2ND MODULE OF INVESTMENTS

WEEK 7

7.1 - Returns and Present Value

Stocks- Is going to be the financial asset that we are going to focus in this part of the course

In this lecture we are going to cover two topics:

• Define the return of the stock

• How to estimate the return of a stock

D1- Dividend that you will receive at time 1

P1 – Price of the stock in time 1

P0 – Price of the stock today

R(0,1) - Return that you are going to get with a stock by buying today and sell it at time 1

We need to understand the negative relation between the price of the stock and its return

If investors require a certain rate of return to invest in the stock (in the last class we saw that
this depends on the time value of money and the risk premium) than in equilibrium the
expected return of the stock must be equal to the this require rate of return

Later on we will see in detail what is equilibrium, for now let’s think that if the stock return
gives something different than the rate required then nobody would want to buy the stock

So if the above equation is true, then we can take the first equation and write:

If we rearrange it we have the price of the stock as:

In the end we get this formula:

The price of the stock is the discounted value of all future dividends. In this case this stream of
uncertain future cashflows is infinite because a stock doesn’t have an expiration date.
As we can see the K - required rate/expected return is always in the denominator. This
highlights the negative relation between the price of the stock and its expected return. Higher
expected return means you will discount more future dividends and the price will be lower.

What if we want to hold the stock for 2 periods?

We buy today and sell it in time 2

In this case the return is the product between each per period return. This is very different
than just add the two returns of the two periods because in that case we wouldn’t be
considering the effect of compounding.

If we want to invest in a stock what we want to know is:

- What is my expected return

- What is the risk I’m going to take

To calculate the expected return we need to make an assumptions:

1st assumption: In each period the expected return of that period is going to be the same as
the one in the following periods and are equal to the bellow expression. In theory it says that is
the product of the expected rates in all around the world and the corresponding probability of
that rate happening.

2nd assumption: Returns of each period are independent of each other. This means that the
return of today is never going to influence the return of the following period.

But what is the risk of our investment?

Again to calculate the risk we need to make some assumptions:

1st – The variance of each period are the same and its equal to sigma square. Again in theory
this would be the product between the probability realization of return in different states of
the world and their respective probabilities but that is not possible of calculating so we are
going to see in practice how to calculate the variance of a stock.

2nd – The variance of each period are also independent

3th – Returns in each period are small enough such that we can ignore the effect of
compounding. With this assumption the return can be simplified as the sum of the returns of
each period. This assumption is possible if we are comparing returns of hours or days. If we
start comparing returns of months then this assumption is not very reliable.

So with this 3 assumptions we can write:

Because the standard deviation is the square of the variance we can write that the standard
deviation of the stock is:
This tells us that the standard deviation of investing on the stock increase not linear with time
but with the square root of time

We can write the previously formula of calculating the expected return with this new third
assumption, it would be:

Meaning the expected return of the stock increases linearly with time

Now we have the two formulas for variance and expected return but the problem is that we
assume in the first assumptions that we would need to check the expected return on all states
of the world and multiply by their probability of happening and in practice we know that this is
not possible of getting. So we need of sample estimates:

We use the historical return of past periods returns

Tradeoff: In one hand we would want to get as many historical returns because than our
estimation would be more precise but in the other hand if we take returns that are very “old”
then higher is the risk that we are using returns that are not anymore reliable to calculate the
future return.