6-1

 Function of both return and risk

◦ At the center of security analysis
 Historical risk-return relationships useful
indicators
◦ No guarantee future will be like the past
◦ Also no reason to assume that relative relationships
will be much different in the future than they are
now
◦ Especially useful in the long-run

6-2
 Returns consist of two elements:
◦ Yield
 Periodic cash flows such as interest or dividends
 Measures return relative to purchase or current price
◦ Capital gain (loss)
 The change in price of the asset
 Total Return =Yield + Price Change
 Investors sometimes focus only on yield

6-3
 For comparing performance over time or across
different securities
 Total Return is a percentage relating all cash
flows received during a given time period,
denoted CFt + (PE - PB), to the start of period
price, PB
CFt  (PE  PB )
TR 
PB

6-4
 Total Return can be either positive or negative
◦ When cumulating or compounding, negative returns
are problem
 A Return Relative solves the problem because
it is always positive

CFt  PE
RR   1  TR
PB

6-5
 To measure return in dollars and reflect
compounding returns over a time period,
given a specific initial investment, use
Cumulative Wealth Index
 Cumulative Wealth Index, CWI , over n
n
periods =
WI0( 1  TR1)( 1  TR2 )...( 1  TRn )

6-6
 International investments subject to
exchange rate risk
◦ When you buy a foreign asset, you must use the
foreign currency, so you must first exchange home
currency
◦ If foreign currency depreciates, returns lower in
domestic currency terms
 Total Return in domestic currency =
 End Val. o f For.Curr . 
RR  Begin Val. of For.Cu rr.   1
 

6-7
 TR, RR, and CWI are useful for a given, single
time period
 What about summarizing returns over several

time periods?
 Arithmetic mean, or simply mean,

X
X 
n

6-8
 Arithmetic mean does not measure the
compound growth rate over time
◦ Does not capture the realized change in wealth over
multiple periods
◦ Does capture typical return in a single period
 Geometric mean reflects compound,
cumulative returns over more than one period
 Over multiple periods, the geometric mean

shows the true average compound growth

rate

6-9
 Defined as the n-th root of the product of n
return relatives minus one, or G =

( 1  TR1 )( 1  TR2 )...( 1  TRn )1/n  1

6-
10
 Return measures are nominal, i.e., are not
adjusted for inflation
◦ Purchasing power of investment may change over
time
◦ Nominal return = real return + expected inflation
rate
◦ Consumer Price Index (CPI) is possible measure of
inflation

1  TR 
TRIA  1
1  CPI 
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Risk

 Risk and return are opposite sides of the

same coin
 Risk is the chance that the actual outcome
from an investment will differ from the
expected outcome
 Investors willing to assume large risks may
gain large returns, but they may also lose
money

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 Interest Rate Risk  Financial Risk
◦ Affects income return ◦ Tied to debt financing
 Market Risk  Liquidity Risk
◦ Recession, war, etc. ◦ Marketability of
 Inflation Risk security in secondary
market
◦ Purchasing power
variability  Currency Risk
 Business Risk ◦ Exchange Rate Risk
 Country Risk
◦ Political stability

6-
13
 Risk arises from variability of outcomes
 Variance and standard deviation measure

variability
 Standard Deviation is simply the square root

of the variance

  X  X  2 1/ 2
s 
 n  1 
 

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Returns for Major Asset Classes
200

Spread in Returns for Major Asset Classes, 1962-2011

-60

Inflation Treasury Corporate Treasury S&P 500 Small

bills bonds bonds stocks
 Two general types:
◦ Systematic (general) risk
 Pervasive, affecting all securities, cannot be avoided
 Interest rate or market or inflation risks
◦ Nonsystematic (specific) risk
 Unique characteristics specific to issuer
 Total Risk = General Risk + Specific Risk

6-
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 Premium is additional return earned or
expected for additional risk
◦ Calculated for any two asset classes
 Equity risk premium is the difference between
stock and risk-free returns
◦ Stocks versus Treasury bills
◦ Stocks versus Treasury bonds

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 Equity Risk Premium, ERP, =



1 TR
CS 

1
 1 RF 

 




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 From 1926 - 2010, geometric average annual
return was 9.6% for S&P 500
 Arithmetic mean was 11.4%
 Standard deviation was 19.9%
 Smaller common stocks show greater risks

and returns than large common stocks in that

period
 T-bills showed lowest risk and return

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Cumulative Wealth Indexes
 Cumulative wealth index can be decomposed
into
◦ Dividend component: cumulative dividend yield
(CDY)
◦ Price change component: (CPC)

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