Risk and Return Characteristics

Return Characteristics of Equity Securities

There are two main sources of equity securities’ total return: price change (or capital gain) and dividend income. 

The price change represents the difference between the purchase price (P_t–1) and the sale price (P_t) of a share at the end of time t – 1 and t, respectively.

For investors who purchase depository receipts or foreign shares directly, there is a third source of return: foreign exchange gains (or losses). Foreign exchange gains arise because of the change in the exchange rate between the investor’s currency and the currency that the foreign shares are denominated in. 

Risk of Equity Securities

The type of equity security, as well as its characteristics, affects the uncertainty of its future cash flows and therefore its risk. In general, preference shares are less risky than common shares for three main reasons:

1. Dividends on preference shares are known and fixed, and they account for a large portion of the preference shares’ total return. Therefore, there is less uncertainty about future cash flows.
2. Preference shareholders receive dividends and other distributions before common shareholders.
3. The amount preference shareholders will receive if the company is liquidated is known and fixed as the par (or face) value of their shares. However, there is no guarantee that investors will receive that amount if the company experiences financial difficulty.