Money where C = coupon or periodic payment ( ) + = − n r 1 r 1 r 1 P C
