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CF Lect 3

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2 views

CF Lect 3

Uploaded by

jesusfrjimenez
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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ZOOM lectures ?

Tuesday, November 5
Tuesday, November 12
Thursday, November 14
Tuesday, November 19
Tuesday, November 26

Which of these days would you prefer for Zoom lectures? We would still
keep the classroom booking, so anyone on campus could participate from
the classroom using their own device to join the Zoom session.
Status group assignment
Create groups

Select topic
Corporate Finance

Lecture 3: Risk and return (1)

Joacim Broth 2024


What is ”profit” or ”return”

• Everyone wants to make a profit


• How do we define profit?
– Accounting profit for a year
– Long term investments
• Profit is a vague concept, thus we use the terms
return or yield
• Several methods of calculating returns
Return – in the simplest way

• Absolute return = Difference between money


paid and received
r = CF1 + CF2 + …. + CFn
CF is a positive or negative Cash Flow

• Aritmetic annual return (amount of years= n)


r = (CF1 + CF2 +…+ CFn) / n
Geometric return
• Where CF´s are dependent (time by time added),
arithmetic return will give the wrong answer
• Example:
– You invest 100€ for 3 years
• Return Y1 is 40 %
• Return Y2 is 20 %
• Return Y3 is -30%
– Aritmetic annual return would be: (40+20-30)/3 = 10%

– Geometric return would be: (1,4 * 1,2 * 0,7)1/3 -1 = 5,6 %


• In this case, the next year´s return is earned on the
amount after the previous year, including that return
Geometric return

Where: “Ri”​ is the return for each period (e.g., each year). And “n” is the number of
periods.

- This approach provides a more accurate picture of the investment's overall


performance, especially when returns vary significantly across periods.
• register attendance
Simple interest and compound interest
• With compound interest, the interest (return) is calculated on the previous balance
• With simple interest, the interest (return) is calculated on the initial capital

Source: https://www.google.fi/search?q=graph+of+simple+and+compound+interest&tbm=isch&source=iu&ictx=1&fir=Yp-
B3FtKOEaBTM%253A%252C0xPoeZNhEFO5WM%252C_&usg=__tJkwJG_2QkYjVphRcc3sBx_KwNM%3D&sa=X&ved=
0ahUKEwjo7rjD3tnYAhUC8ywKHVSvBqAQ9QEIMjAB#imgrc=ndHSb-oOGXe9xM:
The time effect
• If you can choose between money now or money
later, which one will you choose?
• The rational investor will take the money now
because
– You can spend it on anything now if you want
– You can invest it and earn a return
• The only reason anyone would take the money later
is if you get compensation = return (interest)
• Calculations that consider the time effect use
discounting (next lecture's topic)
When to use what return concept?
• Absolute return = accounting profit
– Useless as it does not consider how much you had to
invest to get the profit nor the time it took to make it

• (Annualized) arithmetic return


– For cash flows that are independent, for example a fixed
rent. Does not consider the time value of money

• (Annualized) geometric return


– For cash flows that are dependent, for example profits
made on an investment portfolio. Does not consider the
time value of money
When to use what return concept?
• (Annualized) arithmetic return
– For cash flows that are independent, for example a fixed rent. Does not consider the time value of
money
: arithmetic return = average annual return

• (Annualized) geometric return


– For cash flows that are dependent, for example profits made on an investment portfolio. Does not
consider the time value of money

: Geometric return is useful when you have cash flows that depend on past performance or when you
want to understand the cumulative return on an investment over several periods. Instead of simply
taking an average annual amount, the geometric return takes into account how past returns affect
future values.
For investment portfolios or other investments with dependent cash flows, the geometric return is a
better measure of actual returns because it takes into account how past gains or losses affect the value
of the investment over time. The geometric return is often used when you want to assess the return
over several periods and when you want to see how an investment has developed over time without
disregarding the time value of money.
Risk
• The uncertainty regarding outcomes
• Can be positive or negative
• ”Real-life” risks
– Bankruptcy/default on payments
– Profits getting lower
– Profits getting higher
– Products flopping
– Products succeeding over expectations
– Currency getting stronger
– Etc
• Sometimes real risks cannot easily be measured
• Volatility of prices used as a surrogate risk measure as real
risks affect prices and thus volatility
Risk-return
• If you can choose between high risk and low risk,
why take the higher?
• Only if you expect a higher return to compensate
• If there is no risk, you can expect to earn the risk-
free rate of return (usually close to inflation)
• For risky investments the risk premium is relative to
the increase in risk
• Relative to the increase in risk means that if an
investment becomes more uncertain or volatile, the
investor expects a higher premium. (If the risk increases
significantly, the investor will demand a corresponding increase in potential returns to be
willing to take on the risk.)
The risk-free rate
• The only way to get anything more than the risk-free
rate is by taking risk!
• The risk-free rate is theoretical and does not exist in
reality
• But usually a strong government bond is considered
close to risk-free
Year 2023: (So followed inflation expectation)
– German six month government bond return = 2,7- 4,98%
– German 10 year government bond return = 2,5%
– German 30 year government bond return = + 2,6 to 3,0%

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