RISK AND RETURN_S1_2018

Risk is an important concept in financial analysis, especially in terms of how it

affects security prices and rates of return. Investment risk is associated with the
probability of low or negative future returns.

The riskiness of an asset can be considered in two ways: (1) on a stand-alone

basis, where the asset’s cash flows are analysed all by themselves or (2) in a
portfolio context, where the cash flows from a number of assets are combined
and then the consolidated cash flows are analysed.

Assessing the return and risk characteristics of a single security

Risk is often defined as the chance of a loss. However, in a strict financial

context, this is not right. Risk is synonymous with the term uncertainty; it is the
uncertainty surrounding the return an investment will earn. The more variable
the returns to an asset, the more uncertain they are and the more risky they
are.

The total rate of return on an investment is measured as the total gain or loss
experienced on behalf of its owner over a given period of time. Return is the
change in the asset’s value plus any cash distributions received while it is
owned. The return is calculated using the following formula:

Pt - Pt-1 + Ct
Rate of return = Pt-1

Pt : The end of the period value

Pt-1 : The beginning of period value

Scenario analysis, while not a method for measuring risk, can be used to get a
feel for risk. When different scenarios, such as pessimistic (worst case), most
likely (expected), and optimistic (best), are evaluated, the greater the
difference in the outcomes, the greater is the risk. If changing sales, for
example, has little impact on net income, the firm is less risky than one where
a small change in sales greatly affects the bottom line. The range is found by
subtracting the return associated with the pessimistic outcome from the return
associated with the optimistic. It is not unusual to use spreadsheets to create
different scenarios as an aid to evaluating the riskiness of an investment.

Probability distributions describe the riskiness of an asset more precisely. A

probability distribution is a model that relates probabilities to the associated
output. Probability distributions can be shown as either simple bar charts or
continuous graphs.

The most common measure of risk is the statistic called the standard deviation.
The standard deviation measures the dispersion about the mean, or expected
return, r̅. To compute a standard deviation, the mean is found first. The actual
outcomes are subtracted from this mean outcome to find the dispersion. This
dispersion is squared to eliminate the negative signs.

Expected rate of return = r̅ = ∑ni=1 Piri

Standard deviation = σ = √∑ni=t(ri − ri)2 Pi

The coefficient of variation is a measure of the relative dispersion. It should be

used when comparing the risk of assets that have very different expected
returns. CV is computed by dividing the standard deviation by expected
return.
σ
Coefficient of variation = CV = r

The standard deviation and the coefficient of variation are useful in measuring
the risk of an asset only when it is held by itself.

Assessing the return and risk characteristics of a portfolio

Investors should create portfolios consisting of a selection of securities. In this

way, investors can diversify, or spread, their risk. Financial –assets portfolios may
include a selection of ordinary shares, preference share, corporate bonds,
government bonds, Treasury bills and money market investment instruments,
among others.
The expected return on a portfolio,

r̅p is the weighted average of the expected returns on the individual assets in
the portfolio, with the weights being the fraction of the total portfolio invested
in each asset:

r̅ p= ∑ni=1 w1 r̅i

The riskiness of a portfolio,σp , is generally not a weighted average of the

standard deviations of the individual assets in the portfolio; the portfolio’s risk
will be smaller than the weighted average of the assets’ σs . The riskiness of a
portfolio depends not only on the standard deviations of the individual share,
but also on the correlation between the shares.

Correlation is a statistic that measures the relationship between any two series
of numbers. Returns of securities can be either

1. positively correlated; if the series move in the same direction;

2. negatively correlated; if the series move in opposite directions; or

3. uncorrelated; if there is no relationship between the movement of one

security and another.

The correlation coefficient, measures the tendency of two variables to move

together.

Diversification does nothing to reduce risk if the portfolio consists of perfectly

positively correlated share.

As a rule, the riskiness of a portfolio will decline as the number of shares in the
portfolio increases.

However, in the real world, where the correlations among the individual shares
are generally positive but less than +1.0, some, but not all, risk can be
eliminated.

In the real world, it is impossible to form completely riskless share portfolios.

Diversification can reduce risk, but cannot eliminate it.
Diversifiable Risk, Nondiversifiable Risk, and Beta

The capital asset pricing model is the theory that links together risk and return.
To develop this theory, we must first identify the different types of risk. Total risk
can be viewed as consisting of two types: nondiversifiable risk and diversifiable
risk. Diversifiable risk, also called unsystematic risk or firm risk, represents the
portion of an asset’s risk that is associated with random causes that can be
eliminated through diversification. For example, labour problems may affect
one firm in a portfolio, but not the others. This may increase the market share
of other firms in the portfolio so the net return to the investor remains
unchanged. Nondiversifiable risk cannot be eliminated by diversifying. Factors
such as war, inflation, international incidents, and political events tend to
affect all firms in similar ways. This kind of risk is also referred to as the risk of the
market, or systematic risk.

Beta

The beta coefficient is used to measure nondiversifiable risk. It is found by

determining how the return on a share responds to different returns of a
portfolio composed of all of the shares in the whole market.

The beta of a portfolio is found by finding the weighted average of the betas
of the firms in the portfolio.

bp = (w1 × b1 ) + (w2 × b2 ) + (wn × bn)

The Model: The Capital Asset Pricing Model (CAPM)

The Equation

Using the beta coefficient to measure market risk, the capital asset pricing
model is given by the following equation.

rj = Rf +[bj ×(rm − Rf )]

where: rj = required return on asset j

Rf = risk-free rate of return

bj = beta coefficient for asset j

rm = market return

The required return on asset j, rj, is equal to what could be earned with no risk,
Rf, plus a risk premium to compensate the investor for choosing a risky
investment instead of a risk-free investment. The market risk premium, (rm − Rf),
represents the premium the investor receives for taking the average amount
of risk. This average amount is adjusted by multiplying by beta.

The Security Market Line

When the required returns on all stocks are graphed against their
corresponding betas, the result is the security market line (SML). The SML will be
a straight line.

Required Rate
of Return (%) SML = r i = r RF + (r M - r RF)bi

rM
Market risk premium
r RF

0.5 1.0 Risk, bi

Shifts in the Security Market Line

Market conditions will cause the security market line to shift up or down or to
change in slope. For example, if inflation increases, the SML will shift up by the
amount of the increase, while maintaining the same slope. If investors become
more risk averse, the slope of the SML will increase. This results in offering
investors a higher return to compensate them for incurring the risk of the
market.
ASSESSMENT FORMAT

The risk and return study unit will be assessed by means of multiple- choice
questions (MCQ) and long questions (practical application) which will test your
knowledge on application and calculations.

In the examination the formula sheet will not be provided, ensure that you
know the formulas of this study unit very well.

Prescribed book reference: Chapter 8: Principal of Managerial Finance, 2nd

edition

REVIEW QUESTIONS

Question 1

Given the following information, what is the standard deviation of the following
investment?

Probability Return
0,4 20%
0,60 10%

Expected return (𝐫̅̅) = 14%

1. 4,89%
2. 9,60%
3. 14,40%
4. 24,00%
𝛿 =∑( rj - − ̅r)2 × Pj = (20% − 14%)2 × 0,40 +(10% − 14%)2 × 0,60

= 0,144 + 0,096 = 0,24 ≈ √ 0,24 = 0,489

Answer: 1
Question 2

A share has a beta of 1,88, the expected return on the market is 14%, and the
risk-free rate is 5%. What must the expected return on this share be?

1. 9,00%
2. 16,92%
3. 21,92%
4. 26,32%

rj = RF + β (rm − RF )

= 5 + 1,88 (14 – 5) = 21,92%

Answer: 3

Question 3

Given the following expected return and standard deviation of asset A, B and
C, which of the following assets should a financial manager select?

Asset Expected return Standard deviation

A 15% 7%
B 12% 8%
C 20% 10%

1. B
2. C
3. A
4. C and A

The coefficient of variance is a measure of relative dispersion that is useful in

comparing the risks of assets with differing expected returns.

Answer: 3
Question 4

What is the rate of return earned for investment G during the unspecified
period?

Investment Cash flow during the Beginning of the End of the

period period period

G R1 500 R20 000 R21 000

1. 12,20%
2. 12,36%
3. 12,50%
4. 12,88%

1 500 + 21 000 - 20 000

= = 12,5%
20 000
Answer: 3

Question 5

Eight Ltd is considering an investment that will expand its product line. Two
possible expansion projects are considered and the company has made the
following estimates regarding the respective annual rate of return on the two
projects:

State of the economy Expansion K Expansion D

Pessimistic 20% 20%
Most likely 45% 25%
Optimistic 36% 30%

What is the range for Expansion D?

1. 5%
2. 10%
3. 16%
4. 25%
Rang = Optimistic – Pessimistic ∴ 30% - 20% = 10%

Answer: 2

Question 6

If the market risk premium of a share is equal to 7%, the risk-free rate is 5% and
the required return is 8%, what is the beta coefficient?

1. 0,3
2. 0,4
3. 1,4
4. 1,5

RF = rj − β (rm − RF )

8% = 5% +β(7%)
8% - 5% = 7β
3
=β
7

0,4 = β

Answer: 2