G4. FI2. Risk and Return 2

2/13/2024
Financial Investment
Risk and Return
Objectives
• What are different measures of expected risk and expected return?
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Risk and Return

Measures of Expected Risk and Expected Return
• Following measures of risk and return can be computed for our

expectations:
• Expected Return
• Expected Standard Deviation
• Risk Premium
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Expected Return
• There is always considerable uncertainty about the future price of

a share and the expected dividend. Therefore, we cannot be sure
about eventual return.
• However, we can come up with a measure that can indicate our
expectations about eventual return. This measure is called the
expected return.

Expected Return
• The expected rate of return is a probability-weighted average of

the rates of return in each scenario.
• If ps is the probability of each scenario and rs is the return in each
scenario, the expected return [E(r)] can be obtained as follows:
n
E r    p s * rs
s 1
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Expected Return: Example 1
• Assume that you want to invest in a stock that is selling for $100.
Given the following expectations about the future state of a stock,
compute the expected return.

• In order to compute expected return, we proceed by computing

return in each state as follows:
• Return in excellent state = r1 = [$4.50 + ($126.50 - $100)]/$100 = 0.3100
• Return in good state = r2 = [$4.00 + ($110.00 - $100)]/$100 = 0.1400
• Return in poor state = r3 = [$3.50 + ($89.75 - $100)]/$100 = -0.0675
• Return in crash state = r4 = [$2.00 + ($46.00 - $100)]/$100 = -0.5200
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• The expected return is as follows:

• E(r) = (0.25*0.31) + (0.45*0.14) + (0.25*[-0.0675]) + (0.05*[-0.52])
= 0.0976

Expected Standard Deviation
• The underlying uncertainty in expected returns is measured by

standard deviation (σ). It is defined as the square root of variance.
• Mathematically, standard deviation is computed as follows:
n
 p * r  E(r)
2
σ s s
s 1
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Expected Standard Deviation: Example 1
• Assume that you want to invest in a stock that is selling for $90.
Given the following expectations about the future state of a stock,
compute the standard deviation.
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• In order to compute expected return, we proceed by computing

the return in each state as follows:
• Return in excellent state = r1 = [$4.50 + ($126.50 - $90)]/$90 = 0.4556
• Return in good state = r2 = [$4.00 + ($110.00 - $90)]/$90 = 0.2667
• Return in poor state = r3 = [$3.50 + ($89.75 - $90)]/$90 = 0.0361
• Return in crash state = r4 = [$2.00 + ($46.00 - $90)]/$90 = -0.4667
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• The expected return is as follows:

• E(r) = (0.25*0.4556) + (0.45*0.2667) + (0.25*0.0361) + (0.05*[-0.4667]) =
0.2195
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• The standard deviation is computed as follows:

0 . 25 * 0 . 4556  0 . 2195 2
 0 . 45 * 0 . 2667  0 . 2195 2
σ
 0 . 25 * 0 . 0361  0 . 2195 
2
 0 . 05 *  0 . 4667  0 . 2195 
2
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• Common stock of ADA Corporation will generate the following

payoffs to investors next year.
State of the Economy Dividend Stock Price
Boom $5 $195
Normal Economy $2 $100
Recession $0 $0
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• Calculate the standard deviation of ADA Corporation’s returns.

Assume that the three states of economy are equally likely. The
stock is selling today for $80.
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• During boom period, the return is as follows:

$5  ($195  $80)
 150.00%
$80
• During normal period, the return is as follows:
$2  ($100  $80)
 27.50%
$80
• During recession period, the return is as follows:
$0  ($0  $80)
 100.00%
$80
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• The expected return is given as follows:

E r   0.33 *150 %   0.33 * 27 .50 %   0 .33 *  100 % 
E r   25 .83 %
• The expected standard deviation can be computed as follows:
0.33 * (150 %  25 .83 %) 2  0.33 * ( 27 .50 %  25 .83 %) 2
 
 0.33 * ( 100 %  25 .83 %) 2
  10313 .88  101 .55 %
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Risk Premium
• The risk premium is the expected value of the excess return.
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Risk Premium
• The degree to which investors are willing to commit funds to risky

assets depends on their risk aversion. Investors are risk averse in
the sense that, if risk premium were zero, they would not invest
any money in risky assets.
• In theory, there must always be a positive risk premium on stocks
in order to induce risk averse investors to hold the existing supply
of stocks instead of placing all their money in risk-free assets.
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Risk and Return

Determinants of Expected Return
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• Expected return must compensate an investor for the following:

• Time value of money during the period of investment
• Expected rate of inflation during the period of investment
• Risk of investment
• The summation of these three components is the minimum rate of
return that we should accept from an investment.
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Pure Time Value of Money (Real Risk-free Rate)
• The pure time value of money depends on the real risk-free rate
(RRFR) prevailing in the economy.
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• The RRFR is the basic interest rate, assuming no inflation and no

uncertainty about future flows. An investor in an inflation-free
economy who knew with certainty what cash flows he or she
would receive at what time would demand the RRFR on an
investment.
• This rate represents the pure time value of money, because the
only sacrifice the investor makes is deferring the use of money for
a period of time.
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• The RRFR depends on two factors.

• Subjective Factor
• Objective Factor
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• The subjective factor is the time preference of individuals for the

consumption of income.
• It is based on the answer to the following question: When
individuals give up $100 of consumption this year, how much
consumption do they want a year from now to compensate for that
sacrifice?
• The strength of the human desire for current consumption
influences the rate of compensation required.
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• Time preferences for current consumption vary among

individuals, and the market creates a composite rate that includes
the preferences of all investors.
• This composite rate changes gradually over time because it is
influenced by all the investors in the economy, whose changes in
preferences may offset one another.
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• The objective factor that influences the RRFR is the set of

investment opportunities available in the economy.
• The investment opportunities available are determined by the
long-run real growth rate of the economy. A rapidly growing
economy produces more and better opportunities to invest funds
and experience positive rates of return. Therefore, a change in the
economy’s long-run real growth rate causes a change in all
investment opportunities and a change in the required rates of
return on all investments.
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• Just as investors supplying capital should demand a higher rate of

return when growth is higher, those looking to borrow funds to
invest should be willing and able to pay a higher rate of return to
use the funds for investment because of the higher growth rate
and better opportunities. Therefore, a positive relationship exists
between the real growth rate in the economy and the RRFR.
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Inflation Rate
• If investors expect price level to increase (an increase in the

inflation rate) during the investment period, they would require
the rate of return to include compensation for the expected rate of
inflation.
• Assume that you require a 4 percent real rate of return on a risk-
free investment, but you expect prices to increase by 3 percent
during the investment period. In this case, you should increase
your required rate of return to about 7 percent.
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Inflation Rate
• Therefore, the nominal rates of return that prevail in the market

incorporate inflation rate along with the real rates of return.
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Divergence…
• Temporary changes in the rate of return can also happen due to

monetary or fiscal policies adopted by the governments.
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Divergence…
• As an example, assume that there is an increase in the federal

deficit due to an increase in government spending (easy fiscal
policy). This will increase the demand for capital and increase
interest rates.
• In turn, this increase in interest rates should cause an increase in
savings and a decrease in the demand for capital by corporations
or individuals. These changes in market conditions should bring
rates back to the long-run equilibrium, which is based on the long-
run growth rate of the economy.
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Risk of Investment
• A risk-free investment was defined as one for which the investor is

certain of the amount and timing of the expected returns.
• The returns from most investments do not fit this pattern. An
investor is not completely certain of the income to be received or
when it will be received.
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Risk of Investment
• Most investors require higher rates of return on investments if

they perceive that there is any uncertainty about the expected rate
of return. This increase in the required rate of return over the
nominal rate is the risk premium (RP).
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Risk of Investment
• Although the required risk premium represents a composite of all

uncertainty, it is possible to consider several fundamental sources
of uncertainty. Some of them are as follows:
• Business Risk
• Financial Risk
• Liquidity Risk
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Risk of Investment
• Business risk is the uncertainty of income flows caused by the

nature of a firm’s business.
• The less certain the income flows of the firm, the less certain the
income flows to the investor. Therefore, the investor will demand a
risk premium that is based on the uncertainty caused by the basic
business of the firm.
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Risk of Investment
• For example, a retail food company would typically experience

stable sales and earnings growth over time and would have low
business risk compared to a firm in the auto or airline industry,
where sales and earnings fluctuate substantially over the business
cycle, implying high business risk.
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Risk of Investment
• Financial risk is the uncertainty introduced by the method by

which the firm finances its investments. If a firm uses only
common stock to finance investments, it incurs only business risk.
If a firm borrows money to finance investments, it must pay fixed
financing charges (in the form of interest to creditors) prior to
providing income to the common stockholders, so the uncertainty
of returns to the equity investor increases. This increase in
uncertainty because of fixed-cost financing is called financial risk,
and it causes an increase in the stock’s risk premium.
39

Risk of Investment
• Liquidity risk is the uncertainty introduced by the secondary

market for an investment.
• When an investor acquires an asset, he or she expects that the
investment will mature (as with a bond) or that it will be salable to
someone else. In either case, the investor expects to be able to
convert the security into cash and use the proceeds for current
consumption or other investments.
• The more difficult it is to make this conversion to cash, the greater
the liquidity risk.
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Risk of Investment
• An investor must consider two questions when assessing the

liquidity risk of an investment:
• How long will it take to convert the investment into cash?
• How certain is the price to be received?
• Similar uncertainty faces an investor who wants to acquire an
asset:
• How long will it take to acquire the asset?
• How uncertain is the price to be paid?
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Example 1
• Previous discussion has indicated three factors on which expected

return depends on. Which of these factors are common across all
investments?
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Example 1
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Example 2
• You own stock in the Gentry Company, and you read in the
financial press that a recent bond offering has raised the firm’s
debt/equity ratio from 35 percent to 55 percent. Discuss the effect
of this change on the variability of the firm’s net income stream,
other factors being constant. Discuss how this change would affect
your required rate of return on the common stock of the Gentry
Company.
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Example 2
45

Example 3
• Discuss the two major factors that determine the nominal risk-free
rate (NRFR). Explain which of these factors would be more volatile
over the business cycle.
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Example 3
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Risk and Return

Problems
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Problem 1
Question
• Compute mean and standard deviation of the HPR on stocks.

Suppose your expectations regarding the stock price are as
follows:
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Problem 1
Answer
50
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Problem 2
Question
• Compute 1-year HPR on a 30-year U.S. Treasury bond with a face

value of $1000 and coupon rate of 8%. Assume that it is currently
selling at par and its yield to maturity at the end of a year is as
follows:
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Problem 2
Answer
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Problem 4
Question
• Probabilities for three states of the economy and probabilities for

returns on a particular stock in each state are shown in the table
below.
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Problem 4
Question
• What is the probability that the economy will be neutral and the
stock will experience poor performance?
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Problem 4
Question
• The probability that economy will be neutral is 0.50, or 50%.

• Given a neutral economy, the stock will experience poor
performance 30% of the time. The probability of both poor stock
performance and a neutral economy is, therefore, 0.30 * 0.50 =
0.15 = 15%.
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Risk and Return

References
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References
• Bodie, Z., Kane, A., and Marcus, A.J., (2014). Investments (Chapter
5). 10th Edition, McGraw-Hill/Irwin.
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2/13/2024

• What are different measures of expected risk and expected return?

Risk and Return

Measures of Expected Risk and Expected Return

• Following measures of risk and return can be computed for our

Measures of Expected Risk and Expected Return

• There is always considerable uncertainty about the future price of

Measures of Expected Risk and Expected Return

• The expected rate of return is a probability-weighted average of

Measures of Expected Risk and Expected Return

Measures of Expected Risk and Expected Return

• In order to compute expected return, we proceed by computing

Measures of Expected Risk and Expected Return

• The expected return is as follows:

Measures of Expected Risk and Expected Return

• The underlying uncertainty in expected returns is measured by

Measures of Expected Risk and Expected Return

Measures of Expected Risk and Expected Return

• In order to compute expected return, we proceed by computing

Measures of Expected Risk and Expected Return

• The expected return is as follows:

Measures of Expected Risk and Expected Return

• The standard deviation is computed as follows:

Measures of Expected Risk and Expected Return

• Common stock of ADA Corporation will generate the following

Measures of Expected Risk and Expected Return

• Calculate the standard deviation of ADA Corporation’s returns.

Measures of Expected Risk and Expected Return

• During boom period, the return is as follows:

Measures of Expected Risk and Expected Return

• The expected return is given as follows:

Measures of Expected Risk and Expected Return

• The risk premium is the expected value of the excess return.

Measures of Expected Risk and Expected Return

• The degree to which investors are willing to commit funds to risky

Risk and Return

Determinants of Expected Return

• Expected return must compensate an investor for the following:

Determinants of Expected Return

Determinants of Expected Return

• The RRFR is the basic interest rate, assuming no inflation and no

Determinants of Expected Return

• The RRFR depends on two factors.

Determinants of Expected Return

• The subjective factor is the time preference of individuals for the

Determinants of Expected Return

• Time preferences for current consumption vary among

Determinants of Expected Return

• The objective factor that influences the RRFR is the set of

Determinants of Expected Return

• Just as investors supplying capital should demand a higher rate of

Determinants of Expected Return

• If investors expect price level to increase (an increase in the

Determinants of Expected Return

• Therefore, the nominal rates of return that prevail in the market

Determinants of Expected Return

• Temporary changes in the rate of return can also happen due to

Determinants of Expected Return

• As an example, assume that there is an increase in the federal