TOPIC 2

RISK AND RETURN OF

SINGLE SECURITY
Refer to:
Reilly, Brown & Leeds
Chapter 1

1
 At the end of this topic, students should be able to
answer the following questions:

• How do investors measure the rate of return of an

investment?
• How do investors measure the risk related to
alternative investments?
• What is fundamental risk and systematic risk?
• What factors contribute to the rates of return that
investors require on alternative investments?
• What macroeconomic and microeconomic factors
contribute to changes in the required rates of return
for investments?
2
 WHAT IS RETURN?
• Rewards for investments or the benefits that an
investor expects to receive over some period of time

• Two main components of return:

1. Income return/gain from investments
(e.g. dividend, interest, rental)
2. Capital gain: changes in the price/ market value of
asset.

3
 Return: Income gain Vs Capital gain

• You purchased 1000 shares of Stock A for RM5.80

a share and a year later you sold it for RM6.60.
You received a cash dividend of RM0.30 a share
during the period.
– How much is your capital gain ?
(RM6.60-5.80) 1000 shares = RM800
– How much is your current dividend income?
RM0.30 x 1000 shares = RM300
– What is your total return?
800 + 300 = RM1,100
4
 Measurement of Returns

• Can be expressed in percentage annualized or

over the time period the investment is held
(Holding period).

• Measurement of returns allows investors to

compare the expected return, E(R) of the
investments with the actual return required
to justify the investment.

5
 Historical Rates of Return
• Return over a Holding Period
- Holding Period Return (HPR)
HPR= Ending Value of Investment
Beginning Value of Investment
- Holding Period Yield (HPY) or Rate of Return
HPY = HPR-1
- Annual HPR and HPY
Annual HPR = HPR1/n
Annual HPY = Annual HPR -1=HPR1/n – 1
where n=number of years of the investment
1-6
 EXAMPLE 1
Assume that you invest RM2000 at the beginning of
the year and get back RM2200 at the end of the
year. What are the HPR and the HPY for your
investment?

HPR = Ending value / Beginning value

= 2200/2000
= 1.1
HPY = HPR-1
= 1.1-1 = 0.1 or 10%
1-7
 EXAMPLE 2
Your investment of RM2500 in Stock A is worth RM3500 in two
years while the investment of RM1000 in Stock B is worth
RM1200 in six months. What are the annual HPRs and the
HPYs on these two stocks?

• Stock A
– Annual HPR =HPR1/n = (3500/2500)1/2 = 1.1832
– Annual HPY =Annual HPR-1 = 1.1832-1
= 0.1832 or 18.32%
• Stock B
– Annual HPR=HPR1/n = (1200/1000)1/0.5 = 1.44
– Annual HPY=Annual HPR-1 = 1.44-1
= 0.44 or 44%
1-8
• Computing Average Historical Returns
Suppose you have a set of annual rates of return
(HPYs or HPRs) for an investment. How do you
measure the mean annual return?
– Arithmetic Mean Return (AM)
AM=  HPY / n
where  HPY=the sum of all the annual HPYs
n=number of years
– Geometric Mean Return (GM)
GM= [ HPR] 1/n -1
where  HPR= the product of all the annual HPRs
n=number of years
1-9
 EXAMPLE 3
Suppose you invested RM1000 three years ago and it is worth
RM1104 today. The information below shows the annual
ending values and HPR and HPY. This example illustrates the
computation of the AM and the GM over a three-year period
for an investment.

Year Beginning Ending HPR HPY

Value Value

1 1000 1150 1.15 0.15

2 1150 1380 1.20 0.20
3 1380 1104 0.80 -0.20
1-10
AM =  HPY / n
= [(0.15)+(0.20)+(-0.20)] / 3
= 0.15/3
= 5%

GM = [ HPR] 1/n -1
= [(1.15) x (1.20) x (0.80)]1/3 – 1
= (1.104)1/3 -1
= 1.03353 -1
= 3.353%
1-11
Comparison of AM and GM
When rates of return are the same for all years,
the AM and the GM will be equal.

When rates of return are not the same for all

years, the AM will always be higher than the
GM.

While the AM is best used as an “expected

value” for an individual year, while the GM is
the best measure of an asset’s long-term
performance.
1-12
 Historical Rates of Return
(with income)
• HPR
= (EV + Income)
BV

• HPY (or rate of return)

= HPR -1
where EV = Ending Value
BV = Beginning Value
Income = Dividend, interest earned, etc.
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 EXAMPLE 4
Period BV EV Div HPR HPY
1 3.20 3.50 0.30 1.1875 18.75%
2 3.50 4.10 0.50 1.3143 31.43%
3 4.10 4.50 0.80 1.2927 29.27%

AM =  HPY / n
= (18.75 + 31.43 + 29.27 ) / 3
= 26.48%

GM = [ HPR] 1/n -1
= (1.1875 X 1.3143 X 1.2927)1/3 – 1
= 1.2636 – 1
= 0.2636
= 26.36%
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 Average Historical Rates of Return

Therefore, average historical Return =

i = ∑Ri /n

15
 EXAMPLE 5
Calculate the average return of Stock A below
Period Return (%), Ri
1 5.3
2 4.6
3 3.6
4 8.3

i = ∑Ri /n

= (5.3 + 4.6 + 3.6 + 8.3) = 5.45%

4
16
 Historical Rates of Return
• A Portfolio of Investments
– Portfolio HPY: The mean historical rate of return
for a portfolio of investments is measured as the
weighted average of the HPYs for the individual
investments in the portfolio, or the overall change
in the value of the original portfolio.
– The weights used in the computation are the
relative beginning market values for each
investment, which is often referred to as dollar-
weighted or value-weighted mean rate of return.
17
 EXAMPLE 6

Source: Reilly, Brown & Leeds (2018) 18

• In previous examples, we discussed realized
historical rates of return BUT an investor would be
more interested in the expected return on a future
risky investment.

Average Expected Rates of Return

Future or Expected Rate of Return

E(Ri) = ∑ (Probability of Return) x (Possible Return)

= ∑Pi(Ri)

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 EXAMPLE 7
Calculate the Expected rate of return of Stock B below
Stage of Economy Probability Return (%)
Good 0.3 13
Moderate 0.4 9
Poor 0.3 6

E(Ri) = ∑Pi(Ri)
= (0.3 x 13) + (0.4 x 9) + (0.3 x 6)
= 3.9 + 3.6 + 1.8
= 9.30%
20
 WHAT IS RISK?
• Risk refers to the uncertainty of the future
outcomes of an investment
- There are many possible variation of returns from
an investment due to the uncertainty
- Probability (variation) is the likelihood of an
outcome
- The larger variation indicates higher risk.
- The sum of the probabilities of all the possible
outcomes is equal to 1.0.
• Types of Risk
- Business risk, financial risk, liquidity risk, exchange
risk, country risk
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 Risk of Expected Return

• Risk refers to the uncertainty of an

investment; therefore the measure of risk
should reflect the degree of the uncertainty.
• The risk of expected return reflect the degree
of uncertainty that actual return will be
different from the expect return.

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 Measuring the Risk of Historical Return
• Given a series of historical returns measured by HPY,
the risk of returns is measured as:
1. Variance, σn2 =  [HPYi – E(HPY)i]2 

 2   [ HPYi  nE ( HPY)] 2  / n
 i 1 =  (Rᵢ-Ṝᵢ)² 
n
where, σ2 = the variance of the series
HPYi = the holding period yield during period i
E(HPY) = the expected value of the HPY equal to the
arithmetic mean of the series (AM)
n = the number of observations
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2. Standard Deviation, σ
σ =

= (Rᵢ−Ṝᵢ)²
n
SD measures the dispersion of return from the mean.
It is the square root of the variance and measures the
total risk.
The larger the dispersion, the smaller the chance to
achieve what are expected, thus the higher the risk

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3. Coefficient of Variation (CV) I

CV measures the risk per unit of expected return and

is a relative measure of risk. The higher the CV, the
riskier the investment, the greater the dispersion
relative to the mean of the series.

SD of Return
 
CV 
Average Rate Return
i

25
 Measuring the Risk of Expected Return

• Since risk is characterized by uncertainties of

future returns, it is therefore a measure of
the variability of returns.

Risk again can be measured through:

1. Variance (σ2) of the rate of return
2. Standard deviation (σ) of the rate of return
3. Coefficient of variation of the rate of return

26
1. The Variance,  2
Variance ( 2 )
n
  (Probability) x ( Possible  Expected ) 2
i 1 Return Return
n
  Pi [ Ri  E ( Ri )] 2
i 1

27
2. Standard Deviation,  or   √ 2
n
   Pi [ Ri E ( Ri )]
 2

i 1

3. Coefficient of Variation (CV)

Standard Deviation of Return
CV 
Expected Rate of Return

E (Ri)
1-28
 EXAMPLE 8 : Measuring Risk using Historical Return

Given the following information, calculate the Variance,

the SD and the CV of the return for Stock A.
Period Return (%)
1 5.3
2 4.6
3 3.6
4 8.3
Average Return, Ṝi = ∑Ri /n
= (5.3 + 4.6 + 3.6 + 8.3) = 5.45%
4
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 Period Return(%)
1 5.3
2 4.6
3 3.6
4 8.3
Average return, ṜA 5.45

Variance, σ² =  (Rᵢ-Ṝᵢ)²
n
= [(5.3-5.45)² + (4.6-5.45)² + (3.6-5.45)² + (8.3-5.45)²]
4
= [0.0225 + 0.7225 + 3.4225 + 8.1225) = 12.29 / 4
4 = 3.073%
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Standard Deviation, σ

= σ² = 3.073

= 1.753%

Coefficient of Variation (CV)

= σ / Ṝᵢ
= 1.753 / 5.45
= 0.322

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EXAMPLE 9 : Measuring Risk using Expected Return
Given the following information, calculate the Variance,
the SD and the CV of the return for Stock B:
Stage of Economy Probability Return (%)
Good 0.3 13
Moderate 0.4 9
Poor 0.3 6

E(Ri) = ∑Pi(Ri)
= (0.3 x 13) + (0.4 x 9) + (0.3 x 6)
= 3.9 + 3.6 + 1.8
= 9.30%
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 Stage of Economy Pi Ri (%)
Good 0.3 13
Moderate 0.4 9
Poor 0.3 6
E(RB) = 9.3
Variance, σ² =  Pi[Ri – E(Ri)]2
= 0.3(13-9.3)² + 0.4(9-9.3)² + 0.3(6-9.3)²
= 4.107 + 0.036 + 3.267 = 7.410%

Standard Deviation, σ
= 7.41 = 2.722 %

CV = σ / E(Ri) = 2.722 / 9.3 = 0.292

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 SUMMARY OF RETURN AND RISK
for Stock A and Stock B above
Stock A Stock B
E(Ri) or Ṝi 5.45 9.3

σ²i 3.073 7.410

SD, σi 1.753 2.722

CV = σ/E(Ri) or σ/Ṝi 0.3216 0.2927

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Determinants of Required Rate of Return
• Three Components of Required Return:
– The time value of money during the time period
– The expected rate of inflation during the period
– The risk involved
• Complications of Estimating Required Return
– A wide range of rates is available for alternative
investments at any time.
– The rates of return on specific assets change
dramatically over time.
– The difference between the rates available on
different assets change over time.
35
• The Real Risk Free Rate (RRFR)
– Assumes no inflation.
– Assumes no uncertainty about future cash flows.
– Influenced by time preference for consumption
of income and investment opportunities in the
economy
• Nominal Risk-Free Rate (NRFR)
– Conditions in the capital market
– Expected rate of inflation
NRFR=(1+RRFR) x (1+ Rate of Inflation) - 1
RRFR=[(1+NRFR) / (1+ Rate of Inflation)] - 1
36
• Business Risk
– Uncertainty of income flows caused by the
nature of a firm’s business
– Sales volatility and operating leverage determine
the level of business risk.
• Financial Risk
– Uncertainty caused by the use of debt financing.
– Borrowing requires fixed payments which must
be paid ahead of payments to stockholders.
– The use of debt increases uncertainty of
stockholder income and causes an increase in the
stock’s risk premium.
37
• Liquidity Risk
– How long will it take to convert an investment
into cash?
– How certain is the price that will be received?
• Exchange Rate Risk
– Uncertainty of return is introduced by acquiring
securities denominated in a currency different
from that of the investor.
– Changes in exchange rates affect the investors
return when converting an investment back into
the “home” currency.

38
• Country Risk
– Political risk is the uncertainty of returns caused
by the possibility of a major change in the
political or economic environment in a country.
– Individuals who invest in countries that have
unstable political-economic systems must include
a country risk-premium when determining their
required rate of return.

39
• Risk Premium and Portfolio Theory
– From a portfolio theory perspective, the relevant
risk measure for an individual asset is its co-
movement with the market portfolio.
– Systematic risk relates the variance of the
investment to the variance of the market.
– Beta measures this systematic risk of an asset.
– According to the portfolio theory, the risk
premium depends on the systematic risk.

40
• Fundamental Risk versus Systematic Risk
– Fundamental risk comprises business risk,
financial risk, liquidity risk, exchange rate risk,
and country risk.
Risk Premium= f ( Business Risk, Financial Risk,
Liquidity Risk, Exchange Rate Risk,
Country Risk)
– Systematic risk (Beta) refers to the portion of an
individual asset’s total variance attributable to
the variability of the total market portfolio.
Risk Premium= f (Systematic Market Risk)

41
 Relationship Between Risk and Return
• The Security Market Line (SML)
– It shows the relationship between risk and return
for all risky assets in the capital market at a given
time. Investors select investments that are
consistent with their risk preferences.
Expected Return
Low Average High Security
Risk Risk Risk Market Line

The slope indicates the

required return per unit of risk
Rfr
Risk
(business risk, etc., or systematic risk-beta)
42
• Movement along the SML
– When the risk changes, the expected return will
also change, moving along the SML.
– Risk premium: RPi = E(Ri) - Rrf

Expected
Return
SML

Movements along the curve

Rrf that reflect changes in the
risk of the asset
Risk
(business risk, etc., or systematic risk-beta)
43
• Changes in the Slope of the SML
– When there is a change in the attitude of
investors toward risk, the slope of the SML will
also change.
– If investors become more risk averse, then the
SML will have a steeper slope, indicating a higher
risk premium, RPi, for the same risk level.
Expected Return New SML

R m’
Original SML
Rm

Rrf
Risk
44