Chapter 3:

Risk and Return

 Concepts of Risk and Return

Financial assets are generally defined by their risk and return characteristics.

Comparison along these two dimensions simplifies the process of selecting from
millions of assets and makes financial assets substitutable.

These characteristics distinguish financial assets from physical assets, which can be
defined along multiple dimensions.

For example, coffee is characterized by its fragrance, aroma, flavor, body, sweetness
and type, among other factors.

The price of a television depends on picture quality, manufacturer, screen size, number and
quality of speakers, and so on, none of which are similar to the characteristics for coffee.
Therein lies one of the biggest differences between financial and physical assets.

Although financial assets are generally claims on real assets, their commonality
across two dimensions (risk and return) simplifies the issue and makes them easier to
value than real assets.

Return
Financial assets normally generate two types of return for investors.

First, they may provide periodic income through cash dividends or interest payments.

Second, the price of a financial asset can increase or decrease, leading to a capital gain or
loss.
Certain financial assets, through design or choice, provide return through only one of these
mechanisms.

For example, investors in non-dividend-paying stocks, such as Google or Baidu, obtain their
return from capital appreciation only.

Similarly, you could also own or have a claim to assets that only generate periodic income.

THE TWO COMPONENTS OF ASSET RETURNS

Return on a typical investment consists of two components:

Yield: The basic component many investors think of when discussing investing returns
is the periodic cash flows (or income) on the investment, either interest (from bonds) or
dividends (from stocks).
The distinguishing feature of these payments is that the issuer makes the payments
in cash to the holder of the asset.

Yield measures a security’s cash flows relative to some price, such as the purchase
price or the current market price .

Capital gain (loss): The second component is the appreciation (or depreciation) in the price of
the asset, commonly called the capital gain (loss). We will refer to it simply as the price
change. In the case of an asset purchased (long position), it is the difference between the
purchase price and the price at which the asset can be, or is, sold; for an asset sold first and
then bought back (short position), it is the difference between the sale price and the
subsequent price at which the short position is closed out.

In either case, a gain or a loss can occur.

RISK
Risk is defined in Webster’s as “a hazard; a peril; exposure to loss or injury.” Thus, risk refers to
the chance that some unfavorable event will occur. For an investment in financial
assets or in new projects, the unfavorable event is ending up with a lower return than you
expected.

You cannot talk about investment return without talking about risk because
investment
decisions invariably involve a trade-off between the two.

Risk refers to the possibility that the actual outcome of an investment will differ
from its expected outcome.

More specifically, most investors are concerned about the actual outcome being less than the
Sources of Risk
Risk emanates from several sources. The major ones are: business risk, interest rate risk,
market risk, inflation risk, financial risk , liquidity risk, currency risk (exchange rate risk) ,and
country risk.

Business Risk : As a holder of corporate securities (equity shares or debentures), you are
exposed to the risk of poor business performance.

This may be caused by a variety of factors like heightened competition, emergence of new
technologies, development of substitute products, shifts in consumer preferences, inadequate
supply of essential inputs, changes in governmental policies, and so on.

Often, of course, the principal factor may be inept and incompetent management. The poor
business performance definitely affects the interest of equity shareholders, who have a
residual claim on the income and wealth of the firm.
It can also affect the interest of debenture holders if the ability of the firm to meet its interest
and principal payment obligation is impaired. In such a case, debenture holders face the
prospect of default risk.

Interest Rate Risk: The changes in interest rate have a bearing on the welfare of investors.

As the interest rate goes up, the market prices of existing fixed income securities fall, and
vice versa. This happens because the buyer of a fixed income security would not buy it at
its par value or face value if its fixed interest rate is lower than the prevailing interest rate
on a similar security.

While the changes in interest rate have a direct bearing on the prices of fixed income
securities, they affect equity prices too, albeit somewhat indirectly. The changes in the relative
yields of debentures and equity shares influence equity prices.
Market Risk: Even if the earning power of the corporate sector and the interest rate
structure remain more or less unchanged, prices of securities, equity shares in particular,
tend to fluctuate.

While there can be several reasons for this fluctuation, a major cause appears to be the
changing sentiment of the investors.

There are periods when investors become bullish and their investment horizons lengthen.
Investor optimism, which may border on euphoria during such periods, drives share prices to
great heights.

The buoyancy created in the wake of this development is pervasive, affecting almost all the
shares.
On the other hand, when a wave of pessimism (which often is an exaggerated
response to some unfavorable political or economic development) sweeps the
market, investors turn bearish and myopic.

Prices of equity shares register decline as fear and uncertainty pervade the
market.
So, the market tends to move in cycles.

Inflation Risk :A factor affecting all securities is purchasing power risk, or the chance that the
purchasing power of invested dollars will decline. With uncertain inflation, the real
(inflation-adjusted) return involves risk even if the nominal return is safe (e.g., a Treasury
bond). This risk is related to interest rate risk, since interest rates generally rise as inflation
increases, because lenders demand additional inflation premiums to compensate for the loss
of purchasing power.
Financial Risk: Financial risk is associated with the use of debt financing by companies.
The larger the proportion of assets financed by debt (as opposed to equity), the larger
the variability in the returns, other things being equal.

Liquidity Risk: Liquidity risk is the risk associated with the particular secondary market
in which a security trades. An investment that can be bought or sold quickly and without
significant price concession is considered liquid. The more uncertainty about the time element
and the price concession, the greater the liquidity risk. A Treasury bill has little or no liquidity
risk, whereas a small OTC stock may have substantial liquidity risk.

Currency Risk (Exchange Rate Risk): All investors who invest internationally in today’s
increasingly global investment arena face the prospect of uncertainty in the returns after
they convert the foreign gains back to their own currency. Investors today must recognize and
understand exchange rate risk .
Country Risk : Country risk, also referred to as political risk, is an important risk for
investors today—probably more important now than in the past.

With more investors investing internationally, both directly and indirectly, the political,
and therefore economic, stability and viability of a country’s economy need to be
considered.

The United States has one of the lowest country risks, and other countries can be
judged on a relative basis using the United States as a benchmark.

In today’s world, countries that may require careful attention include Russia,
Pakistan,
Venezuela, Iraq, and Iran.
Types of Risk

Modern portfolio theory looks at risk from a different perspective. It divides total risk as
follows.

Total risk = Unique risk + Market risk

The unique risk of a security represents that portion of its total risk which stems
from firm-specific factors like the development of a new product, a labor strike, or
the emergence of a new competitor.

Events of this nature primarily affect the specific firm and not all firms in general.

Hence, the unique risk of a stock can be washed away by combining it with other
stocks. In a diversified portfolio, unique risks of different stocks tend to cancel each
other—a favorable development in one firm may offset an adverse happening in
another and vice versa.

Hence, unique risk is also referred to as diversifiable risk or unsystematic risk

The market risk of a security represents that portion of its risk which is attributable to
economy-wide factors like the growth rate of GDP, the level of government spending,
money supply, interest rate structure, and inflation rate.

Since these factors affect all firms to a greater or lesser degree, investors cannot avoid
the risk arising from them, however diversified their portfolios may be.

Hence, it is also referred to as systematic risk (as it affects all securities) or

non-diversifiable risk.
An asset’s risk can be analyzed in two ways:
(1) on a stand-alone basis, where the asset is considered in isolation; and

(2) as part of a portfolio, which is a collection of assets.

Thus, an asset’s stand-alone risk is the risk an investor would face if she held only
this one asset.

Most assets are held in portfolios, but it is necessary to understand stand-alone

risk in order to understand risk in a portfolio context.
 MEASURING HISTORICAL
RETURN

Putting the two components of return together: Adding the two components together
to form the total return:

Total return = Yield + Price change

where the yield component can be 0 or + the price change component can be 0, +, or –
The Total Return (TR) for a given holding period is a decimal or percentage number relating
all the cash flows received by an investor during any designated time period to the purchase
price of the asset calculated as :
Example: Assume the purchase of a 10-percent-coupon Treasury bond at a price of
$960, held one year, and sold for $1,020. The TR is ?

Example: 100 shares of DataShield are purchased at $30 per share and sold one year later at
$26 per share. A dividend of $2 per share is paid. The TR is ?
Conclusions About Total Return:
In summary, the TR concept is valuable as a measure of return because it is all-
inclusive, measuring the total return per dollar of original investment.

TR is the basic measure of the return earned by investors on any financial asset for
any specified period of time. It can be stated on a decimal or percentage basis.

TR facilitates the comparison of asset returns over a specified period, whether the
comparison is of different assets, such as stocks versus bonds, or different securities
within the same type, such as several common stocks.
RETURN RELATIVE
It is often necessary to measure returns on a slightly different basis than total returns.
The total return for an investment for a given period stated on the basis of 1.0.

The Return Relative (RR) eliminates negative numbers by adding 1.0 to the TR.
It provides the same information as the TR, but in a different form.
• RR =TR in decimal form + 1.0
• TR in decimal form = RR - 1.0

Equation of TR can be modified to calculate return relatives directly by using the price
at the end of the holding period in the numerator, rather than the change in price.

Note that even though the total return may be negative, the return relative cannot be
negative. At worst it is zero.
CUMULATIVE WEALTH INDEX
Return measures such as TRs measure the rate of change in an asset’s price or return.
Nevertheless, we all understand dollar amounts!

Therefore, it is often desirable to measure how one’s wealth in dollars changes over time. In
other words, we measure the cumulative effect of returns compounding over time given
some stated initial investment, which typically is shown as $1 for convenience ($1 is the
default value).

Note that having calculated ending wealth (cumulative wealth) over some time period
on the basis of a $1 initial investment, it is simple enough to multiply by an investor’s actual
beginning amount invested, such as $10,000 or $22,536 or any other beginning amount.
Cumulative wealth over time, given an initial wealth and a series of returns on some
asset.

The Cumulative Wealth Index, CWIn, is computed as

where
CWIn = the cumulative wealth index as of the end of period n
WI0 = the beginning index value; typically $1 is used but any amount can be used
TR1,n = the periodic TRs in decimal form when added to 1.0 they become return
relatives.
Example :Let’s calculate cumulative wealth per $1 invested for the 1990s, one of the
two greatest decades in the 20th century in which to own common stocks. This will
provide you with a perspective on common stock returns at their best. Using the
S&P Total Returns in the Table below , and converting them to return relatives, the
CWI for the decade of the 1990s (the 10-year period 1990-1999) would be
Three Measures of Return from a Financial Asset.
Summary Statistics for Returns
The total return, return relative, and cumulative wealth index are useful measures of return
for a specified period of time.

Also needed for investment analysis are statistics to describe a series of returns.

For example, investing in a particular stock for 10 years or a different stock in each of 10
years could result in 10 TRs, which need to be described by summary statistics.

Two such measures used with returns data are arithmetic mean and geometric mean.
Measures of Central Tendency

A measure of central tendency is a single value that attempts to describe a set of

data by identifying the central position within that set of data.

As such, measures of central tendency are sometimes called measures of central

location.
They are also classed as summary statistics.

The mean (often called the average) is most likely the measure of central tendency
that you are most familiar with, but there are others, such as the median(the
middle score for a set of data that has been arranged in order of magnitude) and the
mode(the most frequent score in our data set).
ARITHMETIC MEAN
The best-known statistic to most people is the arithmetic mean. Therefore, when
someone refers to the mean return they usually are referring to the arithmetic mean
unless otherwise specified.

The mean (or average) is the most popular and well known measure of central tendency. The
mean is equal to the sum of all the values in the data set divided by the number of values in
the data set.
S&P 500 Stock Composite Index 1990-99
When you want to know the central tendency of a series of returns, the arithmetic
mean is the appropriate measure. It represents the typical performance for a single period.

However, when you want to know the average compound rate of growth that has actually
occurred over multiple periods, the arithmetic mean is not appropriate.

This point may be illustrated with a simple example. Consider a stock whose price is 100
at the end of the year 0. The price declines to 80 at the end of year 1 and recovers to 100
at the end of year 2. Assuming that there is no dividend payment during the two year
period, the annual returns and their arithmetic mean are as follows:
Thus we find that though the return over the two year period is nil, the arithmetic
mean works out to 2.5 percent. So, this measure of average return can be misleading.
GEOMETRIC MEAN (sometimes referred to as compounded annual growth
rate or time-weighted rate of return)

In a multi-period context, the geometric mean describes accurately the “true” average
return.

When an ending value is the result of compounding over time, the geometric mean, is
needed to describe accurately the “true” average rate of return over multiple periods.
The geometric mean is defined as follows:

where TR is a series of total returns in decimal form. Note that adding 1.0 to each total return
produces a return relative. RRs are used in calculating geometric mean returns, because TRs,
which can be negative or zero, cannot be used in the calculation.

The geometric mean return measures the compound rate of growth over time.
Continuing the example from the previous table , consisting of the 10 years of data
ending in 1999 for the S&P 500, the geometric mean is
Think of the annual geometric mean as the equal annual return that makes a
beginning amount of money grow to a particular ending amount of money.

For example, we saw in Example that $1 invested in the S&P 500 Composite Index
on January 1, 1990 would have grown to $5.23 by December 31, 1999 (10 years).

This is a result of the money compounding at the annual rate of 18 percent. At the end of
year 1, the $1 would grow to $1.18; at the end of year 2, the $1.18 would grow to $1.39; at
the end of year 3, the $1.39 would grow to $1.64, and so on, until at the end of year 10 the
original $1 is worth $5.23.

Notice that this geometric average rate of return is lower than the arithmetic average
rate of return of 18.76 percent, because it reflects the variability of the returns
ARITHMETIC MEAN VERSUS GEOMETRIC MEAN
The geometric mean will always be less than the arithmetic mean unless the values being
considered are identical, an unlikely event.

The spread between the two depends on the dispersion(the scale of distribution of data
around a central point or value) of the distribution: the greater the dispersion, the greater
the spread between the two means.

When should we use the arithmetic mean and when should we use the geometric mean to
describe the returns from financial assets?

The answer depends on the investor’s objective:

The arithmetic mean is a better measure of average (typical) performance over single
periods. It measures the rate of return earned in a typical year. It is the best estimate of the
expected return for next period.

The geometric mean is a better measure of the change in wealth over the past (multiple
periods). It is typically used by investors to measure the realized compound rate of return at
which money grew over a specified period of time. GM measures the actual rate of return
earned per year on average, compounded annually.

Over multiple periods, such as years, the geometric mean shows the true average compound
rate of growth that actually occurred—that is, the annual average rate at which an invested
dollar grew, taking into account the gains and losses over time. On the other hand, we should
use the arithmetic mean to represent the likely or typical performance for a single period.
 MEASURING HISTORICAL RISK

Suppose you are analyzing the total return of an equity stock over a period of time.
Apart from knowing the mean return, you would also like to know about the variability
in returns.

Risk is often associated with the dispersion in the likely outcomes. Dispersion refers to
variability. Risk is assumed to arise out of variability, which is consistent with our definition of
risk as the chance that the actual outcome of an investment will differ from the expected
outcome. If an asset’s return has no variability, in effect it has no risk.

Consider an investor analyzing a series of returns (TRs) for the major types of financial
assets over some period of years. Knowing the mean of this series is not enough; the investor
also needs to know something about the variability, or dispersion, in the returns.
Relative to the other assets, common stocks show the largest variability (dispersion)
in returns, with small common stocks showing even greater variability.

Corporate bonds have a much smaller variability and therefore a more compact
distribution of returns. Of course, Treasury bills are the least risky. The dispersion of
annual returns for bills is compact.

Stocks have a considerably wider range of outcomes than do bonds and bills.

Smaller common stocks have a much wider range of outcomes than do large common stocks.
Given this variability, investors must be able to measure it as a proxy for risk.
Measures of Dispersion
Dispersion is the state of getting dispersed or spread. Statistical dispersion means the
extent to which numerical data is likely to vary about an average value. In other words,
dispersion helps to understand the distribution of the data.

Types of Measures of Dispersion

There are two main types of dispersion methods in statistics which are:
•Absolute Measure of Dispersion
•Relative Measure of Dispersion
Absolute Measure of Dispersion
An absolute measure of dispersion contains the same unit as the original data set.
The absolute dispersion method expresses the variations in terms of the average
of deviations of observations like standard or means deviations. It includes
range, standard deviation and variance.

Variance
It is the average of the sum of the square of the difference between each data point from
the mean. The higher the variance, the higher the scattering of data from the mean and
vice-versa.
The symbol σ2 is used to denote the variance.

where
σ 2 = the variance of a set of values
X = each value in the set
𝑋= the mean of the observations
n = the number of returns in the
sample
Standard Deviation(σ): The square
root of the variance is known as the
standard
2
The standard deviation is a measure of the total risk of an asset or a portfolio.

It captures the total variability in the asset’s or portfolio’s return, whatever the
source(s) of that variability.

The standard
deviation of return
measures the total
risk of one security or
the total risk of a
portfolio of securities.
The standard deviation, combined with the normal distribution, can provide some
useful information about the dispersion or variation in returns. For a normal
distribution, the probability that a particular outcome will be above (or below) a
specified value can be determined.

With one standard deviation on either side of the arithmetic mean of the
distribution,
68.3 percent of the outcomes will be encompassed; that is, there is a 68.3 percent
probability that the actual outcome will be within one (plus or minus) standard
deviation of the arithmetic mean.

The probabilities are 95 and 99 percent that the actual outcome will be
within two or three standard deviations, respectively, of the arithmetic mean.
 MEASURING EXPECTED
RETURN AND RISK

So far we looked at the historical return and risk. We now discuss expected return and
risk.

Probability Distribution: When you invest in a stock you know that the return from it can take
various possible values. For example, it may be –5 percent, or 15 percent, or 35 percent.
Further, the likelihood of these possible returns can vary. Hence, you should think in terms of a
probability distribution.

The probability of an event represents the likelihood of its occurrence. Suppose you say that
there is a 4 to 1 chance that the market price of a stock A will rise during the next fortnight.
This implies that there is an 80 percent chance that the price of stock A will increase and a 20
percent chance that it will not increase during the next fortnight.
Your judgment can be represented in the form of a probability distribution as follows:
Outcome Probability
Stock price will rise 0.80
Stock price will not rise 0.20

Consider two equity stocks, Bharat Foods stock and Oriental Shipping stock. Bharat
Foods stock may provide a return of 6 percent, 11 percent, or 16 percent with certain
probabilities associated with them, based on the state of the economy(There is a
30%,50% and 20% probability for economic boom, normal and recession respectively).
The second stock, Oriental Shipping stock, being more volatile, may earn a return of
– 20 percent, 10 percent, or 40 percent with the same probabilities, based on the
state of the economy.
The probability distributions of the returns on these two stocks are shown in the table below.

When you define the probability distribution of rate of return remember that:

• The possible outcomes must be mutually exclusive and collectively exhaustive.

• The probability assigned to an outcome can only vary between 0 and 1 (an impossible event
is assigned a probability 0, a certain event a probability of 1, and an uncertain event a
probability somewhere between 0 and 1).
• The sum of the probabilities assigned to various possible outcomes is 1.
Based on the probability distribution of the rate of return, you can compute two key
parameters, the expected rate of return and the standard deviation of rate of return.

Expected Rate of Return: The expected rate of return is the weighted average of all
possible returns multiplied by their respective probabilities. In symbols,

where E(R) is the expected return from the stock, Ri is the return from stock under
state i, pi is the probability that state i occurs, and n is the number of possible states of
the world .

E(R) is the weighted average of possible outcomes—each outcome is weighted by the

probability associated with it. Why we use expected value?
Expected value is used when we want to calculate the mean of a probability distribution. This
represents the average value we expect to occur before collecting any data.

Mean is typically used when we want to calculate the average value of a given sample. This
represents the average value of raw data that we’ve already collected.
The expected rate of return on Bharat Foods stock is:

E(Rb) = (0.30) (16%) + (0.50) (11%) + (0.20) (6%) = 11.5%

Similarly, the expected rate of return on Oriental Shipping stock is:
E(Ro) = (0.30) (40%) + (0.50) (10%) + (0.20) (–20%) = 13.0%
Standard Deviation of Return :Risk refers to the dispersion of a variable. It is commonly
measured by the variance or the standard deviation. The variance of a probability
distribution is the sum of the squares of the deviations of actual returns from the
expected return, weighted by the associated probabilities. In symbols,

where σ2 is the variance, Ri is the return for the ith possible outcome, pi is the
probability associated with the ith possible outcome, and E(R) is the expected return.

standard deviation i.e. S.D. = √ σ2.

Investment Rules
Investment rule number 1: If two investments have the same expected return and different
levels of risk, the investment with the lower risk is preferred.

Investment rule number 2: If two investments have the same level of risk and different
expected returns, the investment with the higher expected return is preferred.

Since investors aim to maximize return and minimize risk, it is obvious that an
investment
with both a higher expected return and lower level of risk is preferred over another
asset.
The Normal Distribution
The normal distribution, a continuous probability distribution, is the most commonly used
probability distribution in finance.

The normal distribution resembles a bell shaped curve. It appears that stock returns, at least
over short time intervals, are approximately normally distributed.

In a normal distribution the mean is zero and the standard deviation is 1. It has zero skew
and
a kurtosis of 3.

Normal distributions are symmetrical, but not all symmetrical distributions are normal.
The assumption of a normal distribution is applied to asset prices as well as
price action.

Traders may plot price points over time to fit recent price action into a normal
distribution.

The further price action moves from the mean, in this case, the greater the
likelihood
that an asset is being over or undervalued.
RISK PREMIUMS
Risk Premium That part of a security’s return above the risk-free rate of return.

A risk premium is the additional return investors expect to receive, or did receive, by taking
on increasing amounts of risk. It measures the payoff for taking various types of risk. Such
premiums can be calculated between any two classes of securities.

For example, a time premium measures the additional compensation for investing in long-
term Treasuries versus Treasury bills, and a default premium measures the additional
compensation for investing in risky corporate bonds versus riskless Treasury securities.

Hence risk premium may be defined as the additional return investors expect to get, or
investors earned in the past, for assuming additional risk.
Risk premium may be calculated between two classes of securities that differ in their risk level.
There are three well known risk premiums:
Equity risk premium: This is the difference between the return on equity stocks as a class
and the risk-free rate represented commonly by the return on Treasury bills.
Bond horizon premium: This is the difference between the return on long-term government
bonds and the return on Treasury bills.
Bond default premium : This is the difference between the return on long-term corporate
bonds (which have some probability of default) and the return on long-term government
bonds (which are free from default risk).
Risk Preference
Risk preference refers to the attitude people hold towards risks, which is a key factor
in studies on investors’ decision-making behavior.

Risk aversion is the tendency to avoid risk and have a low risk tolerance. The term risk-averse
describes the investor who chooses the preservation of capital over the potential for a
higher-than-average return.
They prefer liquid investments. That is, their money can be accessed when needed,
regardless of market conditions at the moment.
Risk-averse investors generally favor municipal and corporate bonds, CDs, and
savings
accounts.
Risk-seeking refers to an individual who is willing to accept greater economic
uncertainty in exchange for the potential of higher returns.

Risk seekers are more interested in capital gains from speculative assets than capital
preservation from lower-risk assets.

Risk-seeking confers a high degree of risk tolerance, or the amount of potential

losses an
investor is willing to accept.

Examples of asset types that might attract a risk-seeking investor include options, futures,
currencies, penny stocks, alternative investments, cryptocurrencies, and emerging market
equities.
Risk neutral describes a mindset where investors focus on potential gains when
making investment decisions.

Risk neutral investors may understand that risk is involved, but they aren't considering
it
for the moment.

If the individual focuses solely on potential gains regardless of the risk, they are said to
be
risk neutral.

Risk-neutral investors will not seek much information or calculate the probability of future
returns but focus on the gains. On the other hand, a risk seeker or risk-averse investor will
seek more and more information to ensure they don’t lose money.
END