OVERVIEW OF

RISK AND
RETURN
1st Sem. SY 2021-2022
 • Investment risks force
investors to evaluate the return
and risk
characteristics of each
investment alternative before
CONCEPTmaking a decision.
OF RISK • Investors, however, differ in
• Risks refer to chances that the their attitudes toward risks.
outcome of an event will be Some like taking risks, while
negative or undesirable; others exert efforts to avoid or
returns refer to yields or minimize risk.
earnings on an investment.
 risk-neutral.
• Types of investors include
risk
averse, risk-takers, and
Investments
 A: Guaranteed
return of P1,000

B: 50% chance of
either P2,000 or
nothing
Risks are classified as (Fabozzi and
Modigliani, 2009):
 strike, the outcome of
unfavorable litigation, or a
natural catastrophe.
Systematic Risk – also
called undiversifiable risk
or market risk. Systematic
risk results from the general
market and economic
conditions that cannot be
diversified away.
Unsystematic Risk –
sometimes called diversifiable
risk, residual risk, or company
specific risk. This is the risk that
Measurement of risk involves
is unique to a company such as a
methodologies such as
(Kolakowski, 2016): in random events. Probability is a set of
all possible outcomes like an 80%
probability of success and a 20%
1. Loss of principal and/or interest probability of failure.
payments
• The crudest yet most conservative
measurement of risk is the total sum of
money invested or loaned. The worst
possible outcome is that the entire
investment becomes worthless of that the
borrower defaults.

2. Probability• A refinement is the

introduction of probabilities to the
analysis. The mathematical theory of Measurement of risk involves
probability deals with patterns that occur
methodologies such as from the average or mean value. It also refers
to the extent to which these data points differ
(Kolakowski, 2016): from each other.
• There are four commonly used measures of
variability: range, mean, variance, and
3. Volatility and variability standard deviation.
• Volatility is a basic measure of risks
associated with a financial market’s
instrument. It represents an asset’s price
fluctuation and is accounted as the difference
between the maximum and minimum prices
within the trading session, trading day,
month, and the like.
• The wider range of fluctuations (higher
volatility) means higher trading risks
involved. Standard deviation is the typical
statistic used to measure volatility.

• Variability is the extent to which data points

in statistical distribution or data set diverge
 4. Assessments of counterparty risk•
Counterparty risk, which includes default
risk, is the risk that the other party to a
transaction, such as another firm in the
financial services industry, will prove
unable to fulfill its obligations on time.
Assessments of

Measurement of risk involves counterparty risk often are made based on

methodologies such as the analyses of companies’ financial
(Kolakowski, 2016): strengths provided by rating agencies.
5. Role of actuaries•
Actuaries are most
associated with analyzing mortality
tables on behalf of life insurance
companies and any other venture which
involves measurement of risks. It plays a
critical part in setting of premiums on
policies and payout schedules on
annuities.

CONCEPT OF
RETURNS
• Returns are the revenues, earnings,
yields, proceeds, income, or profit from
some undertakings made, like financial
 investment, capital investment, and an investment and the expenses spent on
business operation. They are measured an investment.
based on the net cash flow realized or • Net cash flows and net income are
expected to be realized from an normally translated in the form of
investment or based on the net income percentages, which are called rates of
from business operations. return. Rate of return is used to compare
• Net cash flows refer to the difference the outcomes of different investments. It
between the cash flows received from an is also used to measure historical
investment and the cash flows expended performance, determining future
on an investment. investment and estimating cost of capital
• Net income from an investment refers for capital investment decision. It shows
to the difference between revenues from the return made on an investment.
• Example:
An investment in a bond of 1,000 with a maturity period of 10 years, paying P40
interest every 6 months, the income on the bond would be equal to P80 a year,
which is equivalent to 8% of the face value of the bond.
If, at any time during the life of the bond, the bond sells at 110 (P1,000 x 110% =
P1,100), the investor would not only earn the P80/year interest in the bond, but
also the increase in price from P1,000 to P1,000 or P100 gain, should he decide to
sell the bond prior to maturity.
The same is true for investment in stocks. The only difference is that, in stocks,
income is in the form of dividends declared by the issuing corporation instead of
interest.
In the example, the computation of interest rate would be:

r = I/P
where r = Interest rate
I = Interest received
P = Principal or cost of investment
 r = P80/P1,000 = 8%
The increase in value or capital gain, which is the growth (g) in the
investment would be:

g = (CP-P)/P

where CP = Current price

P = Principal or cost of investment

g = P1,100 – P1,000 = P100 = 10%

P1,000 P1,000

Therefore, the rate of return (ROR) = r + g = 8% + 10% = 18%

 • Risk is the possibility that actual returns will
deviate or differ from what is expected. The
actual returns can go up or down depending on
the market. If the returns go up, the risk in
investing is worth it; if the returns go down,
then the
risk is not worth taking. Taking risks involves
knowledge of expected returns, terminal value,
RISK AND present value, and rate of return.
RETURN • Expected returns are the future cash flows
• Risk and return associated with the investment.
are interrelated because the returns from an • Terminal Value is the maturity value of the
investment should equate the risk involved. investment.
Returns computed from historical data can be • Present values are the discounted value of the
used in measuring future returns; however, the future returns.
uncertainty of the occurrence or the risk • Rate of return is the ratio of the net cash
involved should also be taken into account. flows and the principal or initial investment.
 dividend that you earn as a stockholder is the return
you earn on your stocks, in addition to any capital
gain or increase in value of said stocks.
• To increase the rate of return of a company, the
company has to take certain risks.
• “Keep your alpha high and your beta low” is an
old adage related to investment and therefore, to
risk and return.
RISK AND • “Alpha” means return and “beta” means risk.
RETURN Alpha denotes excess return and beta denotes risk,
• Return is the profit the latter being a measure of risk. In other words,
we have to keep the return high and the risk low.
or earnings, and rate of return is the percentage of
profit or earnings on a particular investment, which • However, in the business world, “the higher the
is why it is often termed ROI or return on risk, the higher the return” is generally presumed.
investment. why short-term borrowings have
This is the reason
• The yield you get on your investment in lower interest rates than long
government securities is your return on your term borrowings
investment in those government securities. The because the default risk in long term loans are
 higher than in short-term loans because of the period and the uncertainty involved in the long run.
METHODS OF CALCULATING RATES OF RETURN
1. Holding period return – rate of return measured for a given period which can be in a month or in a year. The
period covers 1 month to several months or 1 year to several years. However, if it covers several years, the result
from this method no longer presents realistic rate of return. This is used when the holder of security does not
hold on to the security until maturity. The holding period is the time the investor holds the investment from the
time of acquisition to time of sale generally prior to maturity. The formula is:

R = EV + I – IV
IV
where R = Returns for the period
EV = Ending value of the investment after an interval
I = Income received from investment (Dividends for Stock; Interest for bonds)
IV = Initial value of the investment at the beginning of the interval
METHODS OF CALCULATING RATES OF RETURN

2. Average rate of return – measures the return across months or

 years. a. Arithmetic average - an unweighted average of the returns which
formula is:

AR = (∑ ROR)n/ n
where AR = Average rate of return
n = Number of intervals
RoR = Holding period return for each month or year
b. Geometric average – measures the compounded growth rate of the initial investment which
formula is:

METHODS OF CALCULATING RATES OF RETURN

3. Internal rate of return (IRR)/ yield to maturity – In computing for the IRR of the investment, the present
value of the expected cash flows is taken into account. Internal rate of return is a discount rate that makes the net
present value (NPV) of all cash flows from a particular investment equal to zero. Net present value is the
difference between the present value of future cash inflows and the present value of the investment or the
principal. If the NPV is positive, the investment is accepted; if negative, the investment is rejected.

However, this method will require trial and error and interpolation. Yield to maturity is the IRR for bonds. Since
it will require trial and error, the computation can start with finding the estimated yield to maturity (Mejorada,
1999). The approximate yield to maturity (YM) would be:
F+P
Where C = Coupon/Interest
payment F = Face value 2
P = Price or principal
Approx. YM =
n = Years to maturity
C+F–P n
 STANDARD DEVIATION
OF A
PORTFOLIO
There are two types of
returns: 1. Expected
returns – what you
expect to get on your
investment
EXPECTED RETURN, 2. Unexpected returns
VARIANCE, AND – which are gains or
losses caused by unforeseen events
EXPECTED RETURN
• Expected return is calculated as the weighted average of the likely profits
of the assets in the portfolio, weighted by the likely profits of each asset

class with the following equation: • A simple

way of writing this formula would be:

VARIANCE
• Variance (σ² ) is a measure of the dispersion of a set of data points around their mean
value (μ). Variance measures the variability from an average (volatility). To find the
variance, we follow three basic steps:
1. Subtract the mean from each value in the data set.
2. Square each difference and add all the squares together.
3. Divide the sum of the squares by the number of values in the data set.
• To incorporate expected returns with the concept of variance, we first compute for the
expected returns. Given the probability and the forecasted sales for given scenarios, for
example, we get the expected returns by multiplying each probability by each forecasted
sales. Adding all the expected returns together gives the man, which will be needed in
computing the variance.

PORTFOLIO VARIANCE
• A portfolio is a collection of financial assets or investments such as stocks, bonds, and cash.
Portfolio variance is a measure of risk of a portfolio, a combination of the return variance and co
variance of each security, and its proportion in that portfolio. The variance of a portfolio’s return is a
function of the variance of the component assets, as well as the covariance between each of them.
Covariance is a measure of the degree to which returns on two risky assets move in tandem. A positive
covariance indicates that two assets move together in tandem. A negative covariance indicates two
assets move in opposite directions.

• Modern portfolio theory (MPT) or mean-variance analysis is a mathematical framework for

assembling a portfolio of assets such that the expected return is maximized for a given level or risk,
defined as variance. This theory posits that portfolio variance can be reduced by diversification,
choosing asset classes with a low or negative covariance thereby reducing risk. The fundamental goal
of portfolio theory is to optimally allocate your investments between different assets.

PORTFOLIO VARIANCE
• Portfolio variance is calculated by multiplying the squared weight of each
security by its corresponding variance and adding two times the weighted
average weight multiplied by the covariance of all individual security pairs
expressed in the following formula for a simple two-asset portfolio:
 PORTFOLIO VARIANCE
• This means that we multiply the weight of each asset by their respective
variances to get the total for the assets and then add twice the product of the
weights and the covariances of the assets. Stated in another way:
 STANDARD DEVIATION
• Standard deviation (σ) is a measure of the dispersion of a set of data from its
mean. It is calculated as the square root of variance. The more spread apart the data,
the higher the deviation.

• In finance, standard deviation is also known as historical volatility and is used by

investors as a gauge for the amount of expected volatility. It is applied to the annual
rate of return of an investment to measure the investment’s volatility. For example,
a volatile stock will have a higher standard deviation while a stable blue chip stock
will have a lower standard deviation. The more volatile the investment, the higher
the standard deviation. A large dispersion tells us how much the fund’s return is
deviating from the expected normal returns.
STRUCTURE OF RATES OF RETURN
• The interest rates on various securities or investments are determined by factors such as
length of time to maturity, credit or default risk, and liquidity. The difference in interest rates
arising from differences in length of time to maturity or term of the security is called the
term structure of interest rates. The difference in interest rates arising from the credit or
default risk is termed default-risk or credit risk structure of interest rates. The default risk
premium is the difference between the interest on the debt security of a specific issuer and
the interest on a government treasury security with the same maturity.

• The yield curve is a graphical representation of the term structure of interest rates at a
particular point in time. An ascending or upward-sloping yield curve means that the longer
the maturity of the security, the higher the interest rate. A flat-yield curve means that
interest rates are the same among different maturities. A downward-sloping or inverted
yield curve means that short-term rates are higher than long-term rates.
 STRUCTURE OF RATES OF RETURN

TERM STRUCTURE OF INTEREST RATES

• The term of a loan means the period from the time the loan is acquired up to its maturity date. The
relationship between a security’s yield-to-maturity (YM) and the term-to-maturity is known as the
term structure of interest rates.

• Spot interest rates are the current interest rates that apply to current or outstanding loans of any term
or duration, that is, whether the loan is short-term or long-term. Forward interest rates are for loans of
any term or duration, but to be executed at some future time.
STRUCTURE
1.Pure or unbiased expectations
theory - states that for the same
holding period (term), investors
THEORIES should expect to earn the same
OF TERM return, whether they invest in short
term or long-term securities.
 OF TERM STRUCTURE
2.Liquidity/term premium theory - 3. Segmented markets theory - Under the
segmented markets theory, investors have certain
emanates from the pure expectations preferred investment horizon in accordance with or
theory based on the idea that to jibe with the kinds of assets and the kinds of
investors will hold long-term liabilities they hold.

maturities only if they are offered a 4. Preferred habitat theory - combines the
premium to compensate for future elements of the three other theories of term
structure. Under this theory, borrowers and lenders
uncertainty in a security’s value. have strong preferences for particular maturities,
just like segmented markets theory. The yield curve
therefore will not conform strictly with the
predictions of the pure expectations and liquidity
premium theories. However, if the expected
additional returns (excess returns) to be gained by
deviating from their preferred maturities (habitats)
become large enough, investors will deviate from
THEORIES their preferred habitats. Assuming expected returns
on long-term securities significantly exceed those
on short-term securities, investors will lengthen the securities significantly exceed long-term returns,
maturities of their assets or investments, that is, they investors will stop limiting themselves to the
will buy long-term securities. On the other hand, if long-term securities and will make short-term
the excess returns expected from buying short-term securities a limited portion of their portfolios.
RISK STRUCTURE OF INTEREST RATES

• Risk structure is the relationship between interest rates on

bonds with the same term to maturity. Embedded in the
yields of risk securities is a premium to compensate for the
risk that goes with security. Theoretically, this magnitude
(spread) can be estimated by comparing the yield on the
risky security versus the yield on a similar-risk-free
security. The spread between these yields is known as the
risk premium.