HISTORICAL RETURNS

Method for calculating returns 1. Dollar Return: includes capital gain or loss as well as income (2 cash streams are expected) a. Formula: Capital gain or loss + Income = (Ending value Beginning value ) + Income b. Clicker Q: this includes the total dollar amount of any capital gain (or loss) that occurred as well as any income that you received from a specific investment 2. Percentage Return: returns across diff. investments are more easily compared because theyre standardized (tells you if return is good or bad) & can be used for most types of investments a. Formula: Percentage Return= (End value Beginning value + Income) (Beginning value) X 100%

Assessment method for investment returns good, average, or bad Says historical returns are helpful to predict future returns but past performance isnt necessarily indication of future returns

HISTORICAL RISKS
1. Computing Volatility (good measure if looking at historical return) a. Can quantify risk- high degree of variability (volatility) in historical returns means high degree of future uncertainty b. Volatility has a large bearing using Standard Deviation to help understand stocks future reaction i. Clicker Q: This is the measure of the past volatility/risk of an investment, which includes firm specific & market risk ii. The larger the SD, higher the risk Risk of Asset Classes a. Stocks are more volatile than bonds or T-bills Risk vs. Return a. With any investment, theres riskreturn tradeoff which the Coefficient of Variation (CoV) relatively measures i. CoV tells us in relationship to this risk/reward scenario, how much extra reward do we need in return for taking this risk? ii. The higher the risk, the higher the return we require iii. Amount of risk (measured by volatility) per unit of return iv. As an investor, you want to receive a very high return (denominator) with a very low risk (numerator) a smaller CoV indicates a better risk-reward relationship

2. 3.

FORMING PORTFOLIOS
1. 2. Portfolio : a combination of investment assets held by an investor to reduce risk a. Formed to reduce risk & maximize returns (in relation to risk) Diversifying to Reduce Risk a. Firm-specific risk (micro-econ) referred to as Diversifiable risk, particular to 1 firm i. Poor sales/earnings in a quarter b. Market risk (macro-econ) attributable to overall economic factors; non-diversifiable i. If interest rates rise, this effects ALL firms ii. Formula: Total Risk= Firm-Specific risk + Market risk Modern Portfolio Theory (risks reduced when securities are combines in a portfolio) a. Efficient portfolio is the combo of securities that produce the highest return for the amount of risk taken b. Optimal portfolio is the best portfolio of securities for the investors level of risk aversion c. Dominant Portfolio : higher expected return for the same (or less) risk, or the same (higher) expected return with lower risk

3.

Investment Return Sprint Corp stock ended prev. yr at $23.36/share. Paid $2.37/share dividend last yr. Ended last yr. at $18.89. If you owned 500 shares of Sprint, what was your $$ and % return?

a. $ Return= (End value-begin. Value) + Income (($18.89 x 500) ($23.26 x 500)) + $2.37 X 500 = -$1,050 b. % Return= ($ Return Begin. Value) (-$1,050 (($23.36 x 500)) = 8.99%

Dominant Portfolios Which one of 3 portfolios dominates. Name dominated portfolio & portfolio dominating it. Port. Blue has expected return of 12% & 18% risk. The expected return & risk of port. Yellow are 15% & 17%, & Purple port. are 14% & 21%

EXPECTED RETURNS

a.

(Risk Expected Return)

Blue:(1218)= .67

Yellow: (1517)=.88

Purple: (1421)= .67

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The return investors expect for taking on the risk of investing- its a forward-looking calculation (includes risk measures) 1. Clicker Q: the avg. of the possible returns expected from diff. scenarios weighted by the likelihood of those returns occurring 2. Formula: Expected Return= Sum of each return x Probability of that return (its the avg. of the possible returns weighted by the likelihood of those returns occurring)

RISK PREMIUMS
Asking- how much risk must an investor take to achieve their required return over time? 1. Asset pricings the process of directly specifying the relationship b.w. required risk & return 2. Clicker Q: This model includes an equation that relates a stock s required return to an appropriate risk premium Asset Pricing 3. Beta is a measure of the sensitivity of a stock or portfolio to market risk a. Measures the sensitivity of a stock or portfolio to market risk b. Beta greater than 1= more risky than market (higher risk premium) & Beta less than 1= less risky (lower risk premium) c. Standard Deviation measured volatility based upon historical data VS. Beta 4. Broad Index is the surrogate for the market 5. Required Return is the total return investors need for the level of risk taken & is made up of the risk free rate & a risk premium a. Capital Asset Pricing Model (CAPM) relates to return you should require for taking on various levels of market risk i. Market Risk Premium : the reward for taking general (systematic) stock marker risk Formula: Required Return= Risk-free rate + Risk premium a. Risk-free rate is the return on US Bonds & Bills and equals the real interest rate & the expects inflation prem. (RFR= RIR + IP) i. On treasury bills so investors can invest with no risk b. Risk Premium is the portion of the required reward investors require for taking the risk = risk on the market port. Less the risk-free rate (Rm Rf) i. Predicted on the market rate SNP 500 (the rate of the market risk)

Constant Growth Model for Required Return

a. Assumes stock is efficiently priced b. Uses dividend and price data and forward estimate c. Formula: i= Dividend Yield + Constant Growth

(use those that are expected) = D1/P0 + g

Portfolio Weights Investor owns $4,000 of Adobe stock, $5,000 of Dow Chem., & $5,000 of Office D. What are the port. weights of each stock?

a. Total Portfolio= $4,000 + $5,000 + $5,000= $14,000 b. Adobe weight= $4,000 $14,000= 0.2857 c. Dow weight= $5,000 $14,000= 0.3571 (and so on..)

Portfolio Return Year to date, Yum Brands earned a 3.80% return. During same time period, Raytheon earned 4.26% & Coke 0.46%. If you have portfolio made up of 30% Yum Brands, 30% Raytheon, & 40% Coke, whats your portfolio return?

a.

RP= (W1 X R1) + (W2 X R2) + (W3 + R3)

RP= (0.3 x 3.80%) + (0.3 x 4.26%) + (0.4 x -0.46%) RP= 2.23%

Expected Return Compute the expected return given these three economic states, their likelihoods, and the potential returns:

Econ State Fast growth Slow growth Recession

Probability 0.2 0.4 0.4

Return 40% 10 25

Expected Return= (0.2 x 40%) + (0.4 x 10%) + (0.4 x -25%) Expected Return= 2.5%

Required Return If the risk-free rate is 4 percent and the risk premium is 6 percent, what is the required return?

a. Required Return= 4% + 6% Required Return= 10%

Risk Premium The avg annual return on the S&P 500 Index from 1986 - 1995 was 15.8%. The avg annual T-bill yield during same period was 5.6%. What was the market risk premium during these 10 yrs?

a. Avg. Market Risk Premium= 15.8% - 5.6%

Avg. Market Risk Premium= 10.2%

CAPM Required Return Hastings Entert. has a beta of 0.24. If market return is expected to be 11% and the risk-free rate is 4%, whats Hastings required return?

a. CAPM Required return = Rf + (RM Rf) b. Hasting Expected Return= 4% + 0.24 x (11% - 4%) a. Pay Checks Risk Premium= 0.94 x (11% - 3%)

Expected Return= 5.68%

Company Risk Premium Paycheck, Inc. has a beta of 0.94. If market return is expected to be 11% & risk-free rate is 3%, whats Paychecks risk premium?

Risk Premium= 7.52%

Portfolio Beta You have a portfolio with a beta of 1.35. What will be the new portfolio beta if you keep 95% of your money in the old portfolio & 5% in a stock with a beta of 0.78?

a. New Portfolio Beta= (0.95 x 1.35) + (0.05 x 0.78) a. Required Return = Risk-free rate + Risk premium b. Required Return= ($2.69 $73.10) + 0.112

New Portfolio Beta= 1.38

Required Return Paccars current stock price is $73.10 & its likely to pay a $2.69 dividend next yr. Since analysts estimate Paccar will have an 11.2% growth rate, what is its required return?

Required Return= 14.88%