CHAPTER-Three

Risk and Return

“Two Sides of the Investment Coin”

 Introduction
•Risk and return are the most important concepts in finance
•People invest because they hope to get a return from their
investment. Return is the good stuff that makes people feel
better or improves their standard of living.
•Risk is the bad stuff of risk adverse person seeks to avoid. It is a
fact of investment life and is unavoidable for anyone who seeks
more than a trivial rate of return. 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).
 What is Uncertainty ?
• Uncertainty means not knowing exactly
what will happen in the future
• Though the terms “risk” and “uncertainty”
are often used to mean the same thing,
there is a distinction between them
• Uncertainty is not knowing what’s going to
happen. Risk is how we characterize how
much uncertainty exists: The greater the
uncertainty, the greater the risk.
• Risk is the degree of uncertainty
 What is risk?
 Literally risk is defined as “exposing
to danger or hazard”. Which is
perceived as negative terms

 In finance,
Risk refers to the likelihood that we
will receive a return on an investment
that is different from the return we
expected to make.
 Cont’d….
Risk in Finance
 In finance, risk is the probability that an investment’s
actual return will be different than expected. This
includes the possibility of losing some or all of the
original investment.
 Risk is usually measured by calculating the standard
deviation of the historical returns or average
returns of a specific investment.
Measuring Risk
 Risk is measured with probability, which is merely
number that represents the chances of occurrence of
different possible outcomes. Probabilities give hints
about the intensity of risk involved in investments.
 Cont’d….
 Risk is the probability or likelihood that
actual results (rates of return)
deviates from expected returns.
• Thus, risk includes not only the bad outcomes
(returns that are lower than expected), but also good
outcomes (returns that are higher than expected)
• In fact, we can refer to the former as
downside risk and the latter as upside risk.
 Sources of Risk
Business Risk
Uncertainty of income flows caused
by the nature of a firm’s business
Sales volatility, operating income
that determine the level of business
risk.
 Cont’d……..
 Financial Risk
 Uncertainty caused by the use of debt financing (Level
of Financial Leverage).
 There is a risk of default by the company if
operations are not profitable.
 Bondholders are less exposed to financial risk than
common stockholders because they have a priority
claim against the assets of an insolvent firm.
Government securities, however, bear very low risk.
 Cont’d……..
 Liquidity Risk
Uncertainty is introduced by the secondary market for
an investment.
How long will it take to convert an investment into cash?
How certain is the price that will be received?
 Interest Rate Risk:
This is a risk resulting from changes in interest rates.
Changes in interest rates affect the prices of financial
securities such as the prices of bonds etc. for interest
rate rise depresses bond prices and vice, versa.
 Cont’d………
Exchange Rate Risk
 Uncertainty of return is introduced by acquiring
securities denominated in a currency different
from that of the investor.
Country risk
 Political risk is the uncertainty of returns caused
by the possibility of a major change in the
political or economic environment in a country
 Cont’d………
Purchasing Power Risk:
•This risk arises under inflationary situations
(general price rise of goods and services) leading
to a decline in the purchasing power of the asset
held. Financial assets lose purchasing power if
increased inflationary tendencies prevail in the
economy.
 Identify the source of risks
• Unable to pay interest liability
• Shortage of raw material
• Bankruptcy
• Government reset new minimum deposit
interest for all banks
• Stock price decline
• Insolvency
• Money devaluation
• Variations the level of costs
 Systematic Vs Unsystematic risk

1) Systematic risk: The risk inherent to the entire

market or entire market segments is known as systematic
risk. This is also known as: Un-diversifiable risk" or
"market risk” or “uncontrollable risk.
Example: Interest rates, inflation, etc. all
represent sources of systematic risk because they
affect the entire market and cannot be avoided
through diversification. This risk can be mitigated
through hedging.
 Cont’d….
2) Unsystematic Risk: The risk which is
specific to a company or industry is known
as unsystematic risk.
 This risk can be reduced through
appropriate diversification. This is also
known as "specific risk",
"diversifiable risk" or "residual risk“
or “ controllable risk
 Employees strike
 Identify systematic and
Unsystematic Risk
Key person leaving
Economic policies
Recession
Shortage of Raw Material
Reductions of sales turnover
because of economic crisis
Reductions of sales turnover
because of the product quality
Wars
 What is return?
Return: is nothing but the reward for
undertaking investment.
 Quantification of Returns and
Risk
Measuring of Historical Return: If you buy an
asset of any sort, your gain from that
investment is called the return on your
investment. This return will usually have two
components:
• Current return – It is the periodic cash
inflow in the form of interest or dividend.
• Capital return - It represents change in
the price of asset.
• Thus Total Return = Current Return + Capital
Return
 Cont’d……
 The current return can be zero or
positive, whereas capital return
can be zero, positive or negative.
Identify the reason Why Current
return can’t be Negative?
Total Return = Current Return
plus Capital Return.
 Cont’d……
Total return= Current return+ capital return
Dt= cash dividend @ time t
Pt= stock price at time t
Pt-1= stock purchase price @ time
t-1
 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.
 Calculation of Historical
Returns (Ex post)
Current return = Dt x number of shares
Capital gain in terms of dollar
= P t - Pt - 1 * Number of shares
Total return= Current return+ capital return
Dt= cash dividend @ time t
Pt= stock price at time t
Pt-1= stock purchase price @ time
t-1
 Calculation of Historical
Returns (Ex post)
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 $1.85 per share. suppose that the
value of the stock has risen to $40.33 per share by
the end of the year
By the end of the year, then, you would have
received income of:
Measuring return in terms of dollar
1. Current return = Dt x number of shares
= $1.85 x 100 = $185
Also, suppose that the value of the stock has
risen to $40.33 per share by the end of the year
2. Capital gain in terms of dollar
= P t - Pt - 1 * Number of
shares
($40.33 - $37) x 100 = $333
 Cont’d……
Total dollar return = Current gain + Capital gain
Thus: $185 + $333 = $ 518
Measuring return in terms of percentage
R= Dt+(Pt –Pt-1)
Pt-1
Dt= cash dividend @ time t
Pt= stock price at time t
Pt-1= stock purchase price @ time t-1
Dividend yield= D t/ Pt-1
Capital gains yield = (P t –Pt-1)/ Pt-1
The rate of return = Dividend yield +
Capital gain Yield
Measuring return in terms of percentage
Dividend yield: The annual stock dividend
as a percentage of the initial stock price
Dividend yield= D t/ Pt-1
Capital gains yield: The change in stock price as a
percentage of the initial stock price
Capital gains yield = (P t –Pt-1)/ Pt-1
Total percent return: The return on an investment
measured as a percentage that accounts for all cash
flows and capital gains or losses
 Cont’d…..
Example 2: 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
1. Dividend yield= D t/ Pt-1
= $1.85/37 = .05= 5%,
this implies that for each dollar we invest,
we get five cents in dividends
 Cont’d….
2. Capital gains yield = (P t –Pt-1)/ Pt-1
= (40.33 -37)/37 = .09= 9%
3. The rate of return = Dividend
yield + Capital gain Yield

Rate of return = 5%+9%= 14%

 Calculation of Historical Risk
oAs it has already been mentioned, risk is
nothing but possibility that actual outcome of
investment will differ from expected
outcome of investment.

oTo measure this deviation, statistical tools like

Variance and standard deviations( most
common statistical tools to measure risk)
are used

oVariance is the square of standard deviation

 Cont’d…..
• The variance essentially measures
the average squared difference
between the actual returns and
the average return.

• The bigger this number is, the more

the actual returns tend to differ from
the average return
Cont’d…
 Cont’d…..
• Variance ∑(Ri-Ṝ)2
n-1
Ri= Possible return
Ṝ= Average return
N= number of years
Where, Ṝ = Ri1+Ri2…+Rn
n
• Standard deviation=square root of ∑(Ri-Ṝ)2
n-1
Cont’d……
 Portfolio Risk and Return
• The risk-return characteristic of the
portfolio is obviously different from the
characteristics of the assets that makeup
that portfolio, especially with regard to
risk. By recalling what we have been
discussed earlier regarding the calculation
of the expected return, variance, and
standard deviation of an individual
security; let us see computation risk and
return of the portfolio, in this section.
 Calculation the Expected Return

When we talk about expectations,

we talk about probability.
The future or expected return of a
security is uncertain; however it is
possible to describe the future
returns statistically as a probability
distribution
 Cont’d……
If the possible returns are denoted by Xi
and the related probabilities are P(Xi),
expected return may be represented as
and can be calculated as:
E(Ri) = Σ Xi P (Xi)
or
E(Ri) = Σ (Ri x Pri)
 Example
Mr. X is considering the possible rates of return
(dividend yield plus capital gain or loss) that he might
earn next year on a $10,000 investment in the stock of
either Alpha Company or Beta Company.
Required: compute the expected rate
of return on each company’s stock and
recommend where Mr. “X” has to
invest the $10,000 investable fund.
The rates of return probability distributions for the
two companies are shown here under:
 Illustration
State of the Probability of the Rate of return if the state economy
economy state economy occurs

Alpha Co Beta Co.

Boom 0.35 20% 24%

Normal 0.40 15% 12%

Recession 0.25 5% 8%
 Solution
E(Ri) = Σ (Rj x Prj)
E(Ralpha) = (0.35*20) +
(0.4*15) + (0.25 *5)
E(Ralpha) = 7 + 6 + 1.25 =
14.25%
E(RBeta) = (0.35 * 24) + (0.4 * 12)
+ (0.25 * 8)
E(RBeta) = 8.4 + 4.8 + 2 =
 Calculation of Expected Risk

• Standard deviation is the most

common statistical indicator of an
asset’s risk (stand alone risk)
• S.D measures the variability of a set
of observations.
• The larger the standard deviation,
the higher the probability that
actual returns will be far below the
expected return
 Cont’d…….
 Standard deviation is indicator of risk asset
(an absolute measure of risk) of that asset’s
expected return, σ (Ri), which measures the
dispersion around its expected value.

 The standard deviation considers the

distance (deviation) of each possible outcome
from the expected value and the probability
associated with that distance

 This can be calculated using equation below:

 Cont’d…..
E (Risk) = √ Σ [Ri- E(R) ]2 x
Pr

Where:
Ri = Possible outcome
E(R) = Expected return
Pr = Probability of outcome
 Steps to calculate sigma or EX-Ante
• Step1- ∑(R)=(P1*r1)+(P2*r2)+……+(Pn*rn)
• Step 2- deviation= Ri- ∑(R)
• Step 3- squared each deviation- (Ri- ∑(Ri))2
• Step 4- Pi (Ri- ∑(R))2
• Step 5-Sum-up the result of step 4 to reach @
variance (δ)
• Step 6-Standard deviation (δ=square root of
variance)
 Example

Bharat Foods Stock

i. State of the
Economy Ri-E(R) (Ri-E(R))2 pi(Ri-E(R))2

pi Ri piRi
1. Boom 0.30 16 4.8 4.5 20.25 6.075
2. Normal 0.50 11 5.5 -0.5 0.25 0.125
3. Recession 0.20 6 1.2 -5.5 30.25 6.050

E(R ) = ΣpiRi = 11.5 Σpi(Ri –E(R))2 =12.25

σ = [pi(Ri-E(R))2]1/2 = (12.25)1/2 = 3.5σ = [Σpi(Ri-E(R))2]1/2 =
(12.25)1/2 = 3.5
 Coefficient of variation
• Coefficient of variation is per unit measure of
risk for expected return an investment.
• In finance, the coefficient of variation allows
investors to determine how much volatility, or
risk, is assumed in comparison to the amount
of return expected from investments.
• It is calculated by dividing the standard
deviation of an investment by its expected
rate of return. Since most investors are risk-
averse, they want to minimize their risk per
unit of return.
 Coefficient of variation
• The coefficient of variation indicates
how volatile an asset's returns are
relative to its average or expected
return.
• If the coefficient of variation is greater
than 1, it shows relatively high
variability in the data sets. a CV lower
than 1 is considered to be low-
variance.
• The coefficient of variation is helpful
when using the risk/reward ratio to
 Coefficient of variation
• For example, an investor who is risk-
averse may want to consider assets
with a historically low degree
of volatility relative to the return,
in relation to the overall market or
its industry.
• Conversely, risk-seeking investors
may look to invest in assets with a
historically high degree of volatility.
 Coefficient of variation

• Select preferable investment

securities by measuring C.V =
σ/E(ri) of Investment X and
Investment Y
 Coefficient of variation
Investment X Investment Y
E(ri)= 10%, σ= E(ri)= 12%, σ=
8% 8%
E(ri)= 12%, σ= E(ri)= 12%, σ=
8% 10%
E(ri)= 12%, σ= E(ri)= 10%, σ=
10% 7%
 N K
H A !
T O U
Y