Chapter Four

Risk and return

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 RISK AND RETURN
• Risk and return fundamentals
• To maximize share price, the financial manager should assess
two key determinants, risk and return.

• Risk: the chance of financial loss or more formally, the

variability of return associated with a given asset – uncertainty.

• Return: the total gain or loss experienced on an investment over

a given period of time.

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Cont’d….
• The return is the basic motivating force and the principal
reward in the investment process.
• Return can be defined in terms of
I) realized return
II) expected return
• Realized return is the return which has been earned.
• Expected return is the return which the investor anticipates to
earn over some future investment period.
The realized returns in the past allow an investor to estimate cash
inflows in terms of dividends, interest, bonus, capital gains, etc,
available to the holder of the investment.
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Cont’d…
• Return is commonly measured as a cash distribution during a
period plus the change in value.

• The equation for calculating the rate of return earned on any

asset over a period of time t is:
Ct +[Pt −Pt−1 ]
Rate of return =
Pt−1
Kt = actual, expected, or required rate of return during period t; Ct =cash flow received
from the asset investment in the time period t-1 to t; Pt = price (value) of asset at time t;
Pt−1 = price (value) of asset at time t – 1.

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Cont’d…
It Pt −Pt−1
• Rate of return = Pt−1
+
Pt−1
I
• Where asP t is called current yield
t−1

Pt −Pt−1
• is called capital Gain
Pt−1
• RoR = Current yield + Capital gain yield
• Example: The following information is given for a corporate bond. Price of the
bond at the beginning of the year: Br. 90, Price of the bond at the end of the year:
Br. 95.40, Interest received for the year: Br. 13.50. Compute the rate of return.
• Calculate: current yield & capital gain yield

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Cont’d…
Example:
ABC Co. wishes to determine the return on two of its video
machines, A and B. A was purchased one year ago for $20,000 and
currently has a market value of $21,500. During the year, it
generated $800 of after tax cash receipts. B was purchased 4 years
ago; its value in the year just ended declined from $12,000 to
$11,800. During the year it generated $1,700 after tax cash
receipts.
• Calculate the annual rate of return for each video machine.

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Cont’d..
• Solution:
• Return (Kt) on A=800 + 21,500 –20,000 =11.5%
20,000
• Return (Kt) on B=1,700+11,800-12,000 =12.5%
12,000
Video B’s return is better than video A’s return.

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Cont’d….
• Exercise:
• The average market prices and dividend per share of Blue Ltd.
for the past 6 years are given below:
Year Average market Dividend per share
price (Br.) (Br.)
2002 38 1.8
2003 45 2.0
2004 53 2.5
2005 50 2.0
2006 61 2.6
2007 68 3.0
• Required: a) calculate each years yield rate?
• b) calculate each year’s capital gain?
• c) calculate each year’s rate of return?

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• Determinants of the Rate of Return
• Three major determinants of the rate of return expected by the
investor.
➢The time preference risk-free real rate

➢The expected rate of inflation

➢The risk associated with the investment
• Required return = Risk-free real rate + Inflation premium + Risk
premium.
• RR= Rf + Ip + Rp

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RISK
• Risk refers to the chance that the actual outcome (return) from an
investment will differ from an expected outcome.

• The risk may be considered as a chance of variation in return.

• Investments having greater chances of variations are considered
more risky than those with lesser chances of variations.

• The absolute measures of risk is standard deviation

• Type of risk:
➢I) systematic risk/non-diversifiable
➢II) unsystematic risk/ diversifiable 10
Systematic Risk/ Non-diversifiable risk
• It refers to fluctuation in return due to general factors in the
market such as money supply, inflation, economic situation,
interest rate policy of the government, political factors, credit
policy, tax reforms, etc. these are the factors which affect almost
all firms.

• The systematic risk is also called the general risk.

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Types of Systematic Risk
• Market risk: is refers to variability in return due to change in market
price of investment. E.g. social, Economic and political situation.

• Interest Rate Risk: is refers to the variability in return caused by the

change in level of interest rates.

• Purchasing-Power Risk/ Inflation Risk: it refers to the uncertainty of

purchasing power of cash flows to be received out of investment. It
shows the impact of inflation or deflation on the investment.

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Unsystematic Risk/ diversifiable risk
• The unsystematic risk represents the fluctuation in return from an
investment due to factors which are specific to the particular firm and not
the market as a whole.
• these factors are unique to a particular firm, these factors called firm
specific factor
• Types of Unsystematic Risk:
➢ Business risk: the variability in incomes of the firms
➢ Financial risk: the degree of leverage or degree of debt financing used by a firm
➢ Operational risk: It occurs due to breakdowns in the internal procedures, people,
policies and systems.

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Risk and Expected Return
➢Risk and expected return are the two key determinants of an
investment decision.
➢Risk is the variability of the rates of return from an investment.
➢It measures how much individual outcomes deviate from the
expected value.
➢Statistically, risk is measured by any one of the measures of
dispersion such as variance, standard deviation.
➢Another major factor determining the investment decision is
the rate of return expected by the investor.
➢The rate of return expected by the investor consists of the yield
and capital appreciation.
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Risk measurement
❑the measure of risk is the extent to which the actual outcome is likely diverge
from the expected return. For this purpose, range, variance, standard deviation
and coefficient of Variation can be used to measure the risk.

❑standard deviation is the absolute measures of risk

• Example: The rate of return of equity shares of Wipro Ltd., for past six years are
given below:
Year 1 2 3 4 5 06
Rate of return (%) 12 18 -6 20 22 24
• Required: Calculate average rate of return, variance and standard deviation

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Cont’d…
• Example 3: expected return and estimated risk

ഥ )= σ R∗P
• Expected Return( E(R) or 𝑹

ഥ )2 x P
• Variance: 𝛿 2 = ∑(R−𝑹

• Standard deviation: 𝛿= 𝛿 2 = ഥ )2 x P
∑(R−𝑹

• Mr. Red invested in equity shares of White Ltd., its anticipated returns and associated probabilities
are given below:
Return (%) -15 -10 5 10 15 20 30
Probability 0.05 0.10 0.15 0.25 0.30 0.10 0.05

• Required: Calculation of expected rate of return and risk in terms of standard deviation?

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cont’d…
Return(R) Probability (P) (P × R) ഥ)
(R-𝑹 ഥ )2
(R−𝑹 ഥ )2 x p
(R−𝑹
-15 0.05 - 0.75 -24.5 600.25 30.0125
-10 0.10 -1.0 -19.5 380.25 38.0250
5 0.15 0.75 -4.5 20.25 3.0375
10 0.25 2.50 0.5 0.25 0.625
15 0.30 4.50 5.5 30.25 9.0750
20 0.10 2.00 10.5 110.25 11.0250
30 0.05 1.50 20.5 420.25 21.0125
1.00 R= 9.5% ഥ )2 x P= 112.8125
∑(R−𝑹

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Cont’d…
• Example:
• Suppose have estimated possible returns for New Honda Dealership Inc.
and Harry’s Automotive Repair for the coming year based on how the
economy does
• Return on:
• Economy Prob. Dealership Repair
• Boom 0.25 40% 6%
• Average 0.55 15% 15%
• Bust 0.20 -1% 17%
• You are required to calculate the expected rate of return and risk in terms
of standard deviation.

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Cont’d…
• Solution:
• E(r) Dealership = 0.25(40) + 0.55(15) + 0.2(-1) = 18.05%
• E (r) Repair = 13.15%
• 𝛿 2 dealership =0.25(40 − 18.25)2 + 0.55 (15 − 18.25)2 + 0.22
(−1 − 18.25)2 = 198.1475
• 𝛿 leadership= 14.08%
• 𝛿 Repair = 4.20%
• Return is more uncertain for the dealership

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 Portfolio theory
• Portfolio is the combination of various stocks in it.
• Portfolio Management basically deals with three critical
questions of investment planning.

• 1. Where to Invest?

• 2. When to Invest?

• 3. How much to Invest?

• Portfolio is the combination of assets

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Cont’d…
• The weights are based on the percentage composition of the
portfolio.
• The ultimate decisions to be made in investments are:
• 1. What securities should be held?
• 2. How many Birr should be allocated to each?

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Diversification and portfolio risk
• Diversification allows investor to reduce the level of the overall risk
of a portfolio by eliminating the impact of individual risk.
• Efficiently diversified portfolios are those which provide the lowest
possible risk for any level of expected return.

• Principle of diversification states spreading an investment across a

number of assets will eliminate some, but not all, of the risk.
Diversification is not putting all your eggs in one basket.

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Cont’d..
• The process of spreading an investment across assets (and thereby forming a
portfolio) is called diversification.

• The principle of diversification tells us that spreading an investment across many

assets will eliminate some of the risk.
• Unsystematic risk is therefore can be easily avoided virtually at no cost.
• Total risk = Systematic risk + unsystematic risk
• Types of Diversification
• There are two types of diversification. These are:
Random or naive diversification and
Efficient diversification

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Cont’d…
1.Random or naive diversification:

• It refers to the act of randomly diversifying without regard to

relevant investment characteristics such as expected return and
industry classification.

2.Efficient diversification

• Efficient diversification takes place in an efficient portfolio that has

the smallest portfolio risk for a given level of expected return or the
largest expected return for a given level of risk.

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Portfolio Expected Return
Dollar Amount of Asset k
Portfolio return =σ𝑛𝑘=1( Dollar Amount of Portfolio)*return on Asset k

E(R)=σ𝑛𝑖=0 Wr ∗ 𝑅

• The dollar amount of an asset divided by the dollar amount of

the portfolio is the weighted average of the asset and the sum
of all weighted averages must equal 100%.

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Cont’d…
• Example A portfolio consists of four securities with expected returns
of 12%, 15%, 18%, and 20% respectively. The proportions of portfolio
value invested in these securities are 0.2, 0.3, 0.3, and 0.20
respectively.

• The expected return on the portfolio is:

• E(RP) = 0.2(12%) + 0.3(15%) + 0.3(18%) + 0.2(20%)

• = 16.3%

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PORTFOLIO RISK
• The risk of a portfolio is measured by the variance (or standard deviation)
of its return.

 To develop the equation for calculating portfolio risk we need

information on weighted individual security risks and weighted co-
movements between the returns of securities included in the portfolio.

 Co-movements between the returns of securities are measured by

covariance (an absolute measure) and coefficient of correlation (a relative
measure).

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Cont’d…
• Cov(RA,RB) = 𝛿A,B = σ𝑛𝑘=𝑖 Pi(RAi− E[RA])(RBi− E[RB])

• Where:σ𝑛𝑘=𝑖(𝑅𝐴 , 𝑅𝐵 )= the covariance between the returns on stocks A and

B
• N = the number of states
• pi = the probability of state i
• RAi = the return on stock A in state i
• E[RA] = the expected return on stock A
• RBi = the return on stock B in state i
• E[RB] = the expected return on stock B

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Cont’d…
Portfolio Variance=WA2*σ2+WB2*σ2+2*WA*WB*Cov(RA,RB)

• S.D = √ [WA2 * σ2 * + WB2 * σ2 * + 2 * WA* WB* Cov(RA,RB)]

• Example:

• A portfolio consists of two stocks. The value of stock A is $60,000,

and its standard deviation is 15%, while the value of stock B is
$90,000, and its standard deviation is 10%. There is a correlation of
0.85 between the two stocks.

• Determine the variance.

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Cont’d..
• Example: suppose you have an opportunity of investing your wealth
in asset X and asset Y. The possible outcomes of the assets in
different status of economy are given below:
Status of economy probability return (%)
X Y
A 0.1 -8 14
B 0.2 10 -4
C 0.4 8 6
D 0.2 5 15
E 0.1 -4 20

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Cont’d..
• Expected rate of return for individual asset:
X =(.1)(-8)+(.2)(10)+(.4)(8)+(.2)(5)+(.1)(-4) = 5%
Y= (.1)(14)+(.2)(-4)+(.4)(6)+(.2)(15)+(.1)(20) =8%
• Assume you decided to invest 50% of your wealth in X and 50%
in Y. what is your expected rate of return on a portfolio
consisting X and Y.

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Cont’d…
• Solution:
Status of probability combined expected
economy(1) (2) return(3) return(2*3)
A 0.1 .5* -8+.5*14=3 0.3
B 0.2 .5*10 +.5*-4=3 0.6
C 0.4 .5* 8+.5*6 = 7 2.8
D 0.2 .5*5+.5*15 = 10 2.0
E 0.1 .5*-4 +.5*20 =8 0.8
Or 0.5*5%+0.5*8% = 6.5%
The expected return of the portfolio is 6.5%
➢Portfolio risk is determined by the magnitude and direction of
the correlation of any two of the assets in the portfolio.

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Cont’d…
• Correlation: is a statistical measure of the relationship b/n any
two series of numbers.

• If the series move in the same direction, they are positively

correlated. If the series move in opposite direction, they are
negatively correlated.

• Correlation coefficient(CC): a measure of the degree of

correlation b/n two series.

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Cont’d..
• If CC = +1, the two series are perfectly +vely correlated.
• If CC = -1, the two series are perfectly –vely correlated. If CC =
0, no correlation.
• CC (XY) = covariance XY
(st. deviation X)(st. deviation Y)

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Cont’d…
• Covariance of XY for the above example:
Status of proba. return deviation from product
economy exp. Return of deviats.
X Y X Y &probab.
A 0.1 -8 14 -13 6 -7.8
B 0.2 10 -4 5 -12 -12.0
C 0.4 8 6 3 -2 -2.4
D 0.2 5 15 0 7 0.0
E 0.1 -4 20 -9 12 -10.8
covariance = -33

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Cont’d…
• Standard deviation for X:
• Variance (∂2)= 0.1(-8-5)2 +0.2(10-5)2+0.4(8-5)2+0.2(5-5)2+0.1(-4-5)2
= 33.6%
• St. deviation(∂) = √33.6 = 5.8%
• St. deviation for Y:
Variance (∂2)=0.1(14-8)2 +0.2(-4-8)2+0.4(6-8)2+0.2(15-8)2+0.1(20-8)2
= 58.2%
• St. deviation(∂) = √58.2 = 7.63%

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Cont’d…
• Therefore,
• Coefficient of correlation = -33 = -0.746
5.8% *7.63%
• Thus, security X and Y are negatively correlated.
• If an investor invests in the combination of these securities,
he/she can reduce risk.

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Exercise
Probability of Asset A Return Asset B Return
Economic State
State (%) (%)

Boom 20% 22 6

Normal 55% 14 10

Recession 25% 7 12

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Cont’d…
• Required:

• 1. Calculate expected return of asset A &B

• 2. Calculate variance of asset A &B

• 3. Calculate covariance of Asset A &B

• 4. Calculate portfolio variance(σ2𝑃 )

• 5. Calculate portfolio standard deviation

•
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End of chapter four

thank you!!!

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