Corporate Finance

Lecture 5

Corporate Finance
Lecture 5 :
Concept of Risk & Return

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Concept of Risk & Return

! In investment, investors always seek 2 types of return
! Yield : Regular income arising from the investment such as
interest & dividend
! Capital gain : Price appreciation of securities invested
Example
Purchased a XYZ Ltd share on 31 Dec 20X1, when they were
valued at $8 a share & by 31 Dec 20X2, the share price
appreciated to $9. In addition, during the year, XYZ Ltd paid a
dividend of $0.50 per share.

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Corporate Finance

Lecture 5

Concept of Risk & Return

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Concept of Risk & Return

! Under a certainty framework or perfect capital market,
decision making is single-dimensional i.e. investments with
higher return preferred
! With risk or imperfect market, decision making becomes twodimensional
! Risks vs returns
! Required return on a security must commensurate with the
risk

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Corporate Finance

Lecture 5

Concept of Risk & Return

! Assuming no risk, an investor can earn risk-free return (Rf)
then a general formula for required return incorporating risk
would be :
Required Return on Risky Investment = Rf + Risk Premium
! Risk is defined as variability in expected return on investments
! Risks can be measured by variance & standard deviation
=> Variance or standard deviation -> Risk
! Total risk of investments
= Unsystematic Risk + Systematic Risk
! Unsystematic risk is also known as diversifiable or specific
risk
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Concept of Risk & Return

! Systematic risk is also known as non-diversifiable market or
residual risk
! Examples
Changes in interest rates
Changes in oil prices etc
! Risk reduction can be achieved through portfolio
diversification provided returns on securities in portfolio are
NOT highly positively correlated
! Investors are not compensated for specific risk since it is
diversifiable
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Corporate Finance

Lecture 5

Concept of Risk & Return

Portfolio
Standard
Deviation
Unique Risk

Market Risk
5

10

15

Number of Securities

Unique risk eliminated but market risk remains

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Concept of Risk & Return

! Often securities returns & prices move in tandem with overall
economy
! Market as a whole is the MOST diversified portfolio with NO
specific risk
! Each security or investment may have different degree of
market or systematic risk
! The systematic risk of the whole market portfolio is Var[Rm]
=> m2
! Risk of a Security X = Var[Rx] => x2

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Corporate Finance

Lecture 5

Concept of Risk & Return

! Risk of Security X relative to market portfolio is measured by
covariance of return of Security X with market return
=> Cov(Rx,Rm) or x,m
! Hence a relative measure of risk of a security X to the market
can be measured as

! provides a measure of relative risk to determine the risk

premium
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Concepts of Risk & Return

Risk of Individual Stocks
1. Total Risk = Diversifiable Risk + Market Risk
2. Market risk is measured by beta, the sensitivity to market
changes
Expected Stock
Return

+10%
-10%

Beta

+10%

-10%

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Corporate Finance

Lecture 5

Concept of Risk & Return

! Hence, academically the relative measure of risk of the
market portfolio to the market portfolio can be measured as

! Any investment with market risk relative to the market

portfolio that is
! Equal will have a = 1
! Higher will have a > 1
!

Lower will have a < 1

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Review of Probability Distributions

! Probability Distributions
! Complete set of probabilities over all possible outcomes for
that particular event
! Discrete Probability Distributions
! Probability is assigned to each possible outcome in the set
of all outcomes
! Continuous Probability Distributions
! Infinite number of possible outcomes, in which the
probability of an event is related to a range of possible
outcomes
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Corporate Finance

Lecture 5

Review of Descriptive Statistics

! Expected Value of a distribution
! Arithmetic mean or average of all possible outcomes
! Outcomes are weighted by the probability that each
outcome will occur

where

n
Xi
P(Xi)

= No. of possible outcomes

= Value of ith possible outcome
= Probability that the ith outcome will occur

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Review of Descriptive Statistics

Possible Outcome (Xi)

Probability of Occurrence P
(Xi)

$5,000

0.10

$7,000

0.25

$8,000

0.30

$9,000

0.25

$11,000

0.10

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Corporate Finance

Lecture 5

Review of Descriptive Statistics

! Standard Deviation ()
! Provides a measure of the spread of the probability
distribution
! Standard deviation -> Dispersion of the distribution

! Variance (2)

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Review of Descriptive Statistics

! Coefficient of Variation
! Provides a measure of the relative dispersion of a
probability distribution
! Risk per unit of return

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Corporate Finance

Lecture 5

Review of Descriptive Statistics - Example

Project A
$1,000
$200
0.20

Expected Value

Coeff. of Variation

Project B
$2,000
$300
0.15

Project B has more absolute risk as its is greater but Project A

has more risk relative to its expected value

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Risk & Return Calculations - Example

Suppose you own a single share in Company A, which has a
current market value of 10 & you expect that the future possible
value of the share & the dividends at the end of the period are
those set out below.
Probabilit
y

End Period
Share Price

End
Period
Dividend

Total Return @ End

of Period

Favourable

0.20

15.00

1.50

(16.50 - 10)/10 = 65%

Normal

0.60

12.50

1.00

(13.50 - 10)/10 = 35%

Unfavourable

0.20

7.50

0.50

(8.00 - 10)/10 = -20%

Market
Conditions

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Corporate Finance

Lecture 5

Risk & Return Calculations - Example

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Risk & Return Calculations - Example

A rationale investor when choosing between two investments

will prefer the one with the lower coefficient of variation
=> Lower risk per unit of return

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