Extra words of wonder

RISK AND RETURN IN CAPITAL MARKETS

SECURITY RETURNS

Components of security returns
• Stocks –
• Bonds –
• Returns stated in absolute dollar or percentage terms
o Absolute dollar return =
(end price – beginning price + cash flow)
o Percent return =
(end price – beginning price + cash flow)/beginning price
= absolute dollar return / beginning price
•If the security is a stock, the percent return can be separated into the capital gain yield (the first term below) and the dividend yield (the second term):
Rt = (end price – beginning price) / beginning price
+ dividend / beginning price
where Rt is the return for time period t.

Example
You purchase a stock for $50, sell it one year later for $53. During that year, you received adividend of $2. What are your absolute and percent returns? Separate the percent return into the two components.

Example
You purchase a $1000, 5%, 20 year semi-annual bond for $1050 right after a coupon payment. One year later you sell the bond for $1025. What are your absolute and percent returns?

Portfolio returns
• The return on the portfolio is the weighted average of the individualsecurity returns
• The weight on each security is the percent of the portfolio invested in that security

Example

You have 50% of your portfolio in IBM stock, 20% in Microsoft, and 30% in Intel. IBM returned 25% over the last year, Microsoft returned –15%, and Intel returned 5%. What is your portfolio return?

INFLATION

Illustrative Example
In 50 years you are worth $1,000,000 andseek to live a life of luxury. In 50 years, how much does a car that costs $40,000 today cost if the inflation rate is 3% every year? How much does a $500,000 home cost?

Inflation rates
• Inflation is an important consideration when investing
• U.S. inflation
o Traditionally relatively low
o
• Inflation rates are high in many countries

Historic examples ofinflation
• United States
o Civil War
o 1970s – double digit inflation
• Eastern Europe – after collapse of Soviet bloc
o Poland – about 550% in 1990
o Russia – about 900% in 1993
• South America – late 1980s, early 1990s
o Argentina – about 3000% in 1989, 2000% in 1990
o Brazil – about 1500% per year from 1988 to 1994
o Peru –about 7500% in 1990
• Germany – 1920s

Germany in 1920’s
|EXCHANGE RATES IN GERMANY |
|Date |$1 equals |
|July 1914 ||
|January 1920 | |
|January 1923 | |
|July 1923| |
|August 1923 | |
|September 1923 | |
|October 1923| |
|November 15, 1923 | |

Illustrative Example
A country is experiencing hyperinflation. How do different investments fare in this type of environment?

Cash
Saving account
Bonds
Stocks
Real estate...