RISK AND RETURN

What’s Inside

1 Stand-Alone Risk

2 Portfolio Risk
 Risk and Return

Risk – the chance that some unfavorable

event will occur

Types of Risk
 Business (earning fluctuations)
 Liquidity (cash flow fluctuations)
 Default (debt payment fluctuations)
 Market (stock price fluctuations)
 Interest Rate (asset value fluctuations)
 Buying (commodity price
fluctuations)
 Risk and Return

Risk can be analyzed in 2 ways:

1.Stand-alone risk – the risk an investor would

face if he or she held only one type of asset

2.Portfolio risk – the risk an investor would face

if he or she held more than one type of asset
 Concepts and Principles

A steeper line suggests that an investor is very

averse to taking on risk whereas a flatter line would
suggest that the investor is more comfortable bearing
risk

The greater the risk, the higher the return

The tighter the probability distribution of expected

future returns, the smaller the risk of a given
investment

No investment should be undertaken unless the

expected rate of return is high enough to compensate
for the perceived risk
 Definition of Terms
Probability Distribution
– a listing of possible outcomes or events with a
probability (chance of occurrence) assigned to each
outcome

Expected Rate of Return (ȓ)

– rate of return expected to be realized from an
investment; the weighted average of the probability
distribution of possible results

Standard Deviation (ó)

– is a measure of how far (distance) the actual
return is likely to deviate from the expected return.
Used to analyze two investments with the same (ȓ)
 Definition of Terms

Coefficient of Variation (cv)

– the standardized measure of the risk per unit.
Used to analyze two investments with different (ȓ)

Risk Aversion
– risk-averse investors dislike risk and require
higher rates of return as an inducement to buy
riskier securities

Risk Premium
– the difference between the expected rate of
return on a given risky asset and that on a less
risky asset
 Investment Securities

 Small-company stocks
 Large-company stocks
 L-T corporate bonds
 L-T government bonds
 Treasury bills
 Expected Rate of Return

Example:
Status/Condition Probability (p) Rate of Return Product
(r) (p x r)
Strong 30% 80% 24%
Normal 40% 10% 4%
Weak 30% -60% -18%
100% ȓ = 10%

Formula: ȓ = p1r1 + p2r2 + p3r3 + pnpn …

 Standard Deviation
Example:

Status/ Probability Rate of Deviation D₂ Variance

Condition (p) Return (r) (D) (r-ȓ) (V) (p x
D₂)
Strong 30% 80% 70% .4900 .1470
Normal 40% 10% 0 .0000 0
Weak 30% -60% -70% .4900 .1470
100% ϵV = .2940
54.22%
Interpretation: The actual return is 54.22% farther/away from the expected return
The actual return is 54.22% less likely to achieve the targeted return

Formula: Ó = √ ϵV
 Standard Deviation

Conclusion:
The higher the Ó, the riskier
the investment.

Risk-averse : Consider lesser Ó

Risk-taker :Consider higher Ó
 Coefficient of Variation (cv)
Example:

Status/ Probability (p) Rate of Return Rate of Return

Condition (r) X (r) Y
Strong 10% 40% 60%
Normal 60% 20% 40%
Weak 30% -10% -35%
100%

Formula: cv = ó
ȓ
 Coefficient of Variation (cv)
Investment X
Status/ Probability Rate of Return Product (pxr)
Condition (p) (r) cv = ó
Strong 10% 40% 4% ȓ
Normal 60% 20% 12% CV = .1616
Weak 30% -10% -3% .13
100% ȓ = 13%
= 1.2431
Status/ Probabi Rate of Deviatio D₂ Variance
Conditio lity (p) Return n (D) (r- (V) (p x D₂)
n (r) ȓ)
Strong 10% 40% 27% .0729 .00729
Normal 60% 20% 7% .0049 .00294
Weak 30% -10% -23% .0529 .01587
100% ϵV = .0261
16.16%
 Coefficient of Variation (cv)
Investment Y
Status/ Probability Rate of Return Product (pxr)
Condition (p) (r) cv = ó
Strong 10% 60% 6% ȓ
Normal 60% 40% 24% CV = .3616
Weak 30% -35% -10.5% .195
100% ȓ = 19.5%
= 1.8544
Status/ Probab Rate of Deviatio D₂ Variance
Conditio ility (p) Return n (D) (r- (V) (p x D₂)
n (r) ȓ)
Strong 10% 60% 40.5% .164025 .0164025
Normal 60% 40% 20.5% .042025 .025215
Weak 30% -35% -54.5% .297025 .0891075
100% ϵV = .130725
36.16%
 Coefficient of Variation (cv)

Conclusion:
The higher the CV, the riskier
the investment.

Risk-averse : Consider lesser CV

Risk-taker :Consider higher CV
 Portfolio Investment
Portfolio Return: The weighted average return of the
individual assets in the portfolio. The weights being the
fraction of the total investment.

Portfolio Risk: Not simply the sum total of standard

deviations of individual assets in the portfolio but is also
dependent on the asset’s “Correlation of Coefficient”

Correlation of Coefficient: Is a measure of the degree to

which two variables “move” together. It has a numerical
value of: -1 (perfectly negative correlation) ; +1 (perfectly
positive correlation and; 0 (no correlation)

Diversification: process of eliminating portfolio risk by

combining assets relative to their correlation.
 Portfolio Return

Example 1:
Stock ȓ Money % of Total Product
Invested (W1) (ȓ x W1)
Microsoft 7.70% 25,000 25% 1.925%
IBM 8.20% 25,000 25% 2.050%
GE 9.45% 25,000 25% 2.363%
Exxon Mobil 7.45% 25,000 25% 1.863%
8.20% 100,000 100% rp = 8.200%

Formula: ȓp = ϵ (ȓ x W1)
 Portfolio Return

Example 2:

A portfolio consists of assets A and B. Asset a makes

up 1/3 of the portfolio and has an expected return of
18 percent. Asset B makes up the other 2/3 of the
portfolio and is expected to earn 9 percent. What is the
expected return on the portfolio?

Asset Return (r) Weight (W) Product (r x W)

A 18% 1/3 6%
B 9% 2/3 6%
3/3 or 1 or 100 % ȓp = 12%
Formula: ȓp = ϵ (ȓ x W)
 Portfolio Risk

Example 2:

Equation: Ốp = √ W2AỐ2A + W2BỐ2B + 2pABWAWB x ỐAỐB

Assume the following:

Asset Ố W
A 20% 1/3
B 10% 2/3

Ốp equation = √ W2AỐ2A + W2BỐ2B + 2pABWAWB x ỐAỐB

= √ .0089 + .0089pAB
 Portfolio Risk
Example 2:

SCENARIOS (WHAT IF):

Asset A and B have perfect positive correlation
Ốp equation = √ .0089 + .0089pAB
= √ .0089 + .0089(+1)
= 13.34 %
Asset A and B have no correlation
Ốp equation = √ .0089 + .0089pAB
= √ .0089 + .0089(0)
= 9.43 %
Asset A and B have perfect negative correlation
Ốp equation = √ .0089 + .0089pAB
= √ .0089 + .0089(-1)
=0%