Investment and Portfolio Management, Study notes of Investment Management and Portfolio Theory

Download Investment and Portfolio Management and more Study notes Investment Management and Portfolio Theory in PDF only on Docsity! I. UNIT TITLE/CHAPTER TITLE: MEASURE OF RETURN AND RISK II. LESSON TITLE : RETURN AND RISK III. LESSON OVERVIEW This lesson begins with a brainstorming session in which students identify the risks involved in playing sports or driving a car. From these responses, the concept of risk is defined and how to measure it. Then relate to investment by quantifying the relationship between an asset’s risk and its required return. IV. LESSON CONTENT THE CONCEPT OF RETURN People are motivated to invest in a given asset by its expected return. The return is the level of profit from an investment and that is the reward of investing. Suppose you have $ 1, 000 in an insured savings account paying 2% annual interest, and a business associate asks you to lend her the money for one year, at the end of which she pays you back, your return will depend on the amount of interest you charge. Example of Return The stock price for Stock A was $10 per share 1 year ago. The stock is currently trading at $9.50 per share and shareholders just received a $1 dividend. What return was earned over the past year? R= $1.00+($ 9.50−$10.00) $10.00 =5% COMPONENTS OF RETURN 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 investment’s price. We call these two sources of return current income and capital gains or capital losses, respectively. a. Income may take the form of dividends from stocks or mutual funds, or interest on bonds. To be considered income, it must be in the form of cash or be readily convertible into cash. Cash that inventors periodically receive as a result of owning an investment. b. Capital gain or losses the second dimension of return focuses on the change in an investment’s market value. As noted in chapter 1, the amount by which the proceeds from the sale of an investment exceed its original purchase price is capital gain. If an investment sells for less than its original purchase price, a capital loss results. PROFILE OF TWO INVESTMENTS Investment Y Z Purchase Price (beginning of Year) P2,000 P2,000 Cash received 1st Quarter 2nd Quarter 3rd Quarter 4th Quarter 10 20 20 30 0 0 0 120 Total income (for Year) 80 120 Sale Price (end of year) 2,100 1960 TOTAL RETURN OF THE TWO INVESTMENT RETURN Investment Y Z Income P80 P120 Capital gain/loss 100 (40) Total Return 180 80 Percentage return 9% 4% We can compute the capital gain or loss of the investment shown in the table. Investment Y experiences capital gain of Php100 (2100 sale price -P2000 purchase price) while investment Z experiences a capital loss of P40 (1960 sale price – 2000 purchase price). The total return is the addition of income and capital gain/loss. Investment Y earns P180 total returns while investment Z earns P80. Investment A earned 9% return (180/2000); B produced only 4% return (80/2000). At this point, investment A appears preferable, but as we’ll see, the differences in risk might cause some investors to prefer B. IMPORTANCE OF RETURN An asset’s return is a key variable in the investment decision because it indicates how rapidly an investor can build a wealth. Naturally, because most people prefer to have more wealth rather than less, they prefer investments that offer high returns rather than low returns if all else is equal. Historical Performance Interest rate and other measures of financial return are most often cited on an annual basis. Evaluation of past investment returns is typically done on the same basis. Consider the data for ExxonMobil Corp. (XOM) presented below. Exxon paid dividends in very year from 2005- 2014 (and continued to do). Exxon’s stock price generally rose during this decade starting at $51.26 and ending $92.45. Despite the overall upward trend, the company’s stock fell in 2008 and 2009 and it declined again in 2014. Equation 4.3 Required return= risk-free rate + risk On investment premium of investment Equation 4.3a r¡= Rf + RP¡ For example, if the required return on Nike common stock is 11% when the risk-free rate is 6%, investors require a 5% risk premium (11%-6%) as compensation for the risk associated with the common stock (the issue) and Nike (the issuer). Notice also that if investors expect 3% inflation, then the real required rate on Nike is 8% (11%-3%). Next, we consider the specifics of return measurement. We look at two return measures- one used primarily for short-term investments and the other for longer term vehicles. Holding Period Return The return to a saver is the amount of interest earned on a given deposit. Of course, the amount ‘invested’ in a savings account does not change in value, as does the amount invested in stocks, bonds, and mutual funds. Because we are concerned with a broad range of investment vehicles, we need a measure of return that captures both periodic income and changes in value. One such measure is the holding period return. The holding period is the period of time over which one wishes to measure the return on an investment. When comparing returns, be sure to use holding periods of the same length. For example, comparing the return on a stock over a six-month period with a return on a bond over a one year period could result in a poor investment decision. To avoid this problem, be sure you define the holding period. It is common practice to annualize the holding period and use that as a standard. Equation 4.4 Holding Period Return = Current Income + Capital gain (or loss) during period during period Beginning investment value Equation 4.4a HPR¿ Inc+CG V 0 Where: Equation 4.5 Capital gain (or loss) during the period = Ending investment Value - Beginning Investment value Equation 4.5a CG = Vn – V0 The HPR equation provides a convenient method for either measuring the total return realized or estimating the total return expected. COMPONENTS OF RISK Thus far, our primary concern in this chapter has been return. However, we cannot consider return without also looking at risk. Expanding a bit on its definition in chapter 1, risk is the uncertainty surrounding the actual return than an investment will generate. The risk associated with a given investment is directly related to its expected return. In general, the greater the investment’s risk, the higher the expected return it must offer to attract investors. Riskier investments should provide higher levels of return. Otherwise, what incentive is there for an investor to risk his or her capital? SOURCES OF RISK The risk associated with a given investment vehicle may result from a combination of possible sources. A prudent investor considers how the major sources of risk might affect potential investment vehicles. This premium in a broad sense results from the sources of risk, which derive from characteristics of both the issue and the issuer. 1. Business Risk. In general, business risk is the degree of uncertainty associated with an investment’s earnings and the investments ability to pay the returns (interest, principal, dividends) owed investors. 2. Financial Risk. Firms that borrow money sometimes experience financial difficulties because they cannot generate enough cash to pay all their bills, including debt payments. The uncertainty surrounding a firm’s ability to meet its financial obligations because it has borrowed money is financial risk. 3. Purchasing Power Risk. The chance that unanticipated changes in price levels (inflation or deflation) will adversely affect investment returns is purchasing power risk. Specifically, this risk is the chance that generally rising prices (inflation) will reduce purchasing power (the goods and services that can be purchased with a dollar.). 4. Interest Rate Risk. Securities are especially affected by interest rate risk. This is particularly true for those securities that offer purchasers a fixed periodic return. Interest rate risk is the chance that changes in interest rates will adversely affect a security’s value. The interest rate changes themselves result from changes in the general relationship between the supply of and the demand for money. 5. Liquidity Risk. The risk of not being able to sell (or liquidate) an investment quickly and at a reasonable price. One can generally sell an investment by significantly cutting its price. 6. Tax Risk. The chance that Congress will make unfavorable changes in tax laws. Undesirable changes in tax laws include elimination of tax exemptions, limitation of deductions, and increases in tax rates. Congress has passed numerous changes in tax laws through the years. 7. Event Risk. Occurs when something happens to a company that has a sudden and substantial impact on its financial condition. Event risk goes beyond business and financial risk. An example of event risk is the January 2009 announcement by Apple Inc. that its founder and CEO, Steve Jobs, was taking a leave of absence due to health concerns. 8. Market Risk. The risk that investment returns will decline because of market factors independent of the given investment. Examples include political economic, and social events as well as changes in investor tastes and preferences. 9. Risk of a Single Asset. Most people have at some time in their lives asked themselves hoe risky some anticipated course of action is. In such cases, the answer is usually a subjective judgment, such as ‘not very’ or ‘quite’. MEASURING RISK Standard Deviation: An absolute Measure of Risk the most common indicator of an asset’s risk. It measures the dispersion (variation) of returns around an asset’s average or expectedreturn. Equation 4.6 Standard Deviation=√∑ ¿ t=1 n ¿ ¿ ¿¿ ¿¿¿ Equation 4.6a s=√ ∑ t=1 n ¿ (rt – r )❑ 2 n−1 ¿¿¿ CALCULATION OF STANDARD DEVIATION OF RETURN FOR EXXONMOBIL Return (%)(rt) Ave. Return (%) (rt – ŕ) (rt - ŕ) 2 1 2005 11.80 9.57 2.23 4.97 Holding Period Return