# Introduction to Risk and Return

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Introduction to Risk and Return
Time Value of Money & Introduction to Risk and Return Most financial decisions involve costs & benefits that are spread out over time. Time value of money allows comparison of cash flows from different periods.

Present Value (Discounting) Future Value (Compounding)
The value of money a firm has in its possession today is more valuable than money in the future because the money can be invested and earn positive returns. Basic Concepts Used: Time Line Present Value (Discounting) Future Value (Compounding) Single or series of cash flows (annuity & perpetuity)

Basic Models Discounting (Present Value) Compounding (Future Value)

Annuities Annuities are equally-spaced cash flows of equal size.
Annuities can be either inflows or outflows. An ordinary (deferred) annuity has cash flows that occur at the end of each period. An annuity due has cash flows that occur at the beginning of each period. An annuity due will always be greater than an otherwise equivalent ordinary annuity because interest will compound for an additional period.

PVPerp = Payment/Interest Rate
Perpetuity A perpetuity is a special kind of annuity. With a perpetuity, the periodic annuity or cash flow stream continues forever. PVPerp = Payment/Interest Rate

Compounding Interest more frequently than Annually
Compounding more frequently than once a year results in a higher effective interest rate because you are earning on interest on interest more frequently. As a result, the effective interest rate is greater than the nominal (annual) interest rate. Furthermore, the effective rate of interest will increase the more frequently interest is compounded.

Nominal and Effective Annual Rates of Interest
The nominal interest rate is the stated or contractual rate of interest charged by a lender or promised by a borrower. The effective interest rate is the rate actually paid or earned. In general, the effective rate > nominal rate whenever compounding occurs more than once per year Effective Rate:

Using the Financial Calculator
[2nd] [PMT] [2nd] [ENTER] : changes mode to BGN [2nd] [+/-] [ENTER] : resets the calculator [2nd] [.] [6] [ENTER] : changes from 2 to 6 decimals CF0 to enter uneven cash flows NPV to find Present Value for Uneven Cash Flows

Sample Problems You are planning on receiving \$150, years from now. What is it worth today, if the required rate of return is 12%? \$15,550.02 N= 20.00 I=12.00% PV=Solve for PMT= 0.00 FV = -150,000

Sample Problems Instead of receiving \$150,000 in 20 years, you want to know what the equivalent installment amount would be if you received an equal amount each year from next year (time 1) to year 20. What \$ amount would that be, assuming the same discount rate as in problem 1? N=20.00 I=12.00% PV=0 PMT= Solve for \$2,081.82 FV=-150,000

Sample Problems You have \$45,000 today and your aunt, who is a member of an investment club, says that she can turn it into \$500,000 within 10 years. What annual rate of return is she implying that her club could earn with your money? N=10.00 I=Solve for % PV=-45,000 PMT=0.00 FV=500,000 *note the opposite signs for the PV and FV

Sample Problems You think your aunt’s investment club could earn 15% per year. How much would be in the account if you let her invest it for 35 years. For this problem, assume monthly compounding. N= X 12 I=1.25% /12 PV=-45,000 PMT=0.00 FV=Solve for \$8,300,913.84

Assigned Problem 4-31: Value of Mixed Stream
Harte Systems Inc: cash inflows \$30,000 (year 1), \$25,000 (year 2), \$15,000 (years 3-9), \$10,000 (year 10) Required rate of Return: 12% A second company offers \$100,000 on an one-time payment Use Financial Calculator, Inputs: CFo=0, C01=30,000, F01=1, C02=25,000, F02=1, C03=15,000, F03=7, C04=10,000, F04=1 NPV function: I = 12, Compute NPV = \$104,508.28 \$104, > \$100,000  Accept the series of payments

Assigned Problem 4-46: Loan Amortization Schedule
Loan Amount: \$15,000 Annual Rate of Interest: 14% Repaid Period: 3 years (end of year payments) N = 3 , I/Y = 14, PV = 15,000, FV = 0, Solve for PMT = \$ 6,459.97

Definition of Risk In the context of business and finance, risk is defined as the chance of suffering a financial loss. Assets (real or financial) which have a greater chance of loss are considered more risky than those with a lower chance of loss. Risk may be used interchangeably with the term uncertainty to refer to the variability of returns associated with a given asset. If everyone knew ahead of time how much a stock would sell for some time in the future, investing would be simple endeavor. Unfortunately, it is difficult—if not impossible—to make such predictions with any degree of certainty. As a result, investors often use history as a basis for predicting the future. We will begin this chapter by evaluating the risk and return characteristics of individual assets, and end by looking at portfolios of assets.

Sources of Risk Firm – Specific Risk Business Risk Financial Risk
Shareholder – Specific Risk Interest Rate Risk Liquidity Risk Market Risk Firm and Shareholder Risk Event Risk Exchange Rate Risk Purchasing Power Risk Tax

Returns Return represents the total gain or loss on an investment. The most basic way to calculate return is as follows:

Risk Preferences

Portfolio Risk and Return
An investment portfolio is any collection or combination of financial assets. If we assume all investors are rational and therefore risk averse, that investor will ALWAYS choose to invest in portfolios rather than in single assets. Investors will hold portfolios because he or she will diversify away a portion of the risk that is inherent in “putting all your eggs in one basket.” If an investor holds a single asset, he or she will fully suffer the consequences of poor performance. This is not the case for an investor who owns a diversified portfolio of assets.

Returns of a Portfolio The return of a portfolio is a weighted average of the returns on the individual assets from which it is formed and can be calculated as shown in the following equation:

Unsystematic (diversifiable) Risk Systematic (non-diversifiable) Risk
Risk of a Portfolio Portfolio Risk (SD) Unsystematic (diversifiable) Risk σM If you notice in the last slide, a good part of a portfolio’s risk (the standard deviation of returns) can be eliminated simply by holding a lot of stocks. The risk you can’t get rid of by adding stocks (systematic) cannot be eliminated through diversification because that variability is caused by events that affect most stocks similarly. Examples would include changes in macroeconomic factors such interest rates, inflation, and the business cycle. Systematic (non-diversifiable) Risk # of Stocks

Capital Asset Pricing Model (CAPM)
Derived using principles of diversification with simplified assumptions. rRF :The rate of return on Treasury bills rM :The average rate of return in the market i :Correlation/ Coefficient of the risk of the market compared to the returns In the early 1960s, finance researchers (Sharpe, Treynor, and Lintner) developed an asset pricing model that measures only the amount of systematic risk a particular asset has. In other words, they noticed that most stocks go down when interest rates go up, but some go down a whole lot more. They reasoned that if they could measure this variability—the systematic risk—then they could develop a model to price assets using only this risk. The unsystematic (company-related) risk is irrelevant because it could easily be eliminated simply by diversifying. To measure the amount of systematic risk an asset has, they simply regressed the returns for the “market portfolio”—the portfolio of ALL assets—against the returns for an individual asset. The slope of the regression line—beta—measures an assets systematic (non-diversifiable) risk. In general, cyclical companies like auto companies have high betas while relatively stable companies, like public utilities, have low betas.

Assumptions of the CAPM
Individual investors are price takers. Single-period investment horizon. Investments are limited to traded financial assets. No taxes and transaction costs. Information is costless and available to all investors. Investors are rational mean-variance optimizers. There are homogeneous expectations.

Problem on the CAPM Currently under consideration is a project with a beta “b” of 1.5. At this time the risk free rate of return rf is 7% and the return on the market Rm is 10%. The project is expected to earn an annual rate of return of 11%. If the return on the market portfolio was to increase by 10% what do you expect the return on the project’s required return? What if the market return were to decline by 10%? Use the CAPM to find the required return on this investment On the basis of the calculation in part “b” would you recommend this investment and why. Assume that as a result of investors becoming less risk averse the market return drops by 1% to 9%. What impact would this change have on your responses in part b and part c?

Solution Since Beta is 1.5 the required return would change by
1.5 x (+/-) Rate  ri will increase by 15% if rm increases by 10%  ri will decrease by 15% if rm decreases by 10% ri=0.07+(1.5)x( ) = =0.115 = 11.5% Project’s expected return is 11% (0.5% lower than the required return)  Reject the Project ri=0.07+(1.5)x( ) = =0.10 = 10.0%  Go ahead with the project