PowerPoint PresentationKey Concepts and SkillsChapter Outline10.1 ReturnsGraphic Representation of ReturnsFormulaic Definition of ReturnsReturns: ExampleSlide 810.2 Holding Period ReturnsHolding Period Return: ExampleHolding Period ReturnsIllustration: Holding Period ReturnsUps and Downs: A Fact of Investing LifeReturns and Volatility: A Comparison10.3 Return StatisticsExample Frequency DistributionInterpretation of the Example Frequency DistributionSlide 1810.4 Average Stock Returns and Risk-Free ReturnsRisk PremiumThe Risk-Return Tradeoff10.5 Risk StatisticsNormal DistributionSlide 24Slide 2510.6 The U.S. Equity Risk PremiumGlobal Stock Market Risk PremiumsConclusion: U.S. Market Risk Premium10.7 2008: A Year of Financial Crisis2008 Crisis: Lessons Learned10.8 More on Average Returns: Arithmetic vs. Geometric MeanGeometric Return: ExampleSlide 33Forecasting ReturnQuick Quiz10-1RISK AND RETURN LESSONS FROM MARKET HISTORYChapter 10Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.10-2KEY CONCEPTS AND SKILLS•Calculate the return on an investment•Compute the standard deviation of an investment’s returns•Explain the connection between historical returns and risks on various types of investments•Describe the importance of the normal distribution and its relationship to investment return•Contextualize the US market risk premium in global terms•Discern the impact on returns of the 2008 financial crisis•Differentiate between arithmetic and geometric average returns10-3CHAPTER OUTLINE10.1 Returns10.2 Holding Period Returns10.3 Return Statistics10.4 Average Stock Returns and Risk-Free Returns10.5 Risk Statistics10.6 The U.S. Equity Risk Premium10.7 2008: A Year of Financial Crisis10.8 More on Average Returns10-410.1 RETURNS•Returns have two components:•Current Income (e.g., interest or dividends); and,•Capital Gains (or Losses)•Returns can be expressed in dollar or percentage terms.10-5GRAPHIC REPRESENTATION OF RETURNS•Dollar Returns:the sum of the current income received plus the change in value of the asset, in dollars.Time 0 1Initial investmentEnding market valueDividendsPercentage Returnsthe sum of the current income received plus the change in value of the asset, divided by the initial investment.10-6FORMULAIC DEFINITION OF RETURNSDollar Return = Dividend + Change in Market Valueyield gains capitalyield dividenduemarket val beginninguemarket valin change dividenduemarket val beginningreturndollar Return Percentage10-7RETURNS: EXAMPLE•Suppose you bought 100 shares of Wal-Mart (WMT) one year ago today at $50. Over the last year, you received $100 in dividends ($1 per share × 100 shares). At the end of the year, the stock sells for $60. How did you do?•Quite well. You invested $50 × 100 = $5,000. At the end of the year, you have stock worth $6,000 and cash dividends of $100. Your dollar gain was $1,100 = $100 + ($6,000 – $5,000).•Your percentage gain for the year is:• 1,100/5,000 = 22%10-8RETURNS: EXAMPLEDollar Return:$1,100 gainTime 0 1-$5,000$6,000$100Percentage Return:22% = $5,000$1,10010-910.2 HOLDING PERIOD RETURNS•The holding period return is the return that an investor would get when holding an investment over a period of n years, when the return during year i is given as ri.1)1()1()1(return period holding21nrrr 10-10HOLDING PERIOD RETURN: EXAMPLE•Suppose your investment provides the following returns over a four-year period:Year Return1 10%2 -5%3 20%4 15%%21.444421.1)15.1()20.1()95(.)10.1(1)1()1()1()1(return period holdingYour 4321rrrr10-11HOLDING PERIOD RETURNS•A famous set of studies dealing with rates of returns on common stocks, bonds, and Treasury bills was conducted by Roger Ibbotson and Rex Sinquefield.•They present year-by-year historical rates of return starting in 1926 for the following five important types of financial instruments in the United States:•Large-company Common Stocks•Small-company Common Stocks•Long-term Corporate Bonds•Long-term U.S. Government Bonds•U.S. Treasury Bills10-12ILLUSTRATION: HOLDING PERIOD RETURNS10-13UPS AND DOWNS: A FACT OF INVESTING LIFE•Investments don’t offer their returns on a consistent basis:•Some years are higher;•Some years are lower: and, •Some years are losses•Historically:•The most rewarding investments have the most volatile returns•The least rewarding investments have the least volatile returns10-1410-14RETURNS AND VOLATILITY: A COMPARISONSmall Company Stocks U.S. Treasury Bills10-1510.3 RETURN STATISTICS•The history of capital market returns can be summarized by describing the:•average return •Where R1…RT are the individual observed returns•Where T is the time period analyzed•the frequency distribution of the returnsTRRRT)(110-16EXAMPLE FREQUENCY DISTRIBUTION•Frequency distribution is a histogram of yearly returns10-17INTERPRETATION OF THE EXAMPLE FREQUENCY DISTRIBUTION•In the example above notice that:•Small company stocks have a higher average return but a wider array (or variance) of actual returns•Large company stocks have a lower average return but a more narrow array (or variance) of actual returns.•Conclusion: •In any given observation period, it is more likely that large company stocks will produce a return near the mean than small company stocks.•On average, small company stocks produce a greater return than large company stocks, but also present a much greater likelihood of a loss in any given year10-18Historical Returns, 1926-2012 10-1810-1910.4 AVERAGE STOCK RETURNS AND RISK-FREE RETURNS•U.S. government securities have very low volatility, or risk•U.S. debt is considered risk free because the government can raise taxes to repay it•Consider U.S. Treasury Bills, discount bonds that mature in less than a year•The return of such a security is often considered the “risk-free rate.”•The Risk Premium is the added return (over and above the risk-free rate) resulting from bearing risk.10-20RISK PREMIUM•Suppose that The Wall Street Journal announced that the current rate for one-year Treasury bills is 5%. •What is the expected return of small-company stocks?•The average return on large company common stocks for the period 1926 through 2012 was 11.8%.•Given a risk-free rate of 5%, and average