MODULE 1

FINANCIAL MARKET

SESSION TOPIC 1: INTRODUCTION TO RISK AND RETURNS

LEARNING OUTCOMES:
The following specific learning objectives are expected to be realized at the end of the session:
a. Computation of return and risk

KEY POINTS

Risk Return Standard Deviation Annualized

Annual Rate of Return

CORE CONTENT
Introduction:
This module covers the discussion of
a. How to calculate the actual return on an investment using different methods
b. How to calculate the estimate return on an investment
c. How to identify risky investment
d. The relationship between risk and return

IN-TEXT ACTIVITY

Money often costs too much. Returns and costs, under finance subjects, are the different
Ralph Waldo Emerson sides of the same coin.

Returns can be defined as the increase in or the Costs of money, in the same vein, is the
profit of an investor (or lender) from the money additional amount of money to be paid by the
he or she gave for the use of another. Money person who used money that is not his or hers.
given must be in form of debt or as investment. Such additional amount is either interest or
dividends.

Average returns
Return Variability

Returns therefore may be as interest income or And such person received the money in form
dividends income of debt or equity instrument.

MODULE 1: Financial Market 1

Return can be reported in peso value or in percentage, or if the return was already earned or to be
received in the future.

The amount of return on investment is a function of three things: Amount invested, length of time that
amount is invested and the rate of return on the investment. Different instrument varies on these three
things. To compute the rate of return, the function is

Return Received for One Yea r ' s Investment

Annual Rate of Return=
Average Balance of Amount Invested
For example:
1. You invested ₱ for one year and you received a ₱ 500 return on the investment at the end of one
year, you receive back ₱ 10,500. Your rate of return on the investment is

Annual Rate of Return = ₱500 / ₱10,000 = 0.05 or 5%

2. Suppose the ₱10,000 is invested only for 6 months and earns ₱ 300 on the investment. The rate
of return of ₱ 300 / ₱10,000 = 0.03 or 3% is not for annual rate of return.

Annual Rate of Return = (₱300 X 2) / ₱10,000 = 0.06 or 6%

WE annualize the ₱300 that was received for 6 months and we assume if the same P10,000 was
invested for full year.

3. Assume now, that you invested ₱10,000 for 3 months, then withdraws ₱4,000 and leave the
remaining ₱6,000 on deposit for another 3 months. At the end of the 6 months, you withdraw the
remaining ₱6,000 along with the income received of ₱200.

Annual Rate of Return = (₱200 X 2) / ₱8,000 = 0.05 or 5%

We annualize the ₱ 200 received in 6 months and divide it by the average investment you made
which is ((₱10,000 X 3months) + (₱6,000 X 3months)) divide by 6 months.

The study of returns allows the decision-maker to choose the best instrument to get involved with-
assuming that, the decision maker have sufficient money to lend and have several options to work with.

The applying the concepts and computation above in the financial market. The return in an investment
instrument, in form of stocks or shares of corporation, may be classified either dividend yield or capital
yield.

 Dividend yield is the annual stock dividend as a percentage of the initial stocks.
 Capital yield is the change in the stock price as a percentage of the initial stocks.
 Total Percentage Return refers to both or sum of dividend yield and capital yield.

Example:

Supposed you buy some stock of JFC at a price of ₱141.50 per share. Three years later, you sell it at
₱247.625. You received a dividend of ₱14.15 per year per share. What it your annual rate of return?

Dividend Yield+Capital Yield ( ₱ 14.15 X 3 ) +(₱ 247.625−₱ 141.50)

Total Percentage of Return= =
Amount Invested ₱ 141.50
= 1.05 or 105%

Because the period covered is 3 years, we must divide 105% by the period and we have ARR of 35%.

MODULE 1: Financial Market 2

With the dividend yield of 10% per annum (₱14.15 dividends divide by initial investment of ₱141.50), and
capital yield of 25% per annum (₱247.625 price of the stock after 3 years minus initial investment of
₱141.50 divide by period covered, 3 years)
In determining expected return, under a discrete distribution we use the formula of
n
R=∑ (Ri ¿)( Pi) ¿
i=1

Where R = is the expected return for the asset, Ri is the return for the ith possibility, Pi is the probability
of the occurring, n is the total number of possibilities.

For example: You plan to invest in stock KJ and you expect that the following returns may occur, what will
be the expected return of the investment KJ?

Return ( Ri ¿ Probability of Occurrence (in

percentage) Pi
-15 10
-3 20
9 40
21 20
33 10
100

To identify the expected return, we add the column of ( Ri ) ( Pi ) in order to apply the formula stated
above.

Return ( Ri ¿ Probability of Occurrence (in ( Ri)( Pi)

percentage) Pi
-15 10 -1.5
-3 20 -0.6
9 40 3.6
21 20 4.2
33 10 3.3
100 9.0

Given the information above, the expected return of the KJ stocks is 9.0 or 9%.

RISK

Is defined as the chance that an unwanted and harmful event will take place. And in investment and
finance parlance, the risk is the variability of actual returns from expected returns.

And how we measure the risk? How can we say that the investment is too risky or less risky?

The risk again is the variability of actual returns from expected returns; thus, we can measure it using the
variability- or the deviations of the possible outcomes. Statistically, then we can use the standard
deviation, that measure the variability of a distribution around its mean. And is written as,

√∑
n
σ= ( Ri−R )2 ( Pi)
i−1

MODULE 1: Financial Market 3

Example: Using the information from previous example of stocks of KJ, with expected return (R) of 9.0,
we add the column of the computation of measurement of the risk:

Return ( Ri ¿ Probability of Occurrence (Ri)(Pi) ( Ri−R )2 (Pi)

(in percentage) Pi
-15 10 -1.5 0.576
-3 20 -0.6 0.288
9 40 3.6 0
21 20 4.2 0.288
33 10 3.3 0.576
100 9.0 1.728

Therefore:
n

∑ ( Ri−R )2 ( Pi )=1.729
i−1

√∑
n
σ= ( Ri−R )2 ( Pi)
i−1

σ =√ 1.728
σ =0.1315∨13.15%

The Relationship Between Risk and Return.

The rule of thumb is the higher the potential return, the higher the level of risk involved. To undertake
additional risk if it will be adequately compensated for it by receiving extra return.

Risk Attitude:

Example Problem:

You have the choice between (A) a guaranteed dollar reward or (B) a coin-flip gamble of ₱100,000 (50%
chance) or $0 (50% chance). The expected value of the gamble is ₱50,000.

 Fhanny requires a guaranteed ₱25,000, or more, to call off the gamble.

 Mainotaur is just as happy to take ₱50,000 or take the risky gamble.
 Thamuz requires at least ₱52,000 to call off the gamble.

If you are same with:

 Fhanny then you exhibit “risk aversion” because your “certainty equivalent” < the expected value
of the gamble.
 Mainotaur, then you exhibit “risk indifference” because your “certainty equivalent” equals the
expected value of the gamble.
 Thamuz, then you revealed “risk preference” because your “certainty equivalent” > the expected
value of the gamble.

MODULE 1: Financial Market 4

SESSION SUMMARY

Risk and return are useful tool and a necessary information in making investment decisions. Returns can
be actual or expected and can be measured using different approaches. The risk at the same time can be
presented as volatility of the returns and is commonly measured and presented as the standard deviation
of the returns.

SELF-ASSESSMENT
Activity 1

REFERENCES
Refer to the references listed in the syllabus of the subject.

Activities:

Problem 1.

You plan to buy a common stock and hold if tor one year. You expect to receive both ₱150 and ₱260
form the sale of the stock at the end of the year. How much will you pay for the stock, if you want to
a. Have a return of 8%
b. A return of 10%
c. A return of 15%

Problem 2:
You bought 400 shares of Heavy Metal Inc. at ₱300 per share over the year, you received ₱75 per share
in dividends. IF the shares were sold for ₱330 at the end of the year, what was your peso return? And
percentage of return.

Problem 3:
Given six years of percentage return of Stock A and Stock B, identify the expected return, and risk of
each instrument. Assume that each year, has equal chances of reoccurrence.

Stock A Stock B
20X1 10 20
20X2 -15 -20
20X3 20 -10
20X4 25 30
20X5 -30 -20
20X6 20 60

a. Which of the two stocks is riskier? Why?

b. Which of the stocks is expected to yield a higher return? Why?
c. Where will you invest?

MODULE 1: Financial Market 5