Chapter 2 - Measure of Return and Risk

Measure of
Return and
Risk
Measure of Return and Risk
At the end of the chapter the student should:
-Understand how to choose among alternative
investment assets.
- Can estimate and evaluate the expected risk
return trade-offs for the alternative investments
available.
- Able to measure the rate of return and the risk
involved in an investment accurately.
- Able to measure both historical and expected
rates of return and risk.
Subject Teacher: Flormelyn D. Tumenez

Financial Management and Accountancy Department
College of Business Education
COMPONENTS OF RETURN
INCOME
- To be considered income, it must be in the form of cash or
be readily convertible into cash.
- an investment’s income is usually cash that investors
periodically receive as a result of owning an investment.
CAPITAL GAINS (OR LOSSES)

- the amount of which the proceeds from the sale of an
investment exceeds the original purchase price.
- if an investment sells for less than its original purchase price,
a capital loss results
INVESTMENT
A B
Purchase Price 1,000 1,000

Cash received
1st quarter 10 0
2nd quarter 20 0
3rd quarter 20 0
4th quarter 30 0
total income 80 120
Sale price 1,100 960
Total return of two investment
Investment
A B
RETURN
Income 80 120
Capital gain (loss) 100 (40)
Total return 180 80
Investment A earned 18%(180/1000) and B earned 8%

(80/1000)
WHY RETURN IS IMPORTANT?

Measure of Historical Rates of Return
If you commit $200 to an investment at the beginning of the

year and you get back $220 at the end of the year, what is
your return for the period?
The period during which you own an investment is called its
holding period, and the return for that period is the holding
period return (HPR).
In this example, the HPR is 1.10, calculated as follows:
HPR = Ending Value of Investment / Beginning Value of Investment
= $220 / $200
=1:10

The equation for Holding Period Return (HPR)
HPR= Income during prd + Capital gain (loss during prd)

Beginning investment value
HOLDING PERIOD RETURN (HPR).
-HPR value will always be zero or greater—that is, it can
never be a negative value.
-A value greater than 1.0 reflects an increase in your wealth,
which means that you received a positive rate of return
during the period.
-A value less than 1.0 means that you suffered a decline in
wealth, which indicates that you had a negative return
during the period.
-An HPR of zero indicates that you lost all your money
(wealth) invested in this asset.
-Although HPR helps us express the change in value of an
investment, investors generally evaluate returns in
percentage terms on an annual basis.

Using HPR in Investment Decisions
The holding period return is easy to use in making

investment decisions. Because it considers both income
and capital gains relative to the beginning investments of
different size.
HPR provides logical method for evaluating and comparing

investment returns, particularly for holding periods of one
year or less.
Sources of Risk
Business Risk – the degree of uncertainty associated with an

investment’s earnings and the investment’s ability to pay returns
(interest, principal, dividends) owed investors.
Financial Risk – firms that borrow money sometimes experience

financial difficulties because they cannot generate enough cash to
pay all their bills, including debt payments. The uncertainty
surroundings a firm’s ability to meet its financial obligations
because it has borrowed is financial risk.
Purchasing Power Risk – the chance that unanticipated changes in

price levels (inflation or deflation) will adversely affect investment
returns is purchasing power risk.
Sources of Risk
Interest Rate Risk – the chance that changes in interest rates will
adversely affect a security’s value. The interest rate changes
themselves result from changes in the general relationship between
the supply and the demand for money.
Liquidity Risk – the risk of not being able to sell (or liqudate) an
investment quickly and at a reasonable price.
Task Risk – the chance that congress will make unfavorable

changes in tax law. The greater the chance that such changes will
drive down the after-tax returns and market values of certain
investments, the greater the tax risk.

Event Risk – occurs when something happens to a company that as
a sudden and substantial impact on its financial condition.
Ex: event risk in 2009, Steve Jobs CEO of Apple Inc was taking a
leave of absence due to health concerns. The announcement which
was made after trading in Apple stock had closed for the day,
provided few details as to the severity of Mr. Job’s health issues.
When Apple stocked opened for trading the next morning , it was
down to 5.6%
Market Risk- is the risk that investment returns will decline

because of market factors independent of the given investment. Ex
political, economic, and social events as well as changes in
investors tastes and preferences.


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Measure of

Subject Teacher: Flormelyn D. Tumenez

CAPITAL GAINS (OR LOSSES)

Purchase Price 1,000 1,000

Capital gain (loss) 100 (40)

Total return 180 80

Investment A earned 18%(180/1000) and B earned 8%

WHY RETURN IS IMPORTANT?

If you commit $200 to an investment at the beginning of the

Subject Teacher: Flormelyn D. Tumenez

HPR= Income during prd + Capital gain (loss during prd)

Subject Teacher: Flormelyn D. Tumenez

The holding period return is easy to use in making

HPR provides logical method for evaluating and comparing

Business Risk – the degree of uncertainty associated with an

Financial Risk – firms that borrow money sometimes experience

Purchasing Power Risk – the chance that unanticipated changes in

Task Risk – the chance that congress will make unfavorable

Subject Teacher: Flormelyn D. Tumenez

Market Risk- is the risk that investment returns will decline

Subject Teacher: Flormelyn D. Tumenez

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