1 Chapter 09 Characterizing Risk and Return McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Recap Basic Rule of Bonds There is an inverse relationship between bond prices and interest rates (also called yields, market rates, discount rate, opportunity cost). 2

Basic Rule of Risk There is a positive relationship between risk and returns, i.e……. There is a Risk/Return tradeoff! 3

How is risk relevant? Personal Application……consider this question as we cover the topics in this chapter: 4

5 Suppose an investor owns a portfolio of 100 percent long-term Treasury bonds because the owner prefers low risk. The investor has avoided owning stocks because of their high volatility. The Investor’s stockbroker claims that putting 10 percent of the portfolio in stocks would actually reduce total risk and increase the portfolio’s expected return. The investor knows that stocks are riskier than bonds. How can adding the risky stocks to the bond portfolio reduce the risk level?

Assume these returns on two portfolios: Portfolio A Year 1 8% Year 210% Year 312% Portfolio B Year 1 5% Year 2- 5% Year 330% 6

Historical Returns Method for calculating returns Assessment method for investment returns Posits that historical returns are helpful in predicting future returns 9-7

Computing Returns Dollar Return Percentage Return 9-8

Dollar Return Includes capital gain or loss as well as income 9-9

Percentage Returns Returns across different investments are more easily compared because they are standardized Can be used for most types of investments 9-10

Performance of Asset Classes Historically, stocks have outperformed bonds and cash on an average-return basis Average returns not accurate picture of annual returns Assets examined here: Stocks, U.S. Treasury Bonds and Billshttp://people.duke.edu/~charvey/Classes/ba350/history/history.htmhttp://people.duke.edu/~charvey/Classes/ba350/history/history.htm 9-11

Annual, Average Returns by Asset Class 9-12

Historical Risks Computing Volatility Risk of Asset Classes Risk versus Return 9-13

Computing Volatility Standard deviation (StD) measures volatility StD is the square root of the variance Represents the total risk of a security or portfolio 9-14

Standard Deviation The larger the standard deviation, the higher the risk 9-15

XYZ Returns for the last three years: % % % Calculate Standard Deviation 16

Standard deviation: 13.2% What does that mean? 17

Probability Ranges for a Normal Distribution 18

Risk of Asset Classes Stocks are more volatile than bonds or T-bills 9-19

Risk versus Return With any investment, there is a risk/return tradeoff –See page 309, figure 9.4 –See personal application solution, page 313 The coefficient of variation (CoV) is a relative measure of this relationship 9-20

Coefficient of Variation Amount of risk (measured by volatility) per unit of return 9-21

Forming Portfolios Diversifying to reduce risk Modern Portfolio Theory –Diversification –Portfolio Return 9-22

Diversifying to Reduce Risk Two main components of total risk –Firm-specific risk –Market risk 9-23

Diversifying to Reduce Risk Firm-specific risk is referred to as diversifiable risk Market risk is non-diversifiable risk –This risk applies across all securities in any given market 9-24

Adding Stocks to a Portfolio Reduces Risk 9-25

Modern Portfolio Theory Risk is reduced when securities are combined Optimal portfolio is the combination of securities that produce the highest return for the amount of risk taken 9-26

Efficient Portfolios with Four Stocks 9-27

Diversification When stocks’ returns not are perfectly correlated –price movements often counteract each other With perfect positive correlation, diversification does not affect risk 9-28

Portfolio Return Return calculation –comprised of the individual returns of each security in portfolio and the relative weight of each in the portfolio 9-29