ADMN 3116: Financial Management 1 Lecture 6: Risk

1. ADMN 3116: Financial Management 1 Lecture 6: Risk Anton Miglo Fall 2014

2. Topics • Risk and Return • Treasury bond returns • Stock returns • Mean-Variance Approach • Excel: AVE, STDEVP, VARP • Additional readings: B ch. 8

3. Calculating Total Dollar and Total Percent Returns • Suppose you invested $1,400 in a stock with a share price of $35. • After one year, the stock price per share is $49. • Also, for each share, you received a $1.40 dividend. • What was your total dollar return? • $1,400 / $35 = 40 shares • Capital gain: 40 shares times $14 = $560 • Dividends: 40 shares times $1.40 = $56 • Total Dollar Return is $560 + $56 = $616 • What was your total percent return? • Dividend yield = $1.40 / $35 = 4% • Capital gain yield = ($49 – $35) / $35 = 40% • Total percentage return = 4% + 40% = 44% Note that $616 divided by $1,400 is 44%.

4. A $1 Investment in Different Typesof Portfolios, 1926—2009

5. Rates of Return 1926-2000 Percentage Return Year • Source: Ibbotson Associates

6. Average Annual Returns for Five Portfolios and Inflation

7. Average Annual Risk Premiums for Five Portfolios

8. Company A Company B return return What is Risk?

9. Frequency Distribution of Returns on Common Stocks, 1926—2009

10. Benchmark risks and returns Average Annual Variance Standard Portfolio Rate of Return Deviation Treasury Bills 4.1 7.9 2.8 Gov’t Bonds 5.2 68 8.2 Common Stocks 11.7 402.6 20.1

11. Example: Calculating Historical Variance and Standard Deviation • Let’s use data from Table 1.1 for Large-Company Stocks. • The spreadsheet below shows us how to calculate the average, the variance, and the standard deviation (the long way…).

12. Historical Risk and Return Trade-Off

13. Investment returns The rate of return on an investment can be calculated as follows: (Amount received – Amount invested) Return =________________________ Amount invested For example, if $1,000 is invested and $1,100 is returned after one year, the rate of return for this investment is: ($1,100 - $1,000) / $1,000 = 10%.

14. Risk and return Average Annual Risk/Standard Investments Rate of Return (%)Deviation (%) Treasury Bills 4.1 2.8 Gov’t Bonds 5.2 8.2 Common Stocks 11.7 20.1

15. AverageReturn 20% A 15% B 5% C 5% 20% Risk Investment Choices D

17. Excel functions used • AVERAGE • SQRT • VAR • STDEV

18. Treasury bill example • Buy bill 1 June 2008 for $977.04 • Horizon: Pays you back $1,000 in one year • Safety: Payment guaranteed by U.S. government • Liquidity: Highly liquid

19. One year yield on T-bill • If you hold the Bill for one year, you will absolutely get the 2.35% yield. It is totally safe! • This 2.35% yield is both ex-ante and ex-post: • Ex-ante: It is the predicted yield for holding the T-bill when you buy it • Ex-post: It is the yield you will get after one year if you hold the T-bill to maturity

20. Track T-bill prices throughout the year

21. Stock price risk • McDonald’s stock (MCD) is risky • Horizon risk: How long will you hold the stock? • Safety: stock is inherently unsafe • This doesn’t mean it’s not a good stock! • Liquidity risk: minimal—the volume of MCD traded daily is very large, so it should be easy to dispose of the stock.

23. Computing the average and standard deviation of annual returns

24. Statistics review

25. For a discussion of average return versus standard deviation