Chapter 7 Risk and Rates of Return
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PROFIL PRODI
UNIVERSITAS PERTAMINA
Chapter 7 :
Risk and Rate of Return
RISK
The chance that some unfavorable event will occur
RESTURN
The earning that will be realized from an invesment
Investment returns
The rate of return on an investment can be calculated as
follows:
(Amount received – Amount invested)
Return = ________________________
Amount invested
For example, if $10,000 is invested and $11,000 is returned
after one year, the rate of return for this investment is:
($11,000 - $10,000) / $10,000 = 10%.
What is investment risk?
• Two types of investment risk
• Stand-alone risk
• Portfolio risk
• Investment risk is related to the probability of earning a
low or negative actual return.
• The greater the chance of lower than expected or
negative returns, the riskier the investment.
Statistical Measures of Stand-Alone Risk
• Probability Disributions
possible outcomes or event with a probability (chance of occurrence)
• Expected rates of return
The rate of return expected to be realized from an invesment
• Standard Deviation,
SD is measure of how far the actual return is likely to deviate from expected return
• Coefficient of Variation (CV)
The standardized measure of the risk per unit of return
Selected Realized Returns,
1926 – 2001
Average Standard
Return Deviation
Small-company stocks 17.3% 33.2%
Large-company stocks 12.7 20.2
L-T corporate bonds 6.1 8.6
L-T government bonds 5.7 9.4
U.S. Treasury bills 3.9 3.2
Source: Based on Stocks, Bonds, Bills, and Inflation: (Valuation
Edition) 2002 Yearbook (Chicago: Ibbotson Associates, 2002), 28.
Expected Rates of Return & Probability Distribution
Case : Anwell Tech vs Hongkong Electric
Economy Probability of Rate of Return on Stock Product
Which Affects This Demand If Demand Occur
Demands Occuring
Anwell Hongkong Anwell Hongkong
Tech Electric’s Tech Electric’s
Strong 0.26 96% 23% 24,96% ....
Normal 0.51 12% 12% 6,12% ....
Weak 0.23 -83% -1% -19,08% ....
1.00 Expected Rate of Return 12% 12%
n
k = ∑ ki. pi k = expected return
ki = actual return
i=1 pi = probability
Measuring Stand Alone Risk with
The Standard Deviation
◼ Standard deviation measures the stand-alone risk
of an investment.
◼ The larger the standard deviation, the higher the
probability that returns will be far below the
expected return.
Measuring Stand Alone Risk with
The Standard Deviation (σ) = √ ∑ (ki – k )2 . p i
Case : Anwell Tech vs Hongkong Electric
Rate of Return Deviation Squared:
Economy Probability of on Stock ( ki – k )2 (ki - k)2 x pi
Which Affects This Demand If Demand Occur (ki)
Demands Occuring
Anwell Hongkong Anwell Hongkong Anwell Hongkong
Tech Electric’s Tech Electric’s Tech Electric’s
Strong 0.26 96% 23% 71% ..... 0,1835 .....
Normal 0.51 12% 12% 0% ..... 0,0000 .....
Weak 0.23 -83% -1% 90% ..... 0,2076 .....
Expected
1.00 Rate of Return ∑ = variance 0,3911 ......
(k) = 12%
Standar deviation = 0,6254 ......
Square root of variance: σ =
Standar deviation expressed as a 62,54% .......
percentage:σ =
Measuring Stand Alone Risk
The Coefficient of Variaton
Case : Hongkong Electric’s vs Shanghai Electric’s
Coefficient of Variation:
The higher the coefficient, the more risky the security.
= S.D. / Return; or Risk / Return
Which one is the better option ?
Measuring Stand Alone Risk
The Coefficient of Variaton
Case : Hongkong Electric’s vs Shanghai Electric’s
Coefficient of Variation:
= S.D. / Return; or Risk / Return
Hongkong Shanghai
Electric’s Electric’s
Expected Rate of Return 12% 15%
Standar Deviation 7,81% 30%
Coefficient Variation = 7,81 = 0.65 30 = 2
12 15
The higher the coefficient, the more risky the security.
Expected Return versus
Coefficient of Variation
Expected Risk: Risk:
Security Return CV
Alta Inds inc. 17.4% 20.0% …
Market 15.0 15.3 …
Am. Foam inc. 13.8 18.8 …
T-bills 8.0 0.0 …
Repo Men 1.7 13.4 …
12
Illustrating the CV as a measure of
relative risk
Prob.
A B
0 Rate of Return (%)
σA = σB , but A is riskier because of a larger probability of
losses. In other words, the same amount of risk (as
measured by σ) for less returns.
Investor attitude towards risk
• Risk aversion – assumes investors dislike risk and require
higher rates of return to encourage them to hold riskier
securities.
• Risk premium – the difference between the return on a
risky asset and less risky asset, which serves as
compensation for investors to hold riskier securities.
Expected Portofolio Returns
Expected return of a portfolio is a weighted
average of each of the component assets of the
portfolio.
Expected Investments
Return (ki) Value (wi)
Toshiba 14% 25,000
Microsoft 13% 25,000
Apple 20% 25,000
Nvidia 18% 25,000
kp = w1k 1 + w2 k 2 + ... + wnkn
kp = i=1wiki
n
Assignment
Economy Prob. LION AA GIAA BTV
Recession 0.1 -22% -28% -10% -13%
Below avg 0.2 -2% 14.7% -10% 1%
Average 0.4 20% 5% 10% 15%
Above avg 0.2 35% 10% 45% 29%
Boom 0.1 50% 20% 30% 43%
1. Calculate the expected rate of return, for all stock!
2. Calculate the standard deviation of expected returns!
3. Calculate the coefficient of variation!
4. Assuming you are a risk-averse investor, which stock would you prefer to hold?
