Finance Management

Module 2: Returns and Risks and Time Value of Money

Dr. Machhindranath Patil

January 2016
Dept. of Instrumentation Engineering
V.E.S. Institute of Technology
University of Mumbai
Returns and Risks
Returns and Risks

• Returns and risks are highly correlated in investing.

Increased potential returns on investment usually
implies increased risk.
• In a well-ordered market there is a linear relationship
between market risk and expected return.
• The return on an investment is expressed as a
percentage and is considered to be a random variable
that takes any value within a given range.
• Risk is present in virtually every decision.
• The objective in risk management is not to eliminate
or avoid risk. In fact, it may be neither feasible nor
desirable to do so.
• However, an objective of decision making is to
properly assess it and determine whether it is worth
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Returns and Risks

• Financial assets are expected to generate cash flows and hence

the riskiness of a financial asset is measured in terms of the
riskiness of its cash flows.
• The riskiness of an asset may be measured on a stand-alone
basis or in a portfolio context.
• An asset may be very risky if held by itself but maybe much less
risky when it is part of a large portfolio.
• In the context of a portfolio, the risk of an asset is divided in to
two parts: diversifiable risk and market risk.
• Diversifiable risk arises from company-specific (or sector
specific) factors and hence can be washed away through
diversification.
• Diversification allows investors to reduce the overall risk
associated with their portfolio but may limit potential returns.
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Returns and Risks

• For example, Making investments in only one market

sector may generate superior returns if that sector
significantly outperforms the overall market.
But should the sector decline then you may
experience lower returns than could have been
achieved with a broadly diversified portfolio.
• For a diversified investor what matters is the market
risk and not the diversifiable risk.

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Historical Returns and Risks
Historical Returns and Risks

• Historical returns helps you to estimate the distribution of returns

expected in future.

Computing Historical Returns over a period

Suppose that,
PB = Price of the investment at the beginning.
PE = Price of the investment in the end of period.
C = Cash Payment Received during the period. So % return R on the
investment can be given by,

C + (PE PB )
R= ⇥ 100 %
PB
Note that, PB > 0, C 0 and PE can be 0, Positive or Negative. So,
return R can be 0, Positive or Negative.

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Example

Suppose that, an investor bought 100 equity shares at the price of

| 600 per share. After one year the price of an equity share was
| 684 and he received dividend of | 300 on his investment.
So his return on Investment can be calculated as follows.
PB =| 600⇥100=| 60000, PE =| 684⇥100=| 68400 and C=| 300
So % return R on the investment is given by,

C + (PE PB )
R= ⇥ 100
PB
300 + (68400 60000)
= ⇥ 100
60000
8700
= ⇥ 100 = 14.5 %
60000
Note that,(300/60000) ⇥ 100 = 0.5% is current yield and
(8400/60000) ⇥ 100 = 14% is capital gain/loss yield.
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Average Annual Returns

• There are two commonly used ways to calculating the average

annual return of an investment one is an arithmetic mean and
another is geometric mean that calculates annual compounded
growth.
Arithmetic Mean
An arithmetic mean is simple average of annual realized returns,
given by Pn
Ri
R̄ = i=1
n
Where, Ri is annual return for the i th year and n is period of
investment in years.

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Example: Annual Growth

Suppose that for an investment of | 60000 for 5 years has annual

returns on each years as R = {10.5%, 6.5%, 3.4%, 7.5%, 11.6%}.
So the simple average returns can be obtained as

10.5 + 6.5 3.4 + 7.5 + 11.6

R̄ = = 6.54%
5
So average yield on the investment is 6.54% or | 3924 per year.

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Compounded Annual Growth Rate (CAGR)

To calculate the Compound Average Growth Rate (CAGR) over a

period of time, the geometric mean is used.
Geometric Mean
An geometric mean for the realized returns can be given by,

n
!1/n
Y
GM = (1 + Ri ) 1
i=1

Where, Ri is annual return (normalized to 1) for the i th year and n is

period of investment in years.

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Example: CAGR

Suppose that for an investment of | 60000 for 5 years has annual

returns on each years as R = {10.5%, 6.5%, 3.4%, 7.5%, 11.6%}.
So the CAGR is given by

CAGR = (1.105 ⇥ 1.065 ⇥ 0.966 ⇥ 1.075 ⇥ 1.116)1/5 1 = 0.064

So CAGR on the investment is 6.4% or | 3840 per year.

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Variance of returns

• Suppose you are analyzing the return of an equity stock over a

period of time.
• In addition to the arithmetic mean return, you would also like to
know the variability of returns.
• The variance is a measure of variability.
• It is calculated by taking the average of squared deviations
from the mean.

Varaince
Let R be the return from the investment, R̄ be the arithmetic mean
and be standard deviation, then variance is given by
Pn
2 (Ri R̄)2
= i=1
n 1

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Example: Variance of Returns

Suppose that for an investment of | 60000 for 5 years has annual

returns on each years as R = {10.5%, 6.5%, 3.4%, 7.5%, 11.6%}.
So the simple average returns can be obtained as

10.5 + 6.5 3.4 + 7.5 + 11.6

R̄ = = 6.54%
5
So average yield on the investment is 6.54% or | 3924 per year.
Furthermore, Here period n = 5 years. So Variance is given by,
Pn
2 i=1 (Ri R̄)2
=
n 1
(10.5 6.54)2 + (6.5 6.54)2 + ( 3.4 6.54)2 + (7.5 6.54)2 + (11.6 6.54)2
=
4
141.012
= = 35.253
4
p
So the Variance is 35.253 and standard deviation is = 35.253 = 5.9374.

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Expected Return and Risk of the Single Asset

• So far we have discussed about past returns.Now we discuss

about prospective returns.
• When you have invested in an asset, return on the investment
can be any value positive, negative or zero return.
• Likelihood of return therefore vary from value to value.
• So one should think in terms of a probability distribution.
• The probability of an event represents the likelihood of its
occurrence.
• For instance, suppose that you think that there is a 4:1 chance
that the market price of an asset will increase. So probability
distribution can be given by,
Outcome Probability
Stock Price will rise 80%
Stock Price will not rise 20%
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Expected Rate of Return

It is calculated by taking the average of the probability distribution of

all possible returns. Suppose that there are n possible returns
(outcomes) Ri , i = 1, 2, · · · , n, then expected rate of return can be
given by
Xn
E(R) = pi Ri (1)
i=1

Where, pi is probability of occurrence of Ri return.

For example, if a stock has a 50% probability of providing a 10% rate
of return, a 30% probability of providing a 15% rate of return, and a
20% probability of providing a 20% rate of return.
So the expected rate of return is,
n
X
E(R) = pi Ri = 0.5 ⇥ 10 + 0.3 ⇥ 15 + 0.2 ⇥ 20 = 13.5%
i=1

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Standard Deviation of Expected Returns

• Risk refers to the dispersion of a variable.

• It is commonly measured by the variance or the standard
deviation.
• The variance of a probability distribution is the sum of the
squares of the deviations of actual returns from the
expected return weighted by the associated probabilities.
• So the variance is given by
n
X
2
= pi (Ri E(R))2 (2)
i=1

Where, Ri is i th possible outcome, E(R) is expected return and

pi is the probability of the i th possible income.

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Example: Standard deviation of Expected Returns.

For example, if a stock has a 50% probability of providing a 10% rate

of return, a 30% probability of providing a 15% rate of return, and a
20% probability of providing a 20% rate of return.
So the expected rate of return is,
n
X
E(R) = pi Ri = 0.5 ⇥ 10 + 0.3 ⇥ 15 + 0.2 ⇥ 20 = 13.5%
i=1

So variance of expected returns is given by,

n
X
2
= pi (Ri E(R))2
i=1

=0.5 ⇥ (10 13.5)2 + 0.3 ⇥ (15 13.5)+ 0.2 ⇥ (20 13.5)2 = 15.25
p
and standard deviation is = 15.25 = 3.9051%.
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Features of Standard Deviation

• Because Ri E(R) is squared, therefore farther the possible

value of Ri higher it impacts on standard deviation.
• As squared difference (Ri E(R))2 is multiplied by associated
probability pi , therefore lesser the probability of occurrence of
particular Ri smaller is the effect on standard deviation.
• As standard deviation and expected value are measured in the
same units and hence the two can be directly compared.

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Rationale for Standard Deviation

Why is standard deviation employed commonly in finance as a

measure of risk?

• If a variable is normally distributed, its mean and standard

deviation contain all the information about its probability
distribution.
• Note that, the normal distribution is a continuous probability
distribution used most commonly in finance. Typically, It is given by
✓ ◆2
1 1 Ri E(R)
PDF = p e2
2⇡
• It has bell shape characteristics as given bellow,
• If the utility of money is represented by a quadratic function (a
function commonly suggested to represent diminishing utility of
wealth),then the expected utility is a function of mean and standard
deviation.
• Standard deviation is analytically more easily tractable.
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Normal distribution

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Risk Aversion and Required Returns

• Suppose that you are given a choice to take one of the two boxes
among them one is empty and another contains | 10000.
• So expected return is | 5000.
• If you are offered to forfeit the option to choose a box at cost of
| 3000. Let us assume you deny it and want to take a risk for
additional | 2000.
• Then you are offered | 3500 for the same.
• Now you may accept the offer as, it is certain that you are getting
| 3500.
• Thus certain returns, ”amounts offered | 3500 is a ”Certainty
Equivalent” which is less than the risky expected value | 5000.
• If the certainty equivalent of a person is less than the expected
value, then he is a risk-averse person.
• If the certainty equivalent of a person is equal to the expected
value, then he is a risk-averse person. risk-neutral
• If the certainty equivalent of a person is greater than the
VESIT
expected value, then heDr.isMachhindranath
a risk-loving Patil
person. 22
Standard deviation and Risk

Risk and return go hand in hand.This indeed is a well-established

empirical fact,particularly over long periods of time. For instance,

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Arithmetic Mean vs Geometric Mean

• Suppose that an equity has expected return of E(R) = 15% each year
with standard deviation of = 30%.
• Assume that there are two equally possible outcomes each year,
E(R) ± . i.e 45% and -15%.
• Clearly AM = (45 15)/2 = 15% and
⇣Y ⌘
GM = (1 + Ri )1/2 1 ⇥100 = ([(1.45)(0.85)]1/2 1)⇥100 = 11%

• So compounded value for | 1 is year 1 : 1.45 or 0.85 year 2:

1.45 0.45 ⇥ 1.45 = 2.10 or 0.85 0.15 ⇥ 0.85 = 0.72
• While median value (Geometric mean) is given by (1.11)2 = 1.23.
(1.11*0.11+0.11)
• For two years probability is 0.25 for each 45% and -15% returns, So
median value has p=50%.
• However, expected value of all possible returns is,
E(R) = (0.25 ⇥ 2.10) + (0.50 ⇥ 1.23) + (0.25 ⇥ 0.72) = 1.32
p
• Note that, 1.32 = 1.15. This means that the expected value of the
terminal wealth is obtained by compounding up the arithmetic mean,not
the geometric mean.
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Risk and Return of Portfolio

• The expected return on a portfolio is simply the weighted average

of the expected returns on the assets comprising the portfolio.
• So in general, we can write expected return on multiple security
portfolio as,
Xn
E(Rp ) = wi E(Ri )
i=1

Where, wi is the proportion of portfolio invested in i th security and

E(Ri ) is the expected return on it.

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Return of Portfolio comprising Two Securities

• Suppose that, a portfolio comprises two stocks with the expected

returns E(R1 ) and E(R2 ) respectively, then effective expected
return on the portfolio can be given by

E(Rp ) = w1 E(R1 ) + w2 E(R2 )

Where w1 is proportion of first stock in the portfolio and w1 is

proportion of first stock in the portfolio i.e. w2 = 1 w1 .

Example
Let Stock A and B has expected returns of 13% and 16%
respectively. Portfolio consists of 45% Stock A and 55% of Stock B.
Then expected return on the portfolio is given by,

E(Rp ) = 0.45 ⇥ 13 + 0.55 ⇥ 16 = 14.65%

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Measurement of Market Risk

• As a risk on individual stock can diversifiable by changing the its

proportion in portfolio.
• So its important to see market risk though the portfolio is
well-diversified.
• The market risk of a security reflects its sensitivity to the market
movements.
• Generally, every security has different sensitivity to market
movements.
• The sensitivity of a security to market movements is called as .
• By definition for a Market Portfolio is 1.
• So if a particular security has > 1 is more sensitive to the
fluctuations in market portfolio while < 1 is less sensitive.
Clearly, = 1 is insensitive to the market fluctuations.

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Standard deviation ( ) and Risk ( )

Figure shows, the returns on the market portfolio RM over a time,

along with returns on two other securities, a risky security,whose
return is denoted by Rr and a conservative security,whose return is
denoted byRc .It is evident that Rr is more volatile than RM where as
Rc is less volatile than RM . So for risky stock is higher than
conservative.

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Calculation of

• of the security can be calculated using simple linear regression

as follows,
Rjt = ↵j + j RMt + ej
Where,
• Rjt is return of the j th security over a period t.
• ↵j is intercept term (It’s value at which regression line intercepts
y axis). j is regression coefficient (slope of the regression line).
• RMt is a market returns over a period t, and
• ej is random error.

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Calculation of

• Covariance between return Rjt on j th security and return RMt on

market portfolio can be given by,
n
X
cov (Rj , RM ) = (Rjt R̄j )(RMt R̄M )/(n 1)
t=1

= ⇢jM j M

Where, ⇢jM is correlation coefficient between Rjt and RMt . j and

th
M are SD in j security and market portfolio.

• reflects the slope of regression, so we can write as the ratio of

covariance between return Rjt and RMt to variance of return on
market RMt . i.e
cov (Rj , RM ) ⇢jM j
j = 2
=
M M

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Example

Consider a security and Market has returns for the period of 5 years
on YOY basis as follows,

Year Return on security (%) Return on Portfolio (%)

1 10 12
2 7 4
3 -3 -5
4 6 8
5 11 10

Find j and ↵j .

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Solution

• Covariance between Rjt and RMt is given by,

n
X
cov (Rj , RM ) = (Rjt R̄j )(RMt R̄M )/(n 1)
t=1

• Here,
10 + 7 3 + 6 + 11 31
R̄j = = = 6.2%
5 5
12 + 4 5 + 8 + 10 29
R̄M = = = 5.8%
5 5

• Now, Rj1 R̄j = 3.8, Rj2 R̄j = 0.8, Rj3 R̄j = 9.2,
Rj4 R̄j = 0.2 and Rj5 R̄j = 4.8
• and, RM1 R̄M = 6.2, RM2 R̄M = 1.8, RM3 R̄M = 10.8,
RM4 R̄M = 2.2 and RM5 R̄M = 4.2.

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 • So covariance is
23.56 1.44 + 99.36 0.44 + 20.16
cov (Rj , RM ) = = 35.3%
4
• Variance in market portfolio,
5
X
2
M = (RMt R̄M )2 /(n 1)
t=1
38.44 + 3.24 + 116.64 + 4.84 + 17.64
= = 45.2
4
• So SD is M = 6.72%.
• Hence, j is,

cov (Rj , RM ) 35.3

j = 2
= = 0.78
M
45.2

• and ↵j is,

↵j = R̄j j R̄M = 6.2 0.78 ⇥ 5.8 = 1.68%

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Determinants of Beta

• beta is determined mainly by

(i) Cyclicality of Revenues
(ii) Operating Leverage
(iii) Financial Leverage

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The Time Value of Money
Doubling Period

• To calculate that how much time will it take to double the amount
for a given interest rate, Rule of 72 is used.
• It is thumb rule and gives approximate time of doubling the
amount for the given interest rate.
• It is given by, 72 ÷ Rate of Interest.
• e.g. doubling period with 6% is approximately 72/12 = 6 years.
• doubling period with 8% is approximately 72/8 = 9 years; and
with 4% is approximately 72/4 = 18 years.
• However, Rule of 69 is more accurate thumb rule.
• It is given by, 0.35 + (62 ÷ Rate of Interest).
• e.g. doubling period with 8% is approximately
0.35 + 69/8 = 8.975 years; and with 4% is approximately
72/4 = 17.6 years.

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Finding Growth Rate

• We have seen that, Future value can be calculated by

FVn = PV (1 + r )n .
• This can be used in general to compute the growth rate.
• Let g be the growth rate, then this can be used to compute FV
with the rate g or compute g from the past data.
• E.g.

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