Chapter 3

Risk and Return

3.1. Introduction
3.2. Concepts and measurement of expected
return of individual security
3.3. Concepts and measurement of stand-alone risk
3.4. Factors that affect risk and return
3.5. Systematic and unsystematic risk
 Concept –Return
• What is a Return?
• Investors have different motives for
investing—
• Regular income—dividend/interest
• Capital gains or capital appreciation
• Hedge against inflation i.e. Positive real returns.
• Safety of funds– regular returns and refund on maturity
• Liquidity and maturity
 COMPONENTS OF RETURNS
• Return is measured by taking the income plus the
price change.
• The term yield is also used in respect of fixed
income securities.
• The return is to be calculated on the purchase
price.
• The expected return may differ from realized
returns and this variation is a risk factor.
• Total return is calculated by income received +
price change divided by purchase price of asset.
Quantitative methods of Investment Analysis

Investment income and risk

• A return is the ultimate objective for any
investor.
• the main characteristics of any investment are
investment return and risk.
• However to compare various alternatives of
investments, the precise quantitative measures
for both of these characteristics are needed.
• The rate of return is the percentage increase in
returns associated with the holding period:
• Rate of return = Income + Capital gains / Purchase price (%)
• Such type of rate of return is called holding period
return, because its calculation is independent of
the passages of the time.
• Investor can‘t compare the alternative investments
using holding period returns, if their holding periods
(investment periods) are different.
 Returns may be
1. Realized return /Actual return
• The rate of return that is earned after
maturity
• Historical return
2. Expected return
• Return from security that investor
anticipate to earn over some future
period.
Measuring historical return of single
asset
– Realized Returns can be expressed in:
1. ($) dollar terms/cash return.
2. (%) percentage terms Or Rate of return
3. Average rate of return
 Measuring historical rate of return

1. Dollar return
 Cash or dollar return= Dividend or
Interest income + Capital gain
2. Rate of return/percentage return
 a percentage of the original investment.
 Income received on an investment plus any change
in market price (if being traded),
traded) expressed as a
percent of the beginning market price (initial value)
of the investment.

Divt 1  ( Pt 1  Pt )
R 
Pt

I t 1  ( Pt 1  Pt )
R 
Pt
P t is price of the stock at the beginning of the year=buying
price
Div t+1 It+1 is dividend paid on the stock during the year
P t+1 is ending price=selling price
• What is Annual income of stock?
• The rate of return on a security consists of its current yield
• and the capital gain percentage.

Rate of Return = Annual income + Ending price-Beginning price

•
Beginning price Beginning price

Current yield Capital gains yield

Example 1: You bought IBM stock at $35 last year. The price of
IBM stock is $40 today. IBM paid $1.25 dividend
yesterday.
– What is your dollar return?
  Dollar return = 1.25 + (40 – 35) = $6.25

– What is your percentage return?

 Dividend yield = 1.25 / 35 = 3.57%

 Capital gains yield = (40 – 35) / 35 = 14.29%

 Total percentage return = 3.57 + 14.29 = 17.86%

Current income  ( PE  PB ) 1.25  (40  35)

R   17.86%
PB 35
 Measuring expected return
n

E(r) =  PI RI
i=1
• It is the weighted average of all possible returns
multiplied by their respective probabilities.

E (r) = Expected return

Ri = return for the i th possible outcome
pi = probability associated with Ri
n = no. of possible outcome
• But both holding period returns and sample mean of
returns are calculated using historical data.

• However what happened in the past for the investor is not

as important as what happens in the future, because all the
investors‘ decisions are focused to the future, or to
expected results from the investments.

• Of course, no one investor knows the future, but he/ she

can use past information and the historical data as well as
to use his knowledge and practical experience to make
some estimates about it.
• Analyzing each particular investment vehicle
possibilities to earn income in the future investor
must think about several “scenarios” of probable
changes in macro economy, industry and
company which could influence asset prices and
rate of return.

• Theoretically it could be a series of discrete

possible rates of return in the future for the
same asset with the different probabilities of
earning the particular rate of return.
• But for the same asset the sum of all probabilities of these rates of
returns must be equal to 1 or 100 %.
• In mathematical statistics it is called simple probability distribution.
• The expected rate of return E(r) of investment is the statistical measure
of return, which is the sum of all possible rates of returns for the same
investment weighted by probabilities:
n
• E(r) = Σ pi × ri
i=1

• i - probability of rate of return;

where; p

ri - rate of return.
• Thus, the decisions should be based on estimated expected rate of
return.
 Determining Expected Return

Example 2
State Probability Sun Tan Return Expected Return
Sunny 0.3333 33% 0.11
Normal 0.3333 12% 0.04
Rainy 0.3333 -9% -0.03
=1 0.12
E r   P1r1  P2 r2  P3 r3  ...Pn rn
n
  Pi ri
i 1

E r   0.333  0.33  0.333  0.12  0.333  ( 0.09)  0.12  12%

Expected return for Sun Tan Company = 12%

 Determining
Determining Expected
Expected Return
Return

Example 3
Assume that stock of ABC com. respond to the state of the economy according to the
following table

State of economy Probability (A) RETURN (B) Expected return(C)=AxB

Strong 0.20 30% 0.06
Normal 0.60 10% 0.06
Weak 0.20 -10% -0.02
=1 0.10
E r   P1r1  P2 r2  P3 r3  ...Pn rn
n
  Pr
i 1
i i

E rA   0.2  0.3  0.6  0.10  0.2  ( 0.10)

 0.10  10%
 Concept of Risk

 Return is expected to be realized in future

 Future is uncertain

 Expected return >or< realized return

variability of return is risk

The greater the variability, the riskier the

security.

 Risk is dispersion of return around expected return

 Measuring stand-alone risk
 The most popular measure of dispersion or risk is Variance or
standard deviation Variance measures the stand-alone risk of an
investment.
 Measure the squared deviations of a security’s return from its
expected return
 it may be defined as extent of variability or deviations (or
dispersion) of possible returns from the expected return

• Variance= 2
Risk of single asset is Calculated by
n
σ   pi (ri  E (r ))
2 2
Standard deviation = Variance
i 1
Example State Probability of state Sun Tan Return Expected Return
X 0.4 33% 0.132
Y 0.3 12% 0.036
Z 0.3 -9% -0.027
=1 E(r)=14.1%

E rs    Pi ri  14.1%
n

i 1
Expected return for Sun Tan Company = 14.1%
 Probability Deviation Deviation square Product
State (pi) (ri-E(r)) (ri-E(r))² pi(ri-E(r))²
X 0.4 0.33-0.141=0.189 0.0357 0.014288
Y 0.3 -0.021 0.000441 0.00012
Z 0.3 -0.231 0.0534 0.016
=1 Var=0.0304

 Pi ri  E r 
n
  S
2

i 1

  0.4  0.33  0.141  0.3  0.12  0.141  0.3  ( 0.09  0.141) 2

2 2
S

S  0.0304  0.174
 Returns on A & B
State of Economy Return on A Return on B Probability
Strong 30% 50% 0.20
Normal 10% 10% 0.60
Weak -10% -30% 0.20

First find expected return: E(rA)=10% and E(rB)=10%

  2
 Pi ri  E r
n
r 
i 1

 r  0.2  0.30  0.102  0.6  0.10  0.102  0.2  (0.10  0.10) 2

A

 r  0.016  0.1265
A

Also :
 r  0.2530
B
 Suppose there are two securities, security A & B. If you want to
hold only a single security-either security A or B, not both, which
security you prefer?
If Security A has expected return of 12% and
standard deviation of 8% and
If Security B has expected return of 12% and
standard deviation of 5%.
.
Thus, which security would most people
prefer?
The answer is simple. Both securities provide
the same expected return but have different
standard deviation.
So people would obviously choose security B
which has lower risk while offering the same
expected return
Similarly, given a choice between two
investments with the same standard
deviations (same risk) but different expected
returns, investors would generally prefer the
investment with the higher expected return.
To most investors, this is common sense.
Return is good and risk is bad.
So everybody wants as much return and as
little risk as possible.
However, if two or more securities have
different expected returns and different
level of risk (standard deviation), how do
we choose between/among such investment
alternatives?
For such situations we use another measure
of risk, the coefficient of variation (CV).
 COEFFICIENT OF VARIATION(CV)

What is coefficient of variation?

It is a statistical measure of the dispersion of
data points in a data series around the mean. It is
calculated as follows:

CV = Standard Deviation
Mean (expected return)
The coefficient of variation
represents the ratio of the standard
deviation to the mean, and it is a
useful statistic for comparing the
degree of variation from one data
series to another, even if the means
are drastically different from each
other.
The coefficient of variation shows the risk per unit
of return.
Suppose that you want to determine the relative risk
of two securities: X and Y.
Security X provides an expected return of 15% and
security Y an expected return of 20%. Security X and
Y has a standard deviation of 12% and 15%
respectively. Which security is relatively riskier?
To determine this, we need to compute the
coefficient of variation of each security.
For security X:
Coefficient of variation = R  12
15
 0 .8
For Security Y  15
Coefficient of variation = R  20  0.75
Thus, security X is relatively riskier than
security Y despite the fact that security X has
lower standard deviation than security Y. So,
which security is attractive?
Consider two stocks: L and U have the expected return and standard
deviation shown below: Which of these stocks would you prefer?
Stock L Stock U
Expected return 25% 20%
Standard deviation 40% 33%
C.V.(L)= 0.40 ÷ 0.25 =1.60
C.V.(U) =0.33 ÷ 0.20 =1.65
When we consider expected return per share, stock L
Seems attractive because it offers the higher expected
return of 25% as opposed to stock U, 20%.
When we consider standard deviation per share, stock L
Seems more risky, (40%) as opposed to stock U, (33%).
However, stock U, (1.65) is more risky than stock L,
(1.60) as revealed by its C.V.
 Factors that affect risk
• Factors that affect risk are
1. Maturity
2. Creditworthiness
3. Priority
4. Liquidity
5. Return
Risks associated with investments
SYSTEMATIC RISK
The portion of the variability of return of a security that is
caused by external factors, is called systematic risk.
Risk due to
Economic and political instability,
Economic recession,
Inflation
Government policy change affect the price of all
Change in interest rate policy shares.
Corporate tax rate
Foreign exchange control
Natural calamities etc.

Thus the variation of return in shares, which is caused by these

factors, is called systematic risk.
This part of risk cannot be reduced through diversification.
 NON - SYSTEMATIC RISK (UNSYSTEMATIC)
The return from a security sometimes varies because of
certain factors affecting only the company issuing such
security.

Risk due to

Shortage of raw material,

Labour strike, affect the share
R & D expert leave the company price of one
management efficiency etc. company.

When variability of returns occurs because of such firm-

specific factors, it is known as unsystematic risk
 Total risk
Total risk of an individual security is the variance(standard
deviation) of its return
It consists of two parts
Total risk of a security= systematic risk + unsystematic
risk
variance variance
attribute to attributable to
macroeconom firm specific
ic factors factors
Systematic and unsystematic risk and
number of securities
End of the chapter