Create Presentation
Download Presentation

Download Presentation
## BSC/BBA III Summer Semester 2010 Lahore School of Economics

- - - - - - - - - - - - - - - - - - - - - - - - - - - E N D - - - - - - - - - - - - - - - - - - - - - - - - - - -

**BSC/BBA III**Summer Semester 2010 Lahore School of Economics**Chap 06**Risks & Returns from Investing**Risk and ReturnOverview & Background**• Investing involves decisions for the future • Key variable with future= Uncertainty • Expected Returns is basis of Investments • Biggest Threat:UNCERTAINTY=RISK • Uncertainty represents RISK conceptually • Investors must estimate & manage Risk • Risk & Return are opposite sides of the same coin • R&R involve a trade-off with each other**Returns**Objective of Investors ?**Returns**Objective of Investors • To maximize expected returns • Constraint:risk**Returns**Components of investment returns ?**Returns**Components of investment returns • Yield Income component of a security’s return from cash flows Relates the C/F’s to the price of the security • Capital gain (loss) Change in price of a security over time**Returns**Components of investment returns Total Return=Yield+ Price Change (CG) Yield can be 0 or + CG can be 0,+ or -**Returns**Examplesof components • A Bond purchased at par held to maturity: ? • A Bond purchased for $800 & held till maturity? • A non-dividend stock? • A dividend paying stock?**Returns**Examplesof components • A Bond purchased at par held to maturity? Yield only • A Bond purchased for $800 & held till maturity? Y+PG • A non-dividend stock? PG only • A dividend paying stock? Y+PG**What is Risk?**• UNCERTAINTY OF FUTURE OUTCOMES • Definition of Risk: Risk is the Probability (chance) theACTUAL OUTCOMEwill be different from theEXPECTED OUTCOME. • Which outcome are we discussing? Specifically, investors are worried the actual outcome (of returns from their investments) will be less than the expected returns.**Finance involves Future time**RISK of deviation UNCERTAINTY Expected Outcome 1,2…n (return) Decision T= Future T=0 Risk Calculation is based on Historical Data T=0 T=-n**What are the Sources of Risk?An Overview**• Price risk • Interest Rate risk • Market risk • Inflation risk • Business risk**What are the Sources of Risk?An Overview**• Price risk Variability in security’s returns due to price fluctuations • Interest Rate risk Variability in ER due to changes in interest rates • Market risk Variability in ER due to changes in overall market • Inflation risk Variability in ER due to changes in purchasing power • Business risk Variability in ER due to exposure to a particular industry**What are the Sources of Risk?An Overview**• Liquidity risk Variability in ER due to inability to trade in secondary markets. Time & price concession required to sell securities • Exchange rate risk Variability in ER due to currency fluctuations. • Country risk(political risk) Variability in ER due to instability of the political system.**Financial Risk**• Effects of Financial Leverage?.. • Financial Leverage refers to the extent to which a firm relies on Debt. • More Debt means MORE leverage • The larger the proportion of assets financed by debt, the larger the variability in returns, other things being equal.**Financial Risk - Example**• We consider case of company X which has no debt & is considering restructuring to include debt in its capital structure. • We look at DEBT&NO DEBT situations • Taxes are ignored**MEASURING RETURNS**• Total return • Return relative • Cumulative wealth index • Inflation adjusted returns**TOTAL RETURN**The Total Return for a given time period is a decimal number (or a percentage) relating all the cash flows received by an investor during designated time period to the purchase price of the Asset. TR=Any Cash Payment Received+Price change over time period Price at which the Asset is Purchased Or TR=CFt + (P.e – P.b) = CFT+PC PB PB**Total Return - Advantages**It is all inclusive Allows comparison b/w different assets Includes realized & unrealized gains**Total Return - Example**Suppose you purchase a 10% coupon Bond at $960. After a year you sell it for $1020. What is the TR?**Total Return - Example**Suppose you purchase a 10% coupon Bond at $960. After a year you sell it for $1020. What is the Total Return? TR ={100 +(1020-960)}/960 ={100 + 60}/960 =0.1667or16.67%**Total Return - Example**Suppose you purchase 100 shares of JNJ at $30 per share. After a year you sell for $26. A dividend of $2 is paid during the year. What is the TR?**Total Return - Example**Suppose you purchase 100 shares of JNJ at $30 per share. After a year you sell for $26. A dividend of $2 is paid during the year. What is the TR? TR ={2 + (26-30)}/ 30 = {2 +(-4)}/ 30 = -0.0667 or(6.67%)**RETURN RELATIVE**Total return of an investment for a given period expressed on a base of 1.0 Why? To calculate cumulative wealth index OR geometric means, both of which cannot use negative returns. RR =TR in decimal+1.0 = {C + PE}/PB Or, TR = RR – 1.0**RETURN RELATIVE - Example**If the TR is 10% & -9.07% then, What is the RR?**RETURN RELATIVE - Example**If the TR is 10% & -9.07% then, What is the RR? CASE 1:TR = 10% RR =TR+1 =0.1+1 =1.1 Case 2:TR= -9.07% RR = TR +1 =-.0907+1 =0.9093**RETURN RELATIVE - Example**If Dividend paid is 13.79 & the security price is 615.93. One year earlier it was 459.27, What is the RR?**RETURN RELATIVE - Example**If Dividend paid is 13.79 & the security price is 615.93. One year earlier it was 459.27, What is the RR? RR=(615.93+13.79)/459.27 =1.3711**Cumulative Wealth Index**Cumulative wealth indexmeasures the cumulative effect of returns over time, given some stated beginning dollar amount invested, which typically is shown as $1 for convenience. WHY? • TR tracks changes in wealth, CWI measures LEVELS of wealth, rather than changes. • Measures ending wealth (cumulative wealth) over some period on the base of beginning $ 1.**Cumulative Wealth Index**CWI=WI0(1+TR1)(1+TR2)…(1 + TRN) where, CWI =end of period wealth WI0=beginning index value usually $1 TRN= Periodic TR’s in decimal form**Cumulative Wealth Index - Example**Values & Total Returns for S&P500 for past few years were as follows: Values Total Return 1990: 330.22 -3.14% 1991: 417.09 30% 1992: 435.71 7.43% 1993: 466.45 9.94% What is the CWI?**Cumulative Wealth Index - Example**Values & Total Returns for S&P500 for past few years were as follows: Values Total Return 1990: 330.22 -3.14% 1991: 417.09 30% 1992: 435.71 7.43% 1993: 466.45 9.94% What is the CWI? CWI = 1(.969)(1.3)(1.0743)(1.0994) =1.4878**Cumulative Wealth & Total return**TRN= (CWIN / CWI N-1)– 1 Where, TRN= Total Return for period N CWIN-1= Cumulative Wealth Index at period N - 1 CWIN = Cumulative Wealth Index at period N**Cumulative Wealth & Total return - Example**Suppose CWI in 2005 = 1.4878 & CWI in 2006 = 2.5787, what’s the TR in year 2006?**Cumulative Wealth & Total return - Example**Suppose CWI in 2005 = 1.4878 & CWI in 2006 = 2.5787, what’s the TR in year 2006? TR2006=(2.5787/1.4878)– 1 = 1.7332 – 1 =73.32%**International Returns & Currency Risk**Currency Risk is the Risk that the change in the value of the domestic & the foreign Currency involved will be unfavorable. When investors buy & sell assets in other countries, they must consider exchange rate or Currency Risk. Why?**International Returns & Currency Risk**When investors buy & sell assets in other countries, they must consider exchange rate or Currency Risk. Why? When investors invest in Assets denominated in Foreign currency, they are actually investing in two Assets: • Financial security in Foreign Country • Foreign Currency Thus, They need to be concerned with the Risks & Returns of both Assets!**Currency Adjusted RETURNS**As investors have invested in two Assets, their Total Return will also comprise of the returns that they are able to earn on both investments: • Return on Foreign Asset • Return on Foreign Currency**Currency Adjusted RETURNS**As investors have invested in two Assets, their Total Return will also comprise of the returns that they are able to earn on both investments: • Return on Foreign Asset • Return on Foreign Currency Thus, TR in Domestic terms =Return earned on Foreign Asset+ Return earned on Foreign Currency Investment**Currency Adjusted RETURNS**Thus, TR in Domestic terms (Approximately) = [{CFT+(PE–PB)}/PB] Plus {Change in Foreign Currency Beginning Value of Foreign Currency}] Where, Foreign Currency is stated in DC/FC Units**Currency Adjusted RETURNS**Or, Total Return in Domestic Terms (Exactly) = {RR earned on Foreign Asset Multiplied by (Ending Value of Foreign Currency/ Beginning Value of Foreign Currency)} Minus 1**Currency Adjusted RETURNS - Example**An investor in Pakistan invests in Walmart at $50 when exchange rate was Rs.60/$. One year later, Walmart is $55 & there is no dividend. The Exchange rate is now Rs. 57/$. Calculate Approximate Total Return for a Pakistani investor?**Currency Adjusted RETURNS - Example**An investor in Pakistan invests in Walmart at $50 when exchange rate was Rs.60/$. One year later, Walmart is $55 & there is no dividend. The Exchange rate is now Rs.57/$. Calculate Approximate Total Return for a Pakistani investor? TR = Return on Walmart +Return on FC Return on Walmart= (55 – 50)/50 = 10% Return on FC = (57 – 60)/60 = -5% TR = 10% + (-5%) = 5%