Seminar 3

Theory of Investments

Ana Santos (as2679@sussex.ac.uk)

University of Sussex

Week 4

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Question 1
[P4.3] Assume you purchased a share of stock in Volkswagen AG at the
beginning of 2019 for e136.26. A year later the stock was worth e156.62
and paid a dividend of e12.5 in 2019. Calculate the following:
A. Income.
B. Capital gain (or loss).
C. Total return (in euros and as a percentage of the initial investment).

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Holding Period Return

Holding Period Return (HPR): the total return earned from holding an
investment for a specified time (the holding period); usually one year or
less.

Total Return = Capital Gain + Income

Income during period + Capital gain (or loss) during period

HP R =
Beginning investment value

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Question 1

A. Income = D = e12.5
B. Capital gain (or loss) = Pt − Pt−1 = e156.62 − e136.26 = e20.36
C. Total return = e12.5 + e20.36 = e32.86
32.86
R= = 24.12%
136.26

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Question 2
[P4.11] You are considering two investment alternatives.
(i) The first is a stock that pays quarterly dividends of $0.25 per share
and is trading at $20 per share; you expect to sell the stock in six
months for $24.
(ii) The second is a stock that pays quarterly dividends of $0.50 per share
and is trading at $27 per share; you expect to sell the stock in one
year for $30.
Which stock will provide the better annualized holding period return?

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Question 2

(i) D = $0.25 quarterly (= every 3 months); P0 = $20; E(Pt ) = $24;

t = 6 months
Income = D = 2 × 0.25 = $0.5 in 6 months
Capital gain = 24 − 20 = $4 in 6 months
Total return = 0.5 + 4 = $4.5

4.5
R= = 22.5% in 6 months
20
Annualized holding period return = 2 × 22.5% = 45%

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Question 2

(ii) D = $0.5 quarterly; P0 = $27; E(Pt ) = $30; t = 1 year

Income = 4 × 0.5 = $2 in 1 year
Capital gain = 30 − 27 = $3 in 1 year
Total return = 2 + 3 = $5

5
R= = 18.5% in 1 year
27
Annualized holding period return = 18.5%

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Question 2

Compare:

44.5% = AHP R1 > AHP R2 = 18.5%

Stock 1 is better.

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Question 4
[P4.24] The historical returns for two investments— A and B— are
summarised in the following table for the period 2016 to 2020. Use the
data to answer the questions that follow.
Year A B
2016 19% 8%
2017 1% 10%
2018 10% 12%
2019 26% 14%
2020 4% 16%
Average 12% 12%
A. On the basis of a review of the return data, which investment appears
to be more risky? Why?

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Question 4

Investment A varies from 1% to 26%

Investment B varies from 8% to 16%

B appears more risky.

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Question 4
Year A B
2016 19% 8%
2017 1% 10%
2018 10% 12%
2019 26% 14%
2020 4% 16%
Average 12% 12%

B. Calculate the standard deviation for each investment’s returns.

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Standard Deviation

Standard Deviation: An indicator of an asset’s risk, it measures the

dispersion (variation) of returns around an asset’s average or expected
return.
sP
n 2
t=1 (Return outcome t − Average or expected return)
s=
Total number of outcomes − 1
sP
n 2
t=1 (rt − r)
=
n−1

Variance = s2

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Question 4

r
(19 − 12)2 + (1 − 12)2 + (10 − 12)2 + (26 − 12)2 + (4 − 12)2
sA =
5−1
= 10.42%
sB = 3.16%

Excel function: STDEV

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Question 4

C. On the basis of your calculations in part B, which investment is more

risky? Compare this conclusion to your observation in part A.

sA = 10.42% > 6.16% = sB ⇒ A is more risky. It confirms the conclusion

in part A.

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Question 6
[P4.15] A local entrepreneur asks you to invest $10,000 in a business
venture. Based on your estimates, you would receive nothing for three
years, at the end of year four you would receive $4,900, and at the end of
year five you would receive $14,500. If your estimates are correct, what
would be the IRR on this investment?

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Internal Rate of Return

The Internal Rate of Return (IRR) is the discount rate that equates the
investment’s cost to the present value of the benefits that it provides for
the investor.
It’s the discount rate that makes NPV=0 (Net Present Value)
NPV: The difference between cost of an investment and the present
value of cash flows that it provides.

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Question 6

Cash flow:

When you pay $: ↓

When you receive $: ↑

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Question 6

Assume the interest rate is r.

Present value of $10,000 today = $10,000
Present value of $4,900 in 4 years:

$4, 900
(1 + r)4

Present value of $14,500 in 5 year:

$14, 500
(1 + r)5

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Question 6

Net Present Value:

When you pay < 0
When you receive > 0

4, 900 14, 500

N P V = −10, 000 + +
(1 + r)4 (1 + r)5

Internal Rate of Return ⇒ N P V = 0

4, 900 14, 500
0 = −10, 000 + +
(1 + IRR)4 (1 + IRR)5

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Question 6

4, 900 14, 500

0 = −10, 000 + 4
+
(1 + IRR) (1 + IRR)5

Solution: IRR = 15.03%

Try and error
Excel: IRR function
Excell: Goal and seek (Tools > Goal and Seek)

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Question 3
On April 5, 2019, shares of the sportswear manufacturer Adidas AG closed
at e227.55 on the Frankfurt Stock Exchange. That night the company
announced better-than-expected earnings results, and the next morning
trading in the stock opened at e235 and then quickly rose to e250 before
ending the day at e240.
A. Suppose that near the end of the day on April 5 an investor placed a
limit order to buy 100 shares of Adidas for e227. What happened in
the investor’s account the next day?

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Types of Order

There are different types of orders:

Market order: buy/sell at the current price
Limit order: buy/sell at a specific price
Stop order: buy/sell at the current price after a specific price is
reached.

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Question 3

Limit order: buy 100 @ e227

The limit order will be executed only if the stock price falls to e227 or
below. A limit order placed late of April 5 to buy 100 shares of Adidas for
e227 will not be executed and the investor will not profit from the next
day’s price increase.

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Question 3
B. Suppose an investor heard about Adidas’ good earnings on an evening
financial news program on April 5. Thinking that Adidas was a good
buy on that day’s e227.55 closing price, the investor submitted a
market order to buy 50 shares of Adidas after the exchange was
closed, so the order is valid for the next day. What was the result?

Market order: buy 50 @ market price

The investor will buy the shares at the opening of the next day. So, the
order will be executed at a price of e235 per share, and the investor will
buy 50 shares of Adidas stock at a total cost of e11,750.

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Question 3
C. Another investor, who already owned 300 shares of Adidas, also heard
the news on the evening of April 5. This investor expected Adidas’
stock price to increase the next day, so he submitted a limit order to
sell 300 shares at e240. What was the result?

Limit order: sell 300 @ 240

The limit order will be executed by the investor as soon as the price of
Adidas stock goes above e240. So, the investor will sell 300 shares at
e240 or higher (the maximum price on that day was e250).

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Question 3
D. A day trader following Adidas placed a market order to buy 1,000
shares at 10.30 a.m. on April 6, at which time Adidas was trading for
e237. The trader watched the price rise to e250 and then, to protect
the morning’s gains, submitted a stop-limit order to sell at e245.
What happened?

Marker order at 10.30 a.m.: buy 1,000 @ market price.

Because the price went down at the end of the day to e240, the day
trader will try to sell the stock at e245. So, the total gain for the day for
the trader is between 1,000 × (e245 - e237) = e8,000 or 1,000 × (e240
- e237) = e3,000 depending on whether the trader sells the stocks at
e245 or e240.

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Question 5
The return of IBM stock over the last 6 months was:
−1%, −3%, 2%, 8%, −9% and 14%. Estimate the standard deviation.
(Provide your answer as a percentage and round to two decimal places).

s = 8.18%

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Question 7

[Case Problem 4.2] Over the past 10 years, Molly O’Rourke has slowly built
a diversified portfolio of common stock. Currently her portfolio includes 20
different common stock issues and has a total market value of $82,500.
Molly is at present considering the addition of 50 shares of either of two
common stock issues— Harry’s Pottery Inc. or Ron’s Rodents Corp. To
assess the return and risk of each of these issues, she has gathered dividend
income and share price data for both over the past 10 years (2010– 2019).
Molly’s investigation of the outlook for these issues suggests that each
will, on average, tend to behave in the future just as it has in the past.
She therefore believes that the expected return can be estimated by
finding the average annual HPR over the past 10 years for each of the
stocks. The historical dividend income and stock price data collected by
Molly are given in the accompanying table Download accompanying table.

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Question 7
A. Determine the HPR for each stock in each of the preceding 10 years.
Find the expected return for each stock, using the approach specified
by Molly.

Expected return = average annual HPR over the past 10 years

E(rHarry Potter ) = 11.74%

E(rRon ) = 11.14%

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Question 7
B. Use the HPRs and expected return calculated in question a to find
the standard deviation of the HPRs for each stock over the 10-year
period.

sHarry Potter = 8.90%

sRon = 2, 78%

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Question 7
C. Use your findings to evaluate and discuss the return and risk
associated with these two stocks. Which stock seems preferable?
Explain.

Comparing the expected returns, Harry’s Pottery provides a return of

11.74%, which is only slightly above the expected return of Ron’s Rodents
(11.14%). However, Harry’s Pottery has a much higher standard deviation
(8.90%) compared to Ron’s Rodents’ standard deviation (2.78%).
Whether the additional return of Harry’s Pottery is sufficient to
compensate for the higher risk would be determined by the “price of risk”
in the financial markets.

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Question 7
D. Ignoring her existing portfolio, what stock do you think Molly should
buy?

I would recommend she buy Ron’s Rodents given it has almost the same
return as Harry’s Pottery but much lower risk.

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Thank you!

Question, comment, feedback:

as2679@sussex.ac.uk

Office-hours: Monday 11-12 a.m. Jubilee 245

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