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Okay, so first session on risk and return,

we're basically going to, first of all,
we're going to think a little bit about
how we calculate a periodic return, and
a periodic return is basically
the return on any given period.
Now, in finance,
we never look at one period.
Sometimes we may look for
any specific purpose,
but when we want to evaluate
the performance of assets,
what we basically do is to
aggregate performance over time.
And in order to that, we need to
aggregate information into statistics,
into measures that tell me something
about the return characteristics and
the risk characteristics
of different assets.
So we're going to look at two different
ways of calculating min returns and
two different ways of assessing risk.
And importantly in everything
that follows in this session,
we're not going to be
looking at any formula.
This session is complemented by two
technical notes and all the formulas and
expressions that you need are contained
in those two technical notes.
So what we're going to do here is to
maximize the intuition, the understanding
of each of these variables that are used
to describe returns and risk, and then you
going to go a little bit deeper into the
actual calculation of these monitors and
then you're going to test yourself with a
little problem set in order to see whether
you are understanding concepts or not.
So we're going to start right away.
And the first thing that we're going
to do, is to define a periodic return.
And, first think about this
in the simplest possible way.
If you buy an asset,
if you buy a share of stock, and
you buy it at the beginning of the year,
and you sell it at the end of the year.
When you compare the price at which you
buy and the price at which you sell,
that price might have gone up,
or it might have gone down.
If the price goes up, then you obtain
a gain and we call that capital gain.
And if the price went down,
then you obtained a loss and
we call that a capital loss.
So when you compare the price at

the beginning of the period and

price at the end of the period,
one of the two sources of return is what
we call a capital gain or a capital loss.
Now, on top of that many assets
actually pay you a cash flow.
Some companies pay dividends.
Some bonds pay coupons.
And that basically is a cash flow
that you put in your pocket and
it will be part of your return.
So, again, if you buy a share
at the beginning of a period and
sell it at the end of the period,
not only you can get that capital gain or
loss, which is given by the change in
price between the beginning and the end of
the period, but you also can pocket a cash
flow, which again, could be a dividend,
could be an interest payment if
it's a bond and on and on and on.
Once you put together these
two sources of returns,
then that is what you actually get,
your return.
Except for,
the fact that we need one more step.
And the one more step that we need
is typically we express everything,
both the change in price and
the cash flow that we get,
relative to the price at
the beginning of the period.
And that basically means,
well the reason for this is simple,
it's not the same thing to actually
get a capital gain and a cash flow.
When you pay $2 for a share of stock then
when you pay $10 for a share of stock.
So suppose that between the beginning and
the end of the period,
there was a capital gain of $1 and
you actually got a dividend of $1.
Well that's a $2 gain that you actually
got, one from the changing price, and
one from the cash that
you put in your pocket.
So if you pay $2 for
that share of the stock,
then you actually got a very big return.
That is, you got $2 in terms of gain,
compared to $2 that you
paid at the beginning.
But if you had paid $10 or $20 or $30 for
that share, in proportional terms, what
you actually got in terms of return is
much lower when you pay $10, $20, or $30.
So, what we typically do In order to
calculate that return is to standardize,
to divide everything by the price that

we paid at the beginning of the period.

So you can put now,
in the back of your head, and
again I don't want to do any
formulas at this point, but
in order to calculate a return
you basically need two things.
You need a change in price between
the beginning and the end of the period.
You need to know the cash flow
you're putting in your pocket,
if any, between the beginning and
end of the period.
And once you have those two components,
you add them up and you divide the whole
thing by the price that you paid
at the beginning of the period.
All right, so
those are the two sources of gains that
you get when you buy a share of stock.
And now we're going to
look at set of data.
And let me clarify a few things
about that data that you're seeing.
You're seeing there
three equity markets and
it's important that we understand that
this is equity, this is not debt.
So this is stock markets.
Now, these are broad diversified indices.
This is not, for example, in the case
of the US, the widely used S&P 500,
all of these are Morgan Stanley indices.
And it doesn't really matter Morgan
Stanley, Financial Times, Dow Jones,
there are many providers of data, this
just happens to be Morgan Stanley data.
And they're basically broad
indicators of the performance
of the equity market in each of the three
countries that you are seeing there.
Now in the last column you
have the world market and
that is basically an aggregation
Of all the equity markets,
developed markets, and emerging markets,
put together into one.
So, that world equity market is
basically the composite of developed and
emerging markets all together and
all expressed in the same currency,
to which I will get to in just a minute.
So, a couple of characteristics
about those returns.
Characteristic number one, they are, all
of them, what we call total returns and
total returns basically mean that
we don't leave anything out.
That means that we're putting together the
change of price between the beginning and

the end of the period, but

we are also putting together the cash
flows, paid by the companies in the index.
So when you look at for example that 10.7%
for the year 2004, in the case of the US,
that means that when you put together
the change in the value of the index,
between the beginning of the period and
the end of the period, and
you put together the cash flow,
the dividends paid by all the companies in
the index, when you aggregate those two
things and put it relative to the value
of the index at the beginning of
the period, you get that 10.7%.
Okay, so characteristic number one
of those returns is that they are,
again, they're total returns and
that means we're putting together all
the sources where we can get a return and
that means capital gains or losses and
dividends paid by these companies.
Characteristic number two, all of them
are expressed in terms of dollars.
If you are actually looking at
those three first countries,
the local currency in each
country is different, and
typically we would express the returns
in that particular currency.
Now, because we want to
make some comparisons and
we will make those comparisons
a few minutes from now,
we want to put everything in the same
currency, and that currency is the dollar.
And we also do that, because if you look
at the last column, that world market
portfolio, we're aggregating many
countries with many different currencies.
And that is like adding apples and
oranges.
It doesn't really make any sense.
Unless you add the map in the same
currency, and that's why,
again, we're using the dollar,
as that particular current.
So keep in mind that
the characteristics of those returns.
Number one is that they're
expressed in dollar.
Number two,
that they state their total returns, and
that they're put together all the sources
from where we can get a guess.
All right?
Now, we're going to go back.
And we're going to think a little
bit in terms of the following.
And that is, suppose that I ask you to

tell me something about the performance

of the U.S. market or
the Spanish market or the Egyptian market.
Well, you're not going to
be looking at one year.
You ideally would like to be looking
at a relatively long period of time.
Which means that you're going to have
a series of many returns, they could be
annual returns, they could be monthly
returns, they could be daily returns.
What we have here are annual returns,
the ones that we're looking at, but
ideally, if I want to be able to tell you
something about the relative performance
of the US market, the Spanish market,
or the Egyptian market, or
any other market, then I would like
to look at a longer period of time.
And the problem is, it's not a problem,
but what happens is that when I'm
looking at a long period of time,
just looking at a series of
returns is not going to help me.
Maybe making a little graph might help me
a little bit, but maybe not a whole lot.
So what I need to do is
to summarize information.
And summarizing information
basically brings,
it implies bringing all the numbers
together into one specific measure.
And that measure could be something
that describes returns or
something that describes risks or
something that describes,
as we're going to discuss in the next
session, risk adjusted returns.
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