Chapter 10: Risk and return:

lessons from market history

Corporate Finance
Ross, Westerfield, and
Jaffe
Outline

1. Returns
2. Capital market returns
3. Portfolio risk statistics
Dollar return

 Suppose that you bought a bond for $1050 a year

ago. You have received two semiannual coupons of
$50 each. The market price of the bond today is
$1100. What is your total dollar return?
 Income = 50 + 50 = $100.
 Capital gain = 1100 – 1050 = $50.
 Total dollar return = 100 + 50 = $150.
 Total dollar return = income + capital gain (loss).
Percentage return

 It is more intuitive to think of returns in terms of

percentages.
 Return = (ending value – beginning value) /
beginning value.
 Return = ((1100 + 100) – 1050) / 1050 = 14.29%.
 Return = income yield (return) + capital gain yield
(return) = 100 / 1050 + 50 / 1050 = 9.52% + 4.76% =
14.29%.
Holding period return

 Holding period return: the cumulative

return that an investor would obtain
when holding an investment over a
period of N years.
Holding period return example

 Suppose that an investment yielded 4%, 7%,

8%, 0%, and 10% for the past 5 years. What
is the holding period return for the 5 years?
 Holding period return = (1 + 4%) × (1 + 7%) ×
(1 + 8%) × (1 + 0%) × (1 + 10%) – 1 =
32.2%.
Why capital market returns?

 Examining capital market returns helps us

determine the appropriate returns on non-
financial assets (e.g., firm projects).
 Lessons from capital market return history:
– There is a reward for bearing risk.
– Return is positively related to risk.
– This is called the “risk-return tradeoff.”
Average return, I

 The simple average of a series of returns is

called arithmetic average return.
 Geometric average return: average
compound return per period over multiple
periods.
Average return example

Year Ret Arithmetic R 1 + Ret Power of 1/N Geometric R

1 0.08 0.076 1.08 1.074811381 0.07481138
2 -0.01 0.99
3 0.12 1.12 GR < AR
4 0.13 1.13
5 0.06 1.06
Multiplication term 1.4344
Average return, II

 The geometric average will be less than the

arithmetic average unless all the returns are equal.
 The arithmetic average is overly optimistic for
multiple horizons.
 If the investment horizon is only 1 period, the
arithmetic average is a better measure of likely
return.
 Arithmetic average return based on historical returns
are often used as an estimate of expected return in
real life.
Portfolio risk statistics

 An investor cares about the return variability

of her/his portfolio.
 This variability at the portfolio level is usually
measured by variance and/or standard
deviation (std.).
Portfolio risk statistics, example

Year Ret Arithmetic R Diff Diff^2 Var Std

1 0.08 0.076 0.004 0.000016 0.00313 0.055946
2 -0 -0.086 0.007396
3 0.12 0.044 0.001936
4 0.13 0.054 0.002916
5 0.06 -0.016 0.000256
Sum 0.01252
Historical performance, 1926-2008

Average Return Std

Large stocks 11.7% 20.6%
Small Stocks 16.4% 33.0%
L-T Corporate Bonds 6.2% 8.4%
L-T Government Bonds 6.1% 9.4%
U.S. Treasury Bills 3.8% 3.1%
Inflation 3.1% 4.2%
If normally distributed?

 If we are willing to assume that asset returns

are normally distributed, can you draw a
return distribution based on the previous
slide?
 Hint: about 95% within +/– 2 std.
End-of-Chapter

 Concept questions: 1-10.

 Questions and problems: 1-16 and 19-23.