Measuring Return and Risk of

Financial Assets

- Tahmina Rahman CSAA

Assistant Professor, BIBM

April 9, 2023 Return and Risk 1

 Risk and Return

• Defining Risk and Return

• Using Probability Distributions to Measure Risk
• Attitudes Toward Risk
• Risk and Return in a Portfolio Context
• Diversification
• Others……..

April 9, 2023 Return and Risk 2

 Concept of Stock

• Stock represents ownership in a company, providing

voting right and entitling the holder to a share of the
company’s success through dividends and / or
capital appreciation.

April 9, 2023 Return and Risk 3

 Defining Return

Income received on an investment plus any

change in market price,
price usually expressed
as a percent of the beginning market price
of the investment.

Dt + (Pt - Pt-1 )
R=
Pt-1
April 9, 2023 Return and Risk 4
 Return Example
The stock price for Stock A was $10 per share
1 year ago. The stock is currently trading at
$9.50 per share and shareholders just received
a $1 dividend.
dividend What return was earned over
the past year?

$1.00 + ($9.50 - $10.00 )

R= = 5%
$10.00
April 9, 2023 Return and Risk 5
 Return
• Return provides investors with a convenient way of
expressing the financial performance of an
investment. That is an individual or business spends
money today with the expectation of earning even
more money in the future.
• We can express return in two forms-
a) Absolute Return and b) Relative Return
• a) Absolute Return = Amount Received – Amount
Invested
• b) Relative Return = (Amount Received – Amount
Invested) / Amount Invested

April 9, 2023 Return and Risk 6

 Expected Rate of Return

• The return that is expected on a risky asset , given

a probability distribution for the possible rates of
return.

• Expected Return = Possible rate of returns x

Probability for individual returns
n
• Formula: E (R) = ∑ Ri x Pi
i= 1

April 9, 2023 Return and Risk 7

 Risk

• Risk means exposure to loss or injury. It denotes a potential negative

impact to some characteristics of value that may arise from a future
event.

• In a single sentence, the chance that actual outcomes may differ from
those expected. This risk can be measured by standard deviation,
variance, coefficient of variation etc.

• In most cases, risk means the possibility you'll lose some or even all
of the money you invest.

April 9, 2023 Return and Risk 8

 Defining Risk
The variability of returns from
those that are expected.
What rate of return do you expect on your
investment (savings) this year?
What rate will you actually earn?

April 9, 2023 Return and Risk 9

 Different Measures of Risk
1) Standard Deviation:

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.
n
( )   i i Pi
[ R
i 1
- E(R )]2

n
2) Variance: Variance ( )   [R i - E(R i )]2 Pi
2

i 1

3) Coefficient of Variation: (CV) =  / E (R)

April 9, 2023 Return and Risk 10

 Sources of Fundamental Risk

• Business Risk
• Financial Risk
• Liquidity Risk
• Exchange Rate Risk
• Country Risk

April 9, 2023 Return and Risk 11

 Measurement of Return and Risk
• ON –
A) Individual basis and
B) Portfolio basis

A) For Individual Stock:

Example:
Probability Distribution of an individual Stock:

Probability Possible Rates of

(Pi) Return (Ri)
.25 .08
.25 .10
.25 .12
.25 .14
April 9, 2023 Return and Risk 12
 Expected Return

Probability Possible Expected

Rates of Return
(Pi) Return (Ri) (Pi) x (Ri)
.25 .08 .0200
.25 .10 .0250
.25 .12 .0300
.25 .14 .0350

E(R)= .1100

April 9, 2023 Return and Risk 13

 Determining Expected
Return (Continuous Dist.)
n
R =  ( Ri ) / ( n )
i=1

Here,
R is the expected return for the asset,
Ri is the return for the ith observation,
n is the total number of observations.

April 9, 2023 Return and Risk 14

 Standard Deviation

Possible Expected
Rate of Rate of Ri - E (Ri) [Ri - E (Ri)] 2 Pi [Ri - E (Ri)] 2 x Pi
Return Return
(Ri) E (Ri)
.08 .11 -.03 0.0009 .25 .000225
.10 .11 -.01 0.0001 .25 .000025
.12 .11 .01 0.0001 .25 .000025
.14 .11 .03 0.0009 .25 .000225
.000500
- Variance ((2) = 0.0005

- Standard Deviation () = 0.02236, i. e., risk is 2.24%

- Coefficient of variation (CV) =  / E (R)
= .02236 / .11000
= .20327
April 9, 2023 Return and Risk 15
 Determining Standard
Deviation (Risk Measure)
n
= 
i=1
( R i - R )2

(n)

Note, this is for a continuous distribution

where the distribution is for a population. R
represents the population mean in this
April 9, 2023
example.
Return and Risk 16
 B) For Portfolio Stock

Portfolio Expected Return:

The return expected from the portfolio investment.

Formula:
Expected Return = Probability for individual returns
x Possible Expected rate of returns
E (Rp) = ∑ Wi x E (Ri)
i= 1

April 9, 2023 Return and Risk 17

 Return and Risk
• How do return and risk vary relative to each other
as the investor alters the proportion of each of the
assets in the portfolio?

• Let E(R1)=8.75% and E(R2)=21.25

• Let w1=0.75 and w2=0.25

• E(Rp)=.75x8.75+.25x21.25=11.88

• σ1=10.83, σ2=19.80, ρ1,2=-.9549

April 9, 2023 Return and Risk 18

• Portfolio Risk :
• The formula stated that the standard deviation
for a portfolio of assets is a function of -
n n n

port
  w 
2
i i
2
  w i w j Cov ij
i 1 i 1 i 1

where :
 port
 the standard deviation of the portfolio

W i  the weights of the individual assets in the portfolio, where

weights are determined by the proportion of value in the portfolio
 i
2
 the variance of rates of return for asset i

Cov  the covariance between the rates of return for assets i and j,
ij

where Cov  r 
ij ij i j

April 9, 2023 Return and Risk 19

 Correlation Coefficient
(r)
A standardized statistical measure of the
linear relationship between two variables.
Its range is from -1.0 (perfect negative
correlation), through 0 (no correlation), to
+1.0 (perfect positive correlation).

April 9, 2023 Return and Risk 20

 Portfolio Risk
• σ2p=(0.75)2x(10.83)2+(0.25)2x(19.80)2+2x(0
.75)x(0.25)x(-0.95)x(10.83)x(19.80)

• =13.7
• σp=√13.7=3.7

April 9, 2023 Return and Risk 21

 Portfolio risk and return
(With Different Status in Weightage)

Equity 1 Equity 2 E(Rp) Risk

State w1 w2
1 1 0 8.75% 10.83%
2 0.75 0.25 11.88% 3.70%
3 0.5 0.5 15% 5%
4 0 1 21.25 19.8%

April 9, 2023 Return and Risk 22

 Choice of weights
• How does the portfolio manager choose the weights?

- That will depend on preferences of the investor.

• Efficient Frontier:
For ‘n’ assets the efficient frontier defines a ‘bundle’ of
risky assets.

April 9, 2023 Return and Risk 23

 How is the efficient frontier
derived?
• The shape of the efficient frontier will depend on
the correlation between the asset returns of the
two assets.
• If the correlation is ρ = +1 then the portfolio risk
is the weighted average of the risk of the
portfolio components.
• If the correlation is ρ = -1 then the portfolio risk
can be diversified away to zero
• When ρ < +1 then not all the total risk of each
investment is non-diversifiable. Some of it can
be diversified away

April 9, 2023 Return and Risk 24

 Efficient frontier
E(Rp)

Ρ = -1

-1 < Ρ < +1 Ρ = +1

σp

April 9, 2023 Return and Risk 25

 Transformation line

E(Rp)

-0.5 borrowing +
0.5 lending + 1.5 in risky
0.5 in risky bundle
bundle
No lending all
investment in
bundle

Rf
All lending
σp

April 9, 2023 Return and Risk 26

 Combining risk-free and risky
portfolios

E(Rp)

C
B

A
Rf

σp

April 9, 2023 Return and Risk 27

 Borrowing and lending frontier

C
E(Rp)

Rf

A
σp

April 9, 2023 Return and Risk 28

 Diversification
• The process of diversifying or minimizing the risk by maintaining the portfolio where
securities are negatively correlated to each other perfectly (r = -1) to off-set the one stock’s
negative return by another stock’s positive return.
• Diversifiable Vs. Market risk:
• Through diversification we can minimize the risk. But that risk is not the total risk rather
only the unsystematic risk. For example- business risk, management risk and so on which
risks are under control but we cant minimize systematic risk even after using diversification
as over this investor has no control. Like- return affected by flood, inflation and so on.

In a simple sense, diversification means to understand what the potential problems with a
certain investment might be, and putting a strategy in place to manage, or offset them.

April 9, 2023 Return and Risk 29

 Summary of the Portfolio
Return and Risk Calculation
Stock C Stock D Portfolio
Return 9.00% 8.00% 8.64%
Stand.
Dev. 13.15% 10.65% 10.91%
CV 1.46 1.33 1.26

The portfolio has the LOWEST coefficient of variation due

to diversification.

April 9, 2023 Return and Risk 30

 Market portfolio and risk reduction

Portfolio
risk

Diversifiable
risk

Non- Number
diversifiable of
risk securities
20
April 9, 2023 Return and Risk 31
 Total Risk = Systematic
Risk + Unsystematic Risk
Factors such as changes in nation’s
STD DEV OF PORTFOLIO RETURN

economy, tax reform by the Congress,

or a change in the world situation.

Unsystematic risk
Total
Risk
Systematic risk

NUMBER OF SECURITIES IN THE PORTFOLIO

April 9, 2023 Return and Risk 32
 Diversify Unsystematic Risk

• There is some risk, called systemic risk, that you can't control. But if
you learn to accept risk as a normal part of investing, you can develop
asset allocation and diversification strategies to help ease the impact
of these situations. And knowing how to tolerate risk and avoid panic
selling is part of a smart investment plan.

• You can manage nonsystematic risk by allocating and diversifying

your portfolio, or spreading your assets among a variety of
investments. That's why, if one of your investments goes down
significantly in value, those losses may be offset to some degree by
gains, or even stable values, in some of your other investments.

April 9, 2023 Return and Risk 33

Relationship between Risk and Rates of Return

• The more the risk associated with a particular security

or portfolio must be compensated by the expected
return in the form of extra risk premium. Other wise the
investor never want to forgo his current consumption
and available other investment opportunities. So, there
is a positive relationship between expected return and
risk.

April 9, 2023 Return and Risk 34

 Relationship Between Risk and Return of a stock

SML : K i = KRF + (kM – kRF )bi

Required Rate of Return (%) = 6% +(11% - 6%) bi
= 6% + (5%) bi
K High = 16

kM1 = 11
Market Risk
Premium, 5%
KRF2 = 8.5
Safe stock’s
risk
premium, 2.5%
KRF1 = 6
Risk-free
rate, kRF

April 9, 2023 Risk, bi

0 0.5 1.0Return and1.5Risk 2.0
 Factors influencing Expected Return and Risk

There are some key factors which can influence the

expected return and risk associated with a stock.
Like –

1) The impact of inflation over the investment return

2) The impact of change in risk aversion
3) The impact of change in stock’s beta coefficient
4) Return realization period
5) Time selection in case of buying and selling stock

April 9, 2023 Return and Risk 36

 Risk Attitudes
Certainty equivalent > Expected value
Risk Preference
Certainty equivalent = Expected value
Risk Indifference
Certainty equivalent < Expected value
Risk Aversion
Most individuals are Risk Averse.
Averse
April 9, 2023 Return and Risk 37
 The Impact of Inflation

Required Rate of Return (%)

SML2 = 8% + 5% (bi)

kM2 = 13 SML1 = 6%+ 5% (bi)

kM1 = 11

KRF2 = 8
Increaser in anticipated Inflation,
IP = 2%
KRF1 = 6
Original IP= 3%

K* = 3
Real Risk-Free Rate of Return, k*

April 9, 2023 Return and Risk Risk, b38i

0 0.5 1.0 1.5 2.0
The Impact of Change in Risk Aversion
Required Rate of Return (%)

SML2 = 6% + 7.5% (bi)

17.25
SML1 = 6%+ 5% (bi)
kM2 = 13.50

kM1 = 11
9.75
8.50
Increaser in anticipated Inflation,
KRF1 = 6 IP = 2%

Original IP= 3%

K* = 3

Real Risk-Free Rate of Return, k*

April 9, 2023 Risk, bi

0 .50 1.0Return and1.5Risk 2.0
39
 Concluding Message

• At the end we can conclude saying every surplus

unit will invest his fund assuming reasonable risk to
materialize his ultimate expected return. So he
should know how to measure these two, minimize
risk or maximize return or at least want to be
ensured about whether he is adequately
compensated for bearing the extra risk.
• So, these two are very sensibly and positively
related to each other.

April 9, 2023 Return and Risk 40

 Food for Thinking

 Physical assets Vs. Security

 Uncertainty Vs. Risk
 Volatility Vs. Risk

April 9, 2023 Return and Risk 41

 Summary

April 9, 2023 Return and Risk 42

 Thanks To All

April 9, 2023 Return and Risk 43