# ch6 - Chapter 6 Introduction to Risk Return and the...

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Chapter 6 - Introduction to Risk, Return, and the Opportunity Cost of Capital ECO389, Spring 2010 This chapter introduces risk concepts, historical rates of return, and the opportu- nity rate concept. Risk, especially ﬁnancial risk, is an important factor in the ﬁnancial valuation, which is related to the variability of the returns of your investments. Remember: One tail on pure risk and two tails for investment returns! 1 Rates of Return: A Review 1. Security return (stock or bond): –dividend or interest payment –capital gain or capital loss –Example: suppose you bought a stock at the beginning of year 2003 when its prices was about \$43 a share. By the end of the year the value of that investment had appreciated to \$49. Capital gain is 49 - 43 = 6. In addition, in 2003, the ﬁrm paid a dividend of \$0.56 a share. This is the dividend income. Your total income from your investment is 6+0.56=6.56 per share. 2. The annual percentage return on investment is: Percentage return = capital gain + dividend initial share price 1

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3. The above return is a nominal return, reﬂecting how much more money an investor has at the end of the year. 4. The same percentage return or total return is the sum of the dividend yield (annual dividends/initial share price) plus the percentage capital gain (annual capital gain/initial share price). Dividend yield = dividend initial share price Percentage capital gain ( Capital gain yield ) = capital gain initial share price Percentage return = dividend yield + percentage capital gain 5. The real rate of return: –The above return is a nominal rate of return because we didn’t consider the impacts of inﬂation in the year. If there is an inﬂation, your real return is less than your nominal return because the purchasing power of the money has decreased. –The real rate of return is the nominal rate adjusted for the inﬂation rate in the period: 1 + real rate of return = 1 + nominal rate of return 1 + inflation rate –Example: the inﬂation rate in 2003 is 2.8%. 2
1.1 Market Indexes But how can we know the rates of return of diﬀerent investments? Market Indexes help us with our estimation. 1. Market Index : Measure of the investment performance of the overall market. 2. Dow Jones Industrial Average (DJIA) : best-known stock market index in the U.S., known as the Dow . It is the Index of the investment performance of a portfolio of 30 “blue-chip” stocks. It is an equal share index of thirty industrial stocks. The Dow tracks the performance of a portfolio that holds one share in each of 30 large ﬁrms. It is an index of important but few ﬁrms, independently of how many shares each company has outstanding. –Example: Dow starts the day at a value of 9,000 and then rises by 90 points to

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ch6 - Chapter 6 Introduction to Risk Return and the...

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