1. 10-0 McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited Chapter Outline 10.1Returns 10.2Holding-Period Returns 10.3Return Statistics 10.4Average Stock Returns and Risk-Free Returns 10.5Risk Statistics 10.6Summary and Conclusions

2. 10-1 McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited 10.1Returns Dollar Returns –the sum of the cash received and the change in value of the asset, in dollars. Time01 Initial investment Ending market value Dividends Percentage Returns – the sum of the cash received and the change in value of the asset divided by the original investment.

3. 10-2 McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited Dollar Return = Dividend + Change in Market Value 10.1Returns

4. 10-3 McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited 10.1Returns: Example Dollar Returns –$520 gain Time01 -$2,500 $3,000$20 Percentage Returns

5. 10-4 McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited Holding Period Return: Example Suppose your investment provides the following returns over a four-year period:

6. 10-5 McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited Holding Period Return: Example An investor who held this investment would have actually realized an annual return of 9.58%: So, our investor made 9.58% on his money for four years, realizing a holding period return of 44.21%

7. 10-6 McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited Holding Period Return: Example Note that the geometric average is not the same thing as the arithmetic average:

8. 10-7 McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited The Future Value of an Investment of $1 in 1957 $42.91 $20.69 Common Stocks Long Bonds T-Bills

9. 10-8 McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited 10.3Return Statistics The history of capital market returns can be summarized by describing the –average return –the standard deviation of those returns –the frequency distribution of the returns.

10. 10-9 McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited Average Standard Investment Annual Return Deviation Distribution Canadian common stocks 10.64%16.41% Long Bonds8.9610.36 Treasury Bills6.804.11 Inflation4.293.63 Historical Returns, 1957-2003 – 60%+ 60%0%

11. 10-10 McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited 10.4 Average Stock Returns and Risk-Free Returns The Risk Premium is the additional return (over and above the risk-free rate) resulting from bearing risk. One of the most significant observations of stock and bond market data is this long-run excess of security return over the risk-free return. –The average excess return from Canadian large- company common stocks for the period 1957 through 2003 was 3.84% = 10.64% – 6.80% –The average excess return from Canadian long-term bonds for the period 1957 through 2003 was 2.16% = 8.96% – 6.80%

12. 10-11 McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited Risk Premia Suppose that The National Post announced that the current rate for one-year Treasury bills is 5%. What is the expected return on the market of Canadian large- company stocks? Recall that the average excess return from Canadian large- company common stocks for the period 1957 through 2003 was 3.84% Given a risk-free rate of 5%, we have an expected return on the market of Canadian large-company common stocks of 8.84% = 3.84% + 5%

13. 10-12 McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited The Risk-Return Tradeoff (1957-2003) Long Bonds T-Bills Large-Company Stocks

14. 10-13 McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited 10.5Risk Statistics There is no universally agreed-upon definition of risk. The measures of risk that we discuss are variance and standard deviation. –The standard deviation is the standard statistical measure of the spread of a sample, and it will be the measure we use most of this time. –Its interpretation is facilitated by a discussion of the normal distribution.

15. 10-14 McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited Normal Distribution A large enough sample drawn from a normal distribution looks like a bell-shaped curve. The probability that a yearly return will fall within 16.41-percent of the mean of 10.64-percent will be approximately 2/3.

16. 10-15 McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited Normal Distribution A large enough sample drawn from a normal distribution looks like a bell-shaped curve. The probability that a yearly return will fall within 32.82-percent (2 × 16.41) of the mean of 10.64-percent will be 0.9544.

17. 10-16 McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited Normal Distribution A large enough sample drawn from a normal distribution looks like a bell-shaped curve. The probability that a yearly return will fall within 49.23-percent (3 × 16.41) of the mean of 10.64-percent will be 0.9974.

18. 10-17 McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited Normal Distribution Source: © Stocks, Bonds, Bills, and Inflation 2002 Yearbook™, Ibbotson Associates, Inc., Chicago (annually updates work by Roger G. Ibbotson and Rex A. Sinquefield). All rights reserved.