Chapter Two

Risk and Return

Introduction
 Risk and return are the most important concepts in finance and they
are the foundations of modern finance theory.
 The first is A dollar today is worth more than a dollar tomorrow, and
is often called the time value of money.
 The second is a safe dollar is worth more than a risky dollar.
 Anyone who studies finance learns the universal application of these
statements and rational decision making. The tradeoff between risk
and return is the principles theme in the investment decision.
 Most people are risk averse, which does not mean, however, they will
not take a risk.
 It means they only take a risk when they expect to be rewarded for
taking it
 People have different degrees of risk aversion; some are more willing
to take a chance than are others.
This chapter explores the fundamental principles underlying the
relationship between risk and return.
 Risk indicates the deviation/variability of expected outcome.
 It may be positive or negative
 Return indicates the expected reward for investors to their capital
invested
 It can be trough dividend and the capital gain (can be get by the
application of invested capital).
Measuring historical rate of Return
 If you buy an asset of any sort, your gain (loss) from that investment
is called the return on your investment.
 This return will usually have two components.
 First, you may receive some cash directly while you own the
investment.
 This is called the income component of your return.
 Second, the value of the asset you purchase will often change.
 In this case, you have a capital gain or capital loss on your investment.
 Example: Suppose, at the beginning of the year, the stock for a
company was selling for $37 per share. If you had bought 100 shares,
you would have a total out lay of $3700.
 Suppose, over the year, the stock paid a dividend of $1.85per share.
 By the end of the year, then, you would have received income of;
 Dividend= $1.85 x 100= $185
 Also, suppose the value of the stock has risen to $40.33per share by
the end of the year. Your 100 shares are now worth $4,033, so you
have a capital gain of:
 Capital gain = ($40.33 - $37) x 100 = $333
 Therefore, the total return on your investment is the sum of the
dividend and the capital gain.
 Total return = dividend income + capital gain (loss)
 = $185 + $333 = $ 518
 It is usually more convenient to summarize information about returns
in percentage terms, rather than in dollar terms, because that way
your return does not depend on how much you actually invest. The
question is, how much do we get for each dollar we invest?
 To answer this question, let
 Pt be the price of the stock at the beginning of the year and
 D t+1 be the dividend paid on the stock during the year.
 In the example above, the price at the beginning of the year was $37
per share and the dividend paid during the year on each share was
$1.85. Therefore, dividend yield is:
Dividend yield = D t+1 / Pt
Dividend yield = $1.85/37
Dividend yield = .05
Dividend yield = 5%,
This implies that for each dollar we invest, we get five cents in
dividends.
 The second component of the return from investment is the capital
gains yield.
 This is calculated as the change in the price during the year (the
capital gain) divided by the beginning price:
Capital gains yield = (P t+1 - Pt) / Pt
Capital gains yield = (40.33 -37)/37
Capital gains yield = .09
Capital gains yield = 9%.
This means that per dollar we invest, we get nine cents in capital gain.
 Putting it together, per dollar invested, we get 5 cents in dividends
and nine cents in capital gains: so, we get a total of 14 cents.
 Our percentage return is 14%. Simply, the total percentage return of
an investment can be calculated as:
Dividend paid at end of period + Change in market value over period
Percentage return =
Beginning market value

1.85+ ( 40.33 – 37 )
Percentage return =
37

$ 1.85+$ 3.33
Percentage return =
37

$ 5.18
Percentage return =
37

Percentage return = 0.14

Percentage return = 14 %
Holding Period Return (HPR)
 When we invest, we defer current consumption in order to
add to our wealth so that we can consume more in the
future.
 Therefore, when we talk about a return on an investment,
we are concerned with the change in wealth resulting from
this investment.
 This change in wealth can be either due to cash inflows,
such as interest or dividends, or caused by a change in the
price of the asset (positive or negative).
 If you commit $200 to an investment at the beginning of
the year and you get back $220 at the end of the year, what
is your return for the period?
 The period during which you own an investment is called its
holding period, and the return for that period is the
holding period return (HPR).
Ending Value of Investment
HPR=
Beginning Value of Investment
 In this example, the HPR is 1.10, calculated as follows:
$ 220
HPR=
$ 200

HPR=1.10
 This HPR value will always be zero or greater—that is, it can
never be a negative value.
 A value greater than 1.0 reflects an increase in your wealth,
which means that you received a positive rate of return
during the period.
 A value less than 1.0 means that you suffered a decline in
wealth, which indicates that you had a negative return
during the period.
 A HPR of zero indicates that you lost all your money
(wealth) invested in this asset.
 Although HPR helps us express the change in value of an
investment, investors generally evaluate returns in
percentage terms on an annual basis.
 This conversion to annual percentage rates makes it easier
to directly compare alternative investments that have
markedly different characteristics.
 The first step in converting a HPR to an annual percentage
rate is to derive a percentage return, referred to as the
Holding Period Yield (HPY).
 The HPY is equal to the HPR minus 1.
HPY for a Single Investment for a Single Year
 The HPY is equal to the HPR minus 1.
 HPY = HPR – 1
 In our example:
 HPY = 1:10 − 1 = 0.10 = 10%
 HPY = 0.10
 HPY = 10%
Annual HPY for a Single Investment for a Multiple or a Fraction of
Year
 The Annual HPY is equal to the Annual HPR minus 1.
 Annual HPY = Annual HPR – 1
 To derive an annual HPY, you compute an annual HPR and
subtract 1.
 Annual HPR is found by:
 Annual HPR = (HPR)1/n
Or
 Annual HPR = √ HPR
n
 Thus,
 Annual HPY = Annual HPR – 1
 Annual HPR = √ HPR
n

 Annual HPY = HPR1/n -1

 Therefore,

Or
 Annual HPY = √n HPR−1
 Consider an investment that cost $250 and is worth $350
after being held for two years:
Computing Mean Historical Returns
 Now, we want to consider mean rates of return for a single
investment and for a portfolio of investments.
 Over a number of years, a single investment will likely give high rates
of return during some years and low rates of return, or possibly
negative rates of return, during others.
 Your analysis should consider each of these returns, but you also
want a summary figure that indicates this investment’s typical
experience, or the rate of return you might expect to receive if you
owned this investment over an extended period of time.
 You can derive such a summary figure by computing the mean annual
rate of return (it’s HPY) for this investment over some period of time.

 Alternatively, you might want to evaluate a portfolio of investments
that might include similar investments (for example, all stocks or all
bonds) or a combination of investments (for example, stocks, bonds,
and real estate).
 In this instance, you would calculate the mean rate of return for this
portfolio of investments for an individual year or for a number of
years.
Single Investment:
 Given a set of annual rates of return (HPYs) for an individual
investment, there are two summary measures of return
performance.
 The first is the arithmetic mean return;
 The second is the geometric mean return.
 To find the arithmetic mean (AM), the sum (Σ) of annual HPYs is
divided by the number of years (n) as follows:
AM =
∑ HPY
 n
 Where:
 ΣHPY= the sum of annual holding period yields
 An alternative computation, the geometric mean (GM), is the n th root
of the product of the HPRs for n years minus one
GM =[ ( 1+r 1 )( 1+r 2 ) .. . ( 1+r n ) ]
1/ n
−1
√
GM = n ( 1+r 1 )( 1+ r 2 ) . .. ( 1+r n ) −1
MEASURING EXPECTED RETURN
 The expected return of the investment is the probability weighted
average of all the possible returns.
 If the possible returns are denoted by x and the related probabilities
i

are P( x ) , expected return may be represented as x and can be

i

calculated as:

x=Σxi P( x i )
Measuring the Risk of Expected Rates of Return
n
Variance( σ 2 )=∑ ( probability ) x ¿ ¿ ¿
i =1
¿

√∑
n
2
S tan dard deviation (σ )= ( Pi ) [ R i−E ( Ri ) ]
i =1
A Relative Measure of Risk:
 In some cases, an unadjusted variance or standard deviation can be
misleading.
 If conditions for two or more investment alternatives are not similar
—that is, if there are major differences in the expected rates of return
—it is necessary to use a measure of relative variability to indicate
risk per unit of expected return.
 A widely used relative measure of risk is the coefficient of variation
(CV), calculated as follows:
S tan dard Deviation of Re turns
coefficient of var iation ( CV )=
Expected Rate of Re turn
σi
=
E ( R)
Risk Measures for Historical Returns
 To measure the risk for a series of historical rates of returns, we use
the same measures as for expected returns (variance and standard
deviation) except that we consider the historical holding period yields
(HPYs) as follows:
 Where:
 σ2 = the variance of the series,
 HPYi = the holding period yield during period,
 E(HPY) = the expected value of the holding period yield that is equal
to the arithmetic mean (AM) of the series
 n=the number of observations
 The standard deviation is the square root of the variance.
 Both measures indicate how much the individual HPYs over time
deviated from the expected value of the series.
TYPES OF RISK:
Thus far, our discussion has concerned the total risk of an asset, which
is one important consideration in investment analysis.
However, modern investment analysis categorizes the traditional
sources of risk identified previously as causing variability in returns into
two general types:
those that are pervasive in nature, such as market risk or interest rate
risk, and
those that are specific to a particular security issue, such as business or
financial risk.
Therefore, we must consider these two categories of total risk.
Dividing total risk into its two components, a general (market)
component and a specific (issuer) component, we have systematic risk
and nonsystematic risk, which are additive:
Total risk = General risk + Specific risk
Total risk = Market risk + Issuer risk
Total risk = Systematic risk + Nonsystematic risk
Systematic (Market) Risk:
Risk attributable to broad macro factors affecting all securities
systematic risk directly encompasses the interest rate, market, and
inflation risks.
Nonsystematic (Non-market) Risk:
Risk attributable to factors unique to the security
is associated with such factors as business and financial risk as well as
liquidity risk.
Student’s package:
Describe the following type of risk, categorize them as systematic or
unsystematic risk and analysis how they affect expected rate of return of an
investment
1. Interest Rate Risk:
2. Market Risk:
3. Inflation Risk:
4. Business Risk:
5. Financial Risk:
6. Liquidity Risk:
7. Exchange Rate Risk
8. Country Risk:
Total variability in returns of a security represents the total risk of that
security.
Systematic risk and unsystematic risk are the two components of total
risk. Thus,
Total risk = Systematic risk + Unsystematic risk.
Figure 2.1: Systematic and Unsystematic risk
Capital Asset Pricing Model (CAPM)
The Capital Asset Pricing Model (CAPM) and the Security Market Line