Learning Objectives:

1. Explain the concept and

relationship between risk
and return.
2. Identify the formula to
measure risk and return

CHAPTER 5: RISK AND RETURN

Fundamentals of Risk and Return
 Different investment have different return and risk
characteristics.
 Some investments will give you immediate returns with little
risk, while others may give higher returns with high risk.
 Identifying investments on the basis of their return and risk
characteristics is not easy.

• Positive Relationship
If we take more risk, we
•The higher the return,
will get more return and
the higher the risk
vice versa

Risk
Return
 Outcome or profit that we get for our investment over some
period.
 Ex: RM 200 investment that pays RM10 in cash dividend and
worth RM208 one year late, your return would therefore be:
(RM10 + RM8)
= 9%
RM200

 For investment in common stock, the return is known as

Holding Period Return (HPR) and involves three cash flow
elements:
1. The initial price of the stock bought (P0)
2. Periodic distribution received while the stock is held (D1)
3. The amount received when the stock is sold (P1)
Return
 Mathematically HPR can be expressed as follow:
RM10 + (RM208 - RM 200)
HPR =
RM200

= 0.09 OR 9%

 Return can be classified as current return and future return.

Current returns are those benefits that you expect to get on a
regular basis. Dividends paid by the company to the investors
or interest payment made to the bondholder annually is an
example of current returns.
 When an investment appreciates in value over time, this is
referred to as future return. Referring to the earlier example,
when your investment increased in value from RM200 to
RM208 the additional RM8 is said to be your future return.
Measuring Expected Return (Ṝ) Using Probability
Distribution

 Conventionally, we can measure expected return as

follows:
n
Ṝ = ∑ Ri P(Ri)
i=1

 When
n = the number of possible states of the economy
Ri = the return/cash flow in its states of the economy
P(Ri) = the probability of the return occurring
Ṝ = the expected return
Measuring Expected Return (Ṝ) Using Probability
Distribution

 Hence, the expected return is simply the weighted

average of the possible returns, with the weights being
the probabilities of occurrence (Van Home, 1995).
 Demonstrates how the expected return (Ṝ) is computed
Probability of Event Expected Return (Ṝ)
Possible Return, Ri
Occurring Pi (Ri) (Pi)
0.2 10.0 (0.2) (10) = 2.0
0.5 8.0 (0.5) (8) = 4.0
0.3 6.0 (0.3) (6) = 1.8
∑ = Ṝ = 7.8

 As seen in the table, the expected return for the

investment is 7.8 percent
Risk
 The degree of uncertainty that things will not happen as
we want.
 The are two types of risk: unsystematic risk and
systematic risk.

R
I
Total Risk

S
K
Unsystematic
risk
systematic risk
Risk
Unsystematic risk (Non diversifiable risk)
1. The portion of total risk that is unique to a firm or industry.
2. It results in the uncertainty of possible returns on the
investment due to factors: incompetence of management,
labour difficulties and changes in consumers’ preferences.
3. Can be reduced or eliminated through a well-diversified
portfolio of investments.
Systematic Risk (Diversifiable risk)
1. The portion of total risk that affects the overall market.
2. Example: Changes in the country’s economy, inflation rates
and interest rates.
3. Cannot be reduced or eliminated by holding well-diversified
portfolio of investments.
Measuring Risk
 Using standard deviation (a statistical measure of the
variability of a distribution around its mean, Van Home,
1995).
 Measures the differences between the possible returns and the
expected return.

Mathematically, the standard deviation of a particular

investment can be written as:

σ = √ ∑ Ri P (Ri - Ṝ)2 Pi
Measuring Risk
 Example:
Probability of Event Occurring (Pi) Possible Return, Ri (Ri - Ṝ)2 Pi
0.2 10.0 (10 - 7.8)2 (0.2) = 0.968
0.5 8.0 (8 - 7.8)2 (0.5) = 0.020
0.3 6.0 (6 - 7.8)2 (0.3) = 0.972
σ2 = 1.960
σ = 1.400
Calculating risk (σ) standard deviation

 7.8% expected return and a standard deviation of 1.4% indicate that the
actual return of the investment ranges between 6.4% and 9.2% (7.8% ±
1.4%)
 If the other investment B has the same expected return as the previous
investment but a standard deviation of 3%, then, we can say that
investment B is riskier since it has a higher standard deviation.
 To understand the riskiness of an investment relative to another, a
coefficient of variation is used.
Coefficient of Variation
 Used to differentiate investments with different expected returns.
 It is “ the ratio of the standard deviation to the expected return”
(Winger, 1993) and measures the amount of risk for every unit
of expected return.
Coefficient of variation = Standard deviation
Average or expected return

CV = σ (Ri)
E (Ri)
 Using the same example, if investment A has 0.18% (1.4/7.8)
risk per 1.0% of return, while investment B has 0.38% (3/7.8)
risk per 1.0% of return, then investment B is to be riskier not
only in absolute terms but also in relative terms.
Capital Asset Pricing Model (CAPM)
 Was developed by Sharpe (1964), Lintner (1965) and Mossin (1966).
 A model was generated to predict about the risk and return characteristics
of individual assets by specifying how they could covary with the market
portfolio of all risky assets.
 Therefore the specific measure of systematic risk use in CAPM is called
asset’s beta, ßi , and is defined as the correlation of the asset’s return with
the return on the market portfolio, Rm, as specified in the equation below:

βi = COV (Ri, Rm) Where,

Var Rm βi = The beta coefficient of security j
COV im = covariance of the returns on security j
Beta (βi) = COV im with the return on the market
S2m S2m = variance
Capital Asset Pricing Model (CAPM)
 This is a direct, linear estimate of the degree of co-movement
between an asset’s return and the return on the market portfolio.
 Beta is the number that measures non-diversifiable, or market risk.,
indicates how the price of a security responds to market forces.
The more responsive the price of a security is to changes in the
market, the higher that security’s beta.
 Found by relating the historical returns for a security to the market
return. (Market return is the average return for all stock).
 The beta for the market is 1.00. Stocks with betas greater than 1.00
are more responsive to changes in the market return and therefore
are more risky than the market. Stocks with betas less than 1.00 are
less risky than the market. Therefore the higher the stock beta, the
greater should be its level of expected return.
Capital Asset Pricing Model (CAPM)
 To make the final step to the CAPM we must incorporate the option
of investing in the risk-free asset, as well as investing in the market
portfolio of risky assets.
 Risk–free rate is the interest rate that can be earned with certainty. The
rate that one can earn from the government securities (treasury bills) or
bank can be considered as risk-free rate.
 Since investors can choose combinations of this portfolio and the risk-
free asset, we can specify the CAPM predicted return for any risky
asset as equation below:
Required Return on Risk free rate + [Beta for investment j x
=
Investment j (Market return - risk free rate)]

E(R j ) = R F + [ß i x (R m – R F)]

 Where (Rm – RF) term is called the market risk premium (or equity
risk premium), since it is the additional return required by investors in
order to hold the market portfolio instead of the risk-free assets.
Capital Asset Pricing Model (CAPM)
 Reward is measured as the difference between the expected
HPR on the index stock fund and the risk-free rate, that is the
rate you can earn by leaving money in risk-free assets such as
T-bills, money market fund or the bank. We call this difference
the risk premium on common stock.
 Therefore it is define as:
 Risk premium for investment is risk faced by the investors depending
on type of vehicle (stock, bond, etc) financial condition of the
company and etc. Risk premium can be define as

1. The expected return over the risk-free return. For example, if the risk-
free rate is 6% per year, and the expected index fund return is 14%, then
the risk premium on stocks is 8% per year.
2. The additional compensation above the risk-free return.
Capital Asset Pricing Model (CAPM)
Example:
 Assume you are considering security Z with a beta of 1.25. The
risk-free rate is 6% and the market return is 10%.
E(R j ) = R F + [ß i x (R m – R F)]
= 6 % + [1.25 x (10% - 6 % )]
6% + 5 %
= 11%

 If the beta were lower, say 1.00, the required return would be lower

E(R j ) = RF + [ß i x (R m – R F)]
= 6 % + [1.00 x (10% - 6 % )]
6% + 4 %
= 10%
The security Market Line (SML)
 The CAPM is presented graphically, where expected return is again
on the y-axis, by now beta (rather than standard deviation) is on the
x-axis. The ray extending up to the right from R F is referred to
Security Market Line.
 For each level of non diversifiable risk (beta), SML reflects the
required return the investor should earn in the market place

SML

Required SML depict the tradeoff between risk

return (%) 11
and return. At beta of 0, the required
10 return is the risk free of 6%. At a beta
of 1.0 the required return is market
6 return of 10%. Given these data, the
required return on an investment with a
beta of 1.25 is 11%
0 1.0 1.25
Risk (beta)
Questions/Exercises
1. Sambal Daging Inc is evaluating an investment. With the
following information, calculate the investment’s expected
risk and return. Should or not Sambal Daging Inc invest if
the Treasury bill carries a return of 9.40%

Probability Return
0.15 5%
0.30 7%
0.40 10%
0.15 15%
Questions/Exercises
Answer….

A B AxB Weighted
Return Expected Deviation
Probability (Pi) Return (Ṝ)
(Ri) [ (Ri - Ṝ)2 Pi ]
0.15 5% 0.75% 2.52
0.30 7% 2.10% 1.32
0.40 10% 4.00% 0.32
0.15 15% 2.25% 5.22
Ṝ = 9.10% σ2 = 9.39%
σ = 3.06%

No, Sambal Daging Inc should not invest in the investment because the level
of risk is excessive for return which is lower than the return offered by the
Treasury bills.
Questions/Exercises
2. Consider a Malaysian firm making an investment that
produces cash flows in Japan Yen. If the firm invested
¥12,000 today and expects to get ¥15,000 one year from
today, what is the firm’s HPR?

Answer….

HPR = D1 + (P1 — P0)

P0

= 0 + (15,000 — 12,000)
12,000

= 25%