Risk and return

Introduction
 Risk and return are the most important concepts in
finance and they are the foundations of modern
finance theory.
 Risk, in traditional terms, is viewed as a ‘negative’.
 Risk is the possibility that we won’t achieve our
expectations or the chance that actual investment
returns will differ from those expected.
 Risk indicates the deviation/variability of
expected outcome.

 Positive relationship – high risk; high return

CHAPTER -4 – RISK
RETURN ANALYSIS AND
- low risk; low return
PORTFOLIO THEORY BY Dr.
VENKATI PONNALA 21 - 2
Sources of Risk
 Business risk refers to the risk of doing business in a
particular industry or environment.
 Financial risk refers to the degree of uncertainty of
payment attributable to the mix of debt and equity used to
finance a business.
 Purchasing Power Risk refers to the chance that changing
price levels (inflation or deflation) will adversely affect
investment returns.
 Interest rate risk is the chance that changes in interest
rates will adversely affect a security’s value.
CHAPTER -4 – RISK
RETURN ANALYSIS AND
PORTFOLIO THEORY BY Dr.
VENKATI PONNALA 21 - 3
 Cont...............................
 Liquidity Risk : is the risk of not being able to
liquidate an investment conveniently and at a
reasonable price.
Market risk : Market Risk refers to the variability in returns
resulting from fluctuations in the overall market conditions

 Exchange rate or currency risk is the variability of

returns caused by currency fluctuations
CHAPTER -4 – RISK
RETURN ANALYSIS AND
PORTFOLIO THEORY BY Dr.
VENKATI PONNALA 21 - 4
 KINDS OF

Systematic
Risk

Systematic risk and unsystematic Unsystematic

risk are the two components of
total risk. Thus Risk
Total risk
= Systematic risk +
Unsystematic risk
SYSTEMATIC RISK
 It is also known as market risk or non-diversifiable
risk.
 Risk factors that affect a large number of assets
 that affects the overall market such as change in
the country's economic position, tax reforms or a
change in the world energy situation.
 Includes such things as changes in GDP, inflation,
interest rates, etc.
 Economic and political instability, economic
recession, macro policy of the government, etc.
 The “systematic risk” cannot be avoided.
Systematic Risks Risk
due to
inflatio
War like n Interest
situation rate risk

International
Political
events risk

Industrial Market
growth risk

Risk due to
govt.
monsoon
policies
Natural
scams
calamities
1– 7
 UNSYSTEMATIC RISK:
 Risk factors that affect a limited number of assets
 Also known as unique risk and asset-specific risk
 Factors such as management capability, consumer
preferences, raw material scarcity and labour strikes
cause unsystematic variability of returns in a firm.
etc.
 It is associated with a particular company or
industry.
 The investor can only reduce the “unsystematic
risk” by means of a diversified portfolio.
 Return
 Return indicates the expected reward for investors to their
capital invested
 It can be trough dividend and the capital gain (can be get by the
application of invested capital).
 Return on an investment is the financial outcome for the
investor.
 For example, if someone invests $100 in an asset and
subsequently sells that asset for $111, the dollar return is $11.
 Usually an investment’s dollar return is converted to a rate of
return by calculating the proportion or percentage represented
by the dollar return.
 For example, a dollar return of $11 on an investment of $100 is a
rate of return of $11/$100, which is 0.11, or 11 per cent.
Risk and Return of a Single Asset
 Return on security(single asset) consists of two
parts: dividend yield and the capital gain
percentage.
 Return = dividend + capital gain rate
 R = D1 + (P1 – P0)
P0
 WHERE R = RATE OF RETURN IN YEAR 1
D1 = DIVIDEND PER SHARE IN YEAR 1
P0 = PRICE OF SHARE IN THE BEGINNING OF THE YEAR
P1 = PRICE OF SHARE IN THE END OF THE YEAR
 Return

Capital
Yield
Gain
Components of Return
 Yield
The most common form of return for
investors is the periodic cash flows (income)
on the investment, either interest from bonds
or dividends from stocks.
 Capital Gain
The appreciation (or depreciation)
in the price of the asset,
commonly called the
Capital Gain (Loss).
Types of return
Ex Post Returns
 Return calculations done ‘after-the-fact,’ in order to analyze
what rate of return was earned.
 calculations are based on historical data.
 Historical return(realized return): also called as ex-post
(after-the-fact) returns
Ex Ante Returns
Expected returns(future returns): also called as ex-ante or
anticipated returns
 Return calculations may be done ‘before-the-fact,’ in which
case, assumptions must be made about the future
 calculations are based on probabilities of the future states
of nature and the expected return in each state of nature.
 Ex Post Returns or Historical return(realized return):

 ex-ante or anticipated returns

Expected return is what you expect to earn from an
investment in the future.
Ali purchased a stock for birr 6,000. At
the end of the year the stock is worth
birr 7,500. Ali was paid dividends of
birr 260. Calculate the total return
received by Ali.
Solution

Total Return = birr[260+(7,500 - 6,000)]

6,000
= 0.293
= 29.3%
Historic returns - Example 2

Q. Suppose a stock had an initial price of $42 per share,

paid a dividend of $0.84 per share during the year,
and had an ending price of $46.2. Calculate:

a. Percentage total return

b. Dividend yield

c. Capital gains yield

Average rate of return
 R = 1 [ R1+R2+……+Rn]
n
It is calculated based on the
n past data recorded for
R = 1 Σ Rt several periods regarding
n t=1 one investment/asset.
Where
R = average rate of return.
Rt = realised rates of return in periods 1,2, …..t
n = total no. of periods
 Holding Periods return
 A holding period return is the return from holding an asset for a single specified

period of time.

 Measures What The Investment Grows To Within Each Single Period Of Time

 Investors may held their investment in shares for more than one period. How can

you calculate the Holding period return? Suppose you invested Br 1 today in

company share for five periods. The rates of return for each period is:
 Year Return HPR = (1 + R1)(1 + R2)...(1+ RT)-1
1 18%
2 9%
3 0%
4 -10%
5 14%

Calculated the holding period return?

Solution
Initial inv’t = Br. 1
Y1 = (0.18) + 1 = 1.18
Y2 = (0.09) + 1 = 1.09
Y3 = ( 0.00) + 1 = 1.00
Y4 = ( 0.1) + 1 = 0.9
Y5 = (10.14) + 1 = 1.14
 Holding period return will be 1.18 x 1.09 x 1 x 0.9 x 1.14
= 1.32 => the worth of 1 birr after five years:
 Holding period return = worth the inv’t after – Initial
investment
 = 1.32 – 1 = .32 = 32%
 Example 2:Holding Period Returns
What is the 3-year holding period return if the
annual returns are 7%, 9%, and –5%?

R  1  R1  1  R2  1  R3   1
 1  .07(1  .09)(1  .05)  1  .1080  10.80%
 Miscellaneous Return Measures


( R1  R2  R3...  ...RT ) t 1 Rt
T

R 
T T
Example 1
Compute the arithmetic and geometric average for
the following stock.
Year Annual Rate of Value of the
Return stock
0 $25
1 40% $35
2 -50% $17.50

Arithmetic Average = (40-50) ÷ 2= -5%

Geometric Average
= [(1+Ryear1) × (1+Ryear 2)]1/2 - 1
= [(1.4) × (.5)] 1/2 - 1= -16.33%
= (17.5/25)1/2-1=-16.33%.
23
Risk and Rate of Return (Historical):
Variance & SD

Note that probability distribution helps us determine

how likely it is that the ACTUAL outcome will be close
to the EXPECTED outcome
There are statistical measures that will allow the
comparison of the RETURN and RISK measures for
alternative investments
The two popular ones are
 Variance
 Standard deviation
They both help us measure the dispersion of
possible rates of return around the expected rate of
return
VARIANCE
This measure thus helps investors determine the
level at which the ACTUAL will be different from
the EXPECTED due to variations of events
Basically the larger the variance for an expected
rate of return, the greater the dispersion of the
expected returns and the greater the uncertainty or
risk of the investment
STANDARD DEVAITION
 Standard deviation is a tool for assessing risk associated
with a particular investment.
 Standard deviation simply helps us determine how far the
ACTUAL outcome ‘deviates’ from the EXPECTED outcome
 It is a weighted average of the deviations from the expected
value, and therefore provides an idea of how far above or
below the expected value the actual value will be likely to
be
 The smaller the deviation, the less risky, the investment
accordingly

SAN LIO 26
Note the both the variance and the standard deviation
are better used in the comparison of two investment
opportunities: basically to the investor which
investment indicates a greater variation of returns and
therefore greater chance that the expected return will
not be realised.

SAN LIO 27
 The following steps are involved in calculating
variance or standard deviation of rates of return of
assets or securities.
 Calculate the Average Rate of Return;
 Calculate the deviation of individual rates of return
about the Average Rate of Return;
 Square each of the deviations about the Average Rate
of Return;
 Add up the squared deviations [Step 2] and divide the
sum by the number of periods or observations less
one to obtain variance

Year Rate of
return
1992 149.7 51.03
1993 70.54 51.03
1994 16.52 51.03
1995 22.71 51.03
1996 49.52 51.03 calculated the variance and standard
deviation?
1997 92.33 51.03
1998 36.13 51.03
1999 52.64 51.03
2000 7.29 51.03
2001 12.95 51.03
 2 1
𝜎 = ( (149.7 − 51.03)2 + (70.54 − 51.03)2 +
10−1
16.52 − 51.03 2 + 22.71 − 51.03 2 +
49.52 − 51.03 2 + 92.33 − 51.03 2 +
36.13 − 51.03 2 − (52.64 − 51.03)2 +
2 2
(7.29 − 51.03) + (12.95 − 51.03)
Example
Demand prob rate of return
Strong 0.15 0.20
Normal 0.15 -0.20
Weak 0.70 0.10
Required
Calculate the Expected Return (ER)
 EXPECTED RETURN=  probability of return* possible
return
 ER= (P1)(R1) +(P2)(R2)+ ....(Pn)(Rn)
SOLUTION
r= (0.15*0.2 )+( 0.15*-0.20) +( 0.7*0.10)
= 0.03 -0.03 +0.07
= 0.07 = 7%

32
 The Variance and Standard Deviation as
Measures of Risk and returns(ex-ante)

VARIANCE
Based on the understanding that everything varies
This measure thus helps investors determine the
level at which the ACTUAL will be different from the
EXPECTED due to variations of events
VARIANCE is calculated as
Variance of returns: 2 = (Ri - E(R))2pi

33
 4 - 34

The standard deviation is basically the

SQUARE ROOT of the VARIANCE

  Standard deviation

  Variance   2

 2
n
 
   ri  r  Pi .
i 1  

 =  X2 * P(X) – [ X*P(X)]2
 Example 1
 Based on the following information, calculate the variance
and standard deviation.
State of economy Probability of Rate of return if
state of economy state occures
Recession .20 -.07
normal .55 .13
boom .25 .30
 From our previous calculations, E(R) = .1325 or 13.25%.
 = Variance(R) = .20(-.07 - .1325)2 + .55(.13 - .1325)2 + .25(.30 - .1325)2
 = Variance(R) = (.00820125) + (.00000344) + (.00701406) = .01521875
 = Standard Deviation(R) = (.01521875).5 = .123364 = 12.34%
Example 2
DEMAND PROB POSS RETURN
Strong 0.15 20%
Normal 0.15 15%
Weak 0.70 10%
REQUIRED
Calculate the variance and standard deviation

SAN LIO 36
SOLUTION
Expected Return
ER= 0.15*0.20+0.15*0.15+0.70*0.10
= 0.03+0.0225+0.07
= 0.1225
VARIANCE
Prob R-ER (R-ER)2 P(PR-ER)2
0.15 0.0775 0.006006 0.0009009
0.15 0.0275 0.000756 0.0001134
0.70 -0.0225 0.000506 0.0003544
0.001369

SAN LIO 37
STANDARD DEVIATION
√VARIANCE
= 0.037
=3.70%

SAN LIO 38
 Note: The information about the expected
return and standard deviation helps an investor
to make decision about investments.
 A risk averse investor will prefer investments
with higher rates of return and lower standard
deviation.
 It two investments have the same return, the
investor will choose the investment with lower
standard deviation.
 On the other hand if these investments have
same standard deviations, the investor would
prefer the one with higher return.
THANK U