RISK AND RETURN IN CAPITAL MARKETS

SECURITY RETURNS

Components of security returns • Stocks – Capital gains/losses and dividends • Bonds – Capital gains/losses and interest • 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 a dividend of $2. What are your absolute and percent returns? Separate the percent return into the two components.

Capital gain = 53 – 50 = 3
Dividend = 2
Absolute dollar return = 3 + 2 = 5
Percent return = 5/50 = 3/50 + 2/50 = 6% + 4% = 10%
Capital gain yield = 6%
Dividend yield = 4%
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?

Capital loss = 1025 – 1050 = -25
Coupon payments = 5% ( 1000 = 50
Absolute dollar return = -25 + 50 = 25
Percent return = 25 / 1050 = 2.38%

Portfolio returns • The return on the portfolio is the weighted average of the individual security 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