Chapter 1 (continued)

Presented by
Dr. Muhammad Khalid Sohail
 Expected Rates of Return
• Risk is uncertainty that an investment
will earn its expected rate of return,
or
• Risk: the possibility that the realized
return will be different than the
expected return
• Probability is the likelihood of an
outcome
 Expected Rates of Return
1.6
Expected Return  E(R i )
n

 (Probabilit y of Return)  (Possible Return)

i 1

[(P1 )(R 1 )  (P2 )(R 2 )  ....  (Pn R n )

n

 i i
(P
i 1
)(R )
 Risk Aversion
• If the investor is highly uncertain about the
actual rate of return. This would be considered
a risky investment because of that uncertainty.
The assumption that most investors
will choose the least risky alternative,
all else being equal and that they will
not accept additional risk unless they
are compensated in the form of
higher return
 The Tradeoff
Between ER and Risk
• Investors manage
risk at a cost - lower Stocks
expected returns
ER
(ER) Bonds

• Any level of
expected return and
Risk-free Rate
risk can be attained
Risk
 Probability Distributions
100% sure
that you’ll get Exhibit 1.2
5% return
Risk-free Investment
1.00
0.80
0.60
0.40
0.20
0.00
-5% 0% 5% 10% 15%
 Probability Distributions
Exhibit 1.3

Risky Investment with 3 Possible Returns

1.00
0.80
0.60
0.40
0.20
0.00
-30% -10% 10% 30%
 Probability Distributions
Exhibit 1.4
Risky investment with ten possible rates of return
1.00
0.80
0.60
0.40
0.20
0.00
-40% -20% 0% 20% 40%
 Measuring the Risk of
Expected Rates of Return
1.7

Variance ( ) 
n

 (Probabilit
i 1
y)  (Possible Return - Expected Return) 2

 i i
(P
i 1
)[R  E(R i )] 2
 Measuring the Risk of
Expected Rates of Return
1.8

Standard Deviation is the square

root of the variance
 Measuring the Risk of
Expected Rates of Return
1.9

Coefficient of variation (CV) a measure of

relative variability that indicates risk per unit
of return
Standard Deviation of Returns
Expected Rate of Returns
i

E(R)
• Which is more risky investment?
• Comparing absolute measures of risk, investment B appears
to be riskier because it has a standard deviation of 7 percent
versus 5 percent for investment A.
• In contrast, the CV figures show that investment B has less
relative variability or lower risk per unit of expected return
because it has a substantially higher expected rate of return.
 Measuring the Risk of
Historical Rates of Return 1.10

n
   [HPYi  E(HPY) ] / n
2 2

i 1
  2
variance of the series
HPYi  holding period yield during period i
E(HPY)  expected value of the HPY that is equal
to the arithmetic mean of the series
n the number of observations
 Determinants of
Required Rates of Return
• Time value of money
• Expected rate of inflation
• Risk involved
The summation of these three components is
called the required rate of return. This is the
minimum rate of return that you should
accept from an investment to compensate
you for deferring consumption
• The analysis and estimation of the required rate
of return are complicated by the behavior of
market rates over time.
• First, a wide range of rates is available for
alternative investments at any time.
• Second, the rates of return on specific assets
change dramatically over time.
• Third, the difference between the rates available
(that is, the spread) on different assets changes
over time.
• Because differences in yields result from the
riskiness of each investment, you must understand
the risk factors that affect the required rates of return
and include them in your assessment of investment
opportunities.
• Because the required returns on all investments
change over time, and because large differences
separate individual investments, you need to be
aware of the several components that determine the
required rate of return
 The Real Risk Free Rate
(RRFR)
–Assumes no inflation.
–Assumes no uncertainty about future
cash flows.
• we called this the pure time value of money, because
the only sacrifice the investor made was deferring
the use of the money for a period of time.
• This RRFR of interest is the price charged for the
exchange between current goods and future goods.
• The objective factor that influences the RRFR is the
set of investment opportunities available in the econ.
• The investment opportunities are determined in turn
by the long-run real growth rate of the economy.
• A rapidly growing economy produces more and
better opportunities to invest funds and experience
positive rates of return.
• A change in the economy’s long-run real growth
rate causes a change in all investment opportunities
and a change in the required rates of return on all
investments.
• Thus, a positive relationship exists between the real
growth rate in the economy and the RRFR.
 Adjusting For Inflation 1.12

Real RFR =

 (1  Nominal RFR) 
 (1  Rate of Inflation)   1
 
nominal rates of interest that prevail in the market are
determined by real rates of interest, plus factors that will
affect the nominal rate of interest, such as the expected rate
of inflation and the monetary environment
Nominal Risk-Free Rate
Dependent upon
– Conditions in the Capital Markets
– Expected Rate of Inflation
 Adjusting For Inflation 1.11

Nominal RFR =
(1+Real RFR) x (1+Expected Rate of Inflation) - 1
• Assume that you require a 4 percent real rate of
return on a risk-free investment but you expect
prices to increase by 3 percent during the
investment period.
• In this case, you should increase your required
rate of return by this expected rate of inflation to
about 7 percent
Nominal RFR =
(1+Real RFR) x (1+Expected Rate of Inflation) – 1
• = [(1.04 × 1.03) – 1] = 1.0712 – 1 = 0.0712
= 7.12%
• assume that the nominal return on U.S.
government T-bills was 9 percent during a given
year, when the rate of inflation was 5 percent. In
this instance, the RRFR of return on these T-bills
will be:

• RRFR = [(1 + 0.09)/(1 + 0.05)] – 1

• = 1.038 – 1
• = 0.038 = 3.8%
• The Common Effect: All the factors discussed
thus far regarding the required rate of return
affect all investments equally.
• Whether the investment is in stocks, bonds, real
estate, or machine tools, if the expected rate of
inflation increases, the investor’s required rate of
return for all investments should increase
• Most investors require higher rates of return on
investments if they perceive that there is any
uncertainty about the expected rate of return. This
increase in the required rate of return over the
NRFR is the risk premium (RP)
• Although the required risk premium represents a
composite of all uncertainty, it is possible to
consider several fundamental sources of
uncertainty. Major uncertainty includes:
 Facets of Fundamental
Risk
• Business risk
• Financial risk
• Liquidity risk
• Exchange rate risk
• Country risk
 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.