Risk, return, liquidity and time value
◈ 7 cardsThe three words every price is made of: required return as risk-free plus premium, liquidity on two dimensions, and why a dollar later is worth less even at zero inflation.
Three words
Every price in the rest of this course is built from three ideas: the return an investor requires for bearing risk, how quickly and cheaply a position can be liquidated, and the fact that money has a time value. This lesson states each in the form the exam uses.
Risk and return — required return = risk-free rate + risk premium
An investor will not hold a risky claim for the return a riskless one pays. The return they require is the riskless rate plus an extra amount for the risk:
Worked example. Government of Canada Treasury bills yield 3.2 % — the risk-free rate, because the federal government can always pay in its own currency. Ossington Brewing, a mid-sized TSX-listed brewer, is risky enough that investors demand 4.5 % more. The required return on Ossington's shares is ; in a worksheet, =B2+B3. Raise the premium to 6 % for a riskier junior explorer and the required return becomes 9.2 %.
Read the words carefully: a risk premium is extra return, measured up the vertical axis of the risk–return chart. It is not extra risk, and it is not a measure of dispersion — the standard deviation comes later, in Module 13, as one way of measuring the risk that earns the premium.
Liquidity — speed and price impact
An asset is liquid if it can be turned into cash quickly and without a large price concession. Both conditions, together. A T-bill is liquid on both: it sells in minutes at a price within a basis point of its value. A house is illiquid on both. The case the exam sets is the one in between: a TSX Venture listing that trades 2,000 shares a day. It is listed, so a quote exists — but the bid–ask spread is 8 % wide and selling a 40,000-share position would take weeks or knock the price down sharply. Listed is not the same as liquid; liquidity is a property of the market for the asset, not of the listing.
A market is liquid, in turn, when it has many buyers and sellers, narrow spreads and enough depth that a normal-sized order does not move the price.
Time value — even at zero inflation
A dollar next year is worth less than a dollar today. The usual reason offered is inflation, and it is the wrong one, or at least not the fundamental one. Suppose prices are perfectly stable. A dollar today can still be lent at the 3.2 % T-bill rate and become $1.032 next year; a dollar next year cannot. So the dollar today is worth more by exactly the return it could have earned. Inflation adds a second reason on top; the time value exists without it. This is the principle behind every PV in the course: discounting is charging the flow for the interest it did not earn.
Who is trading
Two more pairs the paper likes. Retail investors trade their own money in small amounts; institutional investors — pension plans, insurers, fund managers — manage pooled money in large amounts. "Institutional" describes who manages the money, not who ultimately owns it; a pension plan's assets belong to its members, but the plan trades as an institution. The sell side — dealers — creates and distributes securities and research; the buy side — institutions and their portfolio managers — buys them.