MEASURES OF RISK AND RETURN IN SINGLE INVESTMENT.pptx

Measuring return through assessing the holding period return of the single investment

1. MEASURES OF RETURN AND RISK Chapter II

2. INTRODUCTION

3. HISTORICAL RATES OF RETURN The analysis of historical data and historical performance can provide an overview of how a financial asset or security has been reacting to external or internal events that may have caused returns to grow or decline. Such events can be attributed to changes in the  economic cycle , or they can be global events. Although historical data can be used to project future returns and what investors can expect, the data does not forecast actual future returns. Data that is too old may not be ideal for estimating returns.

4. MEASURES OF HISTORICAL RATES OF RETURN Holding Period of Return- the return for holding a certain investment. HPR= Ending Value of Investment/ Beginning Value of Investment Example: Consider an Investment that cost $250 and is worth $350 after being held for 2 years. How much is its holding period return? Annual Holding Period Return (Annual HPR)= HPR^(1/n) Annual Holding Period Yield (HPY)= HPR-1

5. SAMPLE PROBLEM 1 Consider an investment of $100 held for only six months that earned a return of $12: Find the: A.) HPR B.) Annual HPR C. ) Annual HPY

6. SAMPLE PROBLEM 2 What is the HPR for an  investor  who bought a stock a year ago at $50 and received $5 in  dividends  over the year if the stock is now trading at $60? Find the: A.) HPR B.) Annual HPR C. ) Annual HPY

7. SAMPLE PROBLEM 3 Which investment performed better:  Mutual Fund  X, which was held for three years and appreciated from $100 to $150, providing $5 in distributions, or Mutual Fund B, which went from $200 to $320 and generated $10 in  distributions  over four years? Find the: A.) HPR B.) Annual HPR C. ) Annual HPY

8. COMPUTATION OF HOLDING PERIOD YIELD FOR PORTFOLIO INVESTMENT # OF SHARES BEGINNING PRINCE BEGINNING MARKET VALUE ENDING PRICE ENDING MARKET VALUE A 100,000 10 12 B 200,000 20 21 C 500,000 30 33 TOTAL

9. 1/5 crosswise On February 1, you bought 100 shares of stock in the Francesca Corporation for $34 a share and a year later you sold it for $39 a share. During the year, you received a cash dividend of $2.00 a share. Compute your HPR and HPY on this investment. On August 15, you purchased 100 shares of stock in the Cara Cotton Company at $65 a share and a year later you sold it for $61 a share. During the year, you received dividends at a $3 a share. Compute your HPR and HPY on your investment. At the beginning of last year, you invested $4,000 in 80 shares of the Chang Corporation. During the year, Chang paid dividends of $5 per share. At the end of the year, you sold the 80 shares for $59 share. Compute your HPR.

10. Remember one final point: The ending value of the investment can be the result of a positive or negative change in price for the investment alone, income from investment alone, or a combination of price change and income. Ending value includes the value of everything related to the investment.

11. Computing Mean Historical Returns

12. ARITHMETIC AND GEOMETRIC MEAN GEOMETRIC MEAN ARITHMETIC MEAN

13. Computing Mean Historical Returns GM= (Product of HRP) AM= Year Ending Value Beginning Value HPR HPY 1 100 115 2 115 138 3 138 110.4

14. Computing Mean Historical Returns Year Beginning Value Ending Value HPR HPY 1 50 100 2 100 50

15. Activity: Find the HPR, HPY, Arithmetic Means, and the Geometric Means. Year Beginning Value Ending Value HPR HPY 1 1,000,000 1,200,000 2 4,000,000 4,200,000 3 15,000,000 16,500,000

16. CALCULATING EXPECTED RATES OF RETURN

17. CALCULATING EXPECTED RATES OF RETURN Expected Rate of Return E(Ri)= (Probability of Return) x (Possible Return) Economic Conditions Probability Rate of Return Strong economy, no inflation .15 .20 Weak Economy, above-average inflation .15 -.20 No major change in economy .70 .10

18. Determinants of Market Interest Rates How does the risk affect interest rates?

19. Quoted interest rate (r)= r* + IP + DRP + LP + MRP In general, the quoted (or nominal) interest rate on a debt security, r, is composed of a real risk-free rate, r*, plus several premiums that reflect inflation, the security’s risk, its liquidity (marketability), and the years to its maturity.

20. The Real Risk-Free Rate (RRFR or R*) This is the basic interest rate, assuming no inflation and no uncertainty about future cash flows. An investor in an inflation-free economy who knew with certainty what cash flows he or she would receive at what time would demand the r* on an investment. The only sacrifice of the investor was deferring the use of money for some time. R* is the price charged for the risk-free exchange between current goods and future goods.

21. Inflation Premium (IP) The way the general level of price is changing

22. Default Risk Premium Influence by the borrowers’ financial strength and terms

23. Liquidity Risk Premium (LRP)

24. Market-Risk Premium