CHAPTER TWO

RISK AND RETURN

2.1. Introduction
In this chapter, we start from the basic premise that investors like returns and dislike risk.
Therefore, people will invest in risky assets only if they expect to receive higher returns. We
define precisely what the term risk means as it relates to investments. We examine procedures
managers use to measure risk, and we discuss the relationship between risk and return.
2.2. Meaning of risk
Risk is an important concept in financial analysis, especially in terms of how it affects security
prices and rates of return. Investment risk is associated with the probability of low or negative
future returns.
Thus, risk refers to the chance that some unfavorable event will occur. If you engage in
skydiving, you are taking a chance with your life—skydiving is risky. If you bet on the horses,
you are risking your money. If you invest in speculative stocks (or, really, any stock), you are
taking a risk in the hope of making an appreciable return.
The riskiness of an asset can be considered in two ways: (1) on a stand-alone basis, where
the asset’s cash flows are analyzed, all by themselves or (2) in a portfolio context, where the cash
flows from a number of assets are combined and then the consolidated cash flows are analyzed.
In a portfolio context, an asset’s risk can be divided into two components: (1) a
diversifiable risk component, which can be diversified away and hence is of little concern to
diversified investors, and (2) a market risk component, which reflects the risk of a general stock
market decline and which cannot be eliminated by diversification, hence does concern investors.
Only market risk is relevant; diversifiable risk is irrelevant to most investors because it can be
eliminated.

2.3. Types of risk

Some of the risks you take when you invest your money include the
following:

a) Financial Risk
Financial risk is the risk that the business or government will not be able to return your money-
much less pay a rate of return. Businesses, state agencies, and local governments have on some
occasions declared bankruptcy. Government prints money, so there is no financial risk that it will
not pay off its bonds. Insured savings accounts are insured by an agency of the federal
government, so they carry very little financial risk.
b) Market Price Risk
This is the risk that the price of an investment will go down. This rarely happens to the money
saved in a bank, savings and loan, or credit union. However, the prices of stocks, bonds, and
mutual funds are determined by supply and demand, and they do go down (as well as up). The
supply of an investment is the different quantities of investment that will be offered for sale at
various prices during a specific time period. The demand for an investment refers to the different
quantities of an investment that will be purchased at various prices during a specific time period.
The equilibrium price is the price at which buyers want to buy the same amount of an investment
that sellers want to sell.
The important point is that anything that changes the behavior of buyers and sellers can change
the price of an investment. For example, technology stocks have been “hot” at various times.
Prices increased because more people wanted technology stocks at various price levels (demand

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increased). When investors became less interested in technology stocks, the average price fell
because fewer people wanted technology stocks at every price level (demand decreased).
c) Liquidity Risk
Liquidity is the ability to turn your money into cash or spendable funds, such as a checking
account. Some investments are very liquid. For example, some savings accounts allow you to
withdraw your money at any time without a penalty. Stocks listed on a stock exchange are very
liquid; you can buy or sell them at any time. Real estate and collectibles, on the other hand, are
not very liquid because it takes time for a seller to find a buyer. Although the Internet is speeding
up this process, there is no guarantee that a buyer and seller can get together on price and other
terms for real estate and collectibles.
d) Inflation Risk
Money is invested today in order to spend it tomorrow. The goal is to receive the original
investment back plus a return, so that you will be able to buy more in the future.
Inflation can decrease the value of your investment. When you save or invest, you are deferring
your spending until a later time. If prices rise over that time, your money will not go as far.
Therefore, investors are more interested in the real rate of return than the nominal rate of return.
The real rate of return is the nominal rate of return minus the inflation rate. For example, let’s
say you put your money in a certificate of deposit at an 8 percent rate of return. The annual rate
of inflation is 3 percent. Therefore, your real rate of return is 5% (8% - 3% = 5%). The longer the
time period, the greater the inflation risk.
e) Fraud Risk
Some investments are misrepresented. In these cases, information about the investment is
designed to deceive investors. Anyone can print a fancy brochure, make promises on the
telephone, or guarantee great returns on the Internet. Criminals often make up facts. Therefore, it
is important to investigate before you invest. Most investment fraud occurs in securities and
savings schemes that do not involve banks, savings and loans, credit unions, and brokerage
firms.
2.4. Measuring risk (standalone investment)
An asset’s stand-alone risk is the risk an investor would face if he or she held only this one
asset. Obviously, most assets are held in portfolios, but it is necessary to understand stand-alone
risk in order to understand risk in a portfolio context.
Risk is a difficult concept to grasp, and a great deal of controversy has surrounded attempts to
define and measure it. However, a common definition, and one that is satisfactory for many
purposes, is stated in terms of probability distributions.
To be most useful, any measure of risk should have a definite value—we need a measure of the
tightness of the probability distribution. One such measure is the standard deviation, the
symbol for which is δ pronounced “sigma.” The smaller the standard deviation, the tighter
the probability distribution, and, accordingly, the lower the riskiness of the stock.
To calculate the standard deviation, we use the following steps:
Step 1: calculate the expected rate of return
n
Expected rate of return= r^ =∑ Pi r i
i=1

2
Where:
 ri is the ith possible outcome
 Pi is the probability of the ith outcome
 n is the number of possible outcomes.
Step 2: Subtract the expected rate of return (r^ ) From each possible outcome (ri) to obtain
a set of deviations about r^
Deviation= ri – ȓ

Step 3: square each deviation, then multiply the result by the probability of occurrence
of its related outcome, and sum these products to obtain the variance of the
probability distribution.
n
var=∑ ( ri−ȓ ) Pi
2

i=1

Step 4: find the square root of the variance to obtain standard deviation

√∑
n
SD= ( ri−ȓ )2 Pi
i=1

Thus, the standard deviation is essentially a weighted average of the deviations from the
expected value, and it provides an idea of how far above or below the expected value the actual
value is likely to be.
Illustration-1
Here are given details about wegagen bank and CBE.
DD for the bank's Probability (P) Wegagen bank CBE return
services return (r) (r)

Strong 0.3 100% 20%

Normal 0.4 15% 15%
Weak 0.3 (70)% 10%

Instruction: So based on the above information calculate the standard

deviation of wegagen bank and CBE and select the best
investment in terms of risk and return.

Solution
Standard deviation for Wegagen Bank
Pxri ri- ȓ (ri –ȓ )2 (ri –ȓ )2 Pi
(step-1) ( Step 2) (step 3)
0.3×100%= 30% 100-15= 85 7,225 2167.5
0.4×15%= 6% 15-15= 0 0 0
0.3×(70)%= (21)% -70-15 = -85 7,225 2167.5
∑ ȓ =15% Sum (variance) 4,335
Square root of variance (standard 65.84
deviation)
Calculate the standard deviation for CBE by yourself (answer SD= 3.87)

2.5. Using Historical Data to Measure Risk

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In the example just given, we described the procedure for finding the standard deviation when
the data are in the form of a probability distribution. If only sample returns data over some past
period are available, the standard deviation of returns should be estimated using this formula:

√
n
2
∑ ( r t −r avg )
n=1
estimated σ =s=
N −1
Where
 r t -denotes the past realized rate of return in Period t
 r avg −¿is the average annual return earned during the last N years
 N- year
Illustration
The following is information about the ABC - company
Year rt
2003 15%
2004 -5
2005 20

Required: calculate estimated standard deviation

(15 %−5 % +20 %)

r avg = =10 %
3

√
2 2
( 15 %−10 % ) + (−5 %−10 % ) +(20 %−10 %)2
estimated σ =s=
3−1

=
√ 350 %
2
=13.23 %

2.6. Measuring Stand-Alone Risk: The Coefficient of Variation

If a choice has to be made between two investments that have the same
expected returns, but different standard deviations, most people
would choose the one with the lower the standard deviation and, therefore,
the lower risk. Similarly, given a choice between two investments with the
same risk (standard deviation) but different expected returns, investors
would generally prefer the investment with the highest expected return. To
most people, this is common sense—return is “good,” risk is “bad,” and,
consequently, investors want as much return and as little risk as possible.
But how do we choose between two investments if one has the
higher expected return, but the other the lower standard deviation?
To help answer this question, we use another measure of risk, the
coefficient of variation (CV), which is the standard deviation divided by
the expected return:
σ
cofficient of variation ( CV ) =
r^
The coefficient of variation shows the risk per unit of return, and it provides a more
meaningful risk measure when the expected returns on two alternatives are not the same.

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In a case where the coefficient of variation is necessary, consider Projects X and Y. These
projects have different expected rates of return and different standard deviations. Project X has a
60 percent expected rate of return and a 15 percent standard deviation, while Project Y has an 8
percent expected return but only a 3 percent standard deviation. Is Project X riskier, on a relative
basis, because it has the larger standard deviation? If we calculate the coefficients of variation for
these two projects, we find that Project X has a coefficient of variation of 15/60 = 0.25, and
Project Y has a coefficient of variation of 3/8= 0.375. Thus, we see that Project Y actually has
more risk per unit of return than Project X, in spite of the fact that X’s standard deviation is
larger. Therefore, even though Project Y has the lower standard deviation, according to the
coefficient of variation it is riskier than Project X.
Illustration
Based on the above information calculate coefficient of variation for wegagen and CBE
Soln
Since wegagen bank and CBE have the same expected return, the coefficient of variation is not
necessary in this case. Here the bank with the larger standard deviation, Wegagen bank, must
have the larger coefficient of variation. In fact, the coefficient of variation for Wegagen bank is
65.84/15 = 4.39 and that for CBE is 3.87/15 = 0.26. Thus, Wegagen bank is almost 17 times
riskier than CBE on the basis of this criterion.
NOTE: the coefficient of variation captures the effects of both risk and return; it is a better
measure for evaluating risk in situations where investments have substantially different
expected returns.
2.7. Risk in a portfolio context
Thus far we have considered the riskiness of assets when they are held in
isolation. Now we analyze the riskiness of assets held as a part of a portfolio.
As we shall see, an asset held in a portfolio is less risky than the same asset
held in isolation. Since investors dislike risk, and since the risk can be
reduced by holding portfolios that is, by diversifying most financial assets are
indeed held in portfolios.
This being the case, from an investor’s standpoint the fact that a particular stock goes up or down
is not very important; what is important is the return on his or her portfolio, and the portfolio’s
risk. Logically, then, the risk and return of an individual security should be analyzed in terms of
how that security affects the risk and return of the portfolio in which it is held.
2.7.1. Portfolio returns
The expected return on a portfolio r^ p is simply the weighted average of the expected returns on
the individual assets in the portfolio, with the weights being the fraction of the total portfolio
invested in each asset:
n
r^ p =∑ w i r^ i
i=1
Where:
 r^ i -Expected return on individual stocks
 w i– The fraction of the portfolio’s dollar value invested in Stock i
 N – no of stocks in the portfolio
Note: (1) that Wi is the fraction of the portfolio’s dollar value invested in Stock i (that is, the
value of the investment in Stock i divided by the total value of the portfolio) and (2) that the
wi’s must sum to 1.0.

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Illustration
Assume that in August 2015, a security analyst estimated that the following returns could be
expected on the stocks of four large companies:
EXPECTED RETURN, r^ ❑
Microsoft 12.0%
General Electric 11.5
Samsung 10.0
Coca-Cola 9.5

If we formed a Birr 100,000 portfolio, investing Birr 25,000 in each stock what will be the
expected portfolio return?

Solution
r^ p= w1r^ 1 + w2r^ 2 + w3r^ 3 + w4r^ 4

= 0.25(12%) + 0.25(11.5%) + 0.25(10%) + 0.25(9.5%)

=10.75%

Of course, after the fact and a year later, the actual realized rates of return, r i , on the individual
stocks—the r i , or “r-bar,” values—will almost certainly be different from their expected values,
so r i , will be different from r^ p =10.75%.
For example, Coca-Cola’s price might double and thus provide a return of +100 percent, whereas
Microsoft might have a terrible year, fall sharply, and have a return of -75 percent.
2.7.2. Portfolio Risk
Although the expected return on a portfolio is simply the weighted average of the expected
returns of the individual assets in the portfolio, the riskiness of the portfolio, δ p, is not the
weighted average of the individual assets’ standard deviations. The portfolio’s risk is generally
smaller than the average of the assets δ.
We have shown that we can calculate the expected rate of return and evaluate the uncertainty, or risk, of
an investment by identifying the range of possible returns from that investment and assigning each
possible return a weight based on the probability that it will occur. Although the graphs help us visualize
the dispersion of possible returns, most investors want to quantify this dispersion using statistical
techniques. These statistical measures allow you to compare the return and risk measures for alternative
investments directly. Two possible measures of risk (uncertainty) have received support in theoretical
work on portfolio theory: the variance and the standard deviation of the estimated distribution of
expected returns.
In this section, we demonstrate how variance and standard deviation measure the dispersion of possible
rates of return around the expected rate of return.

i. Variance
The larger the variances for an expected rate of return, the greater the dispersion of expected returns and the
greater the uncertainty, or risk, of the investment. The formula for the variance is as follows:
n
Variance (δ2) = ∑ ( probablity ) ×(Possible return−expected return)2
i=1

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 n
= ∑ pi [r i− r^ i ]
2

i=1

ii. Standard deviation

The standard deviation is the square root of the variance:

√
n
Standard déviation = ∑ pi [r i−^ri ]
2

i=1

iii. A Relative Measure of Risk

In some cases, an unadjusted variance or standard deviation can be misleading. If conditions for
two or more investment alternatives are not similar—that is, if there are major differences in the
expected rates of return—it is necessary to use a measure of relative variability to indicate risk
per unit of expected return. A widely used relative measure of risk is the coefficient of variation
(CV), calculated as follows:
standard deviation of returns(δ i)
Coefficient of variation (CV) =
Expected rate of return ¿ ¿

Illustration-1
Let’s assume that there is a portfolio, which has 50 percent in Stock A and 25 percent in each of
Stocks B and C. The relevant calculations can be summarized as follows:

State of Probability of Rate of Return If State Occurs

Economy State of Economy Stock- A Stock-B Stock-C

0.4 10% 15% 20%
Boom
0.6 8 4 0
Bust

Required: based on the above data calculate:

a) Portfolio return at the time of boom and bust
b) Portfolio variance
c) Standard deviation
Solution

a) Portfolio return at the time of boom

r^ p= war^ b + wbr^ b + wcr^ c

= (50% *10%) + (25%*15%) + (25%*20)

= 5 + 3.75+5
= 13.75%

b) Portfolio variance at the time of boom

n
Variance(δ2) = ∑ pi [r i− r^ i ]
2

i=1

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 = 0.4(10%-13.75%)2 + 0.4(15%-13.75%)2 + 0.4 (20%-13.75%)2

= 5.625+0.625+15.625

= 21.875

c) Standard deviation at the time of boom

Standard deviation (δ)=√ δ 2

=/21.875 =4.677