Risk and Return of Equity Securities

The type of security and its features affect its risk/return profile. Therefore, as an investor’s risk increases, its expected return should also increase to compensate.

Equity Return Characteristics

There are two main sources of total return for equity securities – capital appreciation and dividend income:

$$ \text{Total Return} = \frac{P_1 – P_0 + D}{P_0} $$

Where:

P₁ = Sale price (or price at t = 1)

P₀ = Purchase price (or price at t = 0)

D = Dividend income paid to the investor between t = 0 and t = 1

Exam tip: Most of the return calculations in finance follow the same logic:

$$ \text{Return (%)} = \frac{ \text{Ending price} – \text{Beginning price} + \text{Dividend income}}{ \text{Beginning price}} $$

The Reinvestment of Dividends

Historically, the reinvestment of dividend income has been an extremely important source of compound growth. Of course, the total return of non-dividend paying stocks is entirely based upon capital appreciation.

Direct investments in foreign securities or depository receipts have an additional source of return: foreign exchange gains (or losses) arising from changes in exchange rates.

Equity Risk Characteristics

In general, investors expect lower risks and returns from preference shares than common shares because dividends on preference shares are fixed.

Preference shareholders also have priority to dividend payments, and liquidation proceeds claimed by preference shares are known (although not guaranteed).

Preference shareholders usually expect more of their total return from dividend income, while common shareholders typically expect more return from capital appreciation.

Callable common or preference shares are riskier than their non-callable counterparts, while putable common or preference shares are less risky than their non-putable counterparts.

Question

A US investor makes a direct investment in a foreign equity security with a current dividend yield of 2.5%. If the investor holds the stock for ten years, how many components are likely to make up the investor’s total return?

1. One
2. Two
3. Three

Solution

The correct answer is C.

The total return from investing in a foreign equity security generally includes three components:

1. Dividend Income: The yield on dividends paid by the equity, which is 2.5% in this case.
2. Capital Appreciation: The change in the stock’s price over the holding period. This could be positive or negative, depending on how the stock performs.
3. Currency Fluctuations: Since the investment is in a foreign equity, changes in the exchange rate between the investor’s home currency (USD) and the currency of the foreign stock can affect the total return.

Thus, the total return from holding a foreign equity security would likely be influenced by these three components: dividend income, capital appreciation, and currency fluctuations.