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60 Cards in this Set

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Return
- The level of profit from an investment, or

- The reward for investing
Components of Return
- Income: cash or near-cash that is received as a result of owning an investment

- Capital gains (or losses): the difference between the proceeds from the sale of an investment and its original purchase price
Total Return
the sum of the income and the capital gain (or loss) earned on an investment over a specified period of time
Why Return is Important
- Allows comparison of actual or expected gains with the levels of gain needed

- Allows us to “keep score” on how our investments are doing compared to our expectations

- Historical Performance

- Expected Return
Key Factors in Return
- Internal Characteristics
* Type or risk of investment
* Issuer’s management
* Issuer’s financing
- External Forces
* Political environment
* Business environment
* Economic environment
* Inflation
* Deflation
The Time Value of Money and Returns
- The sooner you receive a return on a given investment, the better

- A dollar received today is worth more than a dollar received in the future

- The sooner your money can begin earning interest, the faster it will grow
Satisfactory Investment:
one for which the present value of benefits equals or exceeds the present value of its costs
Required Return
The rate of return an investor must earn on an investment to be fully compensated for its risk
Required Return formula
RR on Investment = Real rate of Return+Expected inflation premium+Risk premium or investment
Real Rate of Return
- Equals the nominal rate of return minus the inflation rate

- Measures the change in purchasing power provided by an investment
Expected Inflation Premium
The average rate of inflation expected in the future
Risk-free Rate
- The rate of return that can be earned on a risk-free investment

- The most common “risk-free” investment is considered to be the 3-month U.S. Treasury Bill
Risk-free Rate Formula
Risk Free Rate = Real Rate of Return+Expected Inflation Premium
Risk Premium
- Additional return an investor requires on a risky investment to compensate for risks based upon issue and issuer characteristics

- Issue characteristics are the type, maturity and features

- Issuer characteristics are industry and company factors
Holding Period
the period of time over which an investor wishes to measure the return on an investment vehicle
Realized Return:
current return actually received by an investor during the given return period
Paper Return
return that has been achieved but not yet realized (no sale has taken place)
Holding Period Return
The total return earned from holding an investment for a specified holding period (usually 1 year or less)
Holding Period Return formula
= current income during period + Capital gain (Loss) during period / Beg investment vaule
Advantages of Holding Period Return
- Easy to calculate

- Easy to understand

- Considers income and growth
Disadvantages of Holding Period Return
- Does not consider time value of money

- Rate may be inaccurate if time period is longer than one year
Internal Rate of Return:
determines the compound annual rate of return earned on an investment held for longer than one year
Yield (IRR) Example:
What is the yield (IRR) on an investment costing $1,000 today that you expect will be worth $1,400 at the end of a 5-year holding period?
Advantages of IRR
- Uses the time value of money

- Allows investments of different investment periods to be compared with each other

- If the yield is equal to or greater than the required return, the investment is acceptable
Disadvantages of Internal Rate of Return
Calculation is complex
Reinvestment Rate
is the rate of return earned on interest or other income received from an investment over its investment horizon.
Fully compounded rate of return
is the rate of return that includes interest earned on interest.
Rate of Growth
- The compound annual rate of change in the value of a stream of income

- Used to see how quickly a stream of income, such as dividends, is growing
Risk-Return Tradeoff
is the relationship between risk and return, in which investments with more risk should provide higher returns, and vice versa
Risk
is the chance that the actual return from an investment may differ from what is expected
Currency Exchange Risk
is the risk caused by the varying exchange rates between the currencies of two countries.
Currency Exchange Risk: Types of Investments Affected
- International stocks or ADRs

- International bonds
Currency Exchange Risk: Examples of Currency Exchange Risk
U.S. dollar gets “stronger” against foreign currency, reducing value of foreign investment
Business Risk
is the degree of uncertainty associated with an investment’s earnings and the investment’s ability to pay the returns owed to investors.
Business Risk: Types of Investments Affected
- Common stocks

- Preferred stocks
Business Risk: Examples of Business Risk
- Decline in company profits or market share

- Bad management decisions
Financial Risk
is the degree of uncertainty of payment resulting from a firm’s mix of debt and equity; the larger the proportion of debt financing, the greater this risk.
Financial Risk: Types of Investments Affected
-Common stocks

- Corporate bonds
Financial Risk: Examples of Financial Risk
- Company can’t get additional loans for growth or to fund operations

- Company defaults on bonds
Purchasing Power Risk
is the chance that changing price levels (inflation or deflation) will adversely affect investment returns.
Purchasing Power Risk: Types of Investments Affected
- Bonds (fixed income)

- Certificates of deposit
Purchasing Power Risk: Examples of Purchasing Power Risk
Movie that was $8.00 last year is $9.00 this year
Interest Rate Risk
is the chance that changes in interest rates will adversely affect a security’s value.
Interest Rate Risk: Types of Investments Affected
- Bonds (fixed income)

- Preferred stocks
Interest Rate Risk: Examples of Interest Rate Risk
- Market values of existing bonds decrease as market interest rates increase

- Income from an investment is reinvested at a lower interest rate than the original rate
Liquidity Risk
is the risk of not being able to liquidate an investment conveniently and at a reasonable price.
Liquidity Risk: Types of Investments Affected
Some small company stocks
Real estate
Liquidity Risk: Examples of Liquidity Risk
The price of a house has to be lowered for a quick sale
Tax Risk
is the chance that Congress will make unfavorable changes in tax laws, driving down the after-tax returns and market values of certain investments.
Tax Risk: Types of Investments Affected
- Municipal bonds

- Real estate
Tax Risk: Examples of Tax Risk
- Lower tax rates reduce the tax benefit of municipal bond interest

- Limits on deductions from real estate losses
Market Risk
is the risk of decline in investment returns because of market factors independent of the given investment.
Market Risk: Types of Investments Affected
All types of investments
Market Risk: Examples of Market Risk
- Stock market decline on bad news

- Political upheaval

- Changes in economic conditions
Event Risk
comes from an unexpected event that has a significant and unusually immediate effect on the underlying value of an investment.
Event Risk: Types of Investments Affected
All types of investments
Event Risk: Examples of Event Risk
- Decrease in value of insurance company stock after a major hurricane

- Decrease in value of real estate after a major earthquake
Measures of Risk: Single Asset
- Standard deviation is a statistic used to measure the dispersion (variation) of returns around an asset’s average or expected return

- Coefficient of variation is a statistic used to measure the relative dispersion of an asset’s returns; it is useful in comparing the risk of assets with differing average or expected returns

- Higher values for both indicate higher risk
Acceptable Levels of Risk Depend Upon the Individual Investor
- Risk-indifferent describes an investor who does not require a change in return as compensation for greater risk

- Risk-averse describes an investor who requires greater return in exchange for greater risk

- Risk-seeking describes an investor who will accept a lower return in exchange for greater risk
Steps in the Decision Process: Combining Return and Risk
- Estimate the expected return using present value methods and historical/projected return rates

- Assess the risk of the investment by looking at historical/projected returns using standard deviation or coefficient of variation of returns

- Evaluate the risk-return of each investment alternative to make sure the return is reasonable given the level of risk

- Select the investment vehicles that offer the highest expected returns associated with the level of risk you are willing to accept