Example – Time deposit

Suppose Brownie Corporation invested in a time deposit amounting to ₱1,000,000 for 3 months. It earned
interest at 12% per annum. What is the return on investment?

Answer

𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 = ₱1,000,000 × 12% × 3/12

= ₱30,000
30,000
𝑅𝑒𝑡𝑢𝑟𝑛 =
1,000,000

= 3%

The return on investment made in the time deposit is 3%.

ACTIVITY 6.1

Ms. Palacio invests in a T-bill amounting ₱1,000,000. The T-bill will mature in 90 days with an
interest of 9% per annum. What is the return on investment if Ms. Palacio holds the T-bill until
its maturity?

ACTIVITY 6.2

Suppose SGT bought 100 shares of stocks for ₱50,000. The stock paid dividends of ₱10 per
share at the end of the year. Upon receipt of the dividends, SGT sold the stocks at ₱55,000.
What is the return on investment?

A return is coupled by an outflow of cash. A broker fee, commission, and tax are required to buy stocks.
If an investment is made in a time deposit or savings deposit, a final tax on the interest income applies.

ACTIVITY 6.3

Refer to Activity 7.2. assume that at the time SGT bought the stocks, it incurred a broker’s fee
of 2% and a commission of ¼ of 1% of ₱50,000. What is the return on investment?

Chapter 4 Part 1: Risks and Rates of Return 3

PROBABILITY DISTRIBUTION
A probability is the occurrence or non-occurrence of an event. A probability has a range of 0 to 1. Thus, if
these is a 75% chance of buying a car then there must be 25% chance of not buying it. If all the possible
outcomes are considered and a probability is taken into account for each possible outcome, then a
probability is listed.

Probability is applicable not only to statistics but also to finance. If a return on investment is difficult to
estimate because of the different states of possibilities, a probability distribution is used by assigning a
probable return for each states of possibilities. By multiplying the probable return from the different
states of possibilities and then adding them all will give the expected return of that particular investment.

EXPECTED RETURN AND REALIZED RETURN

In making an investment, the investor has to differentiate the expected return and realized return (Mayo,
2011). The expected return is the return after considering the probabilities of occurrence, the state f
economy, and the individual’s expected outcomes. The risk has already been factored in this type of
return.

Example

XYZ Corporation plans to invest in Stock A. The firm expects that the possible returns are dependent on
the state of the economy. Determine the expected return on its planned investment.

State of Economy Possible Return (𝑟𝑖) Probability Distributions

(𝑝𝑖)
Recession 10% 0.20
Normal 15% 0.60
Prosperity 20% 0.20

Answer

𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛 (𝑟𝑖) = (10% × 0.20) + (15% × 0.60) + (20% × 0.20) = 0.15 𝑜𝑟 15%

The expected return is the weighted average of individual possible returns and their probability of
occurrence. If one of the variables change, the expected return will also change.

A realized return is an actual return. It usually turns out to be different from the expected return except
for fixed income securities such as T-bills.

Chapter 4 Part 1: Risks and Rates of Return 4

 ACTIVITY 6.4

EMK Corporation is currently selling its common stock for ₱30 per share. RCBC Securities, Inc.,
a stock dealer, assigned the following probability distribution to the price with the
corresponding return to EMK Corporation
Price Rate of return Probability
₱25 -25% 0.25
₱30 0% 0.25
₱35 +25% 0.25
₱40 +50% 0.25
Assuming that EMK Corporation has no intention of declaring dividends in the coming year,
compute for the expected return on EMK’s stock price.

RISK

In every undertaking, a risk is involved. For example, migrating to another country poses that risk of not
getting a good job or having a good life. If one wants to earn more, he or he might want to take the risk
of resigning from work and take the chance of putting up a business. Making a decision in life is coupled
with the risk of “make or break”. It is the same with business decisions. If the firm would like to earn more,
it would take risks. And in finance, “the higher the risk, the higher the return.” A fundamental idea in
finance is the relationship between risk and return. The investor needs to be compensated for taking the
additional risk. The greater the degree of risk an investor is willing to take, the greater the potential return
is expected.

Risk is the exposure of uncertainty or danger resulting changes in the expected return on a given
investment. It includes the possibility of losing some or all of the original investment. Every time a firm
makes a decision on investing and financing, risk has to be considered with prime importance. Decisions
made must be coupled with a calculated risk as it will affect the firm’s future performance. Risk are
measured in by calculating the standard deviation of historical returns or the expected returns of a specific
investment. High standard deviations indicate a high degree of risk.

Risk is an important factor in an investment decision. It helps determine how individual can efficiently
manage a portfolio of investments through the variations in the returns of an asset or portfolio. The
fundamental concept of risk is that as it increases, the expected return on an investment should also
increase because of the risk premium. Hence, if the investors carry a higher level of risk or uncertainty,
they should expect a higher return on their investments.

Chapter 4 Part 1: Risks and Rates of Return 5

CLASSIFICATIONS OF RISK
1. Systematic risk. It is sometimes called non-controllable risk or undiversifiable risk. This results
from forces outside f the firm’s control and is therefore not unique to the given security.
2. Unsystematic risk. It is sometimes called controllable risk or diversifiable risk. It represents the
portion of a security’s risk that can be controlled through diversification. This type of risk is unique
to a given security.

Systematic risk and unsystematic risk are illustrated below.

Risk

Unsystematic risk

Systematic risk

1 2 3 4 5 6 7 8
Assets
On the y-axis is the risk of an asset and on the x-axis is the number of assets in a portfolio. The systematic
risk is presented by a straight horizontal line which means that regardless of the number of assets in a
portfolio, the risk will still the same. However, the unsystematic risk, is presented by a downward sloping
line. It means that as the assets increase in a portfolio, the risk will decrease. However, unsystematic risk
will never touch the systematic risk even if there are numerous assets in the portfolio.

MEASURING RISK
To measure a risk, a standard deviation is computed. A standard deviation is a widely used measure of
volatility. It shows how much variation exists from the average return of investment. A smaller standard
deviation tells that the data points ten to be very close to the mean and therefore has a lower risk. On the
other hand, a high standard deviation shows that the data points are far from the mean and therefore has
a higher risk

𝛿 = √∑(𝑟𝑖 − 𝑟)2𝑝𝑖
𝑡=1

where 𝛿 = 𝑠𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑑𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛

𝑟𝑖 = 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑖𝑛𝑑𝑖𝑣𝑖𝑑𝑢𝑎𝑙 𝑟𝑒𝑡𝑢𝑟𝑛
𝑟 = 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑟𝑒𝑡𝑢𝑟𝑛
𝑝𝑖 = 𝑝𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛

Chapter 4 Part 1: Risks and Rates of Return 6

STEPS IN COMPUTING THE STANDARD DEVIATION
To compute for the standard deviation, the following steps are followed:

1. Get the expected average return by getting the summation of individual expected return
multiplied by the probability distribution (ri × pi).

2. Subtract the expected average return from each individual expected return(ri − 𝑟).

3. Square the difference (ri − 𝑟)2.

4. Get the summation of the squared difference multiplied to the probability distribution
[(ri − 𝑟)2 × 𝑝𝑖]

5. Get the square root of the summation from the number (4).
𝑛

𝛿 = √∑(𝑟𝑖 − 𝑟)2𝑝𝑖
𝑡=1

Example

Assume that Timbuktu Corporation is considering the possible rate of return that it might earn next year
on a ₱100,000 investment on the stock of FLI. The future returns depend on the state of the economy
with the corresponding probability distribution.

Stock FLI
State of economy Return (𝒓𝒊) Probability (𝒑𝒊)
Recession -8.00% 0.15
Normal 15.00% 0.70
Prosperity 35.00% 0.15

Answer

Using the formula for standard deviation and following the steps indicated above, note that

𝛿 = √∑(𝑟𝑖 − 𝑟)2𝑝𝑖
𝑡=1

Expected return = −0.08 × 0.15 = −0.0120

0.15 × 0.70 = 0.1050
0.35 × 0.10 = 0.0525

0.0120 + 0.1050 + 0.0525 = 0.1455

Chapter 4 Part 1: Risks and Rates of Return 7

𝛿 = √((−0.08 − 0.1455)2 × 0.15) + ((0.15 − 0.1455)2 × 0.70) + ((0.35 − 0.1455)2 × 0.15))

= √0.00763 + 0.00001 + 0.00627

= √0.01391
𝛿 = 0.11794 𝑜𝑟 11.79%

Based on the figures above, FLI has an expected return of 14.55% and a standard deviation of 11.79%.

ACTIVITY 6.5

Summit provides the following information about Stock Yehey’s return. Compute the standard
deviation.
Stock Yehey
Return Probability
25% 0.3
15% 0.4
-15% 0.3

REQUIRED RATE OF RETURN

One common problem encountered by individuals or firms in make an investment is determining the
appropriate required rate of return of an individual asset or a portfolio for different levels of risks. It is in
this context that Capital Asset Pricing Model (CAPM), also called security market line (SML), was
introduced by Jack Treynor in 1961. The model takes into account the risk-free rate (𝑟𝑓), the expected rate
of return in the market (𝑟𝑚), and the volatility of the asset in relation to the market as a whole beta (𝛽).
An asset that has a beta equivalent to 1 has the same risk as the market. A beta whose value is less than
1 has a lesser risk than the market and a value greater than 1 has a greater risk than the market. The CAPM
builds on the proposition that additional risk requires a higher return (Mayo, 2011). The return comprises
of risk-free rate, an investment is asset like T-bills, and the risk premium for taking an additional risk.

To compute for the required rate of return, use

𝑟𝐴 = 𝑟𝑓 + 𝑏(𝑟𝑚 − 𝑟𝑓)

Chapter 4 Part 1: Risks and Rates of Return 8

where rA = the required rate of return of asset A

rf = the risk − free rate

rm = expected rate of return of the market

b = volatility of the asset in relation to the market as a whole

In the given formula, the (𝑟𝑚 − 𝑟𝑓) represents the market premium. The market premium induces
investor to purchase a risky free. However, in order to indicate the asset’s volatility in relation to the
market, the market premium must be adjusted based on the beta coefficient of the individual asset. Thus,
the beta coefficient is multiplied against the market premium, and 𝑏(𝑟𝑚 − 𝑟𝑓)is the risk premium.

Example

Mr. T considers investing in Stock A. the risk-free rate is 9%, the expected rate of return on the market is
12%, and the stock A has a beta of 0.75. what is the required rate of return of stock A?

Answer

𝑟𝐴 = 𝑟𝑓 + 𝑏(𝑟𝑚 − 𝑟𝑓)

𝑟𝐴 = 0.09 + 0.75(0.12 − 0.09)

𝑟𝐴 = 0.1125 𝑜𝑟 11.25%
The CAPM as SML describes a relationship between the beta and the expected rate of return of an asset
or individual assets. The beta is on the x-axis while the expected rate of return is on the y-axis.

Required rate
of return Security market
line (SML)
11.25% -------------------
-------------------

Risk premium
9%

Risk-free rate of
6%
return

3%
Beta
0 0.25 0.50 0.75 1.00 1.25

Based on the graph, as the beta increase, the required rate of return also increases. To further clarify this
concept, refer to the table on the next page.

Chapter 4 Part 1: Risks and Rates of Return 9

 Beta CAPM Model Required Rate
𝑟𝑓 + 𝑏(𝑟𝑚 − 𝑟𝑓) of Return (%)
0 0.09 + 0.0(0.12 − 0.09) 9.00
0.25 0.09 + 0.25(0.12 − 0.09) 9.75
0.50 0.09 + 0.50(0.12 − 0.09) 10.50
0.75 0.09 + 0.75(0.12 − 0.09) 11.25
1.00 0.09 + 1.00(0.12 − 0.09) 12.00
1.25 0.09 + 1.25(0.12 − 0.09) 12.75

Different betas produce different required rates of return in the asset. A illustrated, as the beta increases
by 0.25, the required rate of return increases by 0.75%.

Thus, if the beta has a value of 1, it will give a risk premium that is equivalent to the market premium. The
risk premium reacts primarily on the beta coefficient. If the beta coefficient is higher than 1, the required
rate of return should be higher.

ACTIVITY 6.6

The risk-free rate is 6.5%, the expected return on the market is 10%, and the beta on JG
Summit is 1.5%. What is the required rate of return of JG Summit?

RISK-RETURN TRADE-OFF
There is saying in finance, “The higher the risk, the higher the return”. This best describes a risk-return
trade-off. An investor who desires to get a high return must invest in assets that require higher risks.
However, an investment made in a risky investment does not automatically obtain a higher return. In fact,
a number of cases in which an investment has a higher expected return resulted in a loss of some or even
of all the investment.

For a certain level of risk with different investment opportunities, a knowledgeable and experienced
investor will invest only in those with the highest expected return. For instance, if Mr. X has ₱ million to
invest in either stocks or bonds and both have the same risk level but the expected return in the former
is higher than in the latter, Mr. X will likely invest in stocks. However, if stocks and bonds differ in their
level of risks and expected returns, the decision now lies on the individual’s risk tolerance. Risk tolerance
differs from one individual or firm to another depending on its capacity, objective, and time prescription.

A risk-averse investor avoids a risky investment and therefore should expect a lower return. On the other
hand, a risk-taker is willing to take a higher return and has a high tolerance for possible loss.

Chapter 4 Part 1: Risks and Rates of Return 10

You may notice why bonds have different coupon payments when they similarly pay interest a periodic
basis and principal on its maturity date. The reason is that riskier bonds have higher coupon rates than
other bonds. It is also why bonds have lower returns as compared to many stocks because the former are
a less risky investment.

Risk-Return Trade Off

High risk, high return

Return

Low risk, low return

Risk
(Standard Deviation)
The concept of risk-return trade-off presented in the graph, that low risks are associated with low
potential returns while high risks are associated with high potential returns. The risk-return trade-off is an
attempt to obtain a balance between the desire for the lower possible risk and the highest possible return.
Thus, it is the investor who needs to identify its own risk-return trade-off based on investment objectives,
the prescribed period, and risk tolerance.

Chapter 4 Part 1: Risks and Rates of Return 11