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 19262002.
B.
The following portfolios were studied.
1.
Common stocks of small firms
2.
Common stocks of large companies
3.
Longterm corporate bonds
4.
Longterm U.S. government bonds
5.
U.S. Treasury bills
C.
Investors historically have received greater returns for greater risktaking
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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View Full DocumentThe 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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 Spring '10
 LIbnitz
 Finance, Capital Asset Pricing Model, Interest, Valuation

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