Chapter 7

An Introduction to Risk and

Return: History of Financial
Market Returns

Copyright 2011 Pearson Prentice Hall. All rights reserved.

 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.
 Slide Contents (cont.)
4. Explain Efficient Market Hypothesis and Why
it is Important to Stock Prices.
Key Terms
 7.1 Realized and
Expected Rates of Return
and Risk

Copyright 2011 Pearson Prentice Hall. All rights reserved.

 Calculating the Realized Return from
an Investment
Realized return or cash return measures the
gain or loss on an investment.
 Calculating the Realized Return from
an Investment (cont.)
Example 1: You invested in 1 share of Apple
(AAPL) for $95 and sold a year later for $200.
The company did not pay any dividend during
that period. What will be the cash return on
this investment?
 Calculating the Realized Return from
an Investment (cont.)

Cash Return = $200 + 0 - $95

= $105
 Calculating the Realized Return from
an Investment (cont.)
We can also calculate the rate of return as a
percentage. It is simply the cash return
divided by the beginning stock price.
 Calculating the Realized Return from
an Investment (cont.)
Example 2: You invested in 1 share of share
Apple (AAPL) for $95 and sold a year later for
$200. The company did not pay any dividend
during that period. What will be the rate of
return on this investment?
 Calculating the Realized Return from
an Investment (cont.)

Rate of Return = ($200 + 0 - $95) 95

= 110.53%

Table 7-1 has additional examples on measuring an investors

realized rate of return from investing in common stock.
 Calculating the Realized Return from
an Investment (cont.)
Table 7-1 indicates that the returns from
investing in common stocks can be positive or
negative.
Furthermore, past performance is not an
indicator of future performance.
However, in general, we expect to receive
higher returns for assuming more risk.
 Calculating the Expected Return from
an Investment
Expected return is what you expect to earn
from an investment in the future.

It is estimated as the average of the possible

returns, where each possible return is
weighted by the probability that it occurs.
Calculating the Expected Return from
an Investment (cont.)
 Calculating the Expected Return from
an Investment (cont.)

Expected Return
= (-10%0.2) + (12%0.3) + (22%0.5)
= 12.6%
 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.
 Measuring Risk (cont.)
Standard deviation is given by square root of
the variance and is more commonly used.
 Calculating the Variance and Standard Deviation of the Rate of
Return on an Investment

Let us compare two possible investment

alternatives:
(1) U.S. Treasury Bill Treasury bill is a short-term
debt obligation of the U.S. Government. Assume
this particular Treasury bill matures in one year
and promises to pay an annual return of 5%. U.S.
Treasury bill is considered risk-free as there is no
risk of default on the promised payments.
Calculating the Variance and Standard Deviation of the Rate of
Return on an Investment (cont.)

(2) Common stock of the Ace Publishing Company

an investment in common stock will be a risky
investment.
 Calculating the Variance and Standard Deviation of the Rate of
Return on an Investment (cont.)

The probability distribution of an

investments return contains all possible rates
of return from the investment along with the
associated probabilities for each outcome.

Figure 7-1 contains a probability distribution

for U.S. Treasury bill and Ace Publishing
Company common stock.
 Calculating the Variance and Standard Deviation of the Rate of
Return on an Investment (cont.)

The probability distribution for Treasury bill is

a single spike at 5% rate of return indicating
that there is 100% probability that you will
earn 5% rate of return.
The probability distribution for Ace Publishing
company stock includes returns ranging from -
10% to 40% suggesting the stock is a risky
investment.
 Calculating the Variance and Standard Deviation of the Rate of
Return on an Investment (cont.)

Using equation 7-3, we can calculate the

expected return on the stock to be 15% while
the expected return on Treasury bill is always
5%.

Does the higher return of stock make it a

better investment? Not necessarily, we also
need to know the risk in both the investments.
 Calculating the Variance and Standard Deviation of the Rate of
Return on an Investment (cont.)

We can measure the risk of an investment by

computing the variance as follows:
 Calculating the Variance and Standard Deviation of the Rate of
Return on an Investment (cont.)

Investment Expected Standard

Return Deviation
Treasury Bill 5% 0%
Common Stock 15% 12.85%

So we observe that the publishing company stock offers a

higher expected return but also entails more risk as measured
by standard deviation. An investors choice of a specific
investment will be determined by their attitude toward risk.
 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?
Checkpoint 7.1
Checkpoint 7.1
Checkpoint 7.1
 Checkpoint 7.1: Check Yourself

Compute the expected return and standard deviation for an

investment with the five following possible probabilities for the
coming year:
.2, .2,.3,.2 and .1and rates of return are 20%,0%,15%,30% and
50% Respectively.