Chapter 2

Risk and Return

By: Sabela A.
Chapter Objectives

✔ Define the term risk and return

✔ Differentiate the tradeoff between risk and return

✔ Explain measurement of historical and expected returns

✔ Discuss measurement of absolute and relative risk of expected returns

Risk should be directly related to and proportional to the expected return for the investor to
invest
Definitions

Risk: It is the measurable uncertainty which the possibility of the actual cash flow will be
different from forecasted cash flows (returns) of an investment.

Return: It is the benefit associated with an investment.

★ If an investment’s returns are known for certainty, the security is called a risk free
security. E.g. Government treasury bill
★ Many investments have two components of their measurable return:

✔ Capital gain or loss and

✔ Some form of income.

The analysis and measurement of risk and return helps investors to choose the right investment
vehicle that provide optimal benefit.
 Contd.
Return on Investment:
Investments are made with the primary objective of obtaining a return.
Risk:
Risk may relate to loss of capital, delay in repayment of capital, nonpayment of
interest, or variability of returns. It is a measurable uncertainty.
➔ Risk is the possibility of loss or injury, and/or the possibility of not getting
the expected return.
➔ Investments can be represented as
✔ high-risk,
✔ medium-risk and
✔ low-risk investments.
The higher the risk, the higher is the return expected.
Category of Risk
1. Systematic risk

➔ It is caused by factors external to the particular company, and are uncontrollable by the
company.
➔ It affects the market as a whole.
➔ It refers to that portion of the total variability of the return caused by common factors
affecting the prices of all securities.

2.Unsystematic risk

➔ It is caused by factors that are specific, unique and related to the particular industry or
company.
➔ It refers to portion of the total variability of the return caused due to unique factors, relating
to that firm or industry.
➔ It includes factors like management failure, labor strikes, raw material scarcity, etc.
Sources of Risk
a) Interest rate risk

It is the variation in the single period rates of return caused by the fluctuations in
the market interest rate.

b) Market risk

It is the possibility of incurring a loss due to factors that affect the overall
performance of the financial market in which an investor is involved. Market risk
is also known as systematic risk.

c) Purchasing power risk

It refers to the variation in an investor’s expected return caused by inflation. It is

another type of systematic risk and cannot be diversified away.
 Contd.
d) Business risk

It is a function of the operating conditions faced by a company and is the

variability in operating income caused by the operating conditions of the
company.

e) Financial risk

It is a risk associated with the capital structure of the company.

And also there are other risks like Liquidity, Exchange rate and Country risk.
Measurement of risk and return
➔ Return represents rewards for making an investment.
➔ Investments are made with the primary objective of obtaining a return.
➔ Thus, return is the driving force behind every commercial investment.

Return = Yield (Dividend, Interest) + Capital Appreciation( change in price )

Measurement of return and risk

1. Historical rate of return and

2. Expected rate of return

Contd.
1. Historical Rate of Return

A. Holding Period Return (HPR)

The period during which you own an investment is called its holding period, and
the return for that period is called the Holding Period Return (HPR).

For example, if you commit $200 to an investment at the beginning of the year
and you get back $220 at the end of the year, what is your return during one year
holding period?
Contd.

B. Holding Period Yield (HPY)

➔ Expressing HPR in terms of percentage

HPY = 1.1-1= .1 or 10%

➔ This value will always be zero or greater—that is, it can never be a negative value.
➔ A value greater than 1.0 reflects an increase in your wealth, which means that you received a
positive rate of return during the period.
➔ A value less than 1.0 means that you suffered a decline in wealth, which indicates that you had a
negative return during the period.
➔ An HPR of zero indicates that you lost all your money.
Contd.
C. Annual Holding Period Return (Annual HPR)
➔ It is expression of return on annual bases.
➔ It can be calculated by using overall Holding Period Return (HPR) as
follows;

Where: n = number of years the investment is held

Example 2: Consider an investment that cost $250 initially and it worth $350
after being held for two years. Overall HPR, Annual HPR and Annual HPY of the
investment are calculated as follows;
Contd.
Contd.

Consider an investment that costs $1,000 initially, and it is worth

$750 after being held for two years. A multiple year loss over two
years would be computed as follows
Contd.
In contrast, consider an investment of $100 held for only six months that
earned a return of $112:
Computing Mean (Average) Historical Returns
● Over a number of years, a single investment will likely give high rates
of return during some years and low rates of return, or possibly
negative rates of return, during others.

● A summary figure that indicates this investment’s typical experience,

or the rate of return you should expect to receive if you owned this
investment over an extended period of time is the mean annual rate of
return.
Cont’d

For an individual investment, there are two summary measures of return

performance.

1. Arithmetic mean return,

2. Geometric mean return.
To find the arithmetic mean (AM), the sum (Σ) of annual
HPYs is divided by the number of years (n) as follows:
Cont’d
Cont’d
2. Expected Rate of Return

➔ An investor determines how certain the expected rate of return on an investment is

by analyzing estimates of expected returns.
➔ To do this, the investor assigns probability values to all possible returns.
➔ These probability values range from zero, which means no chance of the return, to
one, which indicates complete certainty that the investment will provide the
specified rate of return.
➔ The expected return from an investment is defined as:
Contd.
➔ Let us begin our analysis of the effect of risk with an example of
perfect certainty wherein the investor is absolutely certain of a
return of 5 percent.
➔ Perfect certainty allows only one possible return, and the
probability of receiving that return is 1.0.
➔ Few investments provide certain returns.
➔ In the case of perfect certainty, there is only one value for PiRi:
E(Ri) = (1.0)(0.05) = 0.05
Contd.

In an alternative scenario, suppose an investor believed an investment could provide

several different rates of return depending on different possible economic conditions and
make the following estimate based on historical data.

The expected return will be

Contd.
Variance

Variance describes how much a random variable differs from its expected value. The formula for
variance is as follows:

The variance for the perfect-certainty example of the above Expected Rates of Return discussion would
be:
Contd.
➔ Note that in perfect certainty, there is no variance of return because
there is no deviation from expectations and therefore no risk or
uncertainty.
➔ On the other hand, the variance for the second example of the above
Expected Rates of Return discussion would be;
Standard Deviation
➔ It is also the measure of the amount of variation or dispersion of a set of values.
➔ It is a more preferred measure of risk than variance because it is expressed in
the same unit as the data itself.
➔ It is the square root of the variance:

For the second example, the standard deviation would be:

Coefficient of Variance: A Relative Measure of Risk

➔ If there are major differences in the expected rates of return, it is necessary to use a
measure of relative variability to indicate risk per unit of expected return.
➔ A widely used relative measure of risk is the coefficient of variation (CV);

The CV for the preceding example would be:

Discussion Questions
1. What is return? Discuss

2. What is risk? Discuss

3. Assume you invested 10,000.00 on January 1/2016 and you received 10,800.00 on January
1/2019.

Required: Measure:

A. Measure the holding period return

B. Measure the holding period yield

C. Measure annual holding period return

D. Measure annual holding period yield

4. Assume you invested the same amount of birr (10,000.00) on January 1/2026
and you received 9,200.00 on January 1/2019. And measure the following and
discuss about the difference between this investment and the investment in the
above question.

A. The holding period return

B. The holding period yield

C. Annual holding period return

D. Annual holding period yield

5. Assume an investor earned from his investment for the last four years:

Year Beginning Ending Value HPR HPY

Value
1 10,000 11,000
2 11,000 12,000
3 12,000 11,500
4 11,500 13,000

Required

1. Complete the blank spaces of the above table

2. Compute the arithmetic mean of the above investment

3. Compute the geometric mean

4. Compute its variance and standard deviation

6. Assume an investment has the following future five possible outcomes
ranging from -20% to 30% (multiples of 10) which have equal probability
of occurrence and calculate:

A. Expected rate of rate of return

B. Its risk (both variance and standard deviation)

C. Coefficient of variation