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Risk and Return

Another connection of mathematics to stock market and economics is the calculation of


risk and return in any type of investment. The fundamental understanding is that the lower the
risk, the lower the possible return, and vice versa. Risk is a constant factor or variable in every
investment, while return depicts the gains in every investment, and has a directly proportional
relationship with risk.
There are different levels of risks, depending on the type of investments it is appended
upon. Treasury bills or stocks have the lowest level of risk, while shares of corporate stock in
highly volatile markets and industries like oil and mining can have a much higher level of risk.
Before divulging much further, a discussion of what risk and return will be needed. Risk,
in its simplest terms, is uncertaintyit is a measure of the uncertainty surrounding the return that
an investment will earn. It is also referred to as the variability of returns associated with a given
asset. Risk is often calculated using the standard deviation of the historical or average returns of
a specific investment.
On the other hand, return refers to the gain or loss of a security or investment over a
period of time. Mathematically, (total) return is the sum of any cash distributions plus the change
in the investments value, divided by the beginning of period value.
Risk, Return, and How They Are Measured
Risk and return comes hand in hand with every investment, likewise with their
measurement. This part will discuss in detail the quantitative methods in measuring risk and
return of a stock.
Investors often use standard deviation to measure the risk of a stock or a stock portfolio.
Since risk is considered to be the measure of the uncertainty or the variability associated with a
specific asset, standard deviation, which is the measure of dispersion around the expected value,
and in this case, around the expected return, is commonly applied to measure the volatility of the
stock.
To come up with the standard deviation, a stocks expected return should be first known.
As mentioned, the variability of returns is the major consideration for standard deviation. To

obtain a sense of variability, investors use scenario analysis to end up with several possible
alternative outcomes, or simply different states of nature to the returns, namely pessimistic, most
likely, and optimistic. The values assigned to these states of nature will be their probability or
chance of occurring and must sum up to 100%.
Applying this, the expected return, r, is the average return that an investment is expected
to produce over time. For an investment that has j different possible returns, the expected return
is as follows:

where rj=return for the jth outcome; Prj= probability of occurrence of the jth outcome; and n=
number of outcomes considered.
Consequently, if all of the outcomes are known and the probabilities equal, the expected
value of the return is simply their arithmetic average:

After computing for the expected values of the returns, calculating for the standard
deviation will be the next step. The following is the formula for standard deviation of returns, r:

Likewise, in the occasion that the full range of possible investment outcomes and their
probabilities is known, the following formula will be applicable:

Stock Valuation Methods


Stockholders and investors buy shares of stock from a corporation not only to own an
interest in the corporation or a voting right, but more importantly to be paid dividends from their
investments. In this section, the method of how to measure the value of a share of a common
stock will be discussed.
Finance-wise, the value of a share of common stock is equal to the value of all future
cash flows or dividends that it is expected to provide. The basic valuation model for common
stock is as follows:

where P0=value today


of common stock;
Dt=per-share dividend expected at the end of year t; and rs=required return on common stock.
Stock valuation is done so that the price of stock will be known. There are many methods
that can be used to value stock prices. Here, the methods to be discussed will be the zero-growth
model, one-period valuation model, constant growth model or Gordon growth model, and
generalized dividend model.
1. Zero-Growth Model
The simplest approach to dividend valuation, the zero-growth model, assumes a
constant, non-growing dividend stream. Let D1 represent the amount of the annual
dividend, and the basic valuation model will be

.
2. One-Period Valuation Model
This approach depicts one of the simplest possible scenario to understand stock
valuation: You buy a stock, hold it for one period to get a dividend, then sell the
stock. This can be translated as

where Div1=the dividend paid at the end of year 1; ke=rs; and P1=the price at the
end of the first period.

3. General Dividend Model

The one-period dividend valuation model can be extended to any number of


periods: The value of a stock today is the present value of all future cash flows
(dividends). This is an approach of generalized multi-period formula for stock
valuation: The current value of a share of stock can be calculated as simply the
present value of the future dividend stream.

4. Constant Growth Model (Gordon Growth Model)


The most widely cited dividend valuation approach, the constant-growth model,
assumes that dividends will grow at a constant rate, but a rate that is less than the
required return. The formula for constant growth model will be

.
Applications

References
http://www.investopedia.com/articles/08/risk.asp
http://www.investopedia.com/terms/r/risk.asp
http://www.investopedia.com/terms/s/standarddeviation.asp
http://www.investopedia.com/terms/r/return.asp
http://davidmlane.com/hyperstat/A40397.html
http://www.investopedia.com/walkthrough/fund-guide/uit-hedge-fund-reit/hf/standard-deviationvalue-at-risk.aspx
Principles of Managerial Finance, 13th edition by Lawrence J. Gitman and Chad J. Zutter 2012
Prentice Hall Pearson Education
The Economics of Money, Banking, and Financial Markets, 9th edition by Frederic S. Mishkin
2010 Addison Wesley Pearson Education

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