CHAPTER FOUR

RISK AND RETURN

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 The concept of risk and return
 In order to analyze the performance of an investment it
is very important that investors learn how to measure
returns such as holding period return, annualized
return, etc.
 Since return and risk are related, the measurement of
return also helps in the understanding of the riskiness
of an investment.
 The rate of return required by a firm to a great extent
depends upon the risk involved, higher the risk, greater
is the return expected by the firm. Thus risk and return
are two side of an investment coin. 2
 Return
 Return is a reward and motivating force behind every
investment. It is the amount or rate of gain or profit
which accrues to an investment.
 A return, also known as a financial return, in its
simplest terms, is the money made or lost on an
investment over some period of time.
 It is also an income received on an investment plus any
change in market price, usually expressed as a percent
of the beginning market price of the investment.

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 Return
• A return is the change in price of an asset, investment,
or project over time, which may be represented in terms
of price change or percentage change.
• Rate of return represents the percentage net gain or loss
of an investment's initial cost over a period of time. The
rate of return calculates the percentage change from the
beginning to the end of a specified period. Return from
an investment can be calculated by;
R=Dt+(Pt-Pt-1)
Pt-1
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 Return
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 Return
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 Return
 Thus, the total return for any security is defined as
Total return = current return + capital return
Current return, can be zero or positive
Capital return, can be negative, zero or positive

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 Risk
• Risk refers to the possibility that the actual outcome
of an investment will differ from its expected outcome.
• Risk refers to the likelihood that we will receive a
return on an investment that is different from the
return we expected to make.
• Risk is the probability or likelihood that actual results
(rates of return) deviates from expected return.
• Risk is also called uncertainty

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 Risk
• The wider the range of possible outcomes, the greater
the risk.
• Risk is the possibility that we won’t achieve our
expectations or the chance that actual investment
returns will differ from those expected.
• Has positive relationship with return
- high risk; high return
- low risk; low return
The relationship between risk and return is called
risk- return tradeoff
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 Sources of Risk
i. Business Risk: Uncertainty of income flows caused by
the nature of a firm’s business
• Sales volatility and operating leverage determine the
level of business risk.
• It is cause for unsystematic risk
ii. Financial Risk; Uncertainty caused by the use of debt
financing. (Level of Financial Leverage)
• Borrowing requires fixed payments which must be paid
ahead of payments to stockholders.

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 Sources of Risk
• The use of debt increases uncertainty of stockholder
income and causes an increase in the stock’s risk
premium.
• It is cause for unsystematic risk
iii. Liquidity Risk; occurs when an individual investor,
business, or financial institution cannot meet its
short-term debt obligations.
• The investor or entity might be unable to convert an
asset into cash without giving up capital and income
due to a lack of buyers or an inefficient market.
• It is a cause for systematic risk
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 Sources of Risk
iv. Exchange Rate Risk; Uncertainty of return is
introduced by acquiring securities denominated in a
currency different from that of the investor.
• Changes in exchange rates affect the investors return
when converting an investment back into the “home”
currency.
• It is cause for systematic risk
v. Country Risk: the uncertainty of returns caused by
the possibility of a major change in the political or
economic environment in a country.
• It is cause for systematic risk
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 Sources of Risk
• Individuals who invest in countries that have unstable
political-economic systems must include a country
risk-premium when determining their required rate of
return.
vi. Interest rate risk; is the chance that changes in
interest rates will adversely affect a security’s value.
• It is cause for systematic risk
vii. Purchasing Power Risk; refers to the chance that
changing price levels (inflation or deflation) will
adversely affect investment returns.
• It is cause for systematic risk
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 Components of risk
Although there are many reasons why actual returns
may differ from expected returns, we can group the
reasons into two categories:
- Market wide/Systematic Risk/Non-Diversifiable
-Firm-specific/ Unsystematic Risk/Unique risk
I. Systematic risk
• The risk inherent to the entire market or entire market
segments is known as systematic risk.
• The portion of the variability of return of a security
that is caused by external factors, is called systematic
risk.
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 Components of risk
 This risk can be due to;
• Economic and political instability,
• Economic recession,
• Inflation
• Change in Government policy
 - Change in interest rate policy
 - Corporate tax rate
 - Foreign exchange control
• Natural disasters etc.
 these factors affect the price of all share in the market
• Thus the variation of return in shares, which is caused
by these factors, is called systematic risk. 15
 Components of risk
• Systematic risk cannot be reduced through
diversification. This risk can be mitigated through
hedging or by using the correct asset allocation strategy.
II. NON - SYSTEMATIC RISK (UNSYSTEMATIC)
• The return from a security sometimes varies because of
certain factors affecting only the company issuing such
security.
• Risk due to; -Shortage of raw material,
- Labor strike,
-R & D expert leave the company
- Management inefficiency etc 16
 Components of risk
• These factors affect the share price of one company.
• When variability of returns occurs because of such
firm- specific factors, i t is known as unsystematic risk
• Unsystematic risk can be reduced through
diversification.
Total risk
• Risk of an individual security is the variance (standard
deviation) of its return.
• It consists of two parts:
• Total risk of a security= systematic risk + unsystematic
risk
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 Measurement of Returns and Risk
 Measuring of Return:
• If you buy an asset of any sort, your gain (loss) from
that investment is called the return on your
investment. As we have seen return will usually have
two components:
• Current return – It is the periodic cash inflow in the form of
interest or dividend.
• Capital return --- It represents change in the price of asset.
• Total Return = Current Return + Capital Return
Thus; return is nothing but the reward for undertaking
investment.
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 Measuring of Return:
Calculation of Historical Returns :
• Assessment of historical returns is must to know the
performance of the fund manager. This also helps as
an important input to estimate future returns. So it is
important to assess the historical return for a period.
• Example: Suppose, at the beginning of the year, the
stock for a company was selling for $37 per share. If
you had bought 100 shares, you would have a total
out-lay of $3700 (37*100). Suppose, over the year,
the stock paid a dividend of $1.85per share.

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 Measuring of Return:
• By the end of the year, then, you would have received
income of:
– Dividend Income in terms of dollar = $1.85 x 100=
=$185
• Also, suppose that the value of the stock has risen to
$40.33 per share by the end of the year. Your 100
shares are now worth; $40.33*100=$4,033,
• So you have a capital gain of:
• Capital gain = ($40.33 - $37) x 100 = $333
• Or; Capital gain = $4,033 - $3,700 = $333

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 Measuring of Return:
• Therefore, the total return on your investment is the
sum of the dividend and the capital gain.
• Total dollar return = dividend income + capital gain
(loss)
• = $185 + $333 = $ 518
• Notice that, if you sold the stock at the end of the year,
the total amount of cash you would have would equal
your initial investment plus total return. Then, total
cash if the stock is sold is :
• Total cash = initial investment + total return
• $ 3700 + $ 518 = $ 4,218
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 Measuring of Return:
• As a check, notice that this is the same as the proceeds
from the sale of the stock plus the dividends:
• Proceeds from stock sale + dividends
= $40.33 x 100 + 185
= $ 4,218

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 Measuring of Return:
 Although expressing returns in dollars is easy,
two problems arise:
 to make a meaningful judgment about the return,
you need to know the scale (size) of the
investment;
 A $100 return on a $100 investment is a great
return (assuming the investment is held for 1
year), but a $100 return on a $10,000
investment would be a poor return.

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 Measuring of Return:
 The question is, how much do we get for each
dollar we invest?
 You also need to know the timing of the return; a
$100 return on a $100 investment is a great return if
it occurs after 1 year, but the same dollar return
after 20 years is not very good.
 The solution to these scale and timing problems is
to express investment results as rates of return, or
percentage returns.
 Basic Terms: which indicated as rate of return are;

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 Measuring of Return:
 Dividend yield: The annual stock dividend as a
percentage of the initial stock price.
 Capital gains yield: The change in stock price as a
percentage of the initial stock price.
 Total percent return: The return on an investment
measured as a percentage that accounts for all cash
flows and capital gains or losses.
 It is usually more convenient to summarize
information about returns in percentage terms, rather
than in dollar terms; because that way your return
does not depend on how much you actually invest.
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 Measuring of Return:
• Assume; Pt-1 be the price of the stock at the
beginning of the year and Dt be the dividend paid on
the stock during the year.
• In the example above, the price at the beginning of the
year was $37 per share and the dividend paid during
the year on each share was $1.85. Therefore, dividend
yield is:
Dividend yield= Dt/ Pt-1= $1.85/37 = .05= 5%,
• This implies that for each dollar we invest, we get five
cents in dividends.

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 Measuring of Return:
• The second component of the return from investment
is the capital gains yield. This is calculated as the
change in the price during the year (the capital gain)
divided by the beginning price:
Capital gains yield = (P t –Pt-1)/ Pt-1
= (40.33 -37)/37 = .09= 9%.
• This means that per dollar we invest, we get nine
cents in capital gain.
• therefore, the total return per dollar invested, we get
5 cents in dividends and nine cents in capital gains: so
we get a total of 14 cents.
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 Measuring of Return:
• Simply, the total percentage return of an investment
can be calculated as:
• Total Percentage return =
Dividend paid at end of period + Change in market value over period
Beginning market value
= $1.85 + (40.33 – 37)/ 37 = 5.18/37 = .14 = 14%

• In general; Total Percentage return

R=Current yield+ Capital gain yield

=𝐷𝑡/ 𝑃𝑡 − 1+ (𝑃 𝑡 – 𝑃𝑡 − 1)/ 𝑃𝑡 − 1
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 Measuring historical risk
• As we have seen risk refers to the possibility that the
actual outcome of the investment will differ from the
expected outcome.
• It refers to variability or dispersion.
• If an asset return has no variability, it is riskless.
• Suppose you are analysing the total return of an equity
stock over the period of time apart from knowing the
mean return, you would also like to know about the
variability of in returns.

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 Measuring of Risk:
• The most commonly used measures of risk in finance
are variance and standard deviation.
• The variance and standard deviation of historical
return series are defined as follows:
n
Ri−Ṝ)2
Variance (δ2)=
i=1 n−1
Where: δ2 = variance of return
Ri = Return from the stock in period i (=1,.., n)
Ṝ =Arithmetic return
n = number of period
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 Measuring of Risk:
• There fore standard deviation is the square root of
variance;
standard deviation of return =δ = δ2
Example: Consider returns from the stock over a six
years period.R1 = 15%, R2 =12%, R3 = 20%, R4= -
10% R5 =14%and R6 =9%. Calculate the variance
and standard deviation of return.

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 Measuring of Risk:
O Solution;
Period Return Deviation (Ri-R− ) Square of deviation
Ri (Ri- R− )2
1 15 5 25
2 12 2 4
3 20 10 100
4 -10 -20 400
5 14 4 16
6 9 -1 1
n n − )2
i=1 Ri =60 i=1 Ri (Ri- R = 546
R− = 10

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 Measuring of Risk:
n 6
Ri−R−)2 546
• δ2 = = 1/2 =109.2
i=1 n−1 i=1 6−1
δ = δ2= 109.2=10.4
 In general; The variance is a measure of variability
which tells you the degree of spread in your data set.
 The more spread the data, the larger the variance is in
relation to the mean.
The standard deviation is derived from variance and
tells you, on average, how far each value lies from the
mean. It’s the square root of variance.

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 Measuring expected return and risk
Expected rate of return:
• Investors estimate future rate of return based on
historical return and by assigning probability to each
year rate of return.
• The expected rate of return is the weighted average of
all possible returns multiplied by their respective
probabilities. In symbols,
E(R) = 𝐧𝐢=𝟏 𝐑𝐢𝐏𝐢
Where: E(R) = expected return
Ri = return from the stock at year i
Pi = probability of return at year i
n = number of possible year 34
 Measuring of Risk:
Expected risk:
• Risk refers to the dispersion of a variable.
• It is commonly measured by the variance or the
standard deviation.
• The variance of the probability distribution is the sum
of the squares of the deviations of the actual returns
from the expected return, weighed by the associated
probabilities.

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 Measuring of Risk:
In symbols,
σ2 = ∑ Pi (Ri –E(R))2
Where:
σ2 =variance
Ri =return for the ith possible outcome
Pi =probability associated with the ith possible outcome
E(R) = expected return
Then; standard deviation δ = δ2

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 Measuring of Risk:
Example: The table below provides a probability
distribution for the returns on stocks A and B.
compute expected return and expected risk by using
variance and standard deviation.

Year Probability Return on Stock A Return on Stock B

1 20% 5% 50%

2 30% 10% 30%

3 30% 15% 10%

4 20% 20% -10%

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 Measuring of Risk:
Solution:
Expected return for stock A and B calculated as follows:
• E[R]A =0.2(5%)+0.3(10%)+0 .3(15%) + 0.2(20%)
= 12.5%
• E[R]B =0.2(50%)+0.3(30%)+0.3(10%)+0.2(-10%)
= 20%,
 Based on expected return stock B will perform well
than stock A.
 so investment manager select and invest on stock B to
get future better return.

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 Measuring of Risk:
Expected risk; Variance and Standard deviation on Stocks
A and B:
Stock A =>

Stock B =>

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 Measuring of Risk:
• Based on expected risk, investor may select the second
stock to minimize risk.
• Generally, the above result shows that as return
increase risk also increase and investors select security
based on their risk tolerance.

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THANK
YOU!!!
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