4504c6 - Returns and Risk Realized Returnsexpect (after the...

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Unformatted text preview: Returns and Risk Realized Returnsexpect (after the fact) return Expected Return- estimated return Investment Decisiontrade off between risk (expected) and return (expected) Trade-Off Between Risk and Return Required Return = Risk free rate + Risk premium Required Return = Cost of Capital to Firm Two components of Required Return: Risk-free rate Risk premium First step in the investment decision process Knowledge of long-term return (actual) and risk (actual) The past is a good guidepost but Dont use it as a hitching post Historical returns play a large part in estimating future unknown returns Return o Objective of investor: Maximize Wealth Micro-basismaximize expected returns given a level of risk Components of Return Yieldincome component Dividend Yield Current Yield Capital gain (loss) [ Price Change] Change on price of a security over some period Total Return for period = Yield over period + Price Change over period 5-1 Risk the chance that the actual outcome from an investment will differ from the expected outcome Greater the variability----the greater the risk Sources of Risk: 1. Interest Rate Risk security prices move inversely to interest rates bonds more directly affected 2. Market Risk variability in returns resulting from fluctuations in the overall market common stock affected more than bonds Market risk components: Recessions, wars, structural change in the economy, and changes in consumer preferences 3. Inflation Risk purchasing power risk with unexpected inflation, the real return (inflation-adjusted) involves risk even when the nominal return is certain (fixed) Fisher equation 4. Business Risk risk associated with a particular industry or environment risks associated with the business cycle factors that affect the business cycle monetary policy, changes in technology, changes in supply of raw materials 5. Financial Risk debt financing financial leverage 5-2 6. Liquidity Risk 7. Exchange Rate Risk (Currency Risk) variability in returns on securities caused by currency fluctuations 8. Country Risk (Political Risk) Types of Risk Systematic (Market) Nonsystematic (Company) Total Risk= Systematic Risk + Nonsystematic Risk Holding Period Return (Total Return) period the of beginning at Price period) over the change (Price period) over the received pymts Cash (Any TR + = Change Price s Period' Yield s Period' TR period the of beginning at ice Pr period over change Price period the of beginning at Price period over the received pymts Cash Any TR + = + = 5-3 Return Relative Total return for an investment for a given time period stated on the basis of B E t P P CF Relative Return TR 1 RR + = + = Cumulative Wealth Index Measures the cumulative effect of returns over time, typically on the basis pf a $1 invested Measures the level rather than the changes in wealth...
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4504c6 - Returns and Risk Realized Returnsexpect (after the...

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