Risk and retain

Return

Return can be defined as the income received on the investment plus any change in the market
price, usually expressed as a percentage of the beginning market price of the investment. For
common stock one period return can be expressed as; Dt

𝐷𝑡+(𝑃𝑡−𝑃𝑡−1)
R=
𝑃𝑡−𝑡
Where R is the actual (expected) return when t referred to a particular period in the past (future);

Dt is the cash dividend at the end of time period t; Pt is the stock price at the time period t: and Pt-
1 is the stock price at time period t-1

Example: the stock price for stock A was K100 per share 1 year ago. The stock is currently trading
at K95 per share, and shareholders just received a K10 dividend. What return was earned over the
past year?

Solution

𝐷𝑡+(𝑃𝑡−𝑃𝑡−1)
R=
𝑃𝑡−𝑡
10+(95−100)
=
100
=5%

Risk

Risk is the variability of returns from those that are expected. In other words, risk is the probability
that the actual return will deviate from the expected return.

A potential investor has various options as far as investing is concerned. He may invest in treasury
bills for which a return is guaranteed at maturity. Or he may invest in common stock. For which
he will expect dividends at the end of the year which can materialize or not. In addition the price
of common stock may fall compared to the actual buying price resulting in the loss of value. There
is uncertainty in the return on common stock unlike in treasury bills. Thus we can say that treasury
bills are risk-free security while common stock is a risky security.

Sources of risk include;

1. Market Risk
Market risk is the possibility for an investor to experience losses due to factors that affect
the overall performance of the financial markets. Market risk is also called systematic risk
2. Interest rate risk
The variability in the market price of a security caused by changes in interest rate is referred
to as the interest rate risk (Yield risk)
3. Inflation risk
Probability of loss resulting from erosion of an income or in the value of assets due to the
rising costs of goods and services.
4. Political risk
This is the risk that an investments returns could suffer as a result of political changes or
instability in the country. Instability affecting investment returns could stem from a change
in government, legislative bodies, other foreign policy makers or military control.
Political risk is also known as ‘geopolitical risk’ and becomes more of a factor as the time
horizon of an investment gets longer.
Measuring Risk using probability distribution

Probability distribution is a set of possible values that a random variable can assume and their
associated probabilities of occurrence. For risky securities, the actual return can be viewed as
random variable subject to a probability distribution. The probability distribution can be
summarized in terms of two parameters of the distribution namely;

a. The expected return

b. The standard deviation
Expected return

Expected return is the weighted average of possible return with the weights being the probabilities
of occurrence. It is given by

Ṝ = ∑n t=I (Ri)(pi)
Where Ri = return for the ith possibility

Pi = Probability of that return occurring

N = total number of possibilities

Standard Deviation

The standard deviation is a statistical measure of the variability of a distribution around its mean.
It is the square root of the variance. The interpretation is that the greater the standard deviation of
the returns the greater the variability of returns, and the greater the risk of the investment. The
standard deviation is the convention measure of dispersion it is expressed as;

σ = √∑n t=1 (R1-Ṝ)2 (Pi)

Example: Given that the following probability distribution of possible one-year returns, calculate
the expected returns and the standard deviation.

Possible returns (Ri) Probability of occuranceExpected Return Ṝ=(Ri)(P(i)variance (Ri-Ṝ)2 (Pi)

-0.1 0.05 -0.005 0.001805
-0.02 0.1 -0.002 0.00121
0.04 0.2 0.008 0.0005
0.09 0.3 0.027 0
0.14 0.2 0.028 0.0005
0.2 0.1 0.02 0.00121
0.28 0.05 0.014 0.001805
1 0.09 0.00703

α = √0.00703

=0.0838

Coefficient of variation

The coefficient of variation (CV) is the ratio of the standard deviation of a distribution to the mean
of that distribution. It is measure of relative risk. That is, it is a measure of risk per unit of expected
return. It is most useful when it comes to comparing risk or uncertainty alternatives if they differ
in size. The larger the CV, the larger the relative risk of the investment.
Coefficient of variation (CV) = σ/Ṝ

Example: Compare the CV for investment A and investment B given their standard deviation and
their expected returns.

Investment Expected Return (Ṝ) Standard Deviation (σ) Coefficient of variation

(CV)=σ/Ṝ

A 0.08 0.06 0.75

B 0.24 0.08 0.33

Using CV as a risk measure, it can be concluded that investment A with a return distribution CV
of 0.75 is more risky than investment B whose CV is 0.33. Relative to the size of the expected
return investment A has greater variability. However, when you look at standard deviation, you
would say investment B with a wider spread of 0.08 is riskier than B with a spread of 0.06.

Risk and return in a portfolio context

In the real world, investors rarely place their entire wealth into a single asset or investment. It is
common for investors to construct a portfolio or a group of investments. The whole idea of
investing in a portfolio or a group of investments. The whole idea of investing in a portfolio is the
to diversify risk or to reduce the level of exposure to risk if one invested everything in a single
security of investment. We can consider analysis of risk and return given a portfolio.

A portfolio is a combination of two or more securities or assets.

Portfolio Return

The expected return of a portfolio is simply the weighted average of the expected returns of the
securities constituting that portfolio. The weights are the proportion of total funds invested in each
security.

Ṝp = ∑mj=1 WjṜj

Where Wj = the proportion or weight of tota funds invested in security j

Ṝj = the expected returns for security j

M = the total number of different securities in the portfolio

Or Ṝp = WaṜa+WbṜb+WcṜc…
Example: The expected returns and standard deviation of the probability distribution of possible
returns for two securities are shown below;

Security A Security B

Expected return Ṝj 14.0% 11.5%

Standard deviation σj 10.7% 1.5%

Calculate the expected return of the portfolio if equal amounts of money are invested in the two
securities.

Solution: WA = 50% = 0.50, WB = 50% =0.50

Ṝp = ∑mj=1 Wj Ṝj

Ṝp = WAṜA + WBṜB

Ṝp = 0.50(14.0) + 0.50 (11.5%)

= 7% + 5.7 %

= 12.75%

Covariance

The covariance is a statistical measure of the degree to which two variables (e.g securities returns)
move together. A positive value means that on average they move in the same direction. A negative
covariance shows that on average the two variables move in opposite direction. Zero covariance
means that the two variables show no tendency to vary together in either a positive or negative
linear fashion. This is known as covariance. Covariance between securities provides for possibility
of eliminating some risk without reducing potential returns. The general formula for determining
the covariance is given by;

Cov (RaRb) = ∑Pi (Ra-Ṝa) (Rb-Ṝb)

Example: The information below relates to two different stocks A and B.

State of the economy Probability Returns of stock A Returns of stock B

Boom 0.3 25% 19%

Normal 0.4 15% 12%

Recession 0.3 -10% 8%

Total probability 1 ER (Ṝ) = 10.5% ER (Ṝ) = 12.9%

Cov (RaRb) = ∑Pi (Ra-Ṝa) (Rb-Ṝb)

Cov(RaRb) = (0.3)(25%-10.5%)(19%-12.9%)+0.4(15%-10.5%)(12%-12.9%)+0.3(-10%-
10.5%)(8%-12.9%)

=0.3(14.5) (6.1) +0.4(4.5) (-0.9) +0.3(-20.5) (-4.9)

=55.05%

This means that the relationship between returns of stock A and B move in the same direction,
therefore the portfolio will have increased risk.

The standard Deviation of a portfolio

The standard deviation of a portfolio is not as straight forward as the calculation of the expected
return of the portfolio. To make the weighted average of individual security standard deviation
would be to ignore the relationship or covariance between the returns on securities. Thus we need
to determine the covariance of the returns of the securities before we can determine the standard
deviation. The standard deviation of a portfolio is given by the formula below;

σp=√W2aσ2a+Wb2σb2+2WaWbCov(Ra, Rb)

Where W = percentage of weights for amounts invested in A and B

σ=The standard deviation for A and B

Cov (Ra, Rb) = the covariance for A and B