Risk and Rates of Return

1. Risk and Rates of Return Chapter 6

2. Interest Rate • Interest rate represents the cost of money • It is the opportunity cost of money: • It shows the return lost from not investing in a comparable risk investment. • It is expected to compensate the investor for the time, inflation, and risk.

3. Interest Rates Conceptually:

4. Conceptually: Nominal risk-free Interest Rate krf Interest Rates

5. Conceptually: Nominal risk-free Interest Rate krf = Interest Rates

6. Conceptually: Real risk-free Interest Rate k* Nominal risk-free Interest Rate krf = Interest Rates

7. Conceptually: Real risk-free Interest Rate k* Nominal risk-free Interest Rate krf = + Interest Rates

8. Conceptually: Real risk-free Interest Rate k* Nominal risk-free Interest Rate krf Inflation- risk premium IRP = + Interest Rates

9. Conceptually: Real risk-free Interest Rate k* Nominal risk-free Interest Rate krf Inflation- risk premium IRP = + Mathematically: Interest Rates

10. Conceptually: Real risk-free Interest Rate k* Nominal risk-free Interest Rate krf Inflation- risk premium IRP = + Mathematically: (1 + krf) = (1 + k*) (1 + IRP) Interest Rates

11. Conceptually: Real risk-free Interest Rate k* Nominal risk-free Interest Rate krf Inflation- risk premium IRP = + Mathematically: (1 + krf) = (1 + k*) (1 + IRP) This is known as the “Fisher Effect” Interest Rates

12. Interest Rates • Suppose the real rate is 3%, and the nominal rate is 8%. What is the inflation rate premium? • (1 + krf) = (1 + k*) (1 + IRP) • (1.08) = (1.03) (1 + IRP) • (1 + IRP) = (1.0485), so • IRP = 4.85%

13. Term Structure of Interest Rates • The pattern of rates of return for debt securities that differ only in the length of time to maturity.

14. yield to maturity time to maturity (years) Term Structure of Interest Rates • The pattern of rates of return for debt securities that differ only in the length of time to maturity.

15. yield to maturity time to maturity (years) Term Structure of Interest Rates • The pattern of rates of return for debt securities that differ only in the length of time to maturity.

16. yield to maturity time to maturity (years) Term Structure of Interest Rates • The yield curve may be downward sloping or “inverted” if rates are expected to fall.

17. yield to maturity time to maturity (years) Term Structure of Interest Rates • The yield curve may be downward sloping or “inverted” if rates are expected to fall.

18. For a Treasury security, what is the required rate of return?

19. Required rate of return = For a Treasury security, what is the required rate of return?

20. Required rate of return Risk-free rate of return = For a Treasury security, what is the required rate of return? • Since Treasuries are essentially free of default risk, the rate of return on a Treasury security is considered the “risk-free” rate of return.

21. For a corporate stock or bond, what is the required rate of return?

22. Required rate of return = For a corporate stock or bond, what is the required rate of return?

23. Required rate of return Risk-free rate of return = For a corporate stock or bond, what is the required rate of return?

24. Required rate of return Risk-free rate of return Risk premium = + For a corporate stock or bond, what is the required rate of return? • How large of a risk premium should we require to buy a corporate security?

25. Returns • Expected Return - the return that an investor expects to earn on an asset, given its price, growth potential, etc. • Required Return - the return that an investor requires on an asset given itsriskand market interest rates.

26. Risk and Rates of Return • Two Components of return • Periodic cash flows

27. Risk and Rates of Return • Two Components of return • Periodic cash flows • Price Change (capital gains)

28. Risk and Rates of Return • Holding Period return

29. Risk and Rates of Return • Holding Period return • Pt + Dt • = ---------- - 1 • Pt-1

30. Risk and Rates of Return • Holding Period return • Pt + Dt • = ---------- - 1 • Pt-1 • (Pt - Pt-1) + Dt • = ---------------- • Pt-1

31. Risk and Rates of Return • Expected Return • Expected return is based on expected cash flows (not accounting profits) Return can be expressed as Cash Flows or Percentage Return

32. Risk and Rates of Return • Expected Return • Expected return is based on expected cash flows (not accounting profits) • In an uncertain world future cash flows are not known with certainty

33. Risk and Rates of Return • Expected Return • Expected return is based on expected cash flows (not accounting profits) • In uncertain world future cash flows are not known with certainty • To calculate expected return, compute the weighted average of all possible returns

34. Risk and Rates of Return • Expected Return • Expected return is based on expected cash flows (not accounting profits) • In uncertain world future cash flows are not known with certainty • To calculate expected return, compute the weighted average of possible returns • Calculating Expected Return:

35. Risk and Rates of Return • Expected Return • Expected return is based on expected cash flows (not accounting profits) • In uncertain world future cash flows are not known with certainty • To calculate expected return, compute the weighted average of possible returns • Calculating Expected Return: where ki = Return state i P(ki) = Probability of ki occurring N = Number of possible states

36. Risk and Rates of Return • Expected Return Calculation Example You are evaluating ElCat Corporation’s common stock. You estimate the following returns given different states of the economy State of Economy Probability Return Economic Downturn .10 –5% Zero Growth .20 5% Moderate Growth .40 10% High Growth .30 20%

37. Risk and Rates of Return • Expected Return Calculation Example You are evaluating ElCat Corporation’s common stock. You estimate the following returns given different states of the economy State of Economy Probability Return = –0.5% x Economic Downturn .10 –5% Zero Growth .20 5% Moderate Growth .40 10% High Growth .30 20%

38. Risk and Rates of Return • Expected Return Calculation Example You are evaluating ElCat Corporation’s common stock. You estimate the following returns given different states of the economy State of Economy Probability Return = –0.5% = 1% x x Economic Downturn .10 –5% Zero Growth .20 5% Moderate Growth .40 10% High Growth .30 20%

39. Risk and Rates of Return • Expected Return Calculation Example You are evaluating ElCat Corporation’s common stock. You estimate the following returns given different states of the economy State of Economy Probability Return = –0.5% = 1% = 4% x x x Economic Downturn .10 –5% Zero Growth .20 5% Moderate Growth .40 10% High Growth .30 20%

40. Risk and Rates of Return • Expected Return Calculation Example You are evaluating ElCat Corporation’s common stock. You estimate the following returns given different states of the economy State of Economy Probability Return = –0.5% = 1% = 4% = 6% x x x x Economic Downturn .10 –5% Zero Growth .20 5% Moderate Growth .40 10% High Growth .30 20%

41. Risk and Rates of Return • Expected Return Calculation Example You are evaluating ElCat Corporation’s common stock. You estimate the following returns given different states of the economy State of Economy Probability Return = –0.5% = 1% = 4% = 6% k = 10.5% x x x x Economic Downturn .10 –5% Zero Growth .20 5% Moderate Growth .40 10% High Growth .30 20%

42. Risk and Rates of Return • Expected Return Calculation Example You are evaluating ElCat Corporation’s common stock. You estimate the following returns given different states of the economy State of Economy Probability Return = –0.5% = 1% = 4% = 6% k = 10.5% x x x x Economic Downturn .10 –5% Zero Growth .20 5% Moderate Growth .40 10% High Growth .30 20% Expected (or average) rate of return on stock is 10.5%

43. Risk and Rates of Return • Risk • Risk is the uncertainty of future outcomes

44. Risk and Rates of Return • Risk • Risk is the uncertainty of future outcomes Example You evaluate two investments: ElCat Corporation’s common stock and a one year Gov't Bond paying 6%. The return on the Gov't Bond does not depend on the state of the economy--you are guaranteed a 6% return.

45. Risk and Rates of Return • Risk • Risk is the uncertainty of future outcomes Example You evaluate two investments: ElCat Corporation’s common stock and a one year Gov't Bond paying 6%. The return on the Gov't Bond does not depend on the state of the economy--you are guaranteed a 6% return. T-Bill Probability of Return 100% Return 6%

46. Risk and Rates of Return • Risk • Risk is the uncertainty of future outcomes Example You evaluate two investments: ElCat Corporation’s common stock and a one year Gov't Bond paying 6%. The return on the Gov't Bond does not depend on the state of the economy--you are guaranteed a 6% return. T-Bill ElCat Corp Probability of Return Probability of Return 100% 40% 30% 20% 10% Return Return –5% 5% 10% 20% 6%

47. Risk and Rates of Return • Risk • Risk is the uncertainty of future outcomes Example You evaluate two investments: ElCat Corporation’s common stock and a one year Gov't Bond paying 6%. The return on the Gov't Bond does not depend on the state of the economy--you are guaranteed a 6% return. T-Bill ElCat Corp Probability of Return Probability of Return There is risk in Owning ElCat stock, no risk in owning the Treasury Bill 100% 40% 30% 20% 10% Return Return –5% 5% 10% 20% 6%

48. Risk and Rates of Return • Measuring Risk • Standard Deviation (s) measure the dispersion of returns.

49. Risk and Rates of Return • Measuring Risk • Standard Deviation (s) measure the dispersion of returns.

50. Risk and Rates of Return • Measuring Risk • Standard Deviation (s) measure the dispersion of returns. Example Compute the standard deviation on ElCat common stock. the mean (k) was previously computed as 10.5%