Amity Business School

Financial
Management
FIBA 601
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Risk and Return

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Historical return or holding period yield(HPY)

• Single Asset case

𝐶 + ( 𝑃𝑟𝑖𝑐𝑒 𝑎𝑡 𝑒𝑛𝑑 𝑜𝑓 𝑝𝑒𝑟𝑖𝑜𝑑 − 𝑃𝑟𝑖𝑐𝑒 𝑎𝑡 𝑠𝑡𝑎𝑟𝑡 𝑜𝑓 𝑝𝑒𝑟𝑖𝑜𝑑)

𝑅=
𝑃𝑟𝑖𝑐𝑒 𝑎𝑡 𝑠𝑡𝑎𝑟𝑡 𝑜𝑓 𝑝𝑒𝑟𝑖𝑜𝑑

Where
R = total return over the period
C = Cash payment received during the period
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Numerical (HPY)
• Consider the following information
regarding an equity stock
▪ Price at beginning of the year : Rs 60
▪ Price at end of the year : Rs 69
▪ Dividend paid at end of the year : Rs 2.40

Calculate the return on the equity stock for

one year period.
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Price at beginning of the year 60

Price at end of the year 69
Dividend paid at end of the year 2.4
𝐶 + ( 𝑃𝑟𝑖𝑐𝑒 𝑎𝑡 𝑒𝑛𝑑 𝑜𝑓 𝑝𝑒𝑟𝑖𝑜𝑑 − 𝑃𝑟𝑖𝑐𝑒 𝑎𝑡 𝑠𝑡𝑎𝑟𝑡 𝑜𝑓 𝑝𝑒𝑟𝑖𝑜𝑑)
R 𝑅=
𝑃𝑟𝑖𝑐𝑒 𝑎𝑡 𝑠𝑡𝑎𝑟𝑡 𝑜𝑓 𝑝𝑒𝑟𝑖𝑜𝑑

R [2.4 + (69-60)]/ 60
R 0.19
Return is 19%
Current yield 2.4/60=0.04
Capital return (69-60)/60 = 0.15
R = Current yield + Capital return
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Multi period return :Average annual return

Arithmetic mean
𝑅1 + 𝑅2 + 𝑅3 + ⋯ + 𝑅𝑛
𝑅=
𝑛

∑𝑅𝑖
R=
𝑛
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Numerical (Multi period return)

Suppose that total returns from stock A over a
five year period are as follows. What is return
(AM)for stock A for 5 years?
Year Total Percentage (%)
1 19
2 14
3 22
4 -12
5 5
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Year Total Percentage (%)

1 19
2 14
3 22
4 -12
5 5
sum 48
Average return 48/5
= 9.6%
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Average annual return

• Geometric mean

𝐺𝑀 = [ 1 + 𝑅1 1 + 𝑅2 1 + 𝑅3 … . . 1 + 𝑅𝑛 ]1/𝑛 −1
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Numerical (Multi period return)

Suppose that total returns from stock A over a
five year period are as follows. What is return
(GM) for stock A for 5 years?
Year Total Percentage (%)
1 19
2 14
3 22
4 -12
5 5
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Average annual return

• Geometric mean

𝐺𝑀 = [ 1 + .19 1 + .14 1 + .22 (1 − .12) 1 + .05 ]1/5 −1

= 1.089 -1
= 0.089
5 year return is 8.9% for stock A.
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Risk : Variance of Returns

• It captures the variability of the return

and hence is a measure of risk.
• 𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒 = (𝑠𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑑𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛)2
2
2 ∑ 𝑅𝑖 −𝑅𝑎𝑣𝑔
•𝜎 =
𝑛−1
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Numerical (Risk)
Suppose that total returns from stock A over a
five year period are as follows. What variance
and standard deviation for stock A for 5
years?
Year Total Percentage (%)
1 19
2 14
3 22
4 -12
5 5
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Total
Percentage
Year (%) (Ri-avg) (Ri-avg)^2
1 19 9.4 88.36 Variance 187.3
2 14 4.4 19.36
Std.
3 22 12.4 153.76 deviation 13.68
4 -12 -21.6 466.56
5 5 -4.6 21.16
sum 48 749.2
avg 9.6
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Expected Return of single asset

Expected Returns or prospective returns can be

calculated using likelihood (probability)

𝐸 𝑅 = 𝑝1 𝑅1 + 𝑝2 𝑅2 + 𝑝3 𝑅3 … … … + 𝑝𝑛 𝑅𝑛
Or,
𝐸 𝑅 = ∑𝑝𝑖 𝑅𝑖
Where
𝑅𝑖 is the return for i th outcome
𝑝𝑖 is the probability associated with the i th outcome
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Expected Risk of single asset

𝜎 2 = ∑𝑝𝑖 ( 𝑅𝑖 − 𝐸 𝑅 ) 2

Where
𝑅𝑖 is the return for i th outcome
𝑝𝑖 is the probability associated with the i th outcome
E(R) is the expected return of the asset.
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Numerical (Expected Return)

An analyst had forecasted three economic scenarios and
its associated probabilities. Also he estimates the
conditional returns of stock A. Compute the return,
variance and standard deviation of the stock A.

Conditional
Economic Scenario Probability Returns (%)A

Growth 0.40 15
Stagnation 0.35 12
Recession 0.25 8
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Expected Return Calculation

Economic Conditional Returns
Scenario Probability (%)A p*R

Growth 0.4 15 6

Stagnation 0.35 12 4.2

Recession 0.25 8 2

sum 12.2
E(R)= 12.2%
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Expected Risk Calculation

Economic Conditional [Ri-

Scenario Probability Returns (%)A p*R Ri- Re Re]^2 pi*[Ri- Re]^2

Growth 0.4 15 6 2.8 7.84 3.136

Stagnation 0.35 12 4.2 -0.2 0.04 0.014

Recession 0.25 8 2 -4.2 17.64 4.41

sum 12.2 7.56 σ^2

2.749545417 σ
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Numerical (Expected Return & Risk comparison)

An analyst had forecasted three economic scenarios and its
associated probabilities. Also he estimates the conditional returns of
stock A and B. Compute the return, variance and standard deviation
of the stock A and B and compare the stocks.

Conditional Conditional
Economic Scenario Probability Returns (%)A Returns (%)B

Growth 0.30 16 40
Stagnation 0.50 11 10

Recession 0.20 6 -20

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Expected Return Calculation

Economic Conditional Conditional

Scenario Probability Returns (%)A Returns (%)B E(Ra) E(Rb)

Growth 0.3 16 40 4.8 12

Stagnation 0.5 11 10 5.5 5

Recession 0.2 6 -20 1.2 -4

11.5 13
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Expected Risk Calculation

Conditional
Economic Returns [Ri-
Scenario Probability (%)A E(Ra) Ri- Re Re]^2 pi*[Ri- Re]^2

Growth 0.3 16 4.8 4.5 20.25 6.075

Stagnation 0.5 11 5.5 -0.5 0.25 0.125

Recession 0.2 6 1.2 -5.5 30.25 6.05

11.5 12.25 σ^2

3.5 σ
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Expected Risk Calculation

Condition
Economic Probabilit al Returns [Ri-
Scenario y (%)A E(Ra) Ri- Re Re]^2 pi*[Ri- Re]^2

Growth 0.3 40 12 27 729 218.7

Stagnation 0.5 10 5 -3 9 4.5

Recession 0.2 -20 -4 -33 1089 217.8

13 441 σ^2

21 σ
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Risk and Return of

Portfolio
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Expected return of a portfolio(2 asset)

𝐸 𝑅𝑝 = 𝑤1 𝐸 𝑅1 + 1 − 𝑤1 𝐸(𝑅2 )
𝑤1 is proportion of investment
security 1
is security 1
𝑤2 is proportion of investment is security 2
𝐸 𝑅𝑝 expected return of the portfolio
𝐸 𝑅1 expected return of security 1
𝐸(𝑅2 ) expected return of security 2
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Expected return of a portfolio(n asset)

𝐸 𝑅𝑝 = ∑ 𝑤𝑖 𝐸(𝑅𝑖 )

𝑤𝑖 is proportion of investment is security i

𝐸 𝑅𝑝 expected return of the portfolio
𝐸 𝑅𝑖 expected return of security i
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Numerical (Return & Risk of a 2 asset portfolio)

• Based on the information provided asses

the risk and return of a portfolio investing
equally in security A and B
State of Return of
economy Probability A(%) Return of B(%)
1 0.2 15 -5
2 0.2 -5 15
3 0.2 5 25
4 0.2 35 5
5 0.2 25 35
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Portfolio return
State of Return of Return of
economy Probability A(%) B(%) E(Ra) E(Rb) E(Rp)

1 0.2 15 -5 3 -1 1

2 0.2 -5 15 -1 3 1

3 0.2 5 25 1 5 3

4 0.2 35 5 7 1 4

5 0.2 25 35 5 7 6

sum 15 15 15
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Risk Calculation for security A

State of
economy pi Ra E(Ra) Ri- Avg (Ri- Avg)^2 pi*(Ri- Avg)^2

1 0.2 15 3 0 0 0

2 0.2 -5 -1 20 400 80

3 0.2 5 1 10 100 20

4 0.2 35 7 -20 400 80

5 0.2 25 5 -10 100 20

sum 15 200 σ^2

14.14213562 σ
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Risk Calculation for security B

State of
economy pi Rb E(Rb) Ri- Avg (Ri- Avg)^2 pi*(Ri- Avg)^2

1 0.2 -5 3 20 400 80
2 0.2 15 -1 0 0 0

3 0.2 25 1 -10 100 20

4 0.2 5 7 10 100 20

5 0.2 35 5 -20 400 80

sum 15 200 σ^2

14.14213562 σ
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Risk Calculation for portfolio

State of
economy pi Rp E(Rp) Ri- Avg (Ri- Avg)^2 pi*(Ri- Avg)^2

1 0.2 5 3 10 100 20

2 0.2 5 -1 10 100 20

3 0.2 15 1 0 0 0

4 0.2 20 7 -5 25 5

5 0.2 30 5 -15 225 45

sum 15 90 σ^2

9.486832981 σ
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Risk and Diversification

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Market Risk
• Beta is a measure of market risk.

𝑐𝑜𝑣(𝑅𝑖 , 𝑅𝑚 )
𝛽𝑖 = 2
𝜎𝑀
𝛽𝑖 is the beta of security i
𝑐𝑜𝑣(𝑅𝑖 , 𝑅𝑚 ) is covariance of security i with
market portfolio
2
𝜎𝑀 variance of market portfolio
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Interpretation of Beta
• A 𝛽𝑖 of 1 indicates that the price of a
security moves with the market.
• A 𝛽𝑖 of less than 1 indicates that the
security is less volatile than the market
as a whole.
• Similarly, a 𝛽𝑖 of more than 1 indicates
that the security is more volatile than the
market as a whole.
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𝜌𝑖𝑚 𝜎𝑖𝜎𝑚
𝛽𝑖 = 2
𝜎𝑀
𝜌12 𝜎𝑖
𝛽𝑖 =
𝜎𝑚
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Numerical (Beta)
• Based on the returns provided for security J and
Sensex returns for a period of 10 years calculate the
beta of stock J.
Years Rj (%) Rm(%)
1 10 12
2 6 5
3 13 18
4 -4 -8
5 13 10
6 14 16
7 4 7
8 18 15
9 24 30
10 22 25
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Years Rj (%) Rm(%) (Rj-avg) (Rm-avg) (Rj-avg)*(Rm-avg) (Rm-avg)^2

1 10 12 -2 -1 2 1
2 6 5 -6 -8 48 64
3 13 18 1 5 5 25
4 -4 -8 -16 -21 336 441
5 13 10 1 -3 -3 9
6 14 16 2 3 6 9
7 4 7 -8 -6 48 36
8 18 15 6 2 12 4
9 24 30 12 17 204 289
10 22 25 10 12 120 144
average 12 13 sum 778 1022

covariance 86.444 113.556 σ^2

beta 0.761252446