The Return Characteristics Of Alternative Security Types

When describing securities in the previous section, we alluded to risk and return. One of the basic tenets of this book is that investors like high return, but don't like high risk. Although we will be much more specific about measuring risk and return in future chapters, it is

8There is a difference in that income, if paid out to fund shareholders, is not subject to corporate taxes provided certain conditions are met by the fund.

useful to become familiar with the risk and return characteristics of some of the securities we have discussed.

First, we should discuss what we mean by return. We will in most instances use return to indicate the return on an investment over a particular span of time called holding period return. Return will be measured by the sum of the change in the market price of a security plus any income received over a holding period divided by the price of a security at the beginning of the holding period. Thus, if a stock started the year at $100, paid $5 in dividends at the end of the year, and had a price of $105 at the end of the year, the return would be 10%.9 In describing securities, we mentioned several factors that should affect risk. These included

1. The maturity of an instrument (in general the longer the maturity the more risky it is).

2. The risk characteristic and creditworthiness of the issuer or guarantor of the investment.

3. The nature and priority of the claims the investment has on income and assets.

4. The liquidity of the instrument and the type of market in which it is traded.10

If risk is related to these elements, then measures of risk such as the variability of returns should be related to these same factors.

In Figure 2.1, for example, we have plotted the history of annual returns over the 1946-2000 period for short-term Treasury bills, long-term Treasury bonds, and common

Figure 2.1

9If dividends or other income is received during the period of time over which return is computed, an assumption must be made about the rate at which the cash flow is reinvested until the end of the period.

10This will be discussed in Chapter 3.

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