Skibba-Demape-Roche-Santiago-Ferrer-Capuno-Skibba-Demape-Roche-Santiago-Ferrer-Capuno

RETURN
AND

RISK
GROUP 1

Skibba-Demape-Roche-Santiago-Ferrer-Capuno-Skibba-Demape-Roche-Santiago-Ferrer-Capuno

**Investment is simply any asset into which funds

can be placed with the expectation that it will
generate positive income and/or preserve or increase
its value.

RETURNS
- is the level of profit from an investment --- that is,
the reward for investing.

The return on an investment may come from more than one

source. The most common source is periodic payments, such as
dividends or interest. The other source of return is the change in
the investments price.
We call these two sources as of return as CURRENT INCOME and
CAPITAL GAINS (CAPITAL LOSSES).

 INCOME
Income may take the form of dividends from stocks or
mutual funds, or interest received on bonds. To be
considered income, it must be in the form of cash or be
readily convertible into cash.
Investments income is usually cash that investors
periodically receive as a result of owning an investment.
INVESTMENTS
AAA
BBB
PURCHASE PRICE (beg of the
year)

$ 1,000

$ 1,000

1st quarter

10

2nd quarter

20

3rd quarter

20

4th quarter

30

120

Total income (for the year)

80

120

$ 1,100

$ 960

Cash received:

Sale price (end of the year)

 CAPITAL GAINS (LOSSES)

Amount by which the proceeds from the sale
of an investment exceed its original purchase
price is a capital gain. If an investment sells for
less than its original purchase price, it results a
capital loss.

Return

INVESTMENTS
AAA
BBB

Income

$ 80

$ 120

Capital gain loss)

100

(40)

Total return

$ 180

$ 80

How do investors distinguish investments that offers high returns

than those investments that has low returns

HISTORICAL PERFORMANCE
Most people recognize that future performance is not
guaranteed by past performance, but past often provide a
meaningful basis for future expectations. A common
practice in the investment world is to look closely at the
historical record when formulating expectations about the
future.

EXPECTED RETURN
Future maters when we make investment decisions.
Therefore, expected return is a vital measure of
performance. Its what you think the investment will earn
in the future that determines what you should be willing to
pay for it.

LEVEL OF RETURN
FACTORS:
Internal characteristics
External forces

TIME VALUE
OF MONEY
AND
RETURNS

Three possible benefit-cost relationships and their

interpretations follow:
1. If the present value of the benefits just equals the cost,
you would earn a rate of return equal to the discount
rate.
2. If the present value of benefits exceeds the cost, you
would earn a rate of return greater than the discount rate.
3. If the present value of benefit is less than the cost, you
would earn a rate of return less than the discount rate.

REAL, RISK-FREE, REQUIRED RETURN

Nominal Return is the actual return that the investment
earns expressed in current peso.
Real Rate of Return equals the nominal return minus
the inflation rate, and it measures the increase in
purchasing power provided by an investment.
Required Return rate of return that fully compensates
for an investments risk.

The required return on any investment is consists of three basic components:

the real rate of return, an expected inflation premium, and a risk premium .

Required return =
premium
on investment
investment

Real rate + Expected Inflation + Risk

of return

premium

for

Expected Inflation Premium represents the average rate of inflation

expected in the future.
Risk-free Rate is calculated by adding the real rate of return and expected
inflation premium.

Risk-free rate = Real rate of return + Expected inflation

premium
Risk Premium represents an overall risk of an investment which varies
depending on specific issue and issuer characteristics. Issue characteristics
are the type of the investment (stock, bonds, etc.), its maturity, and its features.
Issuer characteristics are industry and company factors such as the line of
business and financial condition of the issuer.

Required return =
on investment

Risk-free
Rate

Risk premium
for investment

Holding Period Return

Holding Period
- Is the period of time over which an investor holds a given
security.

Holding Period Return

- Thetotal returnearned from holding an investment
for a specified time. Generally expressed in percentage.

Total Return

Income

Capital Gains (losses)

Holding Period Return (formula)

Income during period +

during period

capital gains (loss)

HPR =
Initial Value

1. What is the HPR for an investorwho bought a stock a year

ago at $50 and received $5 individends over the year, if
the stock is now trading at $60?
HPR = 30%
2. A year ago, Gwapo bought a stock at $100 and received
$20 individends over the period. If the stock is now
trading at $60, what is the HPR?
$20 + $40
HPR =

HPR =

$100

30%

Which investment performed better?Mutual fundX that

was held for three years, during which it appreciated from
$100 to $150 and provided $5 in distributions, or Mutual
Fund B that went from $200 to $320 and generated $10
indistributions over four years?

HPR for Fund X = [5 + (150 100)] / 100 = 55%

HPR for Fund B = [10 + (320 200)] / 200 = 65%

Annualized HPR (formula)

Annualized HPR
=

{[(Income + Capital Gains (losses)] / Initial Value}+

1}1/t 1
Or simply,

= (HPR + 1)1/t 1

where,
t = no. of years

Which investment performed better?Mutual fundX that was held for

three years, during which it appreciated from $100 to $150 and
provided $5 in distributions, or Mutual Fund B that went from $200 to
$320 and generated $10 indistributions over four years?

HPR for Fund X = [5 + (150 100)] / 100 = 55%

HPR for Fund B = [10 + (320 200)] / 200 = 65%

Using the formula:

Annualized HPR for Fund X = (0.55 + 1)1/3 1 = 15.73%
Annualized HPR for Fund B = (0.65 + 1)1/4 1 = 13.34%

To convert returns for regular time periods (such as quarters

or years) into a holding period return:
HPR = [(1 + r1) x (1 + r2) x (1 + r3) x (1 + r4)] 1
where ,
r1, r2, r3and r4are periodic returns.
Example:
Your stock portfolio had the following returns in the four
quarters of a given year: +8%, -5%, +6%, +4%. How did it
compare against thebenchmark index, which had total
returns of 12% over the year?
HPR for your stock portfolio =
[(1 + 0.08) x (1 0.05) x (1 + 0.06) x (1 + 0.04)] 1 = 13.1%

Holding Period
Return
Income during period +
during period

capital gains (loss)

HPR =
Initial Value

Annualized Holding Period

Return
Annualized HPR = (HPR + 1)1/t 1

To convert returns for regular time periods into a

holding period return
HPR = [(1 + r1) x (1 + r2) x (1 + r3) x (1 + r4)] 1

Yield

a present-value-based measure to determine the

compound annual rate of return earned on investments held
for longer than one year. It can also be defined as the
discount rate that produces a present value of benefits just
equal to its cost.
Once you know the yield, you can decide whether an
investment is acceptable. If the yield on an investment is
equal to or greater than the required return, then the
investment is acceptable. An investment with a yield
below the required return is unacceptable.

Risk is the uncertainty surrounding the actual return that an

investment will generate.

Risk-return tradeoff is the investors attempt to minimize

risk for a given level of return or to maximize return for a given
level of risk.

Sources of risk:
1. Business risk is a degree of uncertainty associated
with an investments earnings and the investments ability to
pay the returns (interest, principal, dividends) owed investors.
Ex: business owners may receive no return if the firms
earnings is not adequate to meet obligations.
2. Financial risk the uncertainty surrounding a firms
ability to meet its financial obligations because it has borrowed
money. Ex: inability to meet debt obligations could result in
business failure and in losses for bond-holders and
stockholders.
3. Purchasing power risk the chance that unanticipated
changes in price levels (inflation or deflation) will adversely
affect investment returns.
4. Interest rate risk is the chance that changes in
interest rates will adversely affect a securitys value.
Generally, the higher the interest rate, the lower the value of
an investment vehicle, and vice versa.
5. Liquidity risk the risk of not being able to sell (or
liquidate) an investment quickly and at reasonable price. A
liquid investment is one that investors can sell quickly without
having an adverse impact on its price.

6. Tax risk the chance that Congress will make

unfavorable changes in tax laws. Example: Undesirable
changes in tax laws include elimination of tax exemptions,
limitation of deductions, and increase in tax rates.
7. Event risk occurs when something happens to a
company that has a sudden and substantial impact on its
financial condition. It involves an unexpected event that has
a significant and usual immediate effect on the underlying
value of an investment. Example: announcement by Apple
Inc. that its founder and CEO, Steve Jobs, was taking a leave
of absence due to health concerns.
8. Market risk is the risk that investment returns will
decline because of market factors independent of the given
investment. Market risk actually embodies a number of
different risks: purchasing power risk, interest rate risk, and
tax risk. Examples: political, economic, and social events, as
well as changes in investor tastes and preferences.

RISK OF A SINGLE ASSET

Standard Deviation

the most common

single indicator of an assets risk. It measures the dispersion
(variation) of returns around an assets average or expected
return.

SD =

(
t-1

Return for outcome t Average or

expected return

SD =

Total number of outcomes - 1

n

(
t-1

r r
t
n-1

)2

Example.

*Annual rate of return is calculated based on end-of-year prices.

Annual Rate of Return (rt)

Year (t)

ExxonMobil

Panera Bread

1999

12.6 %

14.8 %

2000

10.2

193.8

2001

-7.6

128.2

2002

-8.9

33.8

2003

20.6

13.5

2004

28.1

2.0

2005

11.8

62.9

2006

39.1

-14.9

2007

24.3

-35.9

2008

-13.1

45.8

Average ( r )

11.7

44.4

ExxonMobil

rt r

( rt r
2

Year
(t)

(1)
Return
(rt) - %

(2)
Average
Return %

(3)
(1) (2)
%

1999

12.6

11.7

0.9

0.8

2000

10.2

11.7

-1.5

2.1

2001

-7.6

11.7

-19.3

373.3

2002

-8.9

11.7

-20.6

423.3

2003

20.3

11.7

8.9

79.5

2004

28.1

11.7

16.4

267.8

2005

11.8

11.7

0.1

0.0

2006

39.1

11.7

27.4

748.5

2007

24.3

11.7

12.6

158.2

2008

-13.1

11.7

-24.8

616.0

sum

2,669.6

variance

296.6

Std. Deviation = 17.2

(4)
(3)2
%

Panera Bread

rt r

( rt r
2

Year
(t)

(1)
Return
(rt) - %

(2)
Average
Return %

(3)
(1) (2)
%

1999

14.8

44.4

-29.6

877.3

2000

193.8

44.4

149.4

22321.1

2001

128.2

44.4

873.8

7028.1

2002

33.8

44.4

-10.6

113.0

2003

13.5

44.4

-30.9

953.7

2004

2.0

44.4

-42.4

1796.7

2005

62.9

44.4

18.5

341.7

2006

-14.9

44.4

-59.3

3515.0

2007

-35.9

44.4

-80.3

6455.3

2008

45.8

44.4

1.4

2.0

sum

43,403.8

variance

4,882.6

Std. Deviation = 69.4

(4)
(3)2
%

HISTORICAL RETURNS AND

RISK
ASSESSING RISK
RISK-RETURN CHARACTERISTICS OF ALTERNATIVE
INVESTMENT VEHICLES

AN ACCEPTABLE LEVEL OF RISK

Three basic risk preferences (risk-indifferent, riskaverse, and risk-seeking)
For the risk-indifferent investor, the required return does not
change as risk goes from x1 to x2. In essence, no change in return
would be required for the increase.
For the risk-averse investor, the required return increases for an
increase in risk. Because they do not like risk, these investors
require higher expected returns to compensate them for taking
greater risk.
For the risk-seeking investor, the required return decreases for
an increase in risk. Theoretically, because they enjoy risk, these
investors are willing to give up some return to take more risk.

Steps in the decision process:

combining return and risk
When you are deciding among alternative
investments, you should take the following steps
to combine return and risk.

1. Using historical or projected return data, estimate the expected return

over a given holding period. Use yield (or present-value) techniques to
make sure you give the time value of money adequate consideration.
2. Using historical or projected return data, assess the risk associated with
the investment. Subjective risk assessment, use of the standard
deviation of returns, and use of more sophisticated measures, such as
beta, are the primary approaches available to individual investors.
3. Evaluate the risk-return behaviour of each alternative investment to
make sure that the return expected is reasonable given the level of risk.
If other vehicles with lower levels of risk provide equal or greater returns,
the investment is not acceptable.
4. Select the investments that offer the highest returns associated with the
level of risk you are willing to take. As long as you get the highest return
for your acceptable level of risk, you have made a good investment.

-END

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