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Chapter 06 IM 10th Ed

# Chapter 06 IM 10th Ed - CHAPTER 6 Risk and Rates of Return...

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CHAPTER 6 Risk and Rates of Return CHAPTER ORIENTATION This chapter introduces the concepts that underlie the valuation of securities and their rates of return. We are specifically concerned with common stock, preferred stock, and bonds. We also look at the concept of the investor's expected rate of return on an investment. CHAPTER OUTLINE I. The relationship between risk and rates of return A. Data have been compiled by Ibbotson and Sinquefield on the actual returns for various portfolios of securities from 1926-2002. B. The following portfolios were studied. 1. Common stocks of small firms 2. Common stocks of large companies 3. Long-term corporate bonds 4. Long-term U.S. government bonds 5. U.S. Treasury bills C. Investors historically have received greater returns for greater risk-taking with the exception of the U.S. government bonds. D. The only portfolio with returns consistently exceeding the inflation rate has been common stocks. II. Effects of Inflation on Rates of Return A. When a rate of interest is quoted, it is generally the nominal or, observed rate. The real rate of interest represents the rate of increase in actual purchasing power, after adjusting for inflation. B. Consequently, the nominal rate of interest is equal to the sum of the real rate of interest, the inflation rate, and the product of the real rate and the inflation rate. III. Term Structure of Interest Rates 144

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The relationship between a debt security’s rate of return and the length of time until the debt matures is known as the term structure of interest rates or the yield to maturity. IV. Expected Return A. The expected benefits or returns to be received from an investment come in the form of the cash flows the investment generates. B. Conventionally, we measure the expected cash flow, X , as follows: X = X i P(X i ) where N = the number of possible states of the economy. X i = the cash flow in the i th state of the economy. P(X i ) = the probability of the i th cash flow. V. Riskiness of the cash flows A. Risk can be defined as the possible variation in cash flow about an expected cash flow. B. Statistically, risk may be measured by the standard deviation about the expected cash flow. C. Risk and diversification 1. Total variability can be divided into: a. The variability of returns unique to the security (diversifiable or unsystematic risk) b. The risk related to market movements (nondiversifiable or systematic risk) 2. By diversifying, the investor can eliminate the "unique" security risk. The systematic risk, however, cannot be diversified away. 3. The market rewards diversification. We can lower risk without sacrificing expected return, and/or we can increase expected return without having to assume more risk. 4. Diversifying among different kinds of assets is called asset allocation. Compared to diversification within the different asset classes, the
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Chapter 06 IM 10th Ed - CHAPTER 6 Risk and Rates of Return...

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