Chapter Three
Risk and Return
Risk and Return
• Return: Benefit associated with an Investment
• It is defined as the total gain or loss
experienced on an investment over a given
period of time.
• It does have two components: an income
component and a capital gain or loss
component.
• For example a stock does provide a dividend to
its shareholders during holding period and
capital gain or loss at time of sales.
• Absolute(dollar return)= Periodic income+
Capital gain
• %return= Periodic income+ Capital gain/Initial
value of an investment
• For stock investment,
%return=Dividend/Purchase price+ Capital
gain/purchase price=Dividend yield+ capital
gain rate
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Measuring Return
Historical rate of return/ Holding period
return
represents the return an investor received for holding
an investment for a certain period of time.
• The formula for determining the HPR is as follows:
Periodic income + Capital gain/loss
HPR= Purchase price
04-2014 4
Cont’d….
• The stock price for Stock A was Br.10 per
share 1 year ago. The stock is currently
trading at Br.9.50 per share and shareholders
just received a Br.1 dividend.
dividend What return
was earned over the past year?
Average rate of return
• Determine the investment returns over
multiple periods.
• There are two different measures for average
returns:
(a) arithmetic average, and
(b) geometric average--------Widely used and
applied when values are given in percentage.
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arithmetic average
• It is a rate of return calculated for a longer
period of time.
• It is the sum of various one period returns
divided by the number of periods.
• Average return (AR)=∑ Rt /n
• Where, n= number of periods,
Rt = returns of individual periods.
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Cont’d
• ABC co. reported a return of 10%, 12%, 14%,
8% and 6% returns form year 2000 to 2004
respectively. What is the average return of
ABC co?
• AR= 1/5(10+12+14+8+6) =50/5 = 10%
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Geometric average return
• Geometric Average = [(1+R1) (1+R2) ---+---
(1+Rt)] 1/t -1
• Following the above example average return
will be:
= [(1.10) (1.12) (1.14) (1.08) (1.06)]1/5 - 1 =
(1.60785) 1/5 -1= 1.0996-1= 9.96%
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Calculating Expected rate of Return
• An investor determines how certain the expected
rate of return on an investment by analyzing
estimates of expected returns.
• To do this, the investor assigns probability
values to all possible returns.
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cont..
• These probability values range from zero, which
means no chance of return, to one, which indicates
complete certainty that the investment will provide
the specified rate of the return.
• These probabilities are typically subjective
estimates based on the historical performance of the
investment
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cont..
• The sum of the possible returns multiplied by the
corresponding probability of the return occurring
• The expected return from an investment is defined as;
Expected Return =∑ (probability of return) x
(possible return)
E(Ri) = ∑ (Pi) (Ri)
Example1: The return on securities A and B are given
below:
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CONT..
Probability Security A(%) Security B (%)
0.5 4 0
0.4 2 3
0.1 0 1
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CONT..
• Required:
• Calculate the expected rate of return for both security, and
1) Make a decision based on the rate of returns of these two securities
Solution:
E(Ri) = ∑ (Pi) (Ri)
E(Ri) A = P1R1 +P2R2+P3R3
= 0.5x4+0.4x2+0.1x0 = 2.8%
E(Ri) B = P1R1 +P2R2+P3R3
= 0.5x0+0.4x3+0.1x1 = 1.3%
Decision: On the basis of return, security A is preferable as its return is higher
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• Example: Suppose an investor is considering
an investment of 200,000 in the stock of XYZ
co or ABC co. hoping to gain dividend and
selling it at appreciated price after one year.
Over the year it is presumed that the economy
will be 20% at boom, 60% at normal and 20%
at recession. What is the expected return from
the investment given the following rate of
returns in various economic conditions?
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Economic Probabilities Possible return of XYZ Possible return of ABC
conditions
Boom 0.2 10% -4%
Normal 0.6 11% 20%
Recessions 0.2 26% 40%
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Defining Risk
• Risk: the chance of financial loss or more
formally, the variability of return associated with
a given asset – uncertainty.
Uncertainty and Risk of Investment
• Unknown outcomes in the future is called
uncertainty.
• When it can be quantified then it is called Risk.
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• Risk can be:
systematic and
unsystematic
• Major sources of uncertainty of investment:
Business risk
Financial(leverage) risk
Liquidity Risk
Exchange rate risk
Country Risk
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Measuring Risk
A risk of an investment can be measured in
absolute term using standard deviations and
variance or in relative terms using coefficient of
variation.
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Standard deviation: An absolute
measure of risk
Standard deviation- measures the dispersion
around the expected value – the most likely
value.
It is the statistical measure of the dispersion of
possible outcomes about expected value.
It is the square root of the weighted average
square deviations of possible outcomes from the
expected value.
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Cont’d….
It is used to measure the variability of returns from an
investment and therefore an indication of risk.
The largest the standard deviation, the more the
variability of returns and therefore the riskier the
investment is.
A standard deviation of Zero indicates no variability
and thus no risk involved.
A standard deviation is useful to evaluate
investments, which have approximately equaled in
expected returns.
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Determining Standard
Deviation (Risk Measure)
n
= ( Ri - ER )2( Pi )
i=1
Deviation , is a statistical measure of
Standard Deviation,
the variability of a distribution around its mean.
It is the square root of variance.
•The risk of a single risky asset is calculated as its
standard deviation.
Variance of XYZ Company
Economic Pi Ri ER (Ri-ER)2 (Ri-ER)2 * Pi
conditions
Boom 0.2 10% 13.8% 14.4 2.888
Normal 0.6 1I% 13.8% 7.84 4.704
Recessions 0.2 26% 13.8% 148.84 29.768
Variance 37.36
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Variance of ABC Company
Economic Pi Ri ER (Ri-ER)2 (Ri-ER)2 * Pi
conditions
Boom 0.2 -4% 19.2% 538.24 107.648
Normal 0.6 20% 19.2% 0.64 0.384
Recessions 0.2 40% 19.2% 432.64 86.528
Variance 194.56
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Cont’d….
Standard deviation of XYZ co
=√variance= √37.36 = 6.11
Standard deviation of ABC co
= √variance= √194.56 =13.95
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Coefficient of variation: A relative measure of risk
• It measures the standard deviation in relation to
expected return.
• It measures the risk per unit of expected return.
• As the coefficient of variation increases, so does the
risk of an asset.
• Coefficient of variation= / ER
• Which one of the securities is highly risky?
• XYZ coefficient of variation = 6.11/13.8=0.44
• ABC coefficient of variation =13.95/19.2=0.73
the coefficient of variation of ABC is greater than XYZ
means ABC is more risky than XYZ.
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