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Contemporary Investments: Chapter 2
Chapter 2 FUNDAMENTALS OF RISK AND
RETURN• What are the sources of investment returns?
• How are investment returns measured?
• What is investment risk and how is it measured?
• How are risk and return measured for portfolios of assets?
• Why does diversification benefit investors?
• What is the relationship between risk and required return?
Contemporary Investments: Chapter 2
Sources of investment returns• Income
• Interest
• Dividends
• Price changes: Capital gains or Capital losses
• Paper gains and losses
• Ex-ante and ex-post returns
Contemporary Investments: Chapter 2
Measuring investment returns• Calculating holding period returns
• Breaking down returns between income and capital gains
• Calculating expected returns
• Inflation adjusted returns
• International returns
• Total return indexes
Contemporary Investments: Chapter 2
Investment History –The Agony of Bond Investors: 1965-1981
Contemporary Investments: Chapter 2
Figure 2.1 – Total Return Index for Johnson & Johnson: 1991-2001
Contemporary Investments: Chapter 2
Summarizing returns
• Arithmetic mean
• Annualizing the arithmetic mean
• Geometric mean
• Comparing the geometric and arithmetic means
Contemporary Investments: Chapter 2
Investment risk
• A definition of risk: uncertainty of return
• Types (sources) of risk
• Default, Credit, Tax, Interest Rate, Market, Event, Liquidity, Foreign Exchange
• Measuring risk
• Calculating a standard deviation
• Annualizing a standard deviation
Contemporary Investments: Chapter 2
Figure 2.2 – Probability of Possible Return
Contemporary Investments: Chapter 2
Figure 2.3 – Stock and T-Bill Returns: 1982-2001
Contemporary Investments: Chapter 2
Figure 2.4 – Monthly Returns for 3M and Starbucks
Contemporary Investments: Chapter 2
Risk, return and investment selection
• Portfolio risk and return
• Finding the mean return of a portfolio
• Finding the standard deviation of a portfolio
• Correlation coefficient
Contemporary Investments: Chapter 2
Figure 2.5 – Monthly Returns for Dow Chemical and Verizon Communication
Contemporary Investments: Chapter 2
Diversification
• Naïve versus efficient diversification
• Diversifiable versus non-diversifiable risk
• Diversifiable or unsystematic risk
• Non-diversifiable or systematic risk
• Beta
• Risk and required return
Contemporary Investments: Chapter 2
Figure 2.6 – Real and Nominal Returns on T-Bills: 1981-2001
Contemporary Investments: Chapter 2
Figure 2.7 – Yields on T-Bills, T-Bonds, and Baa Corporate Bonds: 1988-2002