RISKS AND RETURNS 1 year Accurate rfr = [(1+r*) x (1+IP)] – 1
General Rule: More Risks = More Returns - SAMPLE PROBLEM: Unit 3A Part 1 – 12:35
- PREMIUMS ADDED TO r*: Unit 3A Part 1 – 15:45
Less Risks = Less Return - REQUIREMENTS OF THE PROBLEM: Unit 3A Part 1 –
TYPES OF INVESTORS 19:11
- HOW TO COMPUTE FOR THE INFLATION PREMIUM
- Risk Seeking - prefers high risk investments & MATURITY RISK PREMIUM: Unit 3A Part 1 – 21:54
- Risk Neutral - Indifferent to the degree of risk - INFLATION PREMIUM COMPUTATION: Unit 3A Part
involved in an investment 1 – 22:40
- Risk Averse - conservative, unwilling to take on high - MATURITY RISK PREMIUM COMPUTATION: Unit 3A
risk investments unless their turns justify and Part 1 – 24:50 & 26:38
compensates for the high risk taken
Relative Risk & Return of Asset Classes: UNIT 3A YIELD CURVE & THE TERM STRUCTURE OF INTEREST
PART 1 – 4:39 RATES
KINDS OF RISK - The yield curve is a graph of the term structure
- term structure – relationship between interest rates
- Credit Risk - the risk resulting from a borrower's (or yields) and maturities
failure to pay a loan or meet contractual obligations - upward slope due to an increase in expected
- Political Risk - the risk that an investment’s returns inflation and increasing maturity risk premium
could suffer because of political changes or Term Structure picture: UNIT 3A PART 1 – 27:46
instability in an economy
- Interest Rate Risk - is there a risk that there will be RELATIONSHIP BETWEEN THE TREASURY YIELD CURVE
a decline in the value of a security resulting from & THE YIELD CURVES FOR CORPORATE ISSUES
unexpected fluctuations (rising interest rates) in - Corporate yield curves are higher than that of
interest rates; the opposite of reinvestment rate Treasury securities, though not necessarily parallel
risk. to the Treasury curve.
- Market Risk – also known as systematic risk or non- - The spread between corporate and Treasury yield
diversifiable risk; occurs from the characteristics of curves widens as the corporate bond rating
an entire market or asset class. decreases.
DETERMINANTS OF MARKET INTEREST RATE Relationship between corporate and treasury yields
- Factors that determine the interest rate illustration: UNIT 3A PART 1 – 29:36
- Real risk-free rate (r*) - the interest rate that PURE EXPECTATIONS HYPOTHESIS (PEH)
would exist on a riskless security if no inflation
were expected or when inflation is zero during - The PEH contends that the shape of the yield curve
the investment period. It is the rate of interest depends on investor’s expectations about future
from riskless government securities in the interest rates
absence of inflation. - if interest rates are expected to increase, L-T rates
- Inflation Premium (IP) - inflation is the increase will be higher than S-T rates, and if interest rates
in the price overtime. When calculating IP, use are expected to decrease, S-T rates will be higher
the projected average inflation over the life of a than L-T rates. thus, the yield curve can slope up,
security. down, be flat, or even hump.
- Default Risk Premium (DRP) - the risk that the Problem: UNIT 3A PART 2 – 1:08
borrower will default on a loan (not pay the
RISKS ASSOCIATED WITH INVESTING OVERSEAS
principal and interest). Government issued
securities will have zero DRP. - Exchange Rate Risk - If an investment is
- Liquidity Premium (LP) - the premium added to denominated in the currency other than the
the rate of a security based on how quickly the Philippine peso, the investment’s value will depend
security can be converted back to cash near to on what happens to exchange rates.
its original cost. - Country Risk - Arises from investing or doing
- Maturity Risk Premium (MRP) - a premium that business in a particular country and depends on the
reflects interest rate risk. Securities with longer country's economic, political, and social
maturities have greater interest rate risk. environment.
Nominal risk – free rate (rfr) = an interest rate on a
security that has absolutely no risk at all, although
no securities are completely risk-free.
1 year Approximate rfr = r* + IP
MEASURES OF RETURNS MEASURES OF RISK
- Historical Returns - Variance of Rates of Returns (σ2)
Holding Period Return (HPR) Population Variance formula:
- Total return on an asset/portfolio over the N
period during which it was held Variance (σ2) = ∑ pi ¿ ¿)2
i=1
[ MV ¿ ¿ 1 – MV 0+ D]
Formula: { MV 0
¿ } N = the number of states
Pi = the probability of state i
- MV1 = market value, end Ri = the return on the stock in state i
- MV0 = market value, beginning E[R] = the expected return on the stock
- D = cumulative cash distributions (at the
end of the period) Sample Variance formula: UNIT 3A PART 3 –
Problems: UNIT 3A PART 2 – 9:38; 10:43; 2:21
14:51
- Standard Deviation of Rate of Returns (σ)
Annualized HPR
Population Standard Deviation formula:
Formula: ¿
UNIT 3A PART 3 – 3:41
- Alternative Measures N
Arithmetic Mean σ=√ ∑ pi ¿ ¿) 2
Geometric Mean i=1
Harmonic Mean
Problem: UNIT 3A PART 2 – 19:15; 21:41; 24:12
Sample Standard Deviation formula:
- Expected Returns
Typically, returns are not known with absolute
certainty
we need to determine the anticipated or
expected return on the given investment, based
on the asset’s (eg: stock investment) current - Coefficient of Variation (CV)
price and its expected future cash flows. Measures the risk per unit of return
Problem: UNIT 3A PART 2 – 31:42; 35:54 an alternative measure of standalone or
total risk of an investment
RISK
Population CV = σ/E(r)
- the chance that some unfavorable event will Sample CV = s/E(r)
occur
σ = population standard deviation
- Typically, risks are not known with absolute
s = sample standard deviation
certainty
E(r) = expected return on the stock
- Investment risk is the risk that the actual return
on your investment is less than expected
- Problem: UNIT 3A PART 3 – 5:05; 9:07; 12:00;
Example: UNIT 3A PART 3 – 0:28
13:42; 14:59; 19:28
RISKS MAY BE MEASURED ON A…..
LINKS TO SCIENTIFIC CALCULATOR METHOD: Unit
- Stand-alone basis 3A Part 3 – 21:30
The asset’s risk is considered in isolation
Example: Separately compute risks for Ayala
and Bayer
- Portfolio basis
The asset is held as one of a number of
assets in the portfolio
Example: Assuming that Anna invests in
both stocks, and these are the only
stocks in her portfolio, compute the risk
of her portfolio.
