RISK AND RETURN

INTRODUCTION
Any financial decision involves an element of risk. Whether it is selection of plant and machinery
by a production manager or selection of securities for investment by a finance manager, both
decisions face the risk in terms of the returns that will be achieved from the investment. It is
important for a person/ company to assess the financial impact of the risk before taking any
decision. It is not possible to completely eliminate the risks involved; however, a proper analysis
will help the investor to take an informed decision.

Define and measure return and expected returns

The prime objective of making investment in any security is either to yield income on that
investment in form of dividend/ interest or appreciation in the investment value. Return is the
motivating force and the principal reward in the investment. An appreciation in the investment can
also be considered as capital gain on investment. There are two types of return, commonly
discussed under investment management, first realized return and expected return.
The realized return is the actual outcome on investment, on the other hand expected return is the
probable return on investment over future periods.
Return on an asset/ investment is the actual income received plus any change in the market price
of an asset/investment. This is generally expressed as a percentage of the opening market price.
It is given by the following formula:

R= Dt + (Pt - Pt-1)
Pt-1
Where,
R= Return on asset/ investment
𝐷𝑡 = annual income/ cash dividend at the end of the time period t
𝑃𝑡 = security price at time period t (closing security price)
𝑃𝑡−1 = security price at time period t-1 (opening security price)

Example
Andrew has invested in the shares of Z Plc. The price of the shares on 1 January is Tshs 3000,
dividend declared for the year is Tshs 200 and the year- end price on 31 December is Tshs 3500.
Calculate the rate of return.

Expected Returns
Since risk is associated with every financial decision and the returns are received in the future over
a period of time, it is difficult to accurately predict the expected returns. Returns can vary from
say -10% to 10%, 15%, 50% and so on. Also, the likelihood of these returns may vary. Hence an
investor generally takes into consideration the likelihood of the occurrence of the return. It is also
called the probability. Probability represents the percentage chance of the occurrence of an event.
For example, if it is expected that a given outcome will occur six out of ten times, then the
probability is said to be 60%.
There is 60% chance that the outcome will occur. The probability of an event varies between 0
and 1. An event that is not likely to occur at all is said to have zero probability whereas an event
which is certain to occur has a probability of 1. An event which is uncertain will have a probability
between 0 and 1. The total of probabilities assigned to the different possible outcomes of an event
has to be 1.

Expected rate of return is the weighted average of all possible returns multiplied by their
respective probabilities.
This can be expressed as follows in the form of a formula:
n
∑PiRi
i=1
Where,
R = expected return
Ri = return for the ith possible outcome
Pi = probability associated with Ri
n= number of possible outcomes
Example:
Given in the table below are expected rates of returns and their probabilities for investment made
in the
securities of City Corporation Plc:

Rate of Return (%) Probability of occurence

50 0.5
45 0.3
65 0.2

Define and measure risk.

Risk can be defined as the probability or chance of a negative outcome.
Risk can also be defined as the variability of actual returns from expected returns for a given asset,
or in other words, the uncertainty of outcomes.
From the above, it can be seen that risk has two main aspects: probability of occurrence of loss
and amount of potential loss
Measuring Risk
The risk in relation to a single asset is measured with respect to behavioural and quantitative or
statistical point of view.
1. The two techniques for behavioral assessment of risk are
(a) Sensitivity analysis
(b) Probability analysis
1) Sensitivity Analysis
This technique considers the various possible estimates of outcomes for assessing the risk. It takes
intoConsideration the worst (recession in economy), the most likely (normal conditions in the
economy) and the most optimistic outcome (boom) associated with the asset under consideration.
The difference between the worst outcome and the most optimistic outcome is referred to as the
range. Range is the basic measure of risk according to the sensitivity analysis technique. The higher
the range, the higher is the risk to which the asset/investment is exposed.

Probability analysis
This technique is considered to be more accurate than Sensitivity Analysis. As already explained
above, Probability is the likelihood or a chance of occurrence of an event.

Techniques for quantitative or statistical analysis of risk are

(a) Standard deviation
(b) Coefficient of variation

a) Standard Deviation
This commonly used measure of risk measures the standard deviation from the most likely/
expected value of return. Standard deviation of returns is given by the following formula.

∑ (Ri-R)2* Pri

Where,
Ri = return for the ith possible outcome
R = Expected Return
P i = probability associated with R i
n= number of possible outcomes
The greater the standard deviation of returns, the greater is the risk for the asset/ investment.

b) Coefficient of variation
This is the measure of risk per unit of expected return. This is useful for comparing risk of assets
with different expected returns. Co-efficient of variation is given as
CV = σr
𝑅̅
Where
σ r = standard deviation
R = expected return
The greater the coefficient of variation, the greater is the risk for the asset/ investment.

Example
Given below are details of expected returns and the probabilities for asset 1. Calculate standard
deviation
I Ri Pri
1 15% 0.2
2 17% 0.5
3 20% 0.20

Describe the relationship between risk and return.

Any investment involves some amount of risk. In simple words, risk is the possibility that
investment made may not yield returns as expected and that the objectives of investment may not
be fulfilled. Risks are generally classified as market risk (economic changes, market conditions
etc), liquidity risk (investments cannot be sold easily), concentration risk (investing in only one
investment or type of investment; no diversification), capital risk (risk of losing the capital
invested) etc. Returns are the amount earned on the investment. Returns may be in the form of
interest and dividend as well as in the form of capital gains. Returns are affected by inflation and
the tax regulations in the economy. Taxes reduce the amount of returns, whereas inflation reduces
the value of returns. Risks and returns are directly related to each other. The higher the risk an
investment carries, the higher will be the expected returns from the investment. Higher risk in an
investment is compensated by a potential for higher returns. For example, fixed deposits or
government bonds have a lower rate of return as compared to mutual funds and stocks.

In the case of fixed deposits or government bonds, the returns are guaranteed; also the investor is
sure to get his principal back. In some cases, the returns are not guaranteed but the investor is
certain of getting the principle back. In the case of stocks or mutual funds, there is a possibility
that an investor not only gets lower returns but can also lose their principal amount invested.
Risk and return also depend upon the time period for which the investment is held. Returns from
investments carrying high risk tend to be higher if held for a long period of time. For short term
investments, the more conservative options yield higher returns.

An investment may be classified in any of the following categories

(a) High Risk High Return: in this case, investment will yield high returns but the risk will also
be high. For example, shares, mutual funds etc.

(b) Low Risk Low Return: the investment will carry low risk and the return will also be low. For
example, money in fixed deposits, government bonds etc.

(b) High Risk Low Return: in this case, the investment carries a high risk and a high return up to
a certain point but after that the returns do not increase in proportion to the increase in risk.

An investor makes investment decisions based on information available about the risks and
returns of investment options under consideration. The decision also depends upon the risk
preference of the investor. Investors generally show preference for investments with higher
returns and lower risks

Investors can be generally classified as follows:

Risk averse investor- in the case of equal rates of returns from various investment options,
the investor will choose the ones with the lowest standard deviation and vice versa.

Risk neutral investor- is the one who does not take risks into consideration and selects
investments with higher returns.

Risk seeking investor- is the one who shows preference towards investments with higher risk,
irrespective of the rate of return.

Relationship between market risk and return

Sensitivity of a security to market risk is called beta ( β ). According to Capital Asset Pricing
Model), relationship between risk and return is given as follows:

𝐸(𝑅𝑖) = 𝑅𝑓 + 𝛽𝑖[𝐸(𝑅𝑚) – 𝑅𝑓]

Where,
(𝑅𝑖)= Expected Return of security
= Risk- free return
𝛽𝑖= Beta of security
(𝑅𝑚) = Expected return on market portfolio

Expected return of security = Risk- free return + Risk Premium [(𝑅𝑚) − 𝑅𝑓]

Example
Shares of Fair Cosmetics Plc have a beta of 1.5, risk- free rate of 10% and expected return on
market portfolio of 15%. Calculate the expected rate of return on the shares of Fair Cosmetics Plc

QUESTIONS
1. The market price of the share of Star Plc is Tshs 5000. The company is expected to pay a
dividend of Tshs 400 per share one year from now and the expected price one year from now
is Tshs 6500. Calculate the rate of return on investment in the shares of Star Plc.

2. Given below are the details of probability of occurrence and rate of return for Weatherfare Plc:

State of the Economy Pi Ri

Boom 0.3 30
Normal 0.6 25
Recession 0.10 20

Compute the standard deviation.