119Valuation, risk and return
4 Valuing bonds
5 Valuing shares
6 The trade-off between risk and return
7 Risk, return and the capital asset pricing model
8 Options
A bit of wisdom attributed to the English poet
Chaucer says, ‘Nothing ventured, nothing
gained.’ Financial markets give us ample
evidence that Chaucer knew what he was talking
about. Over time, high-risk investments tend to
earn higher returns than do low-risk investments.
When managers invest corporate funds, or
when individuals decide how to allocate their
money between different types of investments,
they must weigh the trade-off between risk and
return. The purpose of the next four chapters is
to explore that trade-off in depth. We begin in
chapters 4 and 5 by describing two of the most
common types of investments available in the
market: bonds and shares.
The bond market is vast, and it plays anextremely important role in the global economy.
In Australia, federal and state governments
issue bonds to finance all kinds of public
works projects and to cover budget deficits.
Companies, both financial and non-financial,
sell bonds within Australia and overseas to raise
funds to meet daily operating needs and to pay
for major investments. Chapter 4 describes the
basic bond features and explains how investors
value bonds.
Chapter 5 examines the stock market. Valuingshares is more complex than valuing bonds
because shares do not promise fixed payment
streams as do bonds. Therefore, Chapter 5
discusses methods that investors and analysts
use to estimate share values. The chapter also
provides a brief explanation of how companies
work with investment bankers to sell shares to
the public, and how investors can trade shares
with each other.
With the essential features of bonds
and shares in hand, Chapter 6 explores the
historical returns earned by different classes
of investments. The data illustrate that a
fundamental trade-off between risk and return
confronts investors. Chaucer was right: investors
who want to get rich have to accept risk as part
of the deal.
Chapter 7 quantifies exactly what we mean
by the term risk. The chapter also introduces
one of the most important theories in finance,
the capital asset pricing model, or CAPM.
The CAPM attempts to quantify the risk–
return trade-off, providing an estimate of the
return that an investor can expect to earn on
an investment with a particular level of risk.
The CAPM can help investors decide how
to allocate their funds across different types
of investments, and it also helps corporate
managers decide whether it is better to invest
a company’s money in a high-risk venture, like
building a manufacturing plant in a foreign
country, or in a low-risk undertaking, such as
upgrading old equipment.