E. Compare and contrast the risk and return characteristics of various types of equity securities Flashcards
SchweserNotes: Book 4 p.264 CFA Program Curriculum: Vol.5 p.173
Equity Investor Returns
Equity investor returns consist of dividends, capital gains or losses from changes in share prices (price changes), and any foreign exchange gains or losses on shares traded in a foreign currency. Compounding of reinvested dividends has been an important part of an equity investor’s long-term return.
Total Return: Rt = (A – B + D) / B
*Include ‘foreign exchange G or L as D when foreign exchange exists
In a period when U.S. equity prices are increasing and the U.S. dollar is depreciating, which of the following investors in U.S. equities is most likely to earn the highest return in the investor’s local currency?U.S. investor who reinvests dividends.
Sources of return on equity securities include price appreciation or depreciation, dividend income, and foreign exchange gains or losses for investors outside the country. In an increasing equity market, reinvesting dividends is likely to increase returns compared to not reinvesting dividends. If the currency is depreciating, investors from outside the country will experience foreign exchange losses that decrease their returns.
Preferred stock is less risky than common stock.
because preferred stock pays a known, fixed dividend to investors; preferred stockholders must receive dividends before common stock dividends can be paid; and preferred stockholders have a claim equal to par value if the firm is liquidated.
Common stock is more risky than preferred stock and is expected to provide higher average returns. Preferred stock promises fixed periodic dividends. Common stock can be dividend-paying or non-dividend paying and the dividends are at management’s discretion.
Cumulative preferred shares have less risk than non‐cumulative
preferred shares.
Cumulative preferred shares are less risky than non-cumulative preferred shares, as any dividends missed must be paid before a common stock dividend can be paid.
Preference shares (preferred stock) has more risk for the investor if they are non-cumulative than if they are cumulative, because with cumulative preference shares the firm must pay the holder any omitted dividends before it can pay any dividends to common shareholders. Callable shares have more risk for the investor than non-callable shares because the call option limits their potential for price appreciation.
Callable shares are the most risky.
Putable shares are the least risky and callable shares are the most risky
Putable shares are the least risky because the investor can sell the shares back to the issuer at a predetermined price. Callable shares are the most risky because the issuer can buy the securities back at a predetermined price, which limits the upside for the investor.
Callable shares have more risk than putable shares because the issuer can exercise the call option (which limits the investor’s potential gains) while the investor can exercise the put option (which limits the investor’s potential losses, assuming the firm is able to meet its obligation). Preferred shares have less risk for the investor than common shares because preferred shares have a higher priority claim on the firm’s assets in the event of liquidation, and because preferred dividends typically must be paid before common dividends may be paid.
In a period when U.S. equity prices are increasing and the U.S. dollar is depreciating, which of the following investors in U.S. equities is most likely to earn the highest return in the investor’s local currency?
U.S. investor who reinvests dividends.
Sources of return on equity securities include price appreciation or depreciation, dividend income, and foreign exchange gains or losses for investors outside the country. In an increasing equity market, reinvesting dividends is likely to increase returns compared to not reinvesting dividends. If the currency is depreciating, investors from outside the country will experience foreign exchange losses that decrease their returns.
