Risk

& Return in Capital Markets

Andreas Bange Diplom Betriebswirt (FH)

Risks & Return in Capital Markets

+++ MCO 201 +++ Finance +++ Spring 2016 +++

Risk & Return in Capital Markets

Lets see how an Investment would have grown if it were

invested from the End of 1929 until the beginning of 2012 in
each of the following:
Standard & Poors 500 (S&P 500)
Small Stocks
World Portfolio
Corporate Bonds
Treasury Bills

+++ MCO 201 +++ Finance +++ Spring 2016 +++

Andreas Bange Diplom Betriebswirt (FH)

A First Look at Risk & Return

Risk & Return in Capital Markets

Andreas Bange Diplom Betriebswirt (FH)

A First Look at Risk & Return

+++ MCO 201 +++ Finance +++ Spring 2016 +++

Risk & Return in Capital Markets

Andreas Bange Diplom Betriebswirt (FH)

Realized Returns in Percentage (%)

+++ MCO 201 +++ Finance +++ Spring 2016 +++

Risk & Return in Capital Markets

Computing Historical Returns

Realized Returns
Individual Investment Realized Returns
The realized return from your investment in the stock
from t to t+1 is:

Divt +1 + Pt +1 Pt Divt +1 Pt +1 Pt
Rt +1 =
=
+
Pt
Pt
Pt
= Dividend Yield + Capital Gain Yield

+++ MCO 201 +++ Finance +++ Spring 2016 +++

Andreas Bange Diplom Betriebswirt (FH)

Historical Risks & Returns of Stocks

Risk & Return in Capital Markets

Problem:
Microsoft paid a one-time special dividend of $3.08 on November 15,
2004. Suppose you bought Microsoft stock for $28.08 on November 1, 2004 and sold
it immediately after the dividend was paid for $27.39. What was your realized return
from holding the stock?
Solution Plan:
We can use the Equation to calculate the Realized Return.
We need the purchase price ($28.08), the selling price ($27.39), and the dividend
($3.08) and now we are ready to proceed.

Divt +1 + Pt +1 Pt Divt +1 Pt +1 Pt
Rt +1 =
=
+
Pt
Pt
Pt
= Dividend Yield + Capital Gain Yield
+++ MCO 201 +++ Finance +++ Spring 2016 +++

Andreas Bange Diplom Betriebswirt (FH)

Realized Return

Risk & Return in Capital Markets

Realized Return

t +1

Rt +1 =

Divt +1 + Pt +1 Pt Divt +1 Pt +1 Pt
=
+
Pt
Pt
Pt
= Dividend Yield + Capital Gain Yield

Divt +1 + Pt +1 Pt 3.08 + (27.39 28.08)

=
= 0.0851, or 8.51%
Pt
28.08

This 8.51% can be broken down into the Dividend Yield and the Capital Gain Yield:
Dividend Yield =

Divt +1
3.08
=
= .1097, or 10.97%
Pt
28.08

Capital Gain Yield =

Pt +1 Pt ( 27.39 28.08 )
=
= 0.0246, or 2.46%
Pt
28.08

Evaluate:
These returns include both the capital gain (or in this case a capital loss) and
the return generated from receiving dividends. Both Dividends and Capital
Gains contribute to the Total Realized Return.
+++ MCO 201 +++ Finance +++ Spring 2016 +++

Andreas Bange Diplom Betriebswirt (FH)

Execute:
Using the Equation, the Return from Nov 1, 2004 R
until Nov 15, 2004 is equal to

Risk & Return in Capital Markets

Problem:
Health Management Associates (HMA) paid a one-time special dividend
of $10.00 on March 2, 2007. Suppose you bought HMA stock for $20.33 on February
15, 2007 and sold it immediately after the dividend was paid for $10.29. What was
your realized return from holding the stock?
Solution Plan:
We can use the Equation to calculate the Realized Return.
We need the purchase price ($20.33), the selling price ($10.29), and the dividend
($10.00) and we are ready to proceed.

Divt +1 + Pt +1 Pt Divt +1 Pt +1 Pt
Rt +1 =
=
+
Pt
Pt
Pt
= Dividend Yield + Capital Gain Yield
+++ MCO 201 +++ Finance +++ Spring 2016 +++

Andreas Bange Diplom Betriebswirt (FH)

Realized Return

Risk & Return in Capital Markets

Realized Return

t +1

R t +1 =

Divt +1 + Pt +1 Pt Divt +1 Pt +1 Pt
=
+
Pt
Pt
Pt
= Dividend Yield + Capital Gain Yield

Div t +1 + Pt +1 Pt 10.00 + 10.29 20.33

=
= 0.002, or 0.2%
Pt
20.33

This -0.2% can be broken down into the Dividend Yield and the Capital Gain Yield:
Dividend Yield =

Divt +1 10.00
=
= 0.4919, or 49.19%
Pt
20.33

Capital GainYield =

Pt +1 Pt 10.29 20.33
=
= 0.4939, or 49.39%
Pt
20.33

Evaluate:

These returns include both the capital gain (or in this case a capital loss)
and the return generated from receiving dividends. Both dividends
and capital gains contribute to the total realized.
+++ MCO 201 +++ Finance +++ Spring 2016 +++

Andreas Bange Diplom Betriebswirt (FH)

Execute:
Using the Equation, the Return from February 15, R
2007 until March 2, 2007 is equal to

Risk & Return in Capital Markets

Problem:
Limited Brands paid a one-time special dividend of $3.00 on December 21,
2010. Suppose you bought LTD stock for $29.35 on October 18, 2010 and sold it
immediately after the dividend was paid for $30.16. What was your realized return
from holding the stock?
Solution Plan:
We can use the Equation to calculate the Realized Return.
We need the purchase price ($29.35), the selling price ($30.16), and the dividend
($3.00) and we are ready to proceed.

Divt +1 + Pt +1 Pt Divt +1 Pt +1 Pt
Rt +1 =
=
+
Pt
Pt
Pt
= Dividend Yield + Capital Gain Yield
+++ MCO 201 +++ Finance +++ Spring 2016 +++

Andreas Bange Diplom Betriebswirt (FH)

Realized Return

Risk & Return in Capital Markets

Realized Return

Rt +1 =

Rt +1 =

Divt +1 + Pt +1 Pt Divt +1 Pt +1 Pt
=
+
Pt
Pt
Pt
= Dividend Yield + Capital Gain Yield

Divt +1 + Pt +1 Pt 3.00 + 30.16 29.35

=
= 0.1298, or 0.12.98%
Pt
29.35

This 12.98% can be broken down into the Dividend Yield and the Capital Gain Yield:
Dividend Yield =

Divt +1 3.00
=
= 0.1022, or10.22%
Pt
29.35

Capital GainYield =

Pt +1 Pt 30.16 29.35
=
= 0.0276, or 2.76%
Pt
29.35

Evaluate:

These returns include both the capital gain (or in this case a capital loss) and
the return generated from receiving dividends. Both dividends and capital
gains contribute to the total realized.
+++ MCO 201 +++ Finance +++ Spring 2016 +++

Andreas Bange Diplom Betriebswirt (FH)

Execute:
Using the Equation, the Return from October 18,
2010 until December 21, 2010 is equal to

Risk & Return in Capital Markets

Computing Historical Returns

Individual Investment Realized Returns
For quarterly returns (or any four compounding periods that
make up an entire year) the annual realized return,
Rannual, is found by compounding:

1 + Rannual = (1 + R1 )(1 + R2 )(1 + R3 )(1 + R4 )

+++ MCO 201 +++ Finance +++ Spring 2016 +++

Andreas Bange Diplom Betriebswirt (FH)

Historical Risks & Returns of Stock

Risk & Return in Capital Markets

Compounding Realized Returns

Solution Plan:
We need to analyze the cash flows from holding MSFT stock for each quarter. In
order to get the cash flows, we must look up MSFT stock price data at the purchase
date and selling date, as well as at any dividend dates. From the data we can
construct the following table to fill out our cash flow timeline:

Next, compute the Realized Return between each set of dates.

Then determine the Annual Realized Return by compounding the returns
for all of the periods in the year.
+++ MCO 201 +++ Finance +++ Spring 2016 +++

Andreas Bange Diplom Betriebswirt (FH)

Problem:
Suppose you purchased Microsoft stock (MSFT) on Nov 1, 2004 and held
it for one year, selling on Oct 31, 2005. What was your annual realized return?

Risk & Return in Capital Markets

Compounding Realized Returns

Execute:
In the previous example, we already computed R = Div + P P = Div + P P
P
P
P
the Realized Return for Nov 1, 2004 to Nov 15,
= Dividend Yield + Capital Gain Yield
2004 as 8.51%. We now continue as in that example, using the Equation for each
period until we have a series of realized returns. For example, from Nov 15, 2004 to
Feb 15, 2005, the realized return is
t +1

t +1

t +1

t +1

Divt +1 + Pt +1 Pt 0.08 + (25.93 27.39)

Rt +1 =
=
= 0.0504, or 5.04%
Pt
27.39
The table below includes the realized return at each period.

+++ MCO 201 +++ Finance +++ Spring 2016 +++

Andreas Bange Diplom Betriebswirt (FH)

t +1

Risk & Return in Capital Markets

Compounding Realized Returns

1 + Rannual = (1 + R1 )(1 + R2 )(1 + R3 )(1 + R4 ) (1 + R5 )

1 + Rannual = (1.0851)(0.9496)(0.9861)(1.0675)(0.9473) = 1.0275
Rannual = 1.0275 1 = .0275 or 2.75%
Evaluate:
By repeating these steps, we have successfully computed the realized annual returns
for an investor holding MSFT stock over this one-year period.
From this exercise we can see that returns are risky. MSFT fluctuated up and down
over the year and ended-up only slightly (2.75%) at the end.

+++ MCO 201 +++ Finance +++ Spring 2016 +++

Andreas Bange Diplom Betriebswirt (FH)

Execute:
We then determine the one-year return by compounding.

Risk & Return in Capital Markets

Problem:
Suppose you purchased Health Management Associates stock (HMA) on
March 16, 2006 and held it for one year, selling on March 15, 2007. What was your
realized return?
Solution Plan:
We need to analyze the cash flows from holding HMA stock for each period. In order
to get the cash flows, we must look up HMA stock price data at the start and end of
both years, as well as at any dividend dates. From the data we can construct the
following table to fill out our cash flow timeline:
Date
16-Mar-06
10-May-06
9-Aug-06
8-Nov-06
15-Feb-07
2-Mar-07
15-Mar-07

Price
21.15
20.70
20.62
19.39
20.33
10.29
11.07

Dividend
0.06
0.06
0.06
10.00

Next, compute the Realized Return between each set of dates.

Then determine the Annual Realized Return by compounding the returns
for all of the periods in the year.
+++ MCO 201 +++ Finance +++ Spring 2016 +++

Andreas Bange Diplom Betriebswirt (FH)

Compounding Realized Returns

Risk & Return in Capital Markets

Compounding Realized Returns

Execute:
Div + P P Div
P P
=
+
In the previous example, we already computed R =
P
P
P
= Dividend Yield + Capital Gain Yield
the realized return for February 15, 2007 to
March 2, 2007 as -.2%. We continue as in that example, using the Equation for each
period until we have a series of realized returns. For example, from August 9, 2006
to November 8, 2006, the realized return is
t +1

t +1

R t +1 =

t +1

t +1

Div t +1 + Pt +1 Pt 0.06 + 19.39 20.62

=
= 0.0567, or 5.67%
Pt
20.62

The table below includes the realized return at each period.

Date
16-Mar-06
10-May-06
9-Aug-06
8-Nov-06
15-Feb-07
2-Mar-07
15-Mar-07

Price
21.15
20.70
20.62
19.39
20.33
10.29
11.07

Dividend

Return

0.06
0.06
0.06

-1.84%
-0.10%
-5.67%
4.85%
-0.20%
7.58%

10.00

+++ MCO 201 +++ Finance +++ Spring 2016 +++

Andreas Bange Diplom Betriebswirt (FH)

t +1

Risk & Return in Capital Markets

Compounding Realized Returns

1 + Rannual = (1 + R1 )(1 + R2 )(1 + R3 )(1 + R4 )(1 + R5 )(1 + R6 )

1 + Rannual = (0.982)(0.999)(0.943)(1.048)(0.998)(1.076)
Rannual =1.0411 1 = .0411or 4.11%
Evaluate:
By repeating these steps, we have successfully computed the realized annual returns
for an investor holding HMA stock over this one-year period. From this exercise we
can see that returns are risky. HMA fluctuated up and down over the year and
yielded a return of only 4.11% at the end.

+++ MCO 201 +++ Finance +++ Spring 2016 +++

Andreas Bange Diplom Betriebswirt (FH)

Execute:
We then determine the one-year return by compounding.

Risk & Return in Capital Markets

Problem:
You are playing a very simple gambling game with your friend:
a $1 bet based on a coin flip. That is, you each bet $1 and flip a coin: heads you win
your friends $1, tails you lose and your friend takes your dollar.
How is your risk different if you play this game 100 times in a row versus just betting
$100 (instead of $1) on a single coin flip?

Solution Plan:
The risk of losing one coin flip is independent of the risk of losing the next one.
Each time you have a 50% chance of losing, and one coin flip does not affect any
other coin flip.
We can compute the expected outcome of any flip as a weighted average by
weighting your possible winnings (+$1) by 50% and your possible losses (-$1) by
50%.
Then we can compute the probability of losing all $100 under either scenario.

+++ MCO 201 +++ Finance +++ Spring 2016 +++

Andreas Bange Diplom Betriebswirt (FH)

Diversification

Risk & Return in Capital Markets

Execute:
If you play the game 100 times, you should lose about 50 times and win
50 times, so your expected outcome is 50 (+$1) + 50 (-$1) = $0.
You should break-even.
Even if you dont win exactly half of the time, the probability that you would lose all
100 coin flips (and thus lose $100) is exceedingly small (far less than 0.0001%).
If this happens, you should take a very careful look at the coin!
If instead, you make a single $100 bet on the outcome of one coin flip, you have a
50% chance of winning $100 and a 50% chance of losing $100, so your expected
outcome will be the same: break-even.
However, there is a 50% chance you will lose $100, so your risk is far greater than it
would be for 100 one dollar bets.
Evaluate:
In each case, you put $100 at risk, but by spreading-out that risk across 100 different
bets, you have diversified much of your risk away compared to placing
a single $100 bet.
+++ MCO 201 +++ Finance +++ Spring 2016 +++

Andreas Bange Diplom Betriebswirt (FH)

Diversification