4chapter 4 FM1
4chapter 4 FM1
4chapter 4 FM1
CHAPTER FOUR
BASICS OF RISK AND RETURN
4.1. Definition of Risk and Return
Return is the total gain or loss experienced on behalf of the owner of an investment over a
given period of time. It is calculated by dividing the asset’s change in value plus any cash
distributions during the period by its beginning of period investment value.
P P C
K= t t 1
Pt-1
t
Some assumptions are needed to describe the way in which financial managers evaluate
risky projects. There are three attitudes toward risk.
1. Risk indifferent – the attitude toward risk in which no change is required for an
increase in risk.
2. Risk averse - the attitude in which an increased return would be required for an
increase in risk. Because managers with this attitude shy away from risk, they
require higher returns to compensate them for taking greater risk.
3. Risk seeking is the attitude toward risk in which a decreased return would be
accepted for an increase in risk. Because they enjoy risk, managers of this attitude
are willing to give up some returns to take more risk.
In general, managers are assumed to be risk averse. i.e. they accept additional risk only if
coupled with an appropriate increase in expected return. Managerial risk aversion provides
two criteria that can be used to rank risky projects:
1. If two projects have the same expected return, the manager will prefer the one with
the lesser amount of risk.
2. If two projects have the same degree of risk, manager will prefer the one with the
higher expected return.
4.2. Measuring Risk and Return
Risk (uncertainty) has to do with the future. So to measure risk we use data from a
probability distribution. Probability distribution lists the set of possible returns that can
occur at a specific time and their associated probabilities of occurrence. Because the
possible returns are mutually exclusive, the probabilities sum to 1.0 or 100%. Probability
distributions are prepared based on past data, industry trends and ratios, and forecasts of
the general economy of the country. From a probability distribution the following
measures are obtained.
1. expected rate of return
2. standard deviation or variance
3. coefficient of variation
N.B. under conditions of risk a separate probability distribution is used for each year.
1. Expected rate of return ( k )
The first step in measuring the desirability of a project is to compute the expected rate
of return of each probability distribution. Expected rate of return is the return expected
to be realized from an investment. It is the sum of the products of each possible
outcome times its associated probability—it is a weighted average of the various
possible outcomes, with the weights being their probabilities of occurrence. It is the
mean value of the probability distribution of possible returns.
n
k = ∑(ki )( pi ) , where, k ki = possible return in year i
i 1
pi = probability of occurrence of ki
n = number of possible returns
Example 1. Mr. Max is considering the possible rates of return (dividend yield plus capital
gain or loss) that he might earn next year on a $10,000 investment in the stock of either
Alpha Co. or Beta Co. The rate-of-return probability distributions for the two companies
are shown below.
State of the Probability of the Rate of return if the state occurs
economy state Alpha Co. Beta Co.
Boom 0.3 100% 20%
Normal 0.4 15% 15%
Recession 0.3 (70%) 10%
Example 2: assuming the data in example 1 above compute the standard deviation of each
Co. stock.
2 2 2
σ (Alpha) = (100 15) (0.3) (15 15) (0.4) (70 15) (0.3) = 65.84%
⇒ The probability-weighted-average deviation from the expected value for Alpha Co.
stock is 65.84%.
2 2 2
σ (Beta) = (20 15) (0.3) (15 15) (0.4) (10 15) (0.3) = 3.87%
⇒ Alpha has a larger standard deviation which indicates a greater variation of returns and
thus a greater chance that the expected return will not be realized. Therefore, Alpha is a
riskier investment than Beta.
N.B. the square of σ is called variance and it indicates the same thing as σ.
3. Coefficient of variation (CV)
Another useful measure of risk is the coefficient of variation (CV), which is the standard
deviation divided by the expected return. It shows the risk per unit of return, and it
provides a more meaningful basis for comparison when the expected returns on two
alternatives are not the same:
Coefficient of variation is a measure of relative dispersion that is useful in comparing the
risk of assets with differing expected returns. It shows the risk per unit of return and it
provides a more meaningful basis for comparison when the expected returns on two
alternatives are not the same. In the above example CV is not necessary.
CV =
K
Example 3: given the following information about two assets which one is of lesser risk?
Asset X Asset Y
Expected return 12% 20%
Standard deviation 9% 10%
CV (X) = 9% = 0.75
10%
CV (Y) = 10%= 0.50
20
Asset Y would be preferred as it gives a lower amount of risk per unit of a return. If the firm
were to compare the assets solely on the basis of standard deviation, it would prefer asset X.
However, comparing the CV of the assets shows that management would be making a serious
error in choosing X over Y.
Exercise 1.Given the following probability distributions of cash flows for two projects A and B,
If the variables move together, they are positively correlated ( a positive correlation
coefficient)
If the variables move in opposite direction they are negatively correlated( a
negative correlation)
A correlation of 0.0 indicates that no relationship between the variables, that is
they are unrelated.
Correlation coefficient of +1.0 indicates that the variables move up and down
together, the relative magnitude of the movements is exactly the same (perfect
positive correlation)
If correlation is between 0.0 and +1.0, the returns usually move up and down
together, but not all the time. The closer the correlation is to 0.0, the lesser the two
sets of returns move together.
Correlation of -1.0 implies that they move exactly opposite to each other. (perfect
negative correlation)
Admas University Compiled BY MG Page 4
Financial Management-I Chapter-4
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∑ pi (k x k x )(k y k y )
CorrXY = i 1
YX
Example 5: Consider a portfolio of two investment ventures under three different
economic climates.
State of the Probability of the Rate of return
economy state
X Y
Bad 0.2 0% -10%
Average 0.6 10% 10%
good 0.2 20% 40%
corrxy 0.2(0 10)(10 12) 0.6(10 10)(10 12) (20 10)(40 12) = +0.988
(6.3246)(16)
NB:-Diversification decreases the variability from unique risk but not from market risk.
Summary - Portfolio Risk and return, systematic and Unsystematic risk
Portfolio Risk
Portfolio – a collection or grouping of investment securities or assets
Efficient Portfolio
Maximize return for a given level of risk
Minimize risk for a given level of return
Portfolio Return
the expected return on a portfolio, kp, is the weighted average of the expected returns on
the individual stocks in the portfolio
the portfolio weights must sum to 1.0
the realized rate of return is the return that is actually earned on a stock or portfolio of
stocks
Portfolio Risk
the riskiness of a portfolio of securities, (p, in general is not a weighted average of the
standard deviations of the individual securities in the portfolio
the correlation coefficient, r, is a measure of the degree of co-movement between two
variables; in this case, the variable is the rate of return on two stocks over some past
period
the riskiness of a portfolio will be reduced as the number of stocks in the portfolio
increases; the lower the correlation between stocks that are added to the portfolio the
greater the benefits of continued diversification
Firm-Specific, Diversifiable, or Unsystematic Risk
That part of a security’s risk associated with random outcomes generated by events or
behaviors specific to the firm; firm-specific risk can be eliminated by proper
diversification
Market, No diversifiable, or Systematic Risk
That part of a security’s risk that cannot be eliminated by diversification because it is
associated with economic or market factors that will affect most firms