NHO Review of 5 6 7 - Chapter 5 Risk and Return Past and...

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Unformatted text preview: Chapter 5 Risk and Return: Past and Prologue Rates of Return: A Review • Investors in stocks and bonds get returns in two forms: 1. Dividends and interest payments 2. Capital gains (or losses) 10.1 Rates of Return: Pre-Tax Consider an investor who bought a share of stock for $65 at the start of the year. At the end of the year, it is worth $76 and has paid a dividend of $1.10 His pre-tax percentage return is given by: price share initial dividend gain capital return Percentage + = $65 10 . 1 $ ) 65 76 $ ( return Percentage +- = % 62 . 18 = gain pain Good Test Question Ignore Taxes. Which of the following statements is true for a stock that sells now for $45, pays an annual dividend of $2.50, and experienced a 20% return on investment over the past year? Its price one year ago was: 1) $47.50 2) $37.43 3) $39.58 4) $38.75 5) $58.33 50 . 2 ) 45 ( 20 . P P +- = price share initial dividend gain capital return Percentage + = 50 . 2 45 20 . +- = × P P Risk and Return (cont.) • What is the differences between speculation and gambling? – Gamblers take on risk for no other purposes but the enjoyment of the risk itself. – Speculators take on risk because they perceive a favorable risk-turn trade-off. – Risk aversion and speculation are not inconsistent. • Return, risk, and hard work are embedded in the capital market. Historical Returns, 1926- 2002 Source: © Stocks, Bonds, Bills, and Inflation 2003 Yearbook™ , Ibbotson Associates, Inc., Chicago (annually updates work by Roger G. Ibbotson and Rex A. Sinquefield). All rights reserved. – 90% + 90% 0% Average Standard Series Annual Return DeviationDistribution Large Company Stocks 12.2% 20.5% Small Company Stocks 16.9 33.2 Long-Term Corporate Bonds 6.2 8.7 Long-Term Government Bonds 5.8 9.4 U.S. Treasury Bills 3.8 3.2 Inflation 3.1 4.4 Numerical Example: Subjective or Numerical Example: Subjective or Scenario Distributions Scenario Distributions State State Prob. of State Prob. of State r r in in State State 1 1 .1 .1-.05-.05 2 2 .2 .2 .05 .05 3 3 .4 .4 .15 .15 4 4 .2 .2 .25 .25 5 5 .1 .1 .35 .35 E(r) = (.1)(-.05) + (.2)(.05)...+ (.1)(.35) E(r) = (.1)(-.05) + (.2)(.05)...+ (.1)(.35) E(r) = .15 E(r) = .15 Standard deviation = [variance] Standard deviation = [variance] 1/2 1/2 Measuring Variance or Dispersion of Returns Subjective or Scenario Variance = Σ s p ( s ) [ r s- E ( r )] 2 Var =[(.1)(-.05-.15) Var =[(.1)(-.05-.15) 2 +(.2)(.05- .15) +(.2)(.05- .15) 2 ...+ .1(.35-.15) ...+ .1(.35-.15) 2 ] ] Var= .01199 Var= .01199 S.D.= [ .01199] S.D.= [ .01199] 1/2 1/2 = .1095 = .1095 Using Our Example: Using Our Example: Historical Return Statistics • The history of capital market returns can be summarized by describing the: – average return – the standard deviation of those returns T R R R T ) ( 1 + + = 1 ) ( ) ( ) ( 2 2 2 2 1-- +- +- = = T R R R R R R VAR SD T Example Year Return 1 10% 2-5% 3 20% 4 15% % 10 4 % 15 % 20 % 5 % 10 4 R 4 3 2 1 = + +- = + + + = r r r r % 7 . 18 1870 ....
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This note was uploaded on 11/23/2010 for the course FINANCE 08FB40447 taught by Professor Raymond during the Spring '10 term at University of Manchester.

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NHO Review of 5 6 7 - Chapter 5 Risk and Return Past and...

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