Risk and Return from Investing - Investment Management by Charles P Jones

Chapter 6-Risk and Return from Investing

Q 6-1: Distinguish between historical returns and expected returns?
Historical returns are the returns that have realised in the past and expected returns are yet to
materialise. Historical returns provide the investor with a trend upon which he builds up his
future expectations.
Q 6-2: How long an asset must be held to calculate a TR?
TR implies total return. The two components of TR are periodic cash flows and capital
gains. Period cash flow may be in the form of interest or dividends. Capital gain refers to the
changeappreciation or depreciationin price. While the capital gains can be earned in
minutes, periodic cash flow income comes in intervals of no less than a quarter. Usually the
interest payments are semi-annual, while the dividends may or may not be announced in a
particular year. However, in certain conditions , an investor can earn a yield without keeping
the security for too long. Such a phenomenon can take place, in case the investor buys the
security of a company which is just about to announce dividends and sells immediately after
receiving the dividend payment. No matter how the cash inflows are coming TR is usually
calculated and expressed in annual terms.
Q 6-3: Define the components of total return. Can any of these components be
negative?
Return on a typical investment consists of two components
1) yield
2) capital gain (loss)
Yield is the periodic cash flow (or return on investment in the form of interest or dividends).
The issuer makes the payment in cash to the holder of the asset, but in some cases, this
part of the return can also be in the form of additional securities, rather than cash. Capital
gain (loss) is the appreciation (depreciation) in the price of the asset. It is also referred to as
price change. It is the difference between the purchase price and the price at which the
asset can be sold. For a short position, it is the difference between the sales price and the
price at which the short position would be closed. In either case, a gain or loss would occur.
Total return can be obtained by adding up the two components of return. However an
important thing to note is that yield can be either zero or greater than zero, but capital gain
can be greater or equal to zero and can also be less than zero. If an investor purchases
security at a higher price and sells it at a lower price, he would be having capital gains in
negative which is a capital loss.
Q 6-4: Distinguish between total return and holding period return?
The total return refers to the sum of capital gains and periodic cash flows received during
the holding period, whereas the holding period return refers only to the yield from holding
the security and the gain or loss resulting from selling the security is not accounted for.
Q 6-5: When should the geometric mean returns be used to measure return? Why will it
always be less than the arithmetic mean?

Geometric mean is used as a measure of central tendency when percentage changes in

value overtime is involved. This measure is used to calculate the compound rate at which
money actually grew overtime. Geometric mean would always be less than the arithmetic
mean unless all the values are identical, having no deviation from the mean. Geometric
mean takes into account the data dispersion, while the arithmetic mean only gives the
central tendency. The relationship between the two means can be expressed as (1+GM) 2=
(1+AM)2 SD2 , which also substantiates the fact that the two means cannot be equal unless
the standard deviation equals zero.
Q 6-6: When should the arithmetic mean be used for measuring stock returns?
Arithmetic mean is the average return for a series and is used to measure the performance
of a stock for a single period. Investors usually use arithmetic mean as a measure of central
tendency when aggregating historical returns. For future returns geometric mean may be a
batter measure.
Q 6-7: What is the mathematical linkage between the arithmetic mean and geometric mean
for a set of security returns?
The mathematical relationship between the two means can be expressed as (1+GM)2 =
(1+AM)2 SD2
Q 6-8: What is the equity risk premium?
A risk premium is the additional return investors expect to receive or did receive by taking
on additional amount of risk. Equity risk premium (ERP), in this context can be
mathematically explained as the difference between the return on a stock and a risk free
security. The level of equity risk premium increases as the share becomes more and more
risky.
Q 6-9: If in a given period, the stocks provide more return than bonds, how can stocks be
considered more risky?
The very fact that the stocks are providing more return gives evidence of their being more
risky. A high return is a reward for taking a higher risk. Moreover, shareholders are the
residual claimants in case of both profit distribution and liquidity of the firm, while the
bondholders have a claim on assets prior to shareholders, hence the risk in shares is
greater than in bonds.
Q 6-10: Distinguish between market risk and business risk? How is interest rate risk related
to inflation risk?
The variability in the returns resulting from fluctuations in the overall marketthat is the
aggregate stock marketis referred to as market risk. Market risk includes a wide range of
factors exogenous to securities, including recession, war, structural changes in economic
and political conditions, law and order, as well as changes in the consumer preferences. On
the other hand, the risk of doing business in a particular industry or environment is
called business risk. For instances, chances that a particular industry is going to face
stringent policies from the government can give rise to business risk.
Q 6-11: Classify the traditional sources of risk as to whether they are general or specific
sources of risk.
Following traditional sources of risk fall in the category of general or systematic risk.
1.
Interest rate risk: the variability of a securitys returns resulting from changes
in the market interest rates is referred to as interest rate risk. Other things being

equal, the returns of the securities move inversely with the market interest rates.
Interest rate risk affects bonds more directly than stocks and is considered as one of
the major risks faced by bondholders.
2.
Market risk: the variability in returns as a result of fluctuations in the overall
marketthat is the aggregate stock marketis referred to as market risk. Market
risk includes a wide range of factors exogenous to securities, including recession,
war structural changes in economy, political conditions, , law and order, and changes
in the consumer preferences.
3.
Inflation risk: A factor affecting all securities is the purchasing power riskthe
chance that the purchasing power of invested dollars would decline. With uncertain
inflation, the real return involves risk even if the nominal return is safe. This risk is
also related to the interest rate risk, since he interest rate generally rises as the
inflation increases, because lenders demand additional premium to compensate for
the loss of purchasing power.
4.
Exchange rate risk: Exchange rate risk is the variability in returns caused by
currency fluctuations. Exchange rate risk is also known as currency risk.
5.
Country risk: Country risk, also known as the political risk is important for
investors. With more investors investing internationally, both directly and indirectly,
the political and therefore economic stability and viability of a countrys economy
need to be considered. United States, until the end of the last century was
considered to have the lowest country risk, and Pakistan was quite risky. However,
with the turn of the new century, the situation has immensely changed.
The following sources of risk fall in non-systematic category, also known as specific risk.
1.
Business risk: The risk of doing business in a particular industry or
environment is known as business risk.
2.
Financial risk: Financial risk is associated with the use of debt financing by
companies. The larger proportion of assets financed by debt, the larger the variability
in returns, other things being equal.
3.
Liquidity risk: Liquidity risk is the risk associated with the particular secondary
market in which a security trades. The more uncertainty about the time element or
concession to sell the security, the greater the liquidity risk.
Q 6-12: Explain what is meant by country risk?
Country risk, also known as political or sovereign risk, is significant to investors. With more
investors investing internationally, both directly and indirectly, the political and economic
viability of the country. United States is arguably considered to be the country with minimum
political risk[1]. The political risk of Pakistan is assumed to be quite high due to intermittent
shifts in power from democracy to dictatorship. When a country faces political turmoil, the
government makes most of its policies on ad hoc basis and the investors cannot be certain
about their returns from different sectors of economy, increasing the risk on their
investments.
Q 6-13: Assume that you purchase a stock on Japanese market, denominated in yen.
During the period you hold back the stock, the yen weakens relative to the dollar. Assume
you sell on profit on the Japanese market. How will your return, when converted into dollars,
be affected?

The return when adjusted to the currency changea decline in this casewould result in a
return less than what was calculated in yen denomination. If the change in the value of the
currency is large, the profits may turn into losses when translated from yen to dollar
denominations.
Q 6-14: Define risk. How does the use of standard deviation as a measure of risk relate to
this definition of risk?
Risk may defined as the chance that the realised return would be different from the
expected return. Usually, the investors build their expectations upon what they have
experienced in the past. If they have secured a certain amount of return every year on a
particular security, without any change for a considerable period of time, as in the case of
treasury bills, there may not be any difference between the expected return and the realised
return.
Standard deviation is a measure of data dispersion from the central tendency. If the values
of a particular data were extremely high or low, such a data would have a higher standard
deviation. As for the treasury bills, since the realised return has not been deviated from the
expected return for a considerable period of time, the standard deviation of the returns
would be zero, making the treasury bill a risk-free security.
Q 6-15: Explain verbally the relationship between the geometric mean and a cumulative
index?
A cumulative index is a measure of increase in the level of wealth, whereas the geometric
mean describes the average growth rate at which the wealth has increased.
Q 6-16: If the geometric mean return for stocks over a long period has been around 11
percent and the returns on corporate bonds for some recent years have been averaged
approximately at this rate. This leads some to recommend that investors avoid stock and
purchase bonds because the returns are similar and risk is far less in bonds. Critique this
argument.
The statement acknowledges that the investors builds his hopes on his past experience, but
ignores the fact that rational investors know that the stock market is about uncertainty and
the historical cycle of returns may not repeat itself, even if the history does! They also know
that a high return is the reward of assuming high risk. Even if the high risk securities like
stock (in comparison to bonds) have not performed well in the past and the bonds did. It
does not mean that the trend is going to continue forever. Moreover, it is quite likely that the
bonds might be paying a high coupon rate because of high market interest rate prevailing at
this time. The likelihood that the interest rates would remain where they are at the moment.
If the interest rates fall in future, most of the bonds offering a high coupon rate, are likely to
be called. If the bonds are called by the issuer, the bondholder is likely to get the call price,
rather than the existing market price of the bond. This makes long term to exposure to
bonds somewhat risky.
Q 6-17: Explain how the geometric mean and annual geometric mean inflation rate can be
used to calculate inflation adjusted returns over the period 1920-2000?
If we divide the geometric mean rate of return for the period 1920-2000, by the geometric
mean inflation rate during the same period, we would get the inflation-adjusted stock returns
for the entire period.

Q 6-18: Explain the two components of the cumulative wealth index for common stocks. If
we know one of these components on a cumulative wealth basis, how can the other be
calculated?
The cumulative wealth index equals the per dollar cumulative total return and can be
decomposed into two components, the yield component and the price change component.
Since CWI is a multiplicative relationship, the total changes of the yield and the price
change can be multiplied to get the geometric mean of the total return.
GTR = GY X GPC
If we know the cumulative yield component and the cumulative wealth index, we can
calculate the cumulative price change with the help of the following formula.
CPC = CWI/CYI, where CPC = cumulative price change, CYI = cumulative yield index, CWI
= cumulative wealth index. Similarly, if the cumulative price change and cumulative wealth
index are known, the cumulative yield index can be calculated by dividing the CWI by CPC.
Q 6-19: Common stocks have returned less than twice the compound annual rate of return
for corporate bonds. Does this mean that the common stock are almost twice as risky as the
corporate bonds?
Although risks and returns have a positive relationship, i.e., the returns increase as the risk
increases, but that does not mean that that any change in risk would result in a proportional
change in return. As we see in case of treasury bills, we can have a risk free return if we
take no risk, however, when an investor takes some risk, he expects a premium as a
compensation for taking risk. Doubling the risk would not double the return. Hence, risk of
the securities need to be assessed considering a number of factors. One percent change in
risk would not ensure that the change in return would also be one percent, it can be higher
or lower depending upon numerous micro and macro environmental factors influencing the
returns of a company.
Q 6-20: What does it mean if the cumulative wealth index for government bond over a long
period is 0.85?
A value less than one for cumulative wealth index means that actual wealth of the investor
has declined over the period from its initial level. Since the government bonds offer low
returns, it is probable that if the CWI is adjusted against inflation, the level of wealth may
decrease from its initial level.
Q 6-21: Fundamental to investing is the control of the investment risk, while maximizing
total investment return. Identify four primary sources of risk and explain the possible impact
on investment returns?
The four primary sources of risk are
1) Interest rate risk: The variability of a securitys returns resulting from the changes in the
interest rates is referred to as interest rate risk. Other things being equal, returns move
inversely with interest rates. Interest rate risk affects bonds more directly than common
stocks and is a major risk faced by all bondholders.
2) Inflation risk: a factor affecting all securities is the purchasing power risk. It is the chance
that the purchasing power of the invested dollars would decline. With uncertain inflation the
real return involves risk even if the nominal return is safe. This risk is related to the interest
rate risk, since the interest rates generally rise as the inflation increases. It is because the
investor demands additional premium to compensate for the loss of purchasing power.
3) Financial risk: Financial risk is associated with debt financing by companies. The larger
proportion of assets financed by debts, the larger the variability in return other things being
equal.

4)

Liquidity risk: Liquidity risk is associated with particular secondary market in which the
security trades. The more uncertainty about the time element and price concession, the
greater the liquidity risk.
The first two sources of risk are classified as general risks. These risks affect the overall
market and best of the investors with best of the portfolios might not be able to escape
those risks. The last two sources of risks fall in the category of specific risks as they belong
to the specific securities. Such risks are easier for investor to avoid.

[1] The notion of United States being a politically risk-free country turned out to be a myth

after September 11 incident. However some of the bitter critics had started questioning the
US economic stability (which ensures the political stability) as the status of the country
changed from being one the worlds largest lender to the worlds biggest debtor country in a
span of few years.
e ' i t ? r offers to sell shares. The dealer profits from the spread between the
two prices. The dealers also share profits with the brokerage firms for supplying the order.
This is called payment of the order flow.