CHAPTER TWO

RISK AND RETURN

MEANING OF RISK
Every investor expects to get some return from the investment in the future. But, as future
uncertain, so is the future expected return. We can distinguish between the expected return and
the realized return from an investment.
 The expected return is the uncertain future return on an investment
 The realized return, on the contrary, is certain that an investor actually obtains
from his investment at the end of the holding period.
The realized return may not correspond to the expected return. There is a possibility of
variation of the actual return from the expected return. This possibility of variation is
termed as risk.

RISK DEFINED
1. Risk can be defined as “potential for variability in returns”.
2. Risk can be defined as “the probability that the expected return from the security will
not materialize”.

ELEMENTS OF RISK
Variation in returns is caused by a number of factors. These factors, we call as elements or
sources of risk. Elements of risk may be classified broadly into two categories or groups.
 Systematic risk
 Unsystematic risk
The above two categories of risk form total risk.

Total risk = Systematic risk + Unsystematic risk

Systematic risk: Systematic risk affects the entire market. This risk is caused because of the
changes occur in social, economic and political systems. These factors are beyond the control of
a corporation and an investor. The investor cannot avoid this risk.
Virtually all securities have some systematic risk, whether bonds or stocks, because systematic
risk directly encompasses interest rate, market, and inflation risks. The investor cannot escape
this part of the risk because no matter how well he or she diversifies, the risk of the overall
market cannot be avoided. If the stock market declines sharply, most stocks will be adversely
affected; if it rises strongly, most stocks will appreciate in value. These movements occur
regardless of what any single investor does. Clearly, market risk is critical to all investors.

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Unsystematic Risk: Systematic risk is for the market as a whole, while unsystematic risk is
specific to an industry or the company individually. The variability in a security's total returns
not related to overall market variability is called the non- systematic risk. This risk is unique to
particular security and is associated with such factors as business and financial risk as well as
liquidity risk. Although all securities tend to have some non-systematic risk, it is generally
connected with common stocks.
Remember the difference: Systematic risk is attributable to broad macro factors affecting
all securities. Non-systematic risk is attributable to factors unique to security.

Systematic risk is sub-divided into the following groups:

 Market risk
 Interest rate risk
 Purchasing power risk

1. Market Risk: This risk arises from the variability in the market returns resulting from
alternating bull and bear market forces. When security index rises fairly consistently from a low
point to peak, over a period of time, this upward trend is called a bull market. The bull market
ends when the market index reaches a peak and starts a downward trend. The period during
which the market declines to the next trough is called a bear market.
The variability in a security's returns resulting from fluctuations in the aggregate market
is known as market risk. The forces that affect the stock market can be either:
 Tangible
 Intangible
Tangible events: Tangible events are real events such recessions, wars, earthquakes, political
uncertainty, structural changes in the economy, and changes in consumer preferences.
Intangible events: Intangible events are related to market psychology. Such psychology is
affected by real events. However, reactions to tangible events become over-reactions and push
the market either upward or downward.
For example, a political event or economic event may lead to rise or fall in the price of a
security, which can be accentuated by the over-reactions of herd-like behavior of investors.

2. Interest Rate Risk: The variability in a security's return resulting from changes in the level
of interest rates is referred to as interest rate risk. Such changes generally affect securities
inversely; that is, other things being equal, security prices move inversely to interest rates. The
reason for this movement is tied up with the valuation of securities. Interest rate risk affects bonds
more directly than common stocks and is a major risk that all bondholders face. As interest rates
change, bond prices change in the opposite direction.

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 For example, A bond having a face value of Birr 100 issued with a coupon rate of 10%. If
the market interest moves up to 12.5%, no investor will buy the bond with 10% interest
bond unless the holder of the bond reduces the price of the bond.
 When interest rate rises, the prices of the older bonds or securities go down.
 When interest rate declines, the prices of the older bonds or securities to up.
Indirect impact on common stocks:
 Most stock traders trade in the stock market with borrowed funds with a small margin. The
increase in the interest rates dampens the spirit of speculative traders and thus they may sell
their securities. The fall in demand leads to fall in the stock prices and index.
 Most corporations use borrowed funds. If interest rates increase, they have to pay more
interest on borrowings out of the profits. This leads to a reduction in the earnings per share,
and thus shares prices may fall.

3. Purchasing Power Risk: It refers to the variation in investor returns caused by inflation.
Inflation results in lowering the purchasing power of money. Because of inflation, an investor
experiences a decline in purchasing power of his investments and return on investments.
Real rate of return:
For example, if an investor gets a return of 12% on his investment and the inflation rate is
6.8%, then the real value would be
1.0 + r
Real rate of return = ___________ _ 1

1.0 + IR
Where, r = return; IR = inflation rate
1.0 + 0.12
= ____________ _ 1

1.0 + 0.068
= 1.0486 – 1
=0.0486 = 4.86%
This shows that his actual rate of return is only 4.86%. The purchasing power has not
increased by 12% according to his earnings because of inflation prevailed in the market at
6.8%.

Unsystematic Risk: The returns from a security may sometimes vary because of certain factors
affecting only the company issuing such security. Examples are raw material scarcity, labor strike,
management inefficiency etc. When variability of returns occurs because of such firm – specific
factors, it is known as unsystematic risk. This risk is unique or peculiar to a company or industry
and affects it in addition to the systematic risk affecting all securities.

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The unsystematic or unique risk affecting specific securities arises from two sources:
a) The operating environment of the company, and
b) The financing pattern adopted by the company.

The two types of unsystematic risk are referred to as business risk and financial risk
respectively.
Business risk: Business risk is that portion of unsystematic risk caused by the operating
environment of the business. Variations in the expected operating income reflect business risks.
Variations that occur in the operating environment are reflected in the operating incomes and
expected dividends. Business risks arise from the inability of a firm to maintain its competitive edge
and the growth or stability of the earnings. Business risks can be divided into internal business risk
and external business risk. Internal risk is caused due to improper allocation fixed and variable
costs, improper product mix, non-availability of raw materials, incompetence to face competition,
absence of strategic management etc. External risks arise from operating conditions imposed on the
firm by circumstances beyond its control. The external environments in which it operates exerts
some pressure on the firm. These could be social and regulatory factors like monetary and fiscal
policies of government, business cycles or the general economic environment in which a firm or an
industry operates. For example, a government policy (like tax relaxations, controls on imports and
exports) that favors an industry will lead to a rise in the stock prices of the particular industry and
vice versa.

2. Financial risk: Financial risk is associated with the capital structure of the company. This
structure consists of equity funds and borrowed funds. The presence of debt and preference capital
results in a commitment of paying interest or pre-fixed rate of dividend. The residual (remaining)
income alone is available to the equity holders. The interest payment affects the payments that are
due to the equity investors. Debt financing increased the variability of the returns to the common
stockholders and affects their expectations regarding the return. The use of debt with own funds to
increase the return to shareholders is known as financial leveraging.
Debt financing enables companies to have funds at a low cost and offer financial leverage to the
shareholders. As long as the earnings of a company are higher than the cost of borrowed funds,
shareholders earnings go up. At the same time, when the earnings are low, it may lead to
bankruptcy for equity holders.
The financial risk is an avoidable risk. Proper planning and other financial adjustments by the
management enables a company avoid the financial risk.

Return: Return is the primary motivating force that drives investment. It represents the reward for
undertaking investment. Since the game of investing is about returns (after allowing risk),
measurement of realized (historical) returns is necessary to assess how well the investment manager
has done. In addition, historical returns are often used as investment input in estimating future
(prospective or expected) returns.

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The return of an investment consists of two components:
Current return: Current return is the periodic income such as dividend or interest, generated by
the investment. It is measured as periodic income in relation to the beginning price of the
investment.
Capital return: The second component of return is reflected in the price change called capital
return. It is measured simply the price appreciation (depreciation) over the beginning price of the
asset.
Thus the total return of a security is defined as:
Total return = Current return + Capital return

Measuring historical return:

𝐈+[𝐏𝐄 −𝐏𝐁 ]
Total return =(𝑹) = 𝐏𝐁

Where R=Rate of return

I = Income received during the period
PE=Price of the investment at the end of period
PB=Price of the investment at the beginning of the period

Illustration:
 Price of a stock at the beginning of the year is Birr 60.00
 Dividend received on the stock at the end of the year is Birr 2.40
 Price of the stock at the end of the year is Birr 69.00
The total return on this stock is calculated as follows:

𝐈+[𝐏𝐄 −𝐏𝐁 ]
Total return =(𝑹) = 𝐏𝐁

𝟐. 𝟒𝟎 + [𝟔𝟗. 𝟎𝟎 − 𝟔𝟎. 𝟎𝟎]

=
𝟔𝟎. 𝟎𝟎

= 0.19 or 19 percent
It is helpful to split the rate of return into two components, viz., current yield and capital
gain/loss.
The total return of 19 percent, in the above illustration, may be broken down as follows:

𝐈 𝐏𝐄 −𝐏𝐁
Rate of return (𝐑) = 𝐏 +
𝐁 𝐏𝐁

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 𝟐.𝟒𝟎 𝟔𝟗.𝟎𝟎−𝟔𝟎.𝟎𝟎
= +
𝟔𝟎.𝟎𝟎 𝟔𝟎.𝟎𝟎

= 4percent + 15 percent = 19 percent

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). In this example, the HPR is 1.10, calculated as follows:

This 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 HPR value less than 1.0 means that you suffered a decline in
wealth, which indicates that you had a negative return during the period. An HPR of zero
indicates that you lost all your money.
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 an 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.

In our example:

To derive an annual HPY, you compute an annual HPR and subtract 1. Annual HPR is
found by:

where:
n = number of years the investment is held

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Consider an investment that cost $250 and is worth $350 after being held for two years:

If you experience a decline in your wealth value, the computation is as follows:

A multiple year loss over two years would be computed as follows:

In contrast, consider an investment of $100 held for only six months that earned a return of
$112:

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Note that we made some implicit assumptions when converting the HPY to an annual basis. This
annualized holding period yield computation assumes a constant annual yield for each year. In the
two-year investment, we assumed an 18.32 percent rate of return each year, compounded. In the
partial year HPR that was annualized, we assumed that the return is compounded for the whole
year.
That is, we assumed that the rate of return earned during the first part of the year is likewise
earned on the value at the end of the first six months. The 12 percent rate of return for the initial
six months compounds to 25.44 percent for the full year. Because of the uncertainty of being able
to earn the same return in the future six months, institutions will typically not compound partial
year results.
Remember one final point: The ending value of the investment can be the result of a positive or
negative change in price for the investment alone (for example, a stock going from $20 a share to
$22 a share), income from the investment alone, or a combination of price change and income.
Ending value includes the value of everything related to the investment.
Computing Mean Historical Returns
Now that we have calculated the HPY for a single investment for a single year, 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 should 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 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 the geometric
mean return. To find the arithmetic mean (AM), the sum (∑) of annual HPYs is divided by the
number of years (n) as follows:
AM =∑HPY/n
where:
∑HPY = the sum of annual holding period yields
An alternative computation, the geometric mean (GM), is the nth root of the product of the
HPRs for n years.

where:
the product of the annual holding period returns as follows:
( HPR1) × (HPR2) ... (HPRn)

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 To illustrate these alternatives, consider an investment with the following data:
Year Beginning value Ending value HPR HPY

1 100 115 1.15 0.15

2 115 138 1.2 0.2
3 138 110.4 0.8 -0.2
Compute AM and GM
Investors are typically concerned with long-term performance when comparing alternative
investments. GM is considered a superior measure of the long-term mean rate of return because it
indicates the compound annual rate of return based on the ending value of the investment versus its
beginning value.
Although the arithmetic average provides a good indication of the expected rate of return for an
investment during a future individual year, it is biased upward if you are attempting to measure an
asset’s long-term performance.
When rates of return are the same for all years, the GM will be equal to the AM. If the rates of
return vary over the years, the GM will always be lower than the AM. The difference between the
two mean values will depend on the year-to-year changes in the rates of return. Larger annual
changes in the rates of return—that is, more volatility—will result in a greater difference between
the alternative mean values.
An awareness of both methods of computing mean rates of return is important because published
accounts of investment performance or descriptions of financial research will use both the AM and
the GM as measures of average historical returns
Historical risk (Ex-post risk):
Ex-post risk (past events) or historical risk is measured by taking the past returns of a security over
a period of time. It helps the investor in analyzing the variability in the returns over a period of
time. It is also helpful to measure the ex-ante risk (expected risk).
The most commonly used statistical measures in measuring historical risk are variance or
standard deviation.
̅ )𝟐
∑(𝐑–𝑹
Variance (𝝈𝟐 ) = 𝑵

Standard deviation (𝝈) = √𝝈𝟐 = √𝑽𝒂𝒓𝒊𝒂𝒏𝒄𝒆

Where: ∑ = Summation
R = Returns
̅ = Mean return
𝐑
N = No. of years

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Measuring Expected Rates of Return
Risk is the uncertainty that an investment will earn its expected rate of return. In the examples in
the prior section, we examined realized historical rates of return. In contrast, an investor who is
evaluating a future investment alternative expects or anticipates a certain rate of return. The
investor might say that he or she expects the investment will provide a rate of return of 10
percent, but this is actually the investor’s most likely estimate, also referred to as a point
estimate.
Pressed further, the investor would probably acknowledge the uncertainty of this point estimate
return and admit the possibility that, under certain conditions, the annual rate of return on this
investment might go as low as –10 percent or as high as 25 percent. The point is, the
specification of a larger range of possible returns from an investment reflects the investor’s
uncertainty regarding what the actual return will be. Therefore, a larger range of expected
returns makes the investment riskier.
An investor determines how certain the expected rate of return on an investment is by analyzing
estimates of expected returns. To do this, the investor assigns probability values to all possible
returns. These probability values range from zero, which means no chance of the return, to one,
which indicates complete certainty that the investment will provide the specified rate of return.
These probabilities are typically subjective estimates based on the historical performance of the
investment or similar investments modified by the investor’s expectations for the future.
As an example, an investor may know that about 30 percent of the time the rate of return on this
particular investment was 10 percent. Using this information along with future expectations
regarding the economy, one can derive an estimate of what might happen in the future. The
expected return from an investment is defined as:

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Let us begin our analysis of the effect of risk with an example of perfect certainty wherein the
investor is absolutely certain of a return of 5 percent. Exhibit 1.2 illustrates this situation.
Perfect certainty allows only one possible return, and the probability of receiving that return is
1.0. Few investments provide certain returns. In the case of perfect certainty, there is only one
value for PiRi:
E(Ri) = (1.0)(0.05) = 0.05
In an alternative scenario, suppose an investor believed an investment could provide several
different rates of return depending on different possible economic conditions. As an example, in
a strong economic environment with high corporate profits and little or no inflation, the investor
might expect the rate of return on common stocks during the next year to reach as high as 20
percent. In contrast, if there is an economic decline with a higher-than-average rate of inflation,
the investor might expect the rate of return on common stocks during the next year to be –20
percent. Finally, with no major change in the economic environment, the rate of return during
the next year would probably approach the long-run average of 10 percent.
The investor might estimate probabilities for each of these economic scenarios based on past
experience and the current outlook as follows:

The computation of the expected rate of return [E(Ri)] is as follows:

Measuring the expected Risk of Expected Rates of Return

We have shown that we can calculate the expected rate of return and evaluate the uncertainty, or
risk, of an investment by identifying the range of possible returns from that investment and
assigning each possible return a weight based on the probability that it will occur. Although the
graphs help us visualize the dispersion of possible returns, most investors want to quantify this
dispersion using statistical techniques. These statistical measures allow you to compare the
return and risk measures for alternative investments directly. Two possible measures of risk

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(uncertainty) have received support in theoretical work on portfolio theory: the variance and the
standard deviation of the estimated distribution of expected returns.
In this section, we demonstrate how variance and standard deviation measure the dispersion
of possible rates of return around the expected rate of return. We will work with the examples
discussed earlier. The formula for variance is as follows:

Variance The larger the variance for an expected rates of return, the greater the dispersion of
expected returns and the greater the uncertainty, or risk, of the investment. The variance for
the perfect-certainty example would be:

Note that, in perfect certainty, there is no variance of return because there is no deviation
from expectations and, therefore, no risk or uncertainty. The variance is

Standard Deviation The standard deviation is the square root of the variance:

For the second example, the standard deviation would be:

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Therefore, when describing this example, you would contend that you expect a return of 7
percent, but the standard deviation of your expectations is 11.87 percent.
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:

The CV for the preceding example would be:

This measure of relative variability and risk is used by financial analysts to compare
alternative investments with widely different rates of return and standard deviations of
returns. As an illustration, consider the following two investments:

Comparing absolute measures of risk, investment B appears to be riskier because it has a

standard deviation of 7 percent versus 5 percent for investment A. In contrast, the CV figures
show that investment B has less relative variability or lower risk per unit of expected return
because it has a substantially higher expected rate of return:

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