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Salaar - Finance Capital Markets Spring Semester 2010 Lahore School of Economics Salaar farooq – Assistant Professor Salaar - Finance Returns and Risks from Investing Lecture Salaar - Finance Returns & Risks from Investing Learning Objectives What is return? What is risk? Sources of risk? Types of risk? How to measure risk? How to measure returns? Realized returns & risks from investing Practice Problems Salaar - Finance Returns Objective of Investors ? Salaar - Finance Returns Objective of Investors To maximize expected returns Constraint: risk Salaar - Finance Returns Components of investment returns ? Salaar - Finance Returns Components of investment returns Yield Income component of a security’s return from cash flows Relates the C/F’s to the price of the security Capital gain (loss) Change in price of a security over time Salaar - Finance Returns Components of investment returns Total Return = Yield + Price Change (CG) Yield can be 0 or + CG can be 0,+ or - Salaar - Finance Returns Examples of components A Bond purchased at par held to maturity: ? A Bond purchased for $800 & held till maturity? A non-dividend stock? A dividend paying stock? Salaar - Finance Returns Examples of components A Bond purchased at par held to maturity: ? Yield only A Bond purchased for $800 & held till maturity? Y+PG A non-dividend stock? PG only A dividend paying stock? Y+PG Salaar - Finance What is Risk? Salaar - Finance What is Risk? UNCERTAINTY OF FUTURE OUTCOMES Definition of Risk: Risk is the Probability… ACTUAL OUTCOME will be different from EXPECTED OUTCOME. Which outcome are we discussing? Future Returns Salaar - Finance • Risk exposure involves Future time. Decision RISK of deviation UNCERTAINTY T= Future T=0 Risk Calculation is on Historical Data T=-n Expected Outcome 1,2…n (return) T=0 Salaar - Finance Deviation possibilities… RISK! Salaar - Finance What are the Sources of Risk? An Overview – Price risk – Interest Rate risk – Market risk – Inflation risk – Business risk Salaar - Finance What are the Sources of Risk? An Overview – Price risk Variability in security’s returns due to price fluctuations – Interest Rate risk Variability in ER due to changes in interest rates – Market risk Variability in ER due to changes in overall market – Inflation risk Variability in ER due to changes in purchasing power (interest rates) – Business risk Variability in ER due to exposure to a particular industry Salaar - Finance What are the Sources of Risk? An Overview – Financial risk – Liquidity risk – Exchange rate risk – Country risk (political risk) Salaar - Finance What are the Sources of Risk? An Overview – Financial risk Arises due to debt financing. Variability in ER due to leverage – Liquidity risk Variability in ER due to inability to trade in secondary mkts. time & price concession required to sell securities – Exchange rate risk Variability in ER due to currency fluctuations. – Country risk (political risk) Variability in ER due to instability of the political system. Salaar - Finance What are the Sources of Risk? Summary – – – – – – – – – Price risk Interest Rate risk (affects market value & resale price) Market risk (overall market effects) Inflation risk (purchasing power variability) Business risk (unique risk) Financial risk (tied to debt financing) Liquidity risk (time & price concession to sell securities) Exchange rate risk (fx) Country risk (political risk) Salaar - Finance What Types of Risk are there? Salaar - Finance What Types of Risk are there? – 2 Main Types – Systematic risk: (MKT) also called market risk or non-diversifiable risk. Caused by the market as a whole – Non-Systematic risk: (COMPANY) also called non-market risk or diversifiable risk. This risk is caused by factors unique to the company Salaar - Finance Types of Risk Average annual standard deviation (%) 49.2 Diversifiable risk (unique risk) 23.9 19.2 Non-diversifiable risk (market risk) 1 10 20 30 40 1000 Number of stocks in portfolio Salaar - Finance How do we measure Risk? • Probability distributions Probability distributions combine outcomes to probabilities Multiply possible returns by associated probabilities and sum them The probabilities must sum to 1.0 Salaar - Finance Prob. Returns Salaar - Finance How do we measure Risk? The risk for a security can be calculated using Standard Deviation measure Salaar - Finance Variance of return R R N Var R = σ 2 = i =1 2 i N 1 where N is the number of returns Standard deviation of return SDR = σ = VarR Salaar - Finance How do we use information regarding risk? Analytical Development • In Finance, decision rules are based on benchmark or alternative comparisons. E.g. consider the statement: • A: an investment (IND: X) has an ER of 35% with SD of 30% Salaar - Finance How do we use this information regarding risk? Analytical Development • In Finance, decision rules are based on benchmark or alternative comparisons. E.g. consider the statement: • A: an investment (IND: X) has an ER of 35% with SD of 30% • B: an investment (IND: X) has an ER of 35% with SD of 15% Salaar - Finance How do we use this information regarding risk? Analytical Development • In Finance, decision rules are based on benchmark or alternative comparisons. E.g. consider the statement: • A: an investment (IND: X) has an ER of 35% with std dev of 30% • B: an investment (IND: X) has an ER of 35% with std dev of 15% • C: IND X has an industry AR of 50% with std dev of 15%. Given the alternatives, & ATE both A & B are inferior. • Therefore, one question you must always ask regarding risk is “what are the alternatives or benchmarks to compare with?” M-10 Salaar - Finance SUMMARY STATISTICS FOR RETURNS Arithmetic mean : The mean return Geometric mean Compounded rate of return over time – r at which end value is obtained. G = (1+TR)^(1/n) – 1 1+TR = RR is used since –ve TR’s cannot be used for G Salaar - Finance SUMMARY STATISTICS FOR RETURNS Arithmetic mean vs geometric mean When should you use the AM or GM? AM: A) better measure of average performance over single periods. B) Best estimate of ER for next period GM: a) better measure of the change in wealth over multiple periods Salaar - Finance Risk Premiums Risk Premium Equity Risk Premium Salaar - Finance Risk Premiums Risk Premium Additional Compensation for assuming risk Equity Risk Premium Difference between return on stocks & the risk-free rate (t-bills) Salaar - Finance Risk Premiums Equity Risk Premium ERP = ( (1+TR stock) / (1+Rf) ) – 1 M6 Salaar - Finance PROBLEM # 9 Calculating ERP Common stocks had a return of 10.0466% over 80yrs. Tbills had a return of 4.0358% over the same period. a) What is the historical Equity Risk Premium? Salaar - Finance PROBLEM # 9 Calculating ERP Common stocks had a return of 10.0466% over 80yrs. T-bills had a return of 4.0358% over the same period. a)What is the historical Equity Risk Premium? ERP = 1.100466/1.040358 – 1 = .0578 = 5.78% Salaar - Finance Some Realities of risk in the real world Realized Returns Over Long Periods (1920-2002) • Some benchmarks for Returns & Risks on major assets over long periods: – Common stocks--approx 13% std dev 20% (more risky) – AAA corporates—approx 6% std dev 9% – Treasury bonds—approx 5.4% std dev 8% – T-bills— approx 4% std dev 3% Salaar - Finance Risk and Return Salaar - Finance Summary We have learnt the following about Risk: • • • • What is Risk? Uncertainty about future outcomes How do we define it? The chance of Actual VS Expected How do we measure it? Standard Deviation How do we use this information to make financial decisions? (benchmarks) • What are the sources of risk? Price,market,interest rate, etc • How many types of risk are there? Unique & Market • What are benchmark Realities of Risk? Stocks, Bonds, T-bills Salaar - Finance • END