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Capital Markets

Capital Markets. Spring Semester 2010 Lahore School of Economics. Salaar farooq – Assistant Professor. Returns and Risks from Investing. Lecture. Returns & Risks from Investing Learning Objectives. What is return? What is risk? Sources of risk? Types of risk? How to measure risk?

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Capital Markets

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  1. Capital Markets Spring Semester 2010 Lahore School of Economics Salaar farooq– Assistant Professor

  2. Returns and Risksfrom Investing Lecture

  3. Returns & Risks from InvestingLearning Objectives • What is return? • What is risk? • Sources of risk? • Types of risk? • How to measure risk? • How to measure returns? • Realized returns & risks from investing • Practice Problems

  4. Returns Objective of Investors ?

  5. Returns Objective of Investors • To maximize expected returns • Constraint: risk

  6. Returns Components of investment returns ?

  7. Returns Components of investment returns • Yield Income component of a security’s return from cash flows Relates the C/F’s to the price of the security • Capital gain (loss) Change in price of a security over time

  8. Returns Components of investment returns • Total Return = Yield + Price Change (CG) Yield can be 0 or + CG can be 0,+ or -

  9. Returns Examples of components • A Bond purchased at par held to maturity: ? • A Bond purchased for $800 & held till maturity? • A non-dividend stock? • A dividend paying stock?

  10. Returns Examples of components • A Bond purchased at par held to maturity: ? Yield only • A Bond purchased for $800 & held till maturity? Y+PG • A non-dividend stock? PG only • A dividend paying stock? Y+PG

  11. What is Risk?

  12. What is Risk? UNCERTAINTY OF FUTURE OUTCOMES Definition of Risk: Risk is the Probability… ACTUAL OUTCOME will be different from EXPECTED OUTCOME. Which outcome are we discussing? Future Returns

  13. Risk exposure involves Future time. Expected Outcome 1,2…n (return) RISK of deviation UNCERTAINTY Decision T= Future T=0 Risk Calculation is on Historical Data T=0 T=-n

  14. Deviation possibilities… RISK!

  15. What are the Sources of Risk?An Overview • Price risk • Interest Rate risk • Market risk • Inflation risk • Business risk

  16. What are the Sources of Risk?An Overview • Price risk Variability in security’s returns due to price fluctuations • Interest Rate risk Variability in ER due to changes in interest rates • Market risk Variability in ER due to changes in overall market • Inflation risk Variability in ER due to changes in purchasing power (interest rates) • Business risk Variability in ER due to exposure to a particular industry

  17. What are the Sources of Risk?An Overview • Financial risk • Liquidity risk • Exchange rate risk • Country risk(political risk)

  18. What are the Sources of Risk?An Overview • Financial risk Arises due to debt financing. Variability in ER due to leverage • Liquidity risk Variability in ER due to inability to trade in secondary mkts. time & price concession required to sell securities • Exchange rate risk Variability in ER due to currency fluctuations. • Country risk(political risk) Variability in ER due to instability of the political system.

  19. What are the Sources of Risk?Summary • Price risk • Interest Rate risk(affects market value & resale price) • Market risk(overall market effects) • Inflation risk(purchasing power variability) • Business risk(unique risk) • Financial risk(tied to debt financing) • Liquidity risk(time & price concession to sell securities) • Exchange rate risk(fx) • Country risk(political risk)

  20. What Types of Risk are there?

  21. What Types of Risk are there? • 2 Main Types • Systematic risk: (MKT) also called market risk or non-diversifiable risk. Caused by the market as a whole • Non-Systematic risk: (COMPANY) also called non-market risk or diversifiable risk. This risk is caused by factors unique to the company

  22. Types of Risk Average annualstandard deviation (%) 49.2 Diversifiable risk (unique risk) 23.9 19.2 Non-diversifiablerisk (market risk) Number of stocksin portfolio 1 10 20 30 40 1000

  23. How do we measure Risk? • Probability distributions Probability distributions combine outcomes to probabilities Multiply possible returns by associated probabilities and sum them The probabilities must sum to 1.0

  24. Prob. Returns

  25. How do we measure Risk? The risk for a security can be calculated using Standard Deviation measure

  26. where N is the number of returns Variance of return Standard deviation of return

  27. How do we use information regarding risk?Analytical Development • In Finance, decision rules are based on benchmark or alternative comparisons. E.g. consider the statement: • A: an investment (IND: X) has an ER of 35% with SD of 30%

  28. How do we use this information regarding risk?Analytical Development • In Finance, decision rules are based on benchmark or alternative comparisons. E.g. consider the statement: • A: an investment (IND: X) has an ER of 35% with SD of 30% • B: an investment (IND: X) has an ER of 35% with SD of 15%

  29. How do we use this information regarding risk?Analytical Development • In Finance, decision rules are based on benchmark or alternative comparisons. E.g. consider the statement: • A: an investment (IND: X) has an ER of 35% with std dev of 30% • B: an investment (IND: X) has an ER of 35% with std dev of 15% • C: IND X has an industry AR of 50% with std dev of 15%. Given the alternatives, & ATE both A & B are inferior. • Therefore, one question you must always ask regarding risk is “what are the alternatives or benchmarks to compare with?” M-10

  30. SUMMARY STATISTICS FOR RETURNS • Arithmetic mean : The mean return • Geometric mean Compounded rate of return over time – r at which end value is obtained. G = (1+TR)^(1/n) – 1 1+TR = RR is used since –ve TR’s cannot be used for G

  31. SUMMARY STATISTICS FOR RETURNS Arithmetic mean vs geometric mean • When should you use the AM or GM? • AM: • better measure of average performance over single periods. • Best estimate of ER for next period • GM: a) better measure of the change in wealth over multiple periods

  32. Risk Premiums • Risk Premium • Equity Risk Premium

  33. Risk Premiums • Risk Premium Additional Compensation for assuming risk • Equity Risk Premium Difference between return on stocks & the risk-free rate (t-bills)

  34. Risk Premiums • Equity Risk Premium ERP = ( (1+TR stock) / (1+Rf) ) – 1 M 6

  35. PROBLEM # 9 Calculating ERP Common stocks had a return of 10.0466% over 80yrs. T-bills had a return of 4.0358% over the same period. a) What is the historical Equity Risk Premium?

  36. PROBLEM # 9 Calculating ERP Common stocks had a return of 10.0466% over 80yrs. T-bills had a return of 4.0358% over the same period. a) What is the historical Equity Risk Premium? ERP = 1.100466/1.040358 – 1 = .0578 = 5.78%

  37. Some Realities of risk in the real world Realized Returns Over Long Periods (1920-2002) • Some benchmarks for Returns & Risks on major assets over long periods: • Common stocks--approx 13% std dev 20% (more risky) • AAA corporates—approx 6% std dev 9% • Treasury bonds—approx 5.4% std dev 8% • T-bills— approx 4% std dev 3%

  38. Risk and Return

  39. Summary We have learnt the following about Risk: • What is Risk?Uncertainty about future outcomes • How do we define it?The chance of Actual VS Expected • How do we measure it?Standard Deviation • How do we use this information to make financial decisions?(benchmarks) • What are the sources of risk?Price,market,interest rate, etc • How many types of risk are there?Unique & Market • What are benchmark Realities of Risk?Stocks, Bonds, T-bills

  40. END

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