LN07Titman 449327 12 LN07

Chapter 7
An Introduction
to Risk and
ReturnHistory of
Financial Market
Returns
Slide Contents
Learning Objectives
Principles Applied in This Chapter
1. Realized and Expected Rates of Return and
Risk.
2. A Brief History of Financial Market Returns
3. Compute Geometric and Arithmetic Average
Rates of Return.
4. What Determines Stock Prices?
Key Terms
Copyright 2014 Pearson Education, Inc. All rights reserved.
7-2
Learning Objectives
1. Calculate realized and expected rates of
return and risk.
2. Describe the historical pattern of financial
market returns.
3. Compute geometric (or compound) and
arithmetic average rates of return.
4. Explain the efficient market hypothesis and
why it is important to stock prices.
7-3
Principles Applied in This Chapter

Principle 2: There is a Risk-Return Tradeoff.
Principle 4: Market Prices Reflect
Information.
7-4
7.1 REALIZED AND EXPECTED

RATES OF RETURN AND RISK
7-5
Calculating the Realized Return from

an Investment
Realized return or cash return measures
the gain or loss on an investment.
Example: You invested in 1 share of Apple
(AAPL) for $95 and sold a year later for
$200. The company did not pay any
dividend during that period. What will be
the cash return on this investment?
7-6

an Investment (cont.)
Cash Return
= $200 + 0 - $95
= $105
7-7

We can also calculate the rate of return as a
percentage. It is simply the cash return
divided by the beginning stock price.
7-8

Example: Compute the rate of return for the
previous example.
Rate of Return = ($200 + 0 - $95) 95
= 110.53%
7-9
Table 7-1 Measuring an Investors Realized Rate

of Return from Investing in Common Stock
7-10

Table 7-1 indicates that the returns from
investing in common stocks can be positive
or negative.
However, past performance is not an
indicator of future performance. In general,
we expect to receive higher returns for
assuming more risk.
7-11
Calculating the Expected Return

from an Investment
Expected return is what the investor
expects to earn from an investment in the
future.
It is the weighted average of the possible
returns, where the weights are determined
by the probability that it occurs.
7-12

from an Investment (cont.)
7-13
Table 7-2 Calculating the Expected Rate

of Return for an Investment in Common
Stock
7-14

from an Investment (cont.)
Using equation 7-3,
Expected Return
= (-10%0.2) + (12%0.3) + (22%0.5)
= 12.6%
7-15
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.
7-16
Measuring Risk (cont.)

Variance is the average squared difference
between the individual realized returns and
the expected return.
Standard deviation is the square root of
the variance and is more commonly used to
quantify risk.
7-17
Calculating the Variance and Standard Deviation

of the Rate of Return on an Investment
Assume two possible investment alternatives:

1. U.S. Treasury Bill U.S. Treasury bill is
considered risk-free as there is no risk of
default on the promised payments of 5%.
1. Common stock of the Ace Publishing Company
An investment in common stock will be a
risky investment.
7-18

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.
7-19
Figure 7-1 Probability Distribution of Returns for

a Treasury Bill and the Common Stock of the Ace
Publishing Company
7-20

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%.
The returns for Ace Publishing company range
from a low of -10% to a high of +40%. Thus the
common stock investment is risky, whereas the
Treasury bill is not.
7-21

Using equation 7-3, expected return on the stock is
15% while the expected return on Treasury bill is
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.
7-22

Risk, as measured by variance:
7-23
Table 7-3 Measuring the Variance and Standard

Deviation of an Investment in Ace Publishings
Common Stock
7-24
Calculating the Variance and Standard

Deviation of the Rate of Return on an
Investment (cont.)
Investment
Expected
Return
Standard
Deviation
Treasury Bill
5%
0%
15%
12.85%
Common
Stock
We observe that the common 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.
7-25
CHECKPOINT 7.1:
CHECK YOURSELF
Evaluating an Investments Return
and Risk
Compute the expected return and standard
deviation for an investment with the same return
but with following probabilities for the coming
year: .2, .2,.3,.2 and .1
7-26
Step 1: Picture the Problem
7-27
Step 2: Decide on a Solution

Strategy
We can use Equation 7-3 to measure its
expected return and Equation 7-5 to measure
its standard deviation.
7-28
Step 3: Solve
Calculating Expected Return
E(r) = (-20%.20) + (0%.2) + (15%.3)

+ (30%.2) + (50%.1)
= 11.5%
7-29
Step 3: Solve (cont.)

Calculating Standard Deviation
= ([-.20-.115]2.2) + ([0-.115]2.2) + ([.15.115]2.3) + ([.30-.115]2.2) + ([.50.115]2.1)

= .2111 or 21.11%
7-30
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, a measure
of the average dispersion of the investment
returns, captures this risk and is equal to
21.11%.
7-31
7.2 A BRIEF HISTORY OF

FINANCIAL MARKET RETURNS
7-32
A Brief History of the Financial

Markets
Investors have historically earned higher rates
of return on riskier investments. However,
having a higher expected rate of return simply
means that investors expect to realize a
higher return. Higher return is not
guaranteed.
7-33
U.S. Financial MarketsDomestic Investment Returns

Figure 7.2
Historical
Rates of
Return for
U.S. Financial
Securities:
19262011
7-34
U.S. Financial MarketsDomestic Investment Returns (cont.)

We observe a clear relationship between risk
and return. Small stocks have the highest
annual return but higher returns are
associated with much greater risk.
Annual
Small
Stocks
Large
Stocks
Governm
ent
Bonds
Treasu
ry Bills
Return
11.9%
9.8%
5.7%
3.6%
S.D.
32.8%
20.5%
9.6%
3.1%
7-35
Lessons Learned
Lesson #1: The riskier investments have
historically realized higher returns.
Lesson #2: The historical returns of the
higher-risk investment classes have higher
standard deviations.
7-36
Figure 7-3 Stocks, Bonds, Commodities, and Real

Estate
7-37
Global Financial Markets:

International Investing
Figure 7.4
Historical
Rates of
Return in
Global
Markets:
19702011
7-38
Global Financial Markets:

International Investing (cont.)
Figure 7.5
Investing in
Emerging
Markets:
19882011
7-39
7.3 GEOMETRIC VS.

ARITHMETIC AVERAGE RATES
OF RETURN
7-40
Geometric vs. Arithmetic Average

Rates of Return
The geometric average rate of return
answers the question, What was the
growth rate of your investment?
The arithmetic average rate of return
answers the question, what was the
average of the yearly rates of return?
7-41
Computing the Geometric or

Compound Average Rate of Return
7-42
Computing the Geometric Average

Rate of Return (cont.)
Compute the arithmetic and geometric
average for the following stock.
Year
Annual Rate
of Return
Value of the
stock
$25
40%
$35
-50%
$17.50
7-43
Computing Geometric Average Rate

of Return (cont.)
Arithmetic Average = (40-50) 2 = -5%
Geometric Average
= [(1+Ryear1) (1+Ryear 2)]1/2 - 1
= [(1.4) (.5)] 1/2 - 1
= -16.33%
7-44
Choosing the Right Average

Both arithmetic average geometric average are
important and correct. The following grid provides
some guidance as to which average is appropriate
and when:
Question being
addressed:
Appropriate Average
Calculation:
What annual rate of

return can we expect
for next year?
The arithmetic
average rate of return
calculated using
annual rates of
return.
What annual rate of

return can we expect
over a multi-year
horizon?
The geometric
average rate of return
calculated over a
similar past period.
7-45
CHECKPOINT 7.2:
CHECK YOURSELF
Computing the Arithmetic and
Geometric Average Rates of
Return
7-46
The Problem
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 stock investment? See table on the
next slide.
7-47
Problem (cont.)
Year
Annual Rate of
Return
Value of the Stock

$10,000.00
-15.0%
$8,500.00
15.0%
$9,775.00
25.0%
$12,218.75
30.0%
$15,884.38
-10.0%
$14,295.94
7-48
Step 1: Picture the Problem

Value of Stock
$18,000.00
$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
3
Year
7-49
Step 2: Decide on a Solution

Strategy
We need to calculate the arithmetic and
geometric average. The arithmetic average
fails to capture the effect of compound
interest, which can be measured by geometric
average.
7-50
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.
7-51
Step 3: Solve (cont.)

Calculate the Geometric Average
Geometric Average = [(1+Ryear1) (1+Ryear 2 )
(1+Ryear3) (1+Ryear4) (1+Ryear5) ]1/5 - 1
= [(.85) (1.15) (1.25) (1.30) (.90)] 1/5 - 1
= 7.41%
7-52
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.
7-53
Step 4: Analyze (cont.)

The arithmetic average answers the
question, what rate of return Mary can
expect from her investment next year
assuming all else remains the same as in
the past?
The geometric average answers the
question, what rate of return Mary can
expect over a five-year period?
7-54
7.4 WHAT DETERMINES

STOCK PRICES?
7-55
What Determines Stock Prices?

In general, stock prices tend to go up when
there is good news about future profits, and
they go down when there is bad news about
future profits. Stock price movements are
also affected by speculation or investor
sentiment.
7-56
The Efficient Market Hypothesis

The efficient market hypothesis (EMH) states
that securities prices accurately reflect future
expected cash flows and are based on all
information available to investors.
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.
7-57
The Efficient Market Hypothesis

(cont.)
1. The weak-form efficient market
hypothesis
2. The semi-strong form efficient market
hypothesis
3. The strong-form efficient market
hypothesis
7-58
Do We Expect Financial Markets To

Be Perfectly Efficient?
In general, markets are expected to be at
least weak-form and semi-strong form
efficient.
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.
7-59
The Behavioral View

Efficient market hypothesis is based on the
assumption that investors, as a group, are
rational. This view has been challenged.
If investors do not rationally process
information, then markets may not
accurately reflect even public information.
7-60
The Behavioral View (cont.)

For example, overconfident investors
may under react when management
announces earnings as they have too much
confidence in their own views of the
companys true value and place little weight
on new information released by
management. As a result, this new
information, even though it is publicly and
freely available, is not completely reflected
in stock prices.
7-61
Market Efficiency: What does the

Evidence Show?
Historically, there has been some evidence of
inefficiencies in the financial markets. Most of
the evidence of market inefficiency can be
summarized by three observations found in
Table 7.4.
7-62
Table 7-4 Summarizing the Evidence of

Anomalies to the Efficient Market Hypothesis
7-63
Market Efficiency What does the

Evidence Show? (cont.)
If equity markets are inefficient it means that
investors can earn returns that are greater
than the risk of their investment by taking
advantage of mispricing in the market. More
recent evidence suggests that strategies that
exploit these patterns have been quite risky
and have not been successful after 2000.
7-64
Market Efficiency What does the

Evidence Show? (cont.)
The initial success and eventual demise of
strategies using these patterns shows that
once the pattern is known, investors will trade
aggressively on these patterns and thereby
eliminate the inefficiencies. Thus financial
markets are likely to be efficient, at least in
the semi-strong form.
7-65
Key Terms
Arithmetic average returns

Cash return
Developed country
Efficient market
Efficient market hypothesis
Emerging market
Equity risk premium
7-66
Key Terms (cont.)
Expected rate of return

Geometric or compound average returns
Holding period return
Probability distribution
Rate of return
Realized rate of return
Risk-free rate of return
7-67
Key Terms (cont.)
Semi-strong form efficient market

Standard deviation
Strong-form efficient market
Variance
Volatility
Weak form efficient market
7-68

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Chapter 7

Copyright 2014 Pearson Education, Inc. All rights reserved.

Copyright 2014 Pearson Education, Inc. All rights reserved.

Principles Applied in This Chapter

Copyright 2014 Pearson Education, Inc. All rights reserved.

7.1 REALIZED AND EXPECTED

Copyright 2014 Pearson Education, Inc. All rights reserved.

Calculating the Realized Return from

Copyright 2014 Pearson Education, Inc. All rights reserved.

Calculating the Realized Return from

Copyright 2014 Pearson Education, Inc. All rights reserved.

Calculating the Realized Return from

Copyright 2014 Pearson Education, Inc. All rights reserved.

Calculating the Realized Return from

Copyright 2014 Pearson Education, Inc. All rights reserved.

Table 7-1 Measuring an Investors Realized Rate

Copyright 2014 Pearson Education, Inc. All rights reserved.

Calculating the Realized Return from

Copyright 2014 Pearson Education, Inc. All rights reserved.

Calculating the Expected Return

Copyright 2014 Pearson Education, Inc. All rights reserved.

Calculating the Expected Return

Copyright 2014 Pearson Education, Inc. All rights reserved.

Table 7-2 Calculating the Expected Rate

Copyright 2014 Pearson Education, Inc. All rights reserved.

Calculating the Expected Return

Copyright 2014 Pearson Education, Inc. All rights reserved.

Copyright 2014 Pearson Education, Inc. All rights reserved.

Measuring Risk (cont.)

Copyright 2014 Pearson Education, Inc. All rights reserved.

Calculating the Variance and Standard Deviation

Assume two possible investment alternatives:

Copyright 2014 Pearson Education, Inc. All rights reserved.

Calculating the Variance and Standard Deviation

The probability distribution of an

Copyright 2014 Pearson Education, Inc. All rights reserved.

Figure 7-1 Probability Distribution of Returns for

Copyright 2014 Pearson Education, Inc. All rights reserved.

Calculating the Variance and Standard Deviation

Copyright 2014 Pearson Education, Inc. All rights reserved.

Calculating the Variance and Standard Deviation

Copyright 2014 Pearson Education, Inc. All rights reserved.

Calculating the Variance and Standard Deviation

Risk, as measured by variance:

Copyright 2014 Pearson Education, Inc. All rights reserved.

Table 7-3 Measuring the Variance and Standard

Copyright 2014 Pearson Education, Inc. All rights reserved.

Calculating the Variance and Standard

We observe that the common stock offers a higher

Step 1: Picture the Problem

Copyright 2014 Pearson Education, Inc. All rights reserved.

Step 2: Decide on a Solution

Copyright 2014 Pearson Education, Inc. All rights reserved.

E(r) = (-20%.20) + (0%.2) + (15%.3)

Copyright 2014 Pearson Education, Inc. All rights reserved.

Step 3: Solve (cont.)

= ([-.20-.115]2.2) + ([0-.115]2.2) + ([.15.115]2.3) + ([.30-.115]2.2) + ([.50.115]2.1)

Copyright 2014 Pearson Education, Inc. All rights reserved.

Copyright 2014 Pearson Education, Inc. All rights reserved.

7.2 A BRIEF HISTORY OF

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A Brief History of the Financial

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