RISK AND

RETURN
FINANCIAL MANAGEMENT. FIN3513

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Learning Outcomes
01 Define both risk and return

02 Describe the relationship between risk and return

03 Explain the various types of risk in investment

Identify how risk is measured and quantified, and perform

04 the computations

Calculate the required rate of return using the Capital

05 Assets Pricing Model (CAPM)

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 Risk is a concept that denotes a
potential negative impact to some
characteristics of value that may
arise from a future event.

Risk
Risk of return is measured by the
standard deviation of return on an
investment. On the other hand, risk for
portfolio can be determined by
calculating the variance as well as the
beta for portfolio.

Business decision making is very much exposed to risk; vendor selection,

for instance. The vendor selected might be somehow less qualified and
might not be able to cope with the company’s stock demand. It might
then affect the company’s production, which also relates to financial
aspects of the company. To a manager who has the responsibility for
investing’ understanding and ability to minimize risks are of utmost
importance. This is because the returns from these investments are very
much dependent on these risks.

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 Investment risk is related
to the probability of earning
a low or negative actual
return.

Stand alone risk Portfolio risk

The greater the chance of lower than expected or negative returns, the
riskier the investment. On the other hand, the greater the range of
possible events that can occur, the greater the risk. This is how
investment risk can be briefly defined in a company.

There are two types of investment risk which are:

1. Stand alone risk
• It is the type of risk where the return is analyzed in isolation. It
assumes that an investment a company intends to pursue is a
single asset that is separated from the company’s other assets.
2. Portfolio risk
• This is a type of risk where the return is analyzed in a portfolio,
which is a group of assets. Whenever an investment is held in a
portfolio, a portion of an individual stock’s risk can be
eliminated.

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 Risk Classification

Systematic Unsystematic
risk risk
- can be diversified
- market risks that
away when the
cannot be reduced by
number of securities
diversification
in portfolio are
increased

Example of systematic risk Example of unsystematic risk

War and global recessions Risk of an individual company, for
example company facing lawsuit

Company-unique risk (unsystematic risk) might also be called diversifiable risk,

because it can be diversified away. Market risk (systematic risk), on the other hand, is
non-diversifiable risk. It cannot be eliminated no matter how much we diversify.

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 Types of Investor
Risk-averse investors

- those who are very careful with the risk they are facing. The
investment will only be made is they are certain of sufficient return

Risk-seeker investors

- those who enjoy taking risky investments, regardless of

whether the investment will give them appropriate return or not

Risk-neutral investors

- those are not particularly concern on the risk, as

long as they are guaranteed some return

Risk-averse behavior is the tendency of a person to reject a bargain with

an uncertain payoff and accept bargain with a more certain, but possibly,
lower expected payoff. As an example, a risk-averse investor will choose
to put his money into Amanah Saham Bumiputera (ASB) with a low but
certain return, rather than into a stock that may have high unexpected
returns.

Risk-loving behavior of an investor is the willingness to take an

additional risk for an investment that has a relatively low expected
return. Gamblers and some people who participate in extreme sports are
good examples or risk lovers.

Risk-neutral people judge risky investments by their expected rates of

return. For them, the level of risks does not matter, as long as the return
is commensurate.

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 What is return?
Definition:
Income received on an investment plus
any change in market price, usually
expressed as a percent of the
beginning market price of the
investment

Types of return
1. Actual return
2. Expected return
3. Required return

Actual return, also known as holding period return, is the return actually
received from an investment. Dividend paid on shares is an example of
actual return.

Expected return is the return on investment you expect to collect when

in investing in any securities. Before investing in shares, per say, an
investor will usually use any relevant information to reasonably estimate
what is the rate of return over a period of time; and that is expected
return.

Required return represents the absolute minimum return on investment

you would accept for that investment to be worthwhile. For example, if
you need 4% return on your money to make your investment
advantageous, then this is your required return. Any investment with a
return of less than 4% will not be accepted.

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 STAND-ALONE BASIS
EXPECTED STANDARD
RETURN DEVIATION
ǩ = ∑ pi ki σ = √∑ (ki – ǩ)² pi

pi ki pi ki
the the return the the return
probability for the probability for the
that the probability that the probability
return might return might
materialized materialized

The bigger the ǩ (expected return), the better the investment is and the
higher chance of the investment to be made.

Standard deviation (σ) is used to measure a security’s volatility; which

means the tendency of the return to rise or fall in a period of time. An
investment with higher standard deviation is deemed to be riskier.

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 STAND-ALONE BASIS
Coefficient of Variation

CV = Standard deviation = σ
Expected return ǩ

Coefficient of variation is a statistical measure of the dispersion of data

points around the mean. From a financial perspective, the financial
metric represents the risk-to-reward ratio where the volatility shows the
risk of an investment and the mean indicates the reward of an
investment. By determining the coefficient of variation of
different securities, an investor identifies the risk-to-reward ratio of each
security and develops an investment decision. Generally, an investor
seeks a security with a lower coefficient of variation because it provides
the most optimal risk-to-reward ratio with low volatility but high returns.
However, the low coefficient is not favorable when the average expected
return is below zero.

CV is different from standard deviation in a way that CV measures

relative risk, while standard deviation measures absolute risk.

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 EXAMPLE
SHARE A

Probability Expected return

(%)
0.05 -10
0.25 15
0.30 20
0.35 25
0.05 30

Expected return of Share A = (0.05 x -0.1) + (0.25 x 0.15) + (0.30 x 0.2) +

(0.35 x 0.25) x (0.05 x 30) = 0.195 @ 19.5%

Standard deviation for Share A = √[(-10-19.5)² x 0.05] + [(15 – 19.5)] ² x

0.25] + [(20 – 19.5)]² x 0.30 + [(25 – 19.5)² x 0.35] + [(30 – 19.5) x
0.05]
= 8.05%

Coefficient of variation = 0.0805/0.195 = 0.4128

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 A portfolio is a collection of
investments held by an
institution or a private
individual
What is portfolio?

Why portfolio?
By splitting the
investment into different
type of financial
securities, the potential
risk of the investment
can be reduced

As per portfolio definition, it is a collection of a wide range of assets that

are owned by investors. The said collection of financial assets may also
be valuables ranging from gold, shares, funds, derivatives, property, cash
equivalents and bonds. Individuals put their money in such assets to
generate revenue while ensuring that the original equity of the asset or
capital does not erode.

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 PORTFOLIO
EXPECTED
BETA
RETURN
ǩp = ∑ w i ǩ i ßp = ∑ biwi

wi ǩi bi wi
the weight the the beta for the weight
(investment expected each (investment
proportion) return for a investment proportion)
for the particular for the
investment investment investment

Beta determines the volatility, or risk, of a stock or fund in comparison to

that of an index or benchmark. A beta which is greater than 1 indicates
greater volatility than the overall market, while a beta less than 1
indicates less volatility than the benchmark.

The correlation coefficient is a statistical measure of the strength of the

relationship between the relative movements of two variables. The
values range between -1.0 and 1.0. A calculated number greater than 1.0
or less than -1.0 means that there was an error in the correlation
measurement. A correlation of -1.0 shows a perfect negative correlation,
while a correlation of 1.0 shows a perfect positive correlation. A
correlation of 0.0 shows no linear relationship between the movement of
the two variables.

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 EXAMPLE

SHARE A SHARE B

Beta Expected return Beta Expected return

(%) (%)
1.30 17.4 -0.87 1.7

Assume that the shares are equally distributed.

Expected return:
Share A = 17.4% x 0.5 = 8.7%
Share B = 1.7% x 0.5 = 0.85%
Expected return = 8.7% + 0.85% = 9.55%

Portfolio beta:
Share A = 1.30 x 0.5 = 0.65
Share B = -0.87 x 0.5 = -0.435
Beta = 0.65 + (-0.435) = 0.215

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 CAPITAL ASSET
PRICING MODEL
(CAPM)
Capital Asset Pricing Model is a model that
describes the relationship between risk
and expected return and is used in the
pricing of risky securities.

Ki = Krf + (Km – Krf)ßi

Krf Km ßi
the risk-free the the beta of
Modern Portfolio rate of expected the
return return on individual
Designed the market security
portfolio

CAPM gives a very precise relationship between the risk of an asset and
its expected returns. It shows that the expected return on a security is
equal to the risk-free return plus a risk premium, which is based on the
beta of that security.

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 EXAMPLE

Beta of Company X 1.86

Yield of Malaysian Government Securities 5.5%
Market return 17%

Ki = 5.5% + (17% - 5.5%)1.86 = 26.89%

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Thank You

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 CLASS EXERCISE
X Bhd is considering an investment in one of two company shares. Given the
information that follows, which investment is better, based on risk and return?

Company C Company D
Probability Return Probability Return
0.30 11% 0.20 25%
0.40 15% 0.30 6%
0.30 19% 0.30 14%
0.20 22%

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 CLASS EXERCISE
C Bhd is currently reviewing information regarding two investment opportunities.
Which investment should be accepted?

Company W Company P
Probability Return Probability Return
0.20 22% 0.10 4%
0.50 18% 0.30 6%
0.30 27% 0.40 10%
0.20 15%

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 CLASS EXERCISE
D Bhd is considering several investments. The rate on Treasury Bills is currently
6.75% and the expected return for the market is 12%. What should be the
required rates of return for each investment?

Security Beta
A 1.50
B 0.82
C 0.60
D 1.15

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 CLASS EXERCISE
You are given the following data for few securities:

Security Percentage of portfolio Estimated return (%) Beta

P 25% 12 1.8
Q 10% 16 2.4
R 50% 21 2.0
S 15% 8 0.9
Note: The market required rate of return is 15% and the risk-free rate is 5%.

a) Calculate the beta portfolio for the company.

b) Calculate the company’s required rate of return using CAPM.

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 CLASS EXERCISE
The following RM5 million investment fund which consists of four types of
securities with various betas and returns as given below:

Security Investments (RM) Estimated return (%) Beta

ABC 400,000 15 1.50
DEF 600,000 10 -0.50
GHI 500,000 25 1.35
JKL 3,500,000 60 0.60
Note: The market required rate of return is 15% and the risk-free rate is 7%.

a) Calculate the company’s beta.

b) Calculate the company’s required rate of return.

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