1.
In the business world, the rear view mirror is always clearer than
the windshield. In finance, we hypothesise the positive relationship
between return and risk since we assume that investors want to be
compensated for additional risk in the form of additional return.
2. Strictly speaking, what we mean is a positive relationship between
expected return and expected risk.
3. As we saw above in the definition of the holding period return, the
lower the price that I pay for an asset, the higher the expected
return.
4. The challenge in testing whether indeed the positive return risk
relationship exists in financial markets is that we do not observe
return expectations. Sometimes historical returns are used as an
approximation of expected returns but this can be very misleading.
It is like confusing the windshield and the rear view mirror view in a
car. The reason why it is important to distinguish expected and
historical realised returns is that the two can be very different.
After a big run up in prices, historical returns can be a poor guide to
future expected returns. Since prices of overvalued assets can
come crashing down at any point in the future. So be careful when
interpreting high returns of risky assets.
5. History may not be a good guide. It might be misleading, so when
we think about return and risk, we care about the relationship
between expected and realised historical returns.
6. Often, expected returns are highest when recently realised
historical returns have been very low. Similarly, expected returns
are often lowest after big run ups in prices and high realised recent
historical returns. This is due to the fact that many asset prices
exhibit mean reversion.
1. An investment that offers a 10% return with certainty will almost
always be preferred to an expected average return of 10% with
risk, for example, an investment that offers a 50/50 chance of 0%
return and 20%. This reflects the fact that most people are risk
averse. Of course, there are some important exceptions to this, not
least some people's willingness to go to casinos or buy lottery
tickets, even when those same people often buy insurance. But as
far as financial markets are concerned, we see clear evidence that
risk is disliked and that investors will accept lower returns from low
risk investments.
2. The simplest measure of the riskiness of an investment is a
standard deviation, which gives a measure of how wide the range
of values is that returns could take. To give a simple example, if the
standard deviation of returns is 1% that means that returns have a
68% chance of being within 1% of the average and a 95% chance
of being within 2% of the average. This example assumes that
returns are normally distributed.
3. As we shall see in the next lecture, once you introduce the idea of
portfolio diversification there are more subtle ways to measure risk,
but for a single asset the standard deviation remains the standard.
The idea of the risk premium suggests that as perceived riskiness
of an asset increases its expected return should also increase to
compensate the investor for that risk, more precisely, the risk
premium on a given asset is that part of its return that is
compensating you for its riskiness, thus, a risk free asset, usually
taken to be a treasury bill since its return is certain, even over the
short term, has no risk premium, while riskier assets have a
positive risk premium that make the expected return higher of that
of the risk free asset.
4. Returns describe the amount you have earned or lost on an
investment over a given holding period. Usually we measure this
holding period return as a percentage, it combines the income from
the asset, for example, dividends or coupon income received over
the holding period and capital gains and losses, that is the change
in the value of the asset over the holding period.
5. Imagine you purchase a share at the beginning of period T for a
price PT and you receive a dividend D, and then you sell the share
at time T + 1 for a price PT + 1. What is your return? As the
formula shows, your return would be equal to the dividend, plus the
difference in the two prices divided by the initial price paid, and this
can also be rewritten as D ˜ PT, which is the dividend yield, plus,
PT + 1 ñ PT ˜ PT, which is the capital gain.
6. Consider the example of HSBC. Between the 23 March 2015 and 22
March 2016, the price fell from 578.7 to 447.9. The dividend
payments over this time period were .34. This leads to a dividend
yield of 5.91 and a capital loss of 22.6%. If we add the dividend
yield to the capital loss over this time period we end up with a
holding period return of -16.69%.
7. In practice, the precise way of calculating the holding period return
is very important because it is important to ask whether the return
of a share includes or excludes dividend payments. We are
interested in total returns which include the capital gains and the
dividend yields, and we always must make sure that the return that
we use includes these two components.
1. Previously, we have identified two defining characteristics of
financial securities, risk and return. Now, we can look how the risk-
return profile of four US asset classes varies over time. The
interaction collects the average return and standard deviation over
the years from 2008 until 2016 for corporate bonds, 10-year T-
notes, Small and Large caps, and plots the data in a typical risk-
return scatter diagram. By moving the toggle in slider we select the
year on interest while the scatter plot is updated accordingly. It is
interesting to note how historical measures differ from
expectations. For instance, asset classes which are usually
perceived as riskier and hence would require a higher
compensation, like Small Caps, sometimes exhibit lower returns
than bonds, like during 2008!