Beruflich Dokumente
Kultur Dokumente
An Introduction to
Risk and Return:
History of Financial
Market Returns
Slide Contents
Learning Objectives
Principles Used in This Chapter
1. Calculate Realized and Expected Rates of Return
and Risk.
2. Describe the Historical Pattern of Financial Market
Returns.
3. Compute Geometric and Arithmetic Average Rates
of Return.
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Cash Return
= $200 + 0 - $95
= $105
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Expected Return
= (-10%0.2) + (12%0.3) + (22%0.5)
= 12.6%
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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.
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Expected
Return
Standard
Deviation
Treasury Bill
5%
0%
Common Stock
15%
12.85%
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Checkpoint 7.1
Evaluating an Investments 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?
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Checkpoint 7.1
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Checkpoint 7.1
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Checkpoint 7.1
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Step 3: Solve
Calculating Expected Return
+ (30%.2) + (50%.1)
= 11.5%
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= ([-.20-.115]2.2) + ([0-.115]2.2) +
([.15-.115]2.3) + ([.30-.115]2.2) +
([.50-.115]2.1)
= .2111 or 21.11%
Copyright 2011 Pearson Prentice Hall. All rights reserved.
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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.
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7.2 A Brief
History of the
Financial Markets
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Governmen Treasur
t Bonds
y Bills
Annual
Small
Stocks
Large
Stocks
Return
11.7%
9.6%
5.7%
3.7%
S.D.
34.1%
21.4%
8.5%
0.9%
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U.S. stocks
Real estate
International stocks
Commodities
Gold
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Global Financial
Markets
International
Investing
(cont.)
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7.3 Geometric
vs. Arithmetic
Average Rates
of Return
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Year
Annual Rate
of Return
Value of the
stock
$25
40%
$35
-50%
$17.50
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Question being
addressed:
Appropriate Average
Calculation:
The arithmetic
average calculated
using annual rates
of return.
The geometric
average calculated
over a similar past
period.
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Checkpoint 7.2
Computing the Arithmetic and Geometric Average Rates of Return
Five years ago Marys grandmother gave her $10,000 worth of stock in the
shares of a publicly traded company founded by Marys grandfather. Mary is now
considering whether she should continue to hold the shares, or perhaps sell
some of them. Her first step in analyzing the investment is to evaluate the rate
of return she has earned over the past five years.
The following table contains the beginning value of Marys stock five years ago
as well as the values at the end of each year up until today (the end of year 5):
What rate of return did Mary earn on her investment in the stock given to her by
her grandmother?
Copyright 2011 Pearson Prentice Hall. All rights reserved.
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Checkpoint 7.2
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Checkpoint 7.2
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Checkpoint 7.2
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Problem (cont.)
Year
Annual Rate of
Return
Value of the
Stock
$10,000.00
-15.0%
$8,500.00
15.0%
$9,775.00
25.0%
$12,218.75
30.0%
$15,884.38
-10.0%
$14,295.94
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Step 3: Solve
Calculate the Arithmetic Average
Arithmetic Average
= Sum of the annual rates of return Number of
years
= 45% 5 = 9%
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Step 4: Analyze
The arithmetic average is 9% while the
geometric average is 7.41%. The
geometric average is lower as it
incorporates compounding of interest.
Both of these averages are useful and
meaningful but in answering two very
different questions.
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7.4 What
Determines
Stock Prices?
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Key Terms
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Standard deviation
Strong-form efficient markets
Variance in investment return
Volatility
Weak form efficient market
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