5- 1 © ADMN 3116, Anton Miglo ADMN 3116: Financial Management 1 Lecture 6: Risk Anton Miglo Fall 2014.

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5- 1 © ADMN 3116, Anton Miglo ADMN 3116: Financial Management 1 Lecture 6: Risk Anton Miglo Fall 2014

5- 2 © ADMN 3116, Anton Miglo Topics  Risk and Return  Treasury bond returns  Stock returns  Mean-Variance Approach  Excel: AVE, STDEVP, VARP  Additional readings: B ch. 8

5- 3 © ADMN 3116, Anton Miglo Calculating Total Dollar and Total Percent Returns  Suppose you invested \$1,400 in a stock with a share price of \$35.  After one year, the stock price per share is \$49.  Also, for each share, you received a \$1.40 dividend.  What was your total dollar return?  \$1,400 / \$35 = 40 shares  Capital gain: 40 shares times \$14 = \$560  Dividends: 40 shares times \$1.40 = \$56  Total Dollar Return is \$560 + \$56 = \$616  What was your total percent return?  Dividend yield = \$1.40 / \$35 = 4%  Capital gain yield = (\$49 – \$35) / \$35 = 40%  Total percentage return = 4% + 40% = 44% Note that \$616 divided by \$1,400 is 44%.

5- 4 © ADMN 3116, Anton Miglo A \$1 Investment in Different Types of Portfolios, 1926—2009

5- 5 © ADMN 3116, Anton Miglo Rates of Return 1926-2000 Source: Ibbotson Associates Year Percentage Return

5- 6 © ADMN 3116, Anton Miglo Average Annual Returns for Five Portfolios and Inflation

5- 8 © ADMN 3116, Anton Miglo What is Risk? Company B return Company A return

5- 9 © ADMN 3116, Anton Miglo Frequency Distribution of Returns on Common Stocks, 1926—2009

5- 10 © ADMN 3116, Anton Miglo Benchmark risks and returns Average Annual Variance Standard PortfolioRate of Return Deviation Treasury Bills 4.1 7.9 2.8 Gov’t Bonds5.2 68 8.2 Common Stocks11.7402.6 20.1

5- 11 © ADMN 3116, Anton Miglo Example: Calculating Historical Variance and Standard Deviation  Let’s use data from Table 1.1 for Large-Company Stocks.  The spreadsheet below shows us how to calculate the average, the variance, and the standard deviation (the long way…).

5- 13 © ADMN 3116, Anton Miglo Investment returns The rate of return on an investment can be calculated as follows: (Amount received – Amount invested) Return = ________________________ Amount invested For example, if \$1,000 is invested and \$1,100 is returned after one year, the rate of return for this investment is: (\$1,100 - \$1,000) / \$1,000 = 10%.

5- 14 © ADMN 3116, Anton Miglo Risk and return Average Annual Risk/Standard InvestmentsRate of Return (%) Deviation (%) Treasury Bills 4.1 2.8 Gov’t Bonds5.28.2 Common Stocks11.7 20.1

5- 15 © ADMN 3116, Anton Miglo Investment Choices AB C Average Return Risk 15% 5% 20% 5% Average Return Risk Risk- averse Risk- neutral Risk- loving D

5- 17 © ADMN 3116, Anton Miglo Excel functions used  AVERAGE  SQRT  VAR  STDEV

5- 18 © ADMN 3116, Anton Miglo Treasury bill example  Buy bill 1 June 2008 for \$977.04  Horizon: Pays you back \$1,000 in one year  Safety: Payment guaranteed by U.S. government  Liquidity: Highly liquid

5- 19 © ADMN 3116, Anton Miglo One year yield on T-bill 19 If you hold the Bill for one year, you will absolutely get the 2.35% yield. It is totally safe! This 2.35% yield is both ex-ante and ex-post:  Ex-ante: It is the predicted yield for holding the T- bill when you buy it  Ex-post: It is the yield you will get after one year if you hold the T-bill to maturity

5- 20 © ADMN 3116, Anton Miglo Track T-bill prices throughout the year 20

5- 21 © ADMN 3116, Anton Miglo Stock price risk  McDonald’s stock (MCD) is risky  Horizon risk: How long will you hold the stock?  Safety: stock is inherently unsafe This doesn’t mean it’s not a good stock!  Liquidity risk: minimal—the volume of MCD traded daily is very large, so it should be easy to dispose of the stock. 21

5- 23 © ADMN 3116, Anton Miglo Computing the average and standard deviation of annual returns23

5- 24 © ADMN 3116, Anton Miglo Statistics review 24 Statistical note: The only consistent way of computing annual average returns is to use the continuously compounded returns, illustrated on page 273. This Excel sheet uses discrete returns, but these give contradictory results. (Compare, for example 10.49% in cell B28 with 6.94% in cell G6.)

5- 25 © ADMN 3116, Anton Miglo For a discussion of average return versus standard deviation 25