Components of return Current return Capital return Total return = current return + capital return
Sources of Risk Business risk Interest rate risk Market risk
“the stock market moves in cycles so that you will infallibly get wonderful bargains every few years, and have a chance to sell again at ridiculously high prices a few years later”
The cycles are caused by mass psychology “the ebb and flow of mass emotion is quite regular: panic is followed by relief, and relief by optimism; then comes enthusiasm, then euphoria and then the bubble bursts, and public feeling slides off again into concern, desperation, and finally a new panic”
Types of risk Unique risk or diversifiable risk or unsystematic risk Market risk or non-diversifiable risk or systematic risk
Measuring historical return Total return = (Cash payment received during the period + price change over the period) / price of the investment at the beginning of period.
Return relative Return relative = 1 + total return If total return is 12%, return relative=1.12 If total return is – 5%, return relative=0.95
Cumulative wealth index It captures the cumulative effect of total returns over time on an investment of Re.1. It is calculated as follows: CWI n = WI 0 (1+R 1 )(1+R 2 )…(1+R n )
Illustration on CWI A Stock earns the following returns over a five year period: R1=0.14, R2=0.12, R3=- 0.08, R4=0.25, R5=0.02 CWI5=1(1.14)(1.12)(0.92)(1.25)(1.02) =1.498 So, Re.1 invested at beginning of year 1 would become Re. 1.498 at the end of year 5.
Real return Real return=[(1+nominal return) / (1+inflation rate)] - 1
Measuring historical risk Variance Standard deviation
Measuring expected (ex-ante) return and risk Probability distribution Expected rate of return Standard deviation of expected return
A Fun Activity You are lucky to be invited in a television game show. The host shows two boxes to you. She tells you that one box contains Rs.10,000 and the other box is empty. The host asks you to open any one of the two boxes and keep whatever you find in it. She also offers you Rs.1,000 if you give away the option to open the box. Would you accept the offer? If no, then at what offer would you give away the option to open the box.
Risk Premiums Risk premium may be defined as the additional return investors expect to get for assuming additional risk. Three types of risk premium: Equity risk premium Bond horizon premium Bond default premium
Beta as a measure of risk Beta measures non-diversifiable risk It shows how the price of a security responds to market forces.
Calculating beta Beta of an investment is the slope of the following regression relationship R s = a + B s R m R s = estimated return on the stock a =estimated return when market return is zero B s =measure of stock’s sensitivity to the market return R m =return on market index
Adjusting historical beta Weighted average of historical beta and the market beta(i.e.1). Merill Lynch assigns a weight of 0.66 to historical beta and 0.34 to market beta for predicting beta.
CAPM Assumptions Security market line The equilibrium portfolio Over priced and under priced securities