Chapter 10: Risk and return: lessons from market

Transcript:Chapter 10: Risk and return: lessons from market:
Chapter 10: Risk and return: lessons from market history Corporate Finance Outline I. Returns II. Capital market returns III. Portfolio risk statistics Dollar return Suppose that you bought a bond for $1050 a year ago. You have received two semiannual coupons of $50 each. The market price of the bond today is $1100. What is your total dollar return? Income = 50 + 50 = $100. Capital gain = 1100 – 1050 = $50. Total dollar return = 100 + 50 = $150. Total dollar return = income + capital gain (loss). Percentage return It is more intuitive to think of returns in terms of percentages. Return = (ending value – beginning value) / beginning value. Return = ((1100 + 100) – 1050) / 1050 = 14.29%. Return = income yield (return) + capital gain yield (return) = 100 / 1050 + 50 / 1050 = 9.52% + 4.76% = 14.29%. A sample question Six months ago, you purchased 100 shares of stock in ABC Co. at a price of $43.89 a share. ABC stock pays a quarterly dividend of $.10 a share. Today, you sold all of your shares for $45.13 per share. What is the total dollar amount of your capital gains on this investment of 100 shares? a. $1.24 b. $1.64 c. $40.00 d. $124.00 e. $164.00 Holding period return Holding period return: the cumulative return that an investor would obtain when holding an investment over a period of N years. Holding period return example Suppose that an investment yielded 4%, 7%, 8%, 0%, and 10% for the past 5 years. What is the holding period return for the 5 years? Holding period return = (1 + 4%) × (1 + 7%) × (1 + 8%) × (1 + 0%) × (1 + 10%) – 1 = 32.2%. Why capital market returns? Examining capital market returns helps us determine the appropriate returns on non-financial assets (e.g., firm projects). Lessons from capital market return history: There is a reward for bearing risk. Return is positively related to risk. This is called the “risk-return tradeoff.” Average return, I The simple average of a series of returns is called arithmetic average return. Geometric average return: average compound return per period over multiple periods. Average return example Average return, II The geometric average will be less than the arithmetic average unless all the returns are equal. The arithmetic average is overly