Chapter 6
The Returns and Risks
from Investing
Asset Valuation
• Function of both return and risk
–
At the centre of security analysis
• How should realized return and risk be
measured?
–
–
The realized risk-return tradeoff is based
on the past
The expected future risk-return tradeoff is
uncertain and may not occur
Return Components
• Returns consist of two elements:
–
Yield: Periodic cash flows such as interest
or dividends (income return)
•
–
“Yield” measures relate income return to a
price for the security
Capital Gain or Loss: Price appreciation or
depreciation
•
The change in price of the asset
• Total Return = Yield + Price Change
Risk Types
• Two general types:
–
Systematic (market) risk
•
–
economy wide factors that impact returns
Non-systematic (non-market) risk
•
Unique characteristics specific to a security
• Total Risk measured by volatility
• Systematic risk measured by beta
Measures Describing a
Return Series
• Arithmetic mean, or simply mean
X

X
n
• Geometric mean defined as the n-th root of the
product of n return relatives minus
(1  TR1)(1  TR2 )...(1  TRn )
1/ n
1
Measuring Risk
• Risk is the chance that the actual
outcome will be different than the
expected outcome
• Standard Deviation measures the
deviation of returns from the mean
  X  X
s  
 n1
2



1/ 2
Risk Premiums
• Premium is additional return earned
or expected for additional risk
• Equity risk premium is the difference
between stock and risk-free returns
• Bond default premium is the difference
between the return on long term
corporate bonds and long term
government bonds
•
http://www.smartmoney.com/onebond/index.cfm?story=yieldcurve
Annual Total Returns
(1938-2003)
Series
Canadian
Common Stocks
US Common
Stocks
Geom
Mean
Arithm
Mean
Standard
Deviation
10.32%
11.53%
16.36%
12.09%
13.5%
17.67%
Long-term
Government of
Canada Bonds
6.07%
6.46%
9.39%
T-bills
5.20%
5.28%
4.36%
Inflation (CPI)
3.97%
4.05%
3.63%