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Slide Contents
Learning Objectives Principles Used in This Chapter
1. Calculate Realized and Expected Rates of Return and Risk. 2. Describe the Historical Pattern of Financial Market Returns. 3. Compute Geometric and Arithmetic Average Rates of Return.
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Measuring Risk
In the example on Table 7-2, the expected return is 12.6%; however, the return could range from -10% to +22%.
This variability in returns can be quantified by computing the Variance or Standard Deviation in investment returns.
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Calculating the Variance and Standard Deviation of the Rate of Return on an Investment
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Calculating the Variance and Standard Deviation of the Rate of Return on an Investment (cont.)
(2) Common stock of the Ace Publishing Company an investment in common stock will be a risky investment.
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Calculating the Variance and Standard Deviation of the Rate of Return on an Investment (cont.)
The probability distribution of an investments return contains all possible rates of return from the investment along with the associated probabilities for each outcome. Figure 7-1 contains a probability distribution for U.S. Treasury bill and Ace Publishing Company common stock.
Copyright 2011 Pearson Prentice Hall. All rights reserved.
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Calculating the Variance and Standard Deviation of the Rate of Return on an Investment (cont.)
The probability distribution for Treasury bill is a single spike at 5% rate of return indicating that there is 100% probability that you will earn 5% rate of return. The probability distribution for Ace Publishing company stock includes returns ranging from -10% to 40% suggesting the stock is a risky investment.
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Calculating the Variance and Standard Deviation of the Rate of Return on an Investment (cont.)
Using equation 7-3, we can calculate the expected return on the stock to be 15% while the expected return on Treasury bill is always 5%. Does the higher return of stock make it a better investment? Not necessarily, we also need to know the risk in both the investments.
Copyright 2011 Pearson Prentice Hall. All rights reserved.
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Calculating the Variance and Standard Deviation of the Rate of Return on an Investment (cont.)
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Calculating the Variance and Standard Deviation of the Rate of Return on an Investment (cont.)
Investment Treasury Bill Common Stock Expected Return 5% 15% Standard Deviation 0% 12.85%
So we observe that the publishing company stock offers a higher expected return but also entails more risk as measured by standard deviation. An investors choice of a specific investment will be determined by their attitude toward risk.
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Checkpoint 7.1
Evaluating an Investments Return and Risk
Clarion Investment Advisors is evaluating the distribution of returns for a new stock investment and has come up with five possible rates of return for the coming year. Their associated probabilities are as follows:
a. What expected rate of return might they expect to realize from the investment? b. What is the risk of the investment as measured using the standard deviation of possible future rates of return?
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Checkpoint 7.1
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Checkpoint 7.1
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Checkpoint 7.1
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Step 3: Solve
Calculating Expected Return
+ (30%.2) + (50%.1)
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Step 4:Analyze
The expected return for this investments is 11.5%. However, it is a risky investment as the returns can range from a low of -20% to a high of 50%. Standard deviation captures this risk and is equal to 21.11%. Standard deviation is a measure of the average dispersion of the investment returns.
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A Brief History of the Financial Markets We can use the tools that we have learned to determine the risk-return tradeoff in the financial markets.
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Annual
Small Stocks
Large Stocks
Governme nt Bonds
Treasur y Bills
Return S.D.
11.7% 34.1%
9.6% 21.4%
5.7% 8.5%
3.7% 0.9%
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Lessons Learned from Historical Returns in the Financial Market (cont.) Lesson #2: The historical returns of the higher-risk investment classes have higher standard deviations.
For example, small stocks had a standard deviation of 34.1% while the standard deviation of treasury bill was only 0.9%.
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The fluctuation in rates of return over a period of time is called the investments volatility, which is measured by standard deviation.
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In contrast, the US stocks had the least volatility with returns ranging from a high of 37.6% and a low of -37.0%.
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The arithmetic average rate of return answers the question, what was the average of the yearly rates of return?
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Year
0 1 2
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What annual rate of The arithmetic average return can we expect for calculated using annual next year? rates of return.
Checkpoint 7.2
Computing the Arithmetic and Geometric Average Rates of Return Five years ago Marys grandmother gave her $10,000 worth of stock in the shares of a publicly traded company founded by Marys grandfather. Mary is now considering whether she should continue to hold the shares, or perhaps sell some of them. Her first step in analyzing the investment is to evaluate the rate of return she has earned over the past five years. The following table contains the beginning value of Marys stock five years ago as well as the values at the end of each year up until today (the end of year 5):
What rate of return did Mary earn on her investment in the stock given to her by her grandmother?
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Checkpoint 7.2
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Checkpoint 7.2
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Checkpoint 7.2
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Checkpoint 7.2: Check Yourself Mary has decided to keep the stock given to her by her grandmother. However, now she wants to consider the prospect of selling another gift made to her five years ago by her grandmother. What are the arithmetic and geometric average rates of return for the following investment? See table on the next slide.
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Problem (cont.)
Year
0 1 2
3 4 5
$8,500.00 $9,775.00
$12,218.75 $15,884.38 $14,295.94
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$16,000.00
$14,000.00 $12,000.00 $10,000.00 $8,000.00 $6,000.00 $4,000.00 $2,000.00
$0.00
0 1 2 3 Year 4 5 6
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Step 3: Solve
Calculate the Arithmetic Average Arithmetic Average
= Sum of the annual rates of return Number of years = 45% 5 = 9%
Based on past performance of the stock, Mary should expect that it would earn 9% next year.
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Step 4: Analyze
The arithmetic average is 9% while the geometric average is 7.41%. The geometric average is lower as it incorporates compounding of interest. Both of these averages are useful and meaningful but in answering two very different questions.
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An efficient market is a market in which all the available information is fully incorporated into the prices of the securities and the returns the investors earn on their investments cannot be predicted.
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If there did exist simple profitable strategies, then the strategies would attract the attention of investors, who by implementing their strategies would compete away the profits.
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Historically, there has been some evidence of inefficiencies in the financial markets. This is summarized by three observations in Table 7-4.
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In other words, market prices will reflect public information fairly accurately.
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Key Terms
Arithmetic average returns Cash return Developed country Efficient market hypothesis Emerging market Equity risk premium Expected rate of return
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