1 / 98

An Introduction to Risk and Return: History of Financial Market Returns

This chapter provides an introduction to the concepts of risk and return in financial markets. It covers how to calculate realized and expected rates of return, the historical pattern of financial market returns, and the efficient market hypothesis. The chapter also discusses the risk-return tradeoff and the role of market prices in reflecting information.

mtuohy
Download Presentation

An Introduction to Risk and Return: History of Financial Market Returns

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. An Introduction to Risk and Return: History of Financial Market Returns Chapter 7

  2. Slide Contents Learning Objectives Principles Used in This Chapter Calculate Realized and Expected Rates of Return and Risk. Describe the Historical Pattern of Financial Market Returns. Compute Geometric and Arithmetic Average Rates of Return.

  3. Slide Contents (cont.) Explain Efficient Market Hypothesis and Why it is Important to Stock Prices. Key Terms

  4. Principles Used in This Chapter Principle 2: There is a Risk-Return Tradeoff. We will expect to receive higher returns for assuming more risk. Principle 4: Market Prices Reflect Information. Depending on the degree of efficiency of the market, security prices may or may not fully reflect all information.

  5. 7.1 Realized and Expected Rates of Return and Risk

  6. Calculating the Realized Return from an Investment Realized return or cash return measures the gain or loss on an investment.

  7. Calculating the Realized Return from an Investment (cont.) Example 1: You invested in 1 share of Apple (AAPL) for $95 and sold a year later for $200. The company did not pay any dividend during that period. What will be the cash return on this investment?

  8. Calculating the Realized Return from an Investment (cont.) Cash Return = $200 + 0 - $95 = $105

  9. Calculating the Realized Return from an Investment (cont.) We can also calculate the rate of return as a percentage. It is simply the cash return divided by the beginning stock price.

  10. Calculating the Realized Return from an Investment (cont.) Example 2: You invested in 1 share of share Apple (AAPL) for $95 and sold a year later for $200. The company did not pay any dividend during that period. What will be the rate of return on this investment?

  11. Calculating the Realized Return from an Investment (cont.) Rate of Return = ($200 + 0 - $95) ÷ 95 = 110.53% Table 7-1 has additional examples on measuring an investor’s realized rate of return from investing in common stock.

  12. Calculating the Realized Return from an Investment (cont.) Table 7-1 indicates that the returns from investing in common stocks can be positive or negative. Furthermore, past performance is not an indicator of future performance. However, in general, we expect to receive higher returns for assuming more risk.

  13. Calculating the Expected Return from an Investment Expected return is what you expect to earn from an investment in the future. It is estimated as the average of the possible returns, where each possible return is weighted by the probability that it occurs.

  14. Calculating the Expected Return from an Investment (cont.)

  15. Calculating the Expected Return from an Investment (cont.) Expected Return = (-10%×0.2) + (12%×0.3) + (22%×0.5) = 12.6%

  16. Measuring Risk In the example on Table 7-2, the expected return is 12.6%; however, the return could range from -10% to +22%. This variability in returns can be quantified by computing the Variance or Standard Deviation in investment returns.

  17. Measuring Risk (cont.) Standard deviation is given by square root of the variance and is more commonly used.

  18. Calculating the Variance and Standard Deviation of the Rate of Return on an Investment Let us compare two possible investment alternatives: (1) U.S. Treasury Bill – Treasury bill is a short-term debt obligation of the U.S. Government. Assume this particular Treasury bill matures in one year and promises to pay an annual return of 5%. U.S. Treasury bill is considered risk-free as there is no risk of default on the promised payments.

  19. Calculating the Variance and Standard Deviation of the Rate of Return on an Investment (cont.) (2) Common stock of the Ace Publishing Company – an investment in common stock will be a risky investment.

  20. Calculating the Variance and Standard Deviation of the Rate of Return on an Investment (cont.) The probability distribution of an investment’s return contains all possible rates of return from the investment along with the associated probabilities for each outcome. Figure 7-1 contains a probability distribution for U.S. Treasury bill and Ace Publishing Company common stock.

  21. Calculating the Variance and Standard Deviation of the Rate of Return on an Investment (cont.) The probability distribution for Treasury bill is a single spike at 5% rate of return indicating that there is 100% probability that you will earn 5% rate of return. The probability distribution for Ace Publishing company stock includes returns ranging from -10% to 40% suggesting the stock is a risky investment.

  22. Calculating the Variance and Standard Deviation of the Rate of Return on an Investment (cont.) Using equation 7-3, we can calculate the expected return on the stock to be 15% while the expected return on Treasury bill is always 5%. Does the higher return of stock make it a better investment? Not necessarily, we also need to know the risk in both the investments.

  23. Calculating the Variance and Standard Deviation of the Rate of Return on an Investment (cont.) We can measure the risk of an investment by computing the variance as follows:

  24. Calculating the Variance and Standard Deviation of the Rate of Return on an Investment (cont.) So we observe that the publishing company stock offers a higher expected return but also entails more risk as measured by standard deviation. An investor’s choice of a specific investment will be determined by their attitude toward risk.

  25. Checkpoint 7.1 Evaluating an Investment’s Return and Risk Clarion Investment Advisors is evaluating the distribution of returns for a new stock investment and has come up with five possible rates of return for the coming year. Their associated probabilities are as follows: a. What expected rate of return might they expect to realize from the investment? b. What is the risk of the investment as measured using the standard deviation of possible future rates of return?

  26. Checkpoint 7.1

  27. Checkpoint 7.1

  28. Checkpoint 7.1

  29. Checkpoint 7.1:Check Yourself Compute the expected return and standard deviation for an investment with the five following possible probabilities for the coming year: .2, .2,.3,.2 and .1

  30. Step 1: Picture the Problem

  31. Step 2: Decide on a Solution Strategy We can use Equation 7-3 to measure its expected return and Equation 7-5 to measure its standard deviation.

  32. Step 3: Solve Calculating Expected Return E(r) = (-20%×.20) + (0%×.2) + (15%×.3) + (30%×.2) + (50%×.1) = 11.5%

  33. Step 3: Solve (cont.) Calculating Standard Deviation = √([-.20-.115]2.2) + ([0-.115]2.2) + ([.15-.115]2.3) + ([.30-.115]2.2) + ([.50-.115]2.1) = .2111 or 21.11%

  34. Step 4:Analyze The expected return for this investments is 11.5%. However, it is a risky investment as the returns can range from a low of -20% to a high of 50%. Standard deviation captures this risk and is equal to 21.11%. Standard deviation is a measure of the average dispersion of the investment returns.

  35. 7.2 A Brief History of the Financial Markets

  36. A Brief History of the Financial Markets We can use the tools that we have learned to determine the risk-return tradeoff in the financial markets.

  37. A Brief History of the Financial Markets (cont.) Investors have historically earned higher rates of return on riskier investments. However, having a higher expected rate of return simply means that investors “expect” to realize a higher return. Higher return is not guaranteed.

  38. U.S. Financial Markets — Domestic Investment Returns Figure 7-2 shows the historical returns earned on four types of investments (small stocks, large stocks, government bonds, treasury bills) over the period 1926-2008. The graph shows the value of $1 investment made in each of these asset categories in 1926 and held until the end of 2008.

  39. U.S. Financial Markets — Domestic Investment Returns (cont.)

  40. U.S. Financial Markets — Domestic Investment Returns (cont.) We observe a clear relationship between risk and return. Small stocks have the highest annual return but higher returns are associated with much greater risk.

  41. Lessons Learned from Historical Returns in the Financial Market Lesson #1: The riskier investments have historically realized higher returns. The difference between the return on riskier stock investments and government securities is called the equity risk premium. For example, the equity risk premium is 6% for small stocks over government bonds.

  42. Lessons Learned from Historical Returns in the Financial Market (cont.) Lesson #2: The historical returns of the higher-risk investment classes have higher standard deviations. For example, small stocks had a standard deviation of 34.1% while the standard deviation of treasury bill was only 0.9%.

  43. U.S. Stocks versus Other Categories of Investments Figure 7-3 illustrates the growth in the value of $1 invested in 1980 until the end of 2008 for five different asset classes: U.S. stocks Real estate International stocks Commodities Gold

  44. U.S. Stocks versus Other Categories of Investments (cont.) We can observe from Figure 7-3 that U.S. stocks had the highest annual return of 10.7% while gold had the lowest return of 1.8%.

  45. Global Financial Markets – International Investing Figure 7-4 compares the historical returns from investing in U.S. stocks and bonds to returns on international stocks and bonds. The fluctuation in rates of return over a period of time is called the investment’s volatility, which is measured by standard deviation.

More Related