Unlock document.
This document is partially blurred.
Unlock all pages and 1 million more documents.
Get Access
Chapter 2 Securities Markets and Transactions 15
Chapter 4
Return and Risk
Outline
Learning Goals
I. The Concept of Return
A. Components of Return
1. Income
2. Capital Gains (or Losses)
B. Why Return Is Important
1. Historical Performance
2. Expected Return
C. Level of Return
1. Internal Characteristics
2. External Forces
D. Historical Returns
E. The Time Value of Money and Returns
1. Computational Aids for Use in Time Value of Money Calculations
2. Determining a Satisfactory Investment
Concepts in Review
II. Measuring Return
A. Real, Risk-Free, and Required Returns
1. Inflation and Returns
2. Risk and Returns
B. Holding Period Return
1. Understanding Return Components
2. Computing the Holding Period Return
3. Using the HPR in Investment Decisions
C. The Internal Rate of Return
1. IRR for a Single Cash Flow
a. Calculator Use
b. Spreadsheet Use
2. IRR for a Stream of Income
a. Calculator Use
©2017 Pearson Education, Inc.
16 Smart/Gitman/Joehnk • Fundamentals of Investing, Thirteenth Edition
b. Spreadsheet Use
3. Interest-on-Interest: The Critical Assumption
D. Finding Growth Rates
1. Calculator Use
2. Spreadsheet Use
Concepts in Review
III. Risk: The Other Side of the Coin
A. Sources of Risk
1. Business Risk
2. Financial Risk
3. Purchasing Power Risk
4. Interest Rate Risk
5. Liquidity Risk
6. Tax Risk
7. Event Risk
8. Market Risk
B. Risk of a Single Asset
1. Standard Deviation: An Absolute Measure of Risk
2. Historical Returns and Risk
C. Assessing Risk
1. Risk-Return Characteristics of Alternative Investments
2. An Acceptable Level of Risk
D. Steps in the Decision Process: Combining Return and Risk
Concepts in Review
Summary
Key Terms
Discussion Questions
Problems
Case Problems
4.1 Coates’ Decision
4.2 The Risk-Return Tradeoff: Molly O’Rourke’s Stock Purchase Decision
Excel@Investing
Chapter-Opening Problem
Key Concepts
1. The concept of return, its component parts, and the forces that affect the level of return realized by
an investor; historical returns reviewed
2. Interest income and the concept of the time value of money, its underlying future and present
value computations, and its use in the investment decision-making process. (Covered in detail in
Appendix 4A.)
©2017 Pearson Education, Inc.
Chapter 2 Securities Markets and Transactions 17
3. Usage of financial calculators, computers, and spreadsheets in measuring risk and return
4. Real, risk-free, and required returns on investments
5. The computation and use of the holding period return and the internal rate of return, and the role
they can play in the investment decision
6. The sources and basic types of risk, the concept of risk, its positive relationship to return, and its
role in investment decision making
7. The basic steps involved in evaluating the risk-return characteristics of an investment
Overview
The concepts of return and risk are developed in this chapter. This chapter is conceptually more
demanding than the preceding one, so the instructor should plan to spend more class time on it.
1. Returns are rewards for investing. The components of total return are income and capital gains (or
losses). Income is cash received for holding an investment, whereas capital gains refers to income
that is attributed to an increase—realized or unrealized—in the value of the investment.
2. Expected return motivates a person to invest in a particular security. Expectations of returns are
based on the past returns of that investment. Measuring the historical return of a particular investment
reveals its average return as well as the trend of its returns.
3. The level of returns for a particular investment depends on internal characteristics, such
as type of investment and issuer characteristics, and external forces, such as war, political events,
and the level of price changes (inflation or deflation).
4. A satisfactory investment is one in which the present value (PV) of benefits (discounted at the
appropriate rate) equals or exceeds the PV of costs. The instructor may indicate that NPV (PV of
benefits minus PV of costs) measures the same thing.
5. The required return of an investment is the rate that compensates the investor for its risk. It is
composed of the real rate of return—the return earned in a perfect world with no risk—plus the
expected inflation premium, which is called the risk-free rate, plus the risk premium for the
investment.
6. The holding period return (HPR), defined next, is useful in making investment decisions. The
instructor may show the class how HPR is computed, stressing that the HPR from identical periods
should be used when comparing two investments.
7. The internal rate of return (IRR), represents the annual rate of return earned on a long-term
investment. A satisfactory investment is one that has an IRR equal to or greater than the appropriate
discount rate. Some instructors may want to spend time discussing the critical assumption that
intermediate cash flows are reinvested at the internal rate of return.. Others may choose to skip this
technical, but important, discussion. Those who cover the reinvestment rate issue should find Figure
4.1 helpful in explaining it. At this point, the instructor should have made it clear to the class that the
returns from an investment may be measured either in dollar or percentage terms although
percentages are more useful if the investments are of unequal size.
8. The chapter next covers the calculation of growth rates for streams of dividends or earnings, a
present value application that is an important part of common stock valuation.
©2017 Pearson Education, Inc.
18 Smart/Gitman/Joehnk • Fundamentals of Investing, Thirteenth Edition
9. The concept of risk is introduced and defined. The possible sources of risk include business risk,
financial risk, purchasing power risk, interest rate risk, liquidity risk, tax risk, market risk, and event
risk. The concepts of diversifiable, nondiversifiable, and total risk are covered in the next chapter.
Next introduced is the risk of a single asset, the standard deviation as a measure of absolute risk. The
risk-return tradeoff is also discussed.
10. The text’s description of the four steps in the investment decision process is useful and should be
highlighted.
Answers to Concepts in Review
4.1 Return on investment can come from either income or capital gains, or both. Income, most
commonly, is periodic payments, such as interest received on bonds, dividends on stock, or rent
The use of percentage returns is generally preferred to dollar returns to allow investors to directly
compare different sizes and types of investments.
4.2 Although future returns are not guaranteed by past performance, historical data often gives the
investor a meaningful basis on which to form future expectations. Past return data, such as average
The level of expected returns depends on many internal characteristics of the investment and the
external forces on the investment. Internal characteristics include the type of investment, the quality
History tells us that stock market returns have averaged well above the interest rates payable on
savings accounts at banks. In recent years, especially during the latter part of the 1990s, the returns
4.3 A satisfactory investment is one for which the present value of benefits discounted at the appropriate
©2017 Pearson Education, Inc.
Chapter 2 Securities Markets and Transactions 19
4.4 a. The real rate of return on an investment measures the increase in purchasing power the
investment provides. It is approximately equal to the nominal rate of return on a security less
b. The expected inflation premium represents the expected average future rate of inflation over an
c. The risk premium varies for different security issues and represents the additional return required
to compensate an investor for the risk characteristics of the issue and the issuer. It is the return on
The risk-free rate of return equals the real rate of return plus the expected inflation premium:
The required rate of return equals the real rate of return plus the expected inflation premium
(together, the risk-free rate) and the risk premium: ri RF RPj. Alternatively, it equals the
risk-free rate of return plus the risk premium.
4.5 The holding period is simply the period of time over which the investor wishes to measure the return
on an investment. In comparing alternative investments, it is essential to use equal-length holding
The holding period return (HPR) is the total return earned from holding an investment for a
4.6 The IRR is the annual rate of return earned by a long-term investment. It is also defined as the
discount rate that produces a present value of benefits received equal to the present value of
©2017 Pearson Education, Inc.
20 Smart/Gitman/Joehnk • Fundamentals of Investing, Thirteenth Edition
4.7 The critical assumption underlying the use of internal rate of return is an ability to earn a return equal
to the calculated rate of return on all income received from the investment during the holding period.
If you earn 10% on all income received from an investment during the holding period, your yield on
the investment will be 10%. On the other hand, if you earn 0% on the income received, your rate of
4.8 If the present value of returns from an investment is greater than the initial cost of the investment, it
In the example given, Investment A is clearly acceptable because its IRR (8%) is greater than the
4.9 Risk is the uncertainty surrounding the actual return that an investment will provide. The standard
deviation is a statistic that is often used to measure risk. The risk-return tradeoff is the relationship
4.10 a. Business risk is concerned with the degree of uncertainty associated with an investment’s
b. Financial risk is the risk associated with the mix of debt and equity (capital structure) used to
c. Purchasing power risk arises because of uncertain inflation rates and price-level changes in the
d. Interest rate risk is risk associated with changes in the prices of fixed-income securities resulting
from changing market interest rates. As the market interest rates change, the prices of these
e. Liquidity risk is the risk of not being able to sell an investment quickly and at a reasonable price.
f. Tax risk is the risk that tax laws enacted by Congress will adversely affect certain types of
investments and decrease their after-tax returns.
©2017 Pearson Education, Inc.
Chapter 2 Securities Markets and Transactions 21
g. Event risk is the risk that comes from a largely or totally unexpected event that has a significant
and usually immediate effect on the underlying value of an investment. The effect of this risk
seems to be isolated in most cases, affecting only certain companies and properties.
4.11 Standard deviation is a common, but somewhat flawed measure of an asset’s risk. It measures the
4.12 Investors’ attitudes toward risk or their risk-return tradeoffs may be classified as one of the following:
In general, most investors are risk averse. They require increased returns from an investment as its
risk increases. The risk preference of an investor is an important determinant of his or her investment
4.13 The investment decision process can be summarized in four steps:
(1) Estimate the expected return over a given holding period using historical data or projected return
data, or both. The time value of these returns must be considered for long-term investments.
©2017 Pearson Education, Inc.
