1.

7 Investment income and risk

1.7.1 Return on investment and expected

rate of return
1.7.2 Investment risk. Variance and
standard deviation

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Learning Goals
1. Understand the relationship (or “trade-off”)
between risk and return.
2. Define risk and return and show how to measure
them by calculating expected return, standard
deviation, and coefficient of variation.
3. Discuss the different types of investor attitudes
toward risk.
4. Explain risk and return in a portfolio context, and
distinguish between individual security and
portfolio risk.

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 Defining Return
Income received on an investment plus any
change in market price, usually expressed as a
percent of the beginning market price of the
investment.

Dt + (Pt - Pt-1 )
R=
Pt-1
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 Return
Example
The stock price for Stock A was Birr 10 per share 1 year
ago. The stock is currently trading at Birr 9.50 per
share and shareholders just received a Birr 1 dividend.
What return was earned over the past year?

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 Return
Solution:
The stock price for Stock A was Birr 10 per share 1 year
ago. The stock is currently trading at Birr 9.50 per
share and shareholders just received a Birr 1 dividend.
What return was earned over the past year?

Birr1.00 + (Birr9.50 - Birr10.00 ) = 5%

R= Birr 10.00
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• Financial assets normally generate two types of
return for investors.
– First, they may provide periodic income through cash
dividends or interest payments.
– Second, the price of a financial asset can increase or
decrease, leading to a capital gain or loss.

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 Return on Financial Assets

Total Return

Periodic Capital Gain or

Income Loss

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 Historical Rates of Return
• Return over A Holding Period
– Holding Period Return (HPR)

= Ending Value of Investment

HPR
Beginning Value of Investment
– Holding Period Yield (HPY)
Yield is the promised rate of return on investment
under certain assumptions.
HPY=HPR-1
– Annual HPR and HPY
Annual HPR=HPR1/n
Annual HPY= Annual HPR -1=HPR1/n – 1
where n=number of years of the investment
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 Difference between HPR & HPY
• Holding period return is the total return from
an investment , including all sources of
income, for a given period of time. A value of
1.0 indicates no gain or loss. It is equal to
ending wealth / beginning wealth.
• Holding period yield is the total return from an
investment for a given period of time stated as
percentage; equal to HPR-1.

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Historical Rates of Return
Example: Assume that you invest $200 at the beginning of
the year and get back $220 at the end of the year. What
are the HPR and the HPY for your investment?

HPR=Ending value / Beginning value

=$220/200
=1.1
HPY=HPR-1=1.1-1=0.1
=10%
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 Historical Rates of Return
Example: Your investment of $250 in Stock A is worth $350
in two years while the investment of $100 in Stock B is
worth $120 in six months. What are the annual HPRs and
the HPYs on these two stocks?

• Stock A
– Annual HPR=HPR1/n = ($350/$250)1/2 =1.1832
– Annual HPY=Annual HPR-1=1.1832-1=18.32%
• Stock B
– Annual HPR=HPR1/n = ($120/$100)1/0.5 =1. 44
– Annual HPY=Annual HPR-1=1. 44-1=.44%

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 Historical Rates of Return
• Computing Mean Historical Returns
Suppose you have a set of annual rates of return
(HPYs or HPRs) for an investment. How do you
measure the mean annual return?
– Arithmetic Mean Return (AM)
AM=  HPY / n
where  HPY=the sum of all the annual HPYs
n=number of years
– Geometric Mean Return (GM)
GM is the nth root of the product of the annual
holding period returns for n years minus 1.
GM= [ HPR] 1/n -1
where  HPR=the product of all the annual HPRs
n=number of years
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Historical Rates of Return
Suppose you invested $100 three years ago and it is
worth $110.40 today. The information below shows the
annual ending values and HPR and HPY. This example
illustrates the computation of the AM and the GM over a
three-year period for an investment.

Year Beginning Ending HPR HPY

Value Value
1 100 115.0 1.15 0.15
2 115 138.0 1.20 0.20
3 138 110.4 0.80 -0.20

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 Historical Rates of Return
AM=[(0.15)+(0.20)+(-0.20)] / 3
= 0.15/3=5%
GM=[(1.15) x (1.20) x (0.80)]1/3 – 1
=(1.104)1/3 -1=1.03353 -1 =3.353%
• Comparison of AM and GM
– When rates of return are the same for all years, the
AM and the GM will be equal.
– When rates of return are not the same for all years,
the AM will always be higher than the GM.
– While the AM is best used as an “expected value” for
an individual year, while the GM is the best measure
of an asset’s long-term performance.
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 Historical Rates of Return
• A Portfolio of Investments
– Portfolio HPY: The mean historical rate of return
for a portfolio of investments is measured as the
weighted average of the HPYs for the individual
investments in the portfolio, or the overall
change in the value of the original portfolio.
– The weights used in the computation are the
relative beginning market values for each
investment, which is often referred to as dollar-
weighted or value-weighted mean rate of return.

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Historical Rates of Return
The following exhibit demonstrates how to compute the
rate of return for a portfolio of 3 stocks.

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 Expected Rates of Return
• In previous examples, we discussed realized historical
rates of return. In contrast, an investor would be more
interested in the expected return on a future risky
investment.
• Risk is the uncertainty that an investment will earn
its expected rate of return.
• Risk refers to the uncertainty of the future outcomes of
an investment
– There are many possible returns/outcomes from an
investment due to the uncertainty
– Probability is the likelihood of an outcome
– The sum of the probabilities of all the possible outcomes is
equal to 1.0.
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 Expected Rates of Return
• Computing Expected Rate of Return
n
E(R i ) =  (Probability of Return)  (Possible Return)
i =1

= [(P1 )(R1 )  (P2 )(R 2 )  ....  (Pn R n )]

n
=  ( Pi )( Ri )
i =1

where P i = Probability for possible return i

R i = Possible return i
1-18
 Probability Distributions
Exhibit 2.2
Risk-free Investment

1.00 An example of perfect

0.80 certainty wherein the
0.60 investor is absolutely
certain of a return of 5
0.40
per cent.
0.20
0.00
-5% 0% 5% 10% 15%

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 Probability Distributions
Exhibit 2.3
Risky Investment with 3 Possible Returns
1.00 Eco Condit Probability Rate of return

0.80 Strong economy 0.15 0.2

no inflation
0.60
Weak economy, 0.15 -0.2
0.40 above average
inflation
0.20
No major change 0.7 0.1
0.00 in economy
-30% -10% 10% 30%

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Measuring the Risk of Expected Return
• Risk is the variability of returns from those that are
expected.
• Risk refers to the uncertainty of an investment;
therefore the measure of risk should reflect the degree
of the uncertainty.
• Two possible measures of risk (uncertainty) have
received support in theoretical work on portfolio
theory: the variance and the standard deviation of the
estimated distribution of expected returns.
• The risk of expected return reflect the degree of
uncertainty that actual return will be different from the
expect return.
• The common measures of risk are based on the
variance of rates of return distribution of an investment
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 Risk of Expected Return
• Measuring the Risk of Expected Return
– The Variance Measure
Variance (s )
n
=  (Pr obability ) x (
Expected 2
Possible - )
i =1 Re turn Re turn
n
=  Pi [ Ri - E ( Ri )]2
i =1

The larger the variance for an expected rate of return , the

greater the dispersion of expected returns and the greater the
uncertainty or risk of the investment.
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Risk of Expected Return
– Standard Deviation (σ): It is the square root of
the variance and measures the total risk
n
s=  i i
P [ R
i =1
- E ( Ri )] 2

– Coefficient of Variation (CV): It measures the risk per

unit of expected return and is a relative measure of risk.

Standard Deviation of Return

CV =
Expected Rate of Return
=s
E (R )
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 Determining Expected Return
(Discrete Dist.)
n
R =  ( Ri )( Pi )
i=1
R is the expected return for the asset,
Ri is the return for the ith possibility,
Pi is the probability of that return occurring,
n is the total number of possibilities.

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 How to Determine the Expected
Return and Standard Deviation

Stock BW
Ri Pi (Ri)(Pi)
The
-.15 .10 -.015 expected
-.03 .20 -.006 return, R,
.09 .40 .036 for Stock
.21 .20 .042 BW is .09 or
9%
.33 .10 .033
Sum 1.00 .090
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 Determining Standard
Deviation (Risk Measure)
n
s =  ( Ri - R )2( Pi )
i=1
Standard Deviation, s, is a statistical measure of
the variability of a distribution around its mean.
It is the square root of variance.
Note, this is for a discrete distribution.

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 How to Determine the Expected
Return and Standard Deviation

Stock BW
Ri Pi (Ri)(Pi) (Ri - R )2(Pi)
-.15 .10 -.015 .00576
-.03 .20 -.006 .00288
.09 .40 .036 .00000
.21 .20 .042 .00288
.33 .10 .033 .00576
Sum 1.00 .090 .01728
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 Determining Standard
Deviation (Risk Measure)
n
s = i=1 ( Ri - R )2( Pi )

s = .01728

s = .1315 or 13.15%

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 Coefficient of Variation

The ratio of the standard deviation of a

distribution to the mean of that distribution.
It is a measure of RELATIVE risk.
CV = s / R
CV of BW = .1315 / .09 = 1.46
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 Discrete vs. Continuous
Distributions

Discrete Continuous
0.4 0.035
0.35 0.03
0.3 0.025
0.25 0.02
0.2 0.015
0.15 0.01
0.1 0.005
0.05
0
0

13%
22%
31%
40%
49%
58%
67%
4%
-50%
-41%
-32%
-23%
-14%
-5%
-15% -3% 9% 21% 33%
 Determining Expected Return
(Continuous Dist.)
n
R =  ( Ri ) / ( n )
i=1
R is the expected return for the asset,
Ri is the return for the ith observation,
n is the total number of observations.

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 Determining Standard
Deviation (Risk Measure)
n
s =  ( Ri - R )2
i=1
(n)
Note, this is for a continuous distribution where
the distribution is for a population. R represents
the population mean in this example.

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 Continuous Distribution
Problem
• Assume that the following list represents the
continuous distribution of population returns for a
particular investment (even though there are only 10
returns).
• 9.6%, -15.4%, 26.7%, -0.2%, 20.9%, 28.3%, -
5.9%, 3.3%, 12.2%, 10.5%
• Calculate the Expected Return and Standard
Deviation for the population assuming a
continuous distribution.
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Risk of Historical Rates of Return
• Given a series of historical returns measured by
HPY, the risk of returns is measured as:

 n 2
s2 =  [ HPYi - E ( HPY)]  / n
 i =1 
where, σ 2 = the variance of the series
HPY i = the holding period yield during period i
E(HPY) = the expected value of the HPY equal to
the arithmetic mean of the series (AM)
n = the number of observations

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Determinants of Required Returns
• Three Components of Required Return:
– The time value of money during the time period
– The expected rate of inflation during the period
– The risk involved
• Complications of Estimating Required Return
– A wide range of rates is available for alternative
investments at any time.
– The rates of return on specific assets change
dramatically over time.
– The difference between the rates available on
different assets change over time.
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Determinants of Required Returns
• The Real Risk Free Rate (RRFR)
– Assumes no inflation.
– Assumes no uncertainty about future cash flows.
– Influenced by time preference for consumption of
income and investment opportunities in the
economy
• Nominal Risk Free Rate (NRFR)
– Conditions in the capital market
– Expected rate of inflation
NRFR=(1+RRFR) x (1+ Rate of Inflation) - 1
RRFR=[(1+NRFR) / (1+ Rate of Inflation)] - 1
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 Determinants of Required Returns…
Example:
• Assume that the nominal return on
government T-bills was 9 per cent during a
given year, when the rate of inflation was 5
per cent. Compute the RRFR of return on this
T-bills?
• Solution:
• RRFR=[(1+NRFR) / (1+ Rate of Inflation)] – 1
• =[(1+0.09) / (1+ 0.05)] – 1
• =1.038-1
• =0.038=3.8%
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Determinants of Required Returns
The major source of Uncertainty or the sources of
fundamental risk are:
• Business Risk
• Financial Risk
• Liquidity Risk
• Exchange Rate Risk
• Country Risk

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 Determinants of Required Returns..
• 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.
• Financial Risk
– It is the uncertainty introduced by the method by
which the firm finances its investments.
– Uncertainty caused by the use of debt financing.
– Borrowing requires fixed payments which must be
paid ahead of payments to stockholders.
– The use of debt increases uncertainty of stockholder
income and causes an increase in the stock’s risk
premium.
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Determinants of Required Returns
• Liquidity Risk
– How long will it take to convert an investment
into cash?
– How certain is the price that will be received?
• 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.
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Determinants of Required Returns
• Country Risk
– Political risk is the uncertainty of returns caused
by the possibility of a major change in the
political or economic environment in a country.
– Individuals who invest in countries that have
unstable political-economic systems must include
a country risk-premium when determining their
required rate of return.

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Determinants of Required Returns
• Risk Premium and Portfolio Theory
– From a portfolio theory perspective, the relevant
risk measure for an individual asset is its co-
movement with the market portfolio.
– Systematic risk relates the variance of the
investment to the variance of the market.
– Beta measures this systematic risk of an asset.
– According to the portfolio theory, the risk
premium depends on the systematic risk.

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Determinants of Required Returns
• Fundamental Risk versus Systematic Risk
– Fundamental risk comprises business risk,
financial risk, liquidity risk, exchange rate risk,
and country risk.
Risk Premium= f ( Business Risk, Financial Risk,
Liquidity Risk, Exchange Rate Risk,
Country Risk)
– Systematic risk refers to the portion of an
individual asset’s total variance attributable to
the variability of the total market portfolio.
Risk Premium= f (Systematic Market Risk)
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Relationship Between Risk and Return
• The Security Market Line (SML)
– It shows the relationship between risk and
return for all risky assets in the capital market at
a given time.
– Investors select investments that are consistent
with their risk preferences.
Expected Return
Low Average High Security
Risk Risk Risk Market Line

The slope indicates the

NRFR required return per unit of risk
Risk
(business risk, etc., or systematic risk-beta)
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Relationship Between Risk and Return
• Movement along the SML
– When the risk of an investment changes due to a
change in one of its risk sources, the expected
return will also change, moving along the SML.
Expected
Return
SML

Movements along the curve

that reflect changes in the
NRFR risk of the asset
Risk
(business risk, etc., or systematic risk-beta)
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Relationship Between Risk and Return
• Changes in the Slope of the SML
– When there is a change in the attitude of
investors toward risk, the slope of the SML will
also change.
– If investors become more risk averse, then the
SML will have a steeper slope, indicating a higher
risk premium, RPi, for the same risk level.
Expected Return New SML
R m’
Original SML
Rm
NRFR
Risk
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Relationship Between Risk and Return
• Changes in Market Condition or Inflation
– A change in the RRFR or the expected rate of
inflation will cause a parallel shift in the SML.
– When nominal risk-free rate increases, the SML
will shift up, implying a higher rate of return
while still having the same risk premium.
Expected Return
New SML

Original SML
NRFR'

NRFR
Risk
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• http://www.ft.com
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• http://money.cnn.com

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