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Investment Risk and Return-1

- Return and risk are the two critical factors in investment decisions as they are closely linked. Return consists of dividends/interest and capital gains. - Risk is the uncertainty and potential financial loss of an investment. Expected return is calculated by weighting possible returns by their probabilities. - A portfolio contains multiple assets. The portfolio's expected return is the weighted average of the assets' individual expected returns. - Portfolio risk depends on the assets' proportions, individual risks, and correlation between their returns. Lower correlation between assets reduces unsystematic risk.

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39 views20 pages

Investment Risk and Return-1

- Return and risk are the two critical factors in investment decisions as they are closely linked. Return consists of dividends/interest and capital gains. - Risk is the uncertainty and potential financial loss of an investment. Expected return is calculated by weighting possible returns by their probabilities. - A portfolio contains multiple assets. The portfolio's expected return is the weighted average of the assets' individual expected returns. - Portfolio risk depends on the assets' proportions, individual risks, and correlation between their returns. Lower correlation between assets reduces unsystematic risk.

Uploaded by

kelvinyessa906
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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AFU 08609: INVESTMENT AND

PORTFOLIO ANALYSIS
SEM 1 2022/2023
BEF III

FACILITATOR: CPB(T) , M Sc. ALLY, FATMA


INVESTMENT
RISK AND RETURN
•Return and risk are the two critical
factors in making investment decisions.
They are closely linked and must be
studied simultaneously.
•Returns on financial assets consist of
dividend/interest of holding the security
and capital gains.
• By definition:
• Return: is the money made or lost on an
investment over some period of time
• Risk: the degree of uncertainty and/or potential
financial loss inherent in an investment decision.
OR
• Risk is defined in financial terms as the chance
that an outcome or investment's actual gains will
differ from an expected outcome
Defining Return

•Income received on an investment plus


any change in market price, usually
expressed as a percent of the beginning
market price of the investment.
•R = Dt + (Pt – Po) / Po
Return Example
The stock price for Stock A was TZS 1,000 per share
1 year ago. The stock is currently trading at TZS 950
per share and shareholders just received a TZS 100
dividend. What return was earned over the past
year?

R = 100 + (950-1000)/ 1000 = 5%


Measuring Expected Return
• In practice, only the current price of an
investment is known. At best only an estimate
can be made about the future which generates
expectations of return.
• There are various ways of measuring expected
return of an investment. We will look into the
statistical method of measuring expected return
for a single and two assets.
Measuring return and Risk of a Single
Asset

• E(R)= ∑ni=1 Pi. Ri


• where;
• Pi= Probability of occurrence of ith outcome
• Ri= return of ith outcome
• n = no. of possible outcomes
• Example 1.1: The table below consist of information concerning asset A.
Calculate the expected return and risk of asset A.

• Therefore,
• E(R) = (P1x R1) + (P2 x R2) + (P3x R3) +(P4 x R4)
• =3 +6 +9 +8
• = 26%
Measurement of risk
• Risk is measured by Standard deviation and
variance.
• Recall, risk is the measurement of how the
actual differs/ deviates to the expected
phenomenon.
• Thus risk (deviation) = X actual – X expected
• Then, Deviation in returns = R – E(R)
• To calculate the risk associated with a single asset we
then multiply the probability of each scenario with
the squared deviation
• i.e. ∑ni=1 Pi x {Ri – E(R)}2 .............................. Variance
(δ2)

• then, Standard Deviation = √(𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒 ()δ2 )

• Solve for Risk of asset A referring to example 1


Two Assets portfolio
• A collection of assets is called a portfolio. Thus, a portfolio of assets
consists of two or more assets.
• PORTFOLIO X ={ Asset A, Asset B, etc.}
• Combination of assets with different correlation reduces unsystematic
risk for the investor.
• The risk of a two-asset portfolio is dependent on the proportions of
each asset, their standard deviations and the correlation (or
covariance) between the assets’ returns. As the number of assets in a
portfolio increases, the correlation among asset risks becomes a more
important determinate of portfolio risk.
Portfolio Return
• Let’s say the returns from the two assets in the
portfolio are R1 and R2. Also, assume the weights of
the two assets in the portfolio are w1 and w2. Note
that the sum of the weights of the assets in the
portfolio should be 1. The returns from the portfolio
will simply be the weighted average of the returns
from the two assets, as shown below:

• RP = w1R1 + w2R2
• Example 1.2: You invested $60,000 in asset
1 that produced 20% returns and $40,000 in
asset 2 that produced 12% returns.

• The portfolio returns will be:


E(Rp) = WA*E (RA) + WB* E(RB) =

E(Rp) = 0.60*20% + 0.40*12% = 16.8%


Portfolio Risk
• The risk of a portfolio is measured using the
standard deviation of the portfolio.
• However, the standard deviation of the
portfolio will not be simply the weighted
average of the standard deviation of the two
assets.
• We also need to consider the covariance and
(or) correlation between the assets.
The portfolio standard deviation can be calculated
as follows:
• W = weight of a particular asset in the portfolio
• δ2 = variance of a particular asset in the portfolio
• Ρ = Correlation between two assets in the portfolio

Correlation and Covariance


• the standard deviation can be calculated using either
covariance or correlation. The relationship between
the two is depicted below:
Both covariance and correlation measure the
relationship and the dependency between two variables.
• Covariance indicates the direction of the linear
relationship between variables.
• Correlation measures both the strength and direction
of the linear relationship between two variables.
• Covariance is when two variables vary with each other,
whereas
• Correlation is when the change in one variable results
in the change in another
• Example 1.3: You invested $60,000 in asset 1 that
produced 20% returns and $40,000 in asset 2 that
produced 12% returns.
• Let’s say the standard deviation of the two assets are
10 and 16, and the correlation between the two
assets is -1. The standard deviation of the portfolio
will be calculated as follows:

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