Wachemo University Accounting and Finance Department

Chapter Two: Risk and Return

Meaning of Return
It is a gain or loss from an investment made. And it does have two components an income component
and a capital gain or loss component. The income component is cash you receive while owning the
asset while the capital gain or loss component is when the value of asset owned is appreciating in
price or depreciating. For example a stock does provide a dividend to its shareholders during holding
period and capital gain or loss at time of sales.

Measuring Return

1. Historical rate of return

One of the measurements of return is the holding period return (HPR), which represents the return an
investor received for holding an investment for a certain period of time. The formula for determining
the HPR is as follows:
(Sale price−Purchase price )+ Current income
HPR=
Purchase price
Capital gain/loss+ Current income
=
Purchase price
It is important to understand that the HPR is an ex-post return, i.e. a return that has already taken
place. It is sometimes known as the historical return. Another thing that you should be aware of is
that the HPR is a measurement for return over a single period (i.e. 4 months, 5 years, etc.)
Example: At the beginning of the year a stock was selling for birr 40 birr per share and at a time Ato
Abebe purchased 100 shares. Over the year the stock paid dividend 5 birr per share and year-end
market price became 45birr. What is the return of Ato Abebe from the investment?
Dividend = 5* 100= 500
Capital gain = (45-40) * 100 =500
Total return = 500+500 = 1000
Percentage of return: this is summarizing returns in terms of percentage than absolute dollars. It
answers a question of how much do we get for each dollar we invest. Following the previous example
Dividend yield = Dt+1/Pt = 5/40= 12.5%
Capital gain = (Pt+1 -Pt)/Pt = (45-40)/40 = 12.5%
Total return = dividend yield + Capital gain = 12.5%+12.5%= 25%
Total percentage of return = (D t+1 + (Pt+1 -Pt))/ Pt

1 Investment and portfolio management Risk and return

Wachemo University Accounting and Finance Department

Exercise: On February 1, you bought 100 shares of a stock for $34 a share and a year later you sold it
for $39 a share. During the year, you received a cash dividend of $1.50 a share. Compute your HPR
and HPY on this stock investment.

Average rate of return

Dear student do you know what happen if you needed to determine the investment returns over
multiple periods? In other words, what if you are interested in the average returns of an investment
over a number of quarters or years? There are two different measures for average returns: (a)
arithmetic average, and (b) geometric average

Arithmetic Average returns

It is a rate of return calculated for a longer period of time. It is the sum of various one period returns
divided by the number of periods.
n

∑ Rt
Average return (AR) = 1/n * t=1 where n= number of observed years,
Rt= is returns of individual observed years.
Example:
ABC co reported a return of 10%, 12%, 14%, 8% and 6% returns form year 2000 to 2004
respectively. What is the average return of ABC co?
AR= 1/5(10+12+14+8+6) =50/5 = 10%

Geometric average return

Geometric Average = [(1+R1) (1+R2) ---- (1+Rn) 1/n -1
Following the above example average return will be:
= [(1.10) (1.12) (1.14) (1.08) (1.06)] 1/5 = (1.60785) 1/5 -1= 1.0996-1= 9.96

Expected Rate of Return

The relevancy of historical rates for predicting the future is dependent on the market efficiency in
which the investment is made. What does it mean to be efficient? Here the word efficiency mean on
informational efficiency, i.e. how well is information disseminated and reflected. An investment is
considered to be efficient if the price of the investment fully reflect all available information about
that investment. The same goes for a financial market. It is considered to be efficient if the prices of
all the investments fully reflect all available information about the investments.

Suppose Intel Inc. announces that it has developed a new chip which will make computers run 100
times faster than what they can right now. This new development will push the price of Intel stock
from its current price of $100 to about $150 per share. In an efficient market, the jump in the stock

2 Investment and portfolio management Risk and return

Wachemo University Accounting and Finance Department

price is almost instantaneous. However, in an inefficient market, the stock price will rise slowly from
$100 to $150 per share over a period of a few hours or even a few days.

Whenever we are expecting about the future the concept of probability comes into being. A
probability distribution indicates the percentage of chance of occurrence of each possible outcome.
The determination of probability distributions can be driven from either form objective basis or
subjective basis. An objective determination basically relies on past occurrence of similar outcomes
while subjective one is solely dependent on opinions made based on perception. So the expected
value of an investment then can be calculated based on the probability that a particular outcome will
occur. Then it can be said that, the expected value is a statistical measure of the mean or average
value of the possible outcomes. In other words, it is the weighted average of possible outcomes, with
the weight being the probabilities of occurrences.
Algebraically,
n

∑ RiPj
ER= i=1
Where ER= the expected return,
Ri is expected outcome in ith case,
n is the possible outcomes and
Pi is the probability that the ith outcome will occur.

Example: Suppose an investor is considering an investment of 200,000 in the stock of XYZ co. or
ABC co. hoping to gain dividend and selling it at appreciated price after one year. Over the year it is
presumed that the economy will be 20% at boom, 60% at normal and 20% at recession. What is the
expected return from the investment given the following rate of returns in various economic
conditions?

Economic Probabilities Return of Return Expected return Expected return

conditions XYZ of ABC of XYZ of ABC
Boom 0.2 10% -4% 2% -0.8%
Normal 0.6 11% 20% 6.6% 12%
Recessions 0.2 26% 40% 5.2% 8%
ER 13.8% 19.2%
Exercise 1:
You are considering acquiring shares of common stock in the ABC Beer Corporation. Your rate of
return expectations are as follows:

ABC BEER CORP.

3 Investment and portfolio management Risk and return

Wachemo University Accounting and Finance Department

Possible Rate of Return Probability

–0.10 0.30
0.00 0.10
0.10 0.30
0.25 0.30
Compute the expected return [E (Ri)] on your investment in ABC Beer.

Meaning of Risk
From the perspective of financial analysis risk can be defined as, it is the possibility that the actual
cash flow will be different from forecasted cash flows (returns). Therefore if an investment’s returns
are known for certainty the security is called a risk free security. An example on this regard is
government treasury securities. This is basically because virtually there is no chance that the
government will fail to redeem these securities at maturity or that the treasury will default on any
interest payment owed.

When it comes to investments, there are always some levels of uncertainty associated with future
holding period returns. Such uncertainty is commonly known as the risk of the investment. Then the
question will be what causes the uncertainty (or volatility) of an investment’s returns? The answer
depends on the nature of the investment, the performance of the economy, and other factors. In other
words, when you “analyze” the uncertainty of an investment’s return, you will realize that it is made
up of different components. The following are some of the components:
(a) Business risk: This is the uncertainty regarding the earnings (or profitability) of a firm as a
result of changes in demand, input prices, and technological obsolescence.
(b) Default risk: This is the uncertainty regarding an issuing firm’s ability to pay interest,
principal, etc. on its debt instruments.
(c) Inflation risk: This is the uncertainty over future rates of inflation. If the return from an
investment is barely keeping up with the rate of inflation, an investor’s purchasing power will
be eroded as time goes on. In other words, the investor will receive a lesser amount of
purchasing power than what was originally invested because the cost of buying everything has
gone up. Inflation risk is also known as purchasing power risk.
(d) Market risk: This represents the changes in an investment’s price (or market value) as a
result of an event that affects the entire market. An example is the impact of a market
correction or a market crash on an investment’s return.
(e) Interest rate risk: This represents the fluctuation in the value of an investment when market
interest rate changes. This has a big impact on interest-paying investments because as market
interest rate rises (falls), an investor’s money is tied up in a bond that pay less (more) than the
going rate, and hence the value of the investor’s bond decreases (increases).
(f) Liquidity risk: This is the risk of not being able to sell an investment immediately with a
reasonable price.

4 Investment and portfolio management Risk and return

Wachemo University Accounting and Finance Department

(g) Political risk: This is caused by changes in the political environment that affect an
investment’s market value. Political risk can be classified as either domestic or foreign
political risk. An example of domestic political risk is a change in the tax laws, and an
example of foreign political risk is a change in a foreign government’s policy regarding
capital outflow.
(h) Callability risk: This is the risk that an investment is recalled (or retired) prior to the original
stated date. This type of risk is most applicable to long-term bonds and preferred stocks. This
usually happens when the issuing firms find the market conditions favorable in “refinancing”
such investments.
(i) Exchange rate risk: This is the uncertainty regarding the changes in exchange rates that
might affect the value of an investment. Exchange rate uncertainty has an impact on both
domestic and foreign investments.

Measurement of risk
A risk of an investment can be measured in absolute term using standard deviations and variance or
in relative terms using coefficient of variation.

Standard deviation: An absolute measure of risk

Variance and the standard deviation are similar measures of risk and can be used for the same
purposes in investment analysis; however, standard deviation in practice is used more often.
It is the statistical measure of the dispersion of possible outcomes from expected value. It is the
square root of the weighted average square deviations of possible outcomes from the expected value.
It is used to measure the variability of returns from an investment and therefore an indication of risk.
The largest the standard deviation, the more the variability of returns and therefore the riskier the
investment is. A standard deviation of zero indicates no variability and thus no risk involved. A
standard deviation is useful to evaluate investments, which have approximately equaled in expected
returns.

√∑
n
2
( Ri−ER) ∗Pi
SD = i=1

Let us calculate the standard deviation of the above example.

The Probability distribution, can be discrete or continuous, it is discrete in our example. A discrete
probability distribution has a limited number of possible outcomes while a continuous probability
distribution indicates the probability of various possible outcomes.
Standard deviation of XYZ co
 = √ var iance 37.36 = 6.11
Standard deviation of ABC co

5 Investment and portfolio management Risk and return

Wachemo University Accounting and Finance Department

= √ var iance = √ 194.56 =13.95

Economic conditions Pi Ri ER (Ri-ER)2 (Ri-ER)2 * Pi

Boom 0.2 10% 13.8% 14.4 2.888
Normal 0.6 1I% 13.8% 7.84 4.704
Recessions 0.2 26% 13.8% 148.84 29.768
The following table
Variance 37.36 shows the
calculation of expected return and variance for XYZ Company and ABC Company respectively.

Economic conditions Pi Ri ER (Ri-ER)2 (Ri-ER)2 * Pi

Boom 0.2 -4% 19.2% 538.24 107.648
Normal 0.6 20% 19.2% 0.64 0.384
Recessions 0.2 40% 19.2% 432.64 86.528
Variance 194.56

Coefficient of variation: A Relative Measure of Risk

This is a relative measurement. It measures the standard deviation in relation to expected return. It
measures the risk per unit of expected return. So as the coefficient of variation increases, so does the
risk of an asset.
Coefficient of variation= / ER
Which one of the securities is highly risky?
XYZ coefficient of variation = 6.11/13.8=0.44
ABC coefficient of variation =13.95/19.2=0.73

The coefficient of variation of ABC is greater than XYZ means ABC is more risky than XYZ.

Relationship between risk and return

The relationship among risk and return is positive which means an increase of one result an increase
to the other. For this reason there will be always a risk return trade off.
Required rate of return = Risk free rate of return+ Risk premium

6 Investment and portfolio management Risk and return

Wachemo University Accounting and Finance Department

Risk premium is a potential reward that an investor expects to receive when making a risky
investment. This is based on a theory that investors are risk averse that is they expect an average to be
compensated for the risk that they assume when making investment.
Risk free rate of return is the return available on security with no risk of default.
Risk free rate of return= Real rate of return + Expected inflation premium
Real rate of return is the return that investors would require from security having no risk of default
in a period of no expected inflation. Real rate of return is a return necessary to convince investors to
postpone current, real consumption opportunities. It is determined by the interaction of the supply of
funds made available by savers and the demand for funds for investment. The second component of
risk free rate of return is an inflation premium or purchasing power loss premium.

Determinants of Risk premium

It is the potential reward that an investor expects to receive when making a risky investment. And it is
a function of several different risk elements. These factors include:
1.Maturity risk premium
It is the extra yield you will earn from buying a bond with a longer time to maturity. It applies to any
investment that pays a fixed rate of interest and has a fixed maturity date
Generally the longer the time to maturity, the higher the required rate return on the security.
2. The default risk premium
The more the default risk, the higher the required rate of return will be. In this regard the order of
lower risk Treasury bills, Government bonds, High quality corporate bonds, High quality preferred
stocks, Junk bonds, High quality common stocks and speculative common stocks are
examples.Business and financial risk are reflected in the default risk premium applied by investors to
firm securities. The higher these risks are the higher the risk premium and required rate of return on
the firm’s securities.
3. Seniority risk premium
It is the difference in securities with respect to their claim on the cash flows generated by the
company and the claim on the company’s assets in the case of default. The less senior the claims of
the security holders, the greater the required rate of return demanded by the investor in the security.
4. Marketability risk premium

7 Investment and portfolio management Risk and return

Wachemo University Accounting and Finance Department

It is the ability of the investor to buy and sell a company’s securities quickly and without a significant
loss of value .The marketability risk premium can be significant for securities that are not regularly
traded.

8 Investment and portfolio management Risk and return