Risk and Return

What are investment returns?

nInvestment returns measure the

financial results of an investment.
nReturns may be historical or
prospective (anticipated).
nReturns can be expressed in:
lRupee terms.
lPercentage terms.
 Return
• Single period return
P
o = Rs.300, P1 = Rs.350
Return for the period is ………. %


P2 = 250


Return for the entire period ….?

Period-wise return ?
 Ex-post Returns
• Return = current income + capital
gains
• [(P2 – P1 ) + D2] / P1
 Expected Return
• Different scenario
• Chance / probability
• Return in case of each chance
 Chance return
 10% 30%
 23% 40%
 67% 25%
 Expected return ?
 Expected return from pf
E =E1W1 + E2 W2 + E3 W 3


E expected return
W proportion of money invested


 Return
Return : It is the primary motivating force that
drives investment.
§ It represents the reward for undertaking the
investment. In security analysis we are
primarily and particularly concerned with
returns from investors’ perspective.
§ The return of an investment consists of two
components : (i) Current return (ii) Capital
return.
1 Current return: Periodic cash flow (income)
such as dividend and interest. This can be
zero or positive.
2 Capital return: The price appreciation or
price changes. This can be zero, positive
and negative also.
Thus Total Return = Current return + Capital
return
 What is investment risk?

nTypically, investment returns are not

known with certainty.
nInvestment risk pertains to the
probability of earning a return less
than that expected.
nThe greater the chance of a return far
below the expected return, the
greater the risk.
Probability distribution
Stock X

Stock Y

Rate of
-20 0 15 50 return (%)
nWhich stock is riskier? Why?
 Risk
• Variability of security returns
• Standard deviation, variance
• SD is extent of deviation from the
average value of return = square
root of variance and variance is
the average of squares deviations
of observed returns from expected
value of returns
 Assume the Following
Investment Alternatives
Economy Prob. T-Bill Alta Repo Am F. MP

Recession 0.10 8.0% -22.0% 28.0% 10.0% -13.0%

Below avg. 0.20 8.0 -2.0 14.7 -10.0 1.0

Average 0.40 8.0 20.0 0.0 7.0 15.0

Above avg. 0.20 8.0 35.0 -10.0 45.0 29.0

Boom 0.10 8.0 50.0 -20.0 30.0 43.0

1.00
 What is unique about
the T-bill return?

nThe T-bill will return 8% regardless

of the state of the economy.
nIs the T-bill riskless? Explain.
In this context of security analysis, we
interpret risk essentially in the terms of the
variability of the security return. The most
common measures of risk ness of security is
SD and Variance of return.
Given below returns of two stocks X and Y.

Period
 Return of stock X(%) Return of stockY(%)
 1 -6 4
 2 3 6
 3 10 11
 4 13 15
 5 16 19
Calculate which stock is more risky ?
Period X Y (X – X) (Y – Y) (X – X)2 (Y – Y)2
1 -6 4 -13.2 -7 174.24 49
2 3 6 -4.2 -5 17.64 25
3 10 11 2.8 0 7.84 0
4 13 15 5.8 4 33.64 16
5 16 19 8.8 8 77.44 64
Sum 36 55 310.84 154

Mean of X = 36/5 = 7.2 =X

Mean of Y = 55/5 =11=Y

Variance of X = ∑(X- X)2/(n -1)= 310.80/(5-1)= 77.7 and

the S.D =√77.7=8.815

 Economic Probability of Return from
scenario occurrence stock A(%)
Boom 0.25 36
Stagnation 0.50 26
Recession 0.25 12

The expected return would be E(R) =

(0.25*36)+(0.50*26)+(0.25*12) = 25%
The risk of the stock :

σ2 =∑P *[R – E(R)]2

i i
=(36-25)2 *0.25 + (26-25)2 * 0.50 + (12-25)2 *

0.25
 = 73%
SD = 8.54%
 Calculate the expected rate
of return on each alternative.
r^ = expected rate of return.
∧ n
r = ∑ rP .
i=1
i i

r^Alta = 0.10(-22%) + 0.20(-2%)

+ 0.40(20%) + 0.20(35%)
+ 0.10(50%) = 17.4%.
 ^
r
Alta 17.4%
Market 15.0
Am. Foam 13.8
T-bill 8.0
Repo Men 1.7

nAlta has the highest rate of return.

nDoes that make it best?
What is the standard
deviation
of returns for each
alternative?
σ = Standard deviation

σ = Variance = σ
2

n ∧ 2
 
= ∑  ri − r  Pi .
i =1  
 n ∧ 2
 
σ = ∑  ri − r  Pi .
i =1  
Alta Inds:
 = ((-22 - 17.4)20.10 + (-2 - 17.4)20.20
+ (20 - 17.4)20.40 + (35 - 17.4)20.20
+ (50 - 17.4)20.10)1/2 = 20.0%.

σ = 0.0%. σ
T-bills Repo = 13.4%.
σ Alta = 20.0%.σ AmFoam = 18.8%.
σ Market = 15.3%.
Prob.
T-bill

Am. F.
Alta

0 8 13.8 17.4
Rate of Return (%)
Expected Return versus Risk
Expected
Security return Risk, σ
Alta Inds. 17.4% 20.0%
Market 15.0 15.3
Am. Foam 13.8 18.8
T-bills 8.0 0.0
Repo Men 1.7 13.4
 Coefficient of Variation:
CV = Expected return/standard
CVT-BILLS
 =deviation.
0.0%/8.0% = 0.0.

CVAltaInds
 = 20.0%/17.4% = 1.1.

CVRepoMen
 = 13.4%/1.7% = 7.9.

CVAm. Foam
 = 18.8%/13.8% = 1.4.

CVM
 = 15.3%/15.0% = 1.0.
 Expected Return versus
Coefficient of Variation
Expected Risk: Risk:
Security return σ CV
Alta Inds 17.4% 20.0% 1.1
Market 15.0 15.3 1.0
Am. Foam 13.8 18.8 1.4
T-bills 8.0 0.0 0.0
Repo Men 1.7 13.4 7.9
Return vs. Risk (Std. Dev.):
Which investment is best?

20.0%
18.0% Alta
16.0% Mkt
14.0% USR
12.0%
10.0%
rnR
tu
e

8.0% T-bills
6.0%
4.0%
2.0% Coll.
0.0%
0.0% 10.0% 20.0% 30.0%

Risk (Std. Dev.)

σ p (%)
Company Specific
35
(Diversifiable) Risk
Stand-Alone Risk, σ p

20

Market Risk

0
10 20 30 40 2,000+

# Stocks in Portfolio
 Stand-alone Market
risk Diversifiable
= risk + risk .

Market risk is that part of a security’s

stand-alone risk that cannot be
eliminated by diversification.
Firm-specific, or diversifiable, risk is
that part of a security’s stand-alone risk
that can be eliminated by
diversification.
 Reduction of risk through
Diversification

Security Analysis: Measuring risk &

return.
Portfolio Mgt: minimize risk or maximize

return.
Example:

Concept of Covariance: the degree to

which the return of two securities vary

or change together.
Concept of Correlation: the degree of

relationship between two variables.

Can an investor holding one stock earn
a return commensurate with its risk?

• No. Rational investors will minimize

risk by holding portfolios.
• They bear only market risk, so
prices and returns reflect this
lower risk.
• The one-stock investor bears higher
(stand-alone) risk, so the return is
less than that required by the risk.
 How is market risk measured for
individual securities?
• Market risk, which is relevant for
stocks held in well-diversified
portfolios, is defined as the
contribution of a security to the
overall riskiness of the portfolio.
• It is measured by a stock’s beta
coefficient. For stock i, its beta is:
 bi = (ρ iM σ i) / σ M
 How are betas calculated?
• In addition to measuring a stock’s
contribution of risk to a portfolio,
beta also which measures the
stock’s volatility relative to the
market.
•
 Thanks