G4. FI1. Risk and Return 1

2/5/2024
Financial Investment
Risk and Return
Objectives
• What are returns?

• How can we adjust returns for various characteristics?
• What are different measures of historic risk and historic return?
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Risk and Return

Returns
Returns
• A return, in its simplest terms, is the money made or lost on an

investment over some period of time (usually expressed as a
percentage of initial investment).
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Returns
• In order to compute return, consider a zero-coupon bond with a

face value of $100 and a price of P0. Assume that time to maturity
is T. The T-period return on this bond is computed as follows:
$100
P0 
1  rT 
$100
 rT  1
P0
Returns
Example 1
• Assume that the prices of zero-coupon bonds with $100 face value
and various maturities are as follows. Compute the return of each
bond.
Maturity Price
0.5 Year $97.36
1 Year $92.52
25 Years $23.20
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Returns
Example 1
• The returns can be computed as follows:

• Return for 0.5 year = [$100/$97.36] – 1
= 2.71%
• Return for 1 year = [$100/$92.52] – 1
= 8.08%
• Return for 25 years = [$100/$23.20] – 1
= 329.18%
Returns
Divergence…
• One commonly quoted measure of return is the Annual

Percentage Rate (APR).
• If there are n compounding periods in a year and the per-period
rate is rT, the APR is given as follows:
• APR = n * rT
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Returns
Divergence…
• Compute the ARR for the security with 0.5 year to maturity and
return of 2.71%.
Returns
Divergence…
• In this case, there are 2 compounding periods. Therefore, ARR is

computed as follows:
• APR = 2 * 2.71% = 5.42%
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Returns
Divergence…
• If there are n compounding periods in a year, the length of each

period (T) is given as follows:
• T =1/n
• For example, if there are two compounding periods in a year (n =
2), the length of each period can be expressed as follows:
• T = 1/2 = 0.5
Returns
Divergence…
• From the above expression for T, we can compute the value of n as

follows:
• n = 1/T
• Inserting the value of n in the equation for APR yields the
following:
• APR = n * rT = (1/T) * rT
• Solving above equation for rT will result in the following:
• rT = APR/n = APR/(1/T) = T*APR
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Returns
Divergence…
• Compute the ARR for the security with 25 year to maturity and
return of 329.18%.
Returns
Divergence…
• In this case, there are 1/25 compounding periods.

• Therefore, ARR is computed as follows:
• APR = (1/25) * 329.18% = 13.16%
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Risk and Return

Adjusting Returns
Adjusting Returns
• Previous example shows that long-term securities offer higher

return than short-term securities. However, such a statement
should be interpreted with caution.
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Adjusting Returns
• Different types of adjustments should be made in returns to obtain

meaningful comparisons. Some of them are as follows:
• Adjustment for Holding Period
• Adjustment for Inflation
• Adjustment for Exchange Rate
Adjusting Returns
Adjustment for Holding Period
• In order to correctly compare returns of securities with different

maturities, we need to convert each return into an Effective
Annual Rate (EAR).
• An EAR is the percentage increase in funds invested over a 1-year
horizon (with yearly compounding).
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Adjusting Returns
Adjustment for Holding Period
• We can relate EAR to the total return over a holding period of

length T (rT) by using the following expression:
• EAR = (1 + rT)1/T – 1
Adjusting Returns
Adjustment for Holding Period: Example 2
• Compute the EAR for the following returns:

• Return for security with 0.5 year maturity = 2.71%
• Return for security with 25 year maturity = 329.18%
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Adjusting Returns
• The EAR for a security with 0.5 year maturity is computed as

follows:
• EAR = (1 + 0.0271)1/0.5 – 1
= 5.49%
Adjusting Returns
• The EAR for a security with 25 years maturity is computed as

follows:
• EAR = (1 + 3.2918)1/25 – 1
= 6.00%
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Adjusting Returns
Divergence…
• There is a link between EAR and APR. From our previous

discussion, we found that return over a holding period (rT) can be
computed as follows:
• rT = T*APR
• We can insert the value of rT in the equation for EAR to arrive at
the relationship between EAR and APR.
Adjusting Returns
Divergence…
• The equation for EAR can be expressed as follows:

• EAR = (1 + rT)1/T – 1
= (1 + [T*APR])1/T – 1
• Above equation can be simplified to the following:
• (1 + EAR) = (1 + [T*APR])1/T
• (1 + EAR)T = (1 + [T*APR])
• (1 + EAR) – 1 = T*APR
T
• Therefore, the exact relationship will be as follows:

• APR = [(1 + EAR)T – 1]/T
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Adjusting Returns
Adjustment for Inflation
• The returns obtained in the previous examples are not adjusted

for inflation. These unadjusted returns are called as the nominal
returns (rN).
Adjusting Returns
Adjustment for Inflation
• In order to adjust the nominal returns (rN) for inflation rate (i), we
can use the following equation. The resulting returns are called as
the real returns (rR).
rR 
1  rN   1
1  i 
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Adjusting Returns
Adjustment for Inflation: Example 1
• Consider a U.S. investor who invested in UAE Telecom at 175.86

Dhs last year. One year later, UAE Telecom is selling at 195.24 Dhs.
What is the nominal return of this investment? What is inflation
adjusted return, if the inflation during this time period was 10%.
Adjusting Returns
Adjustment for Inflation: Example 1
• The nominal return (rN) for the U.S. investor can be computed as
follows:
195.24 Dhs - 175.86 Dhs 
rN     11.02%
 175.86 Dhs 
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Adjusting Returns
Adjustment for Exchange Rate: Example 1
• The inflation adjusted return (rR) can be computed as follows:
1  0.1102 
rR     1  0.92%
 1  0.10 
Adjusting Returns
Adjustment for Exchange Rate
• Sometimes, investors hold assets in other countries. The returns

obtained in foreign countries should be adjusted for exchange rate
fluctuations.
• It is important to make such adjustment because exchange rate
fluctuations can convert a gain into a loss or a loss into a gain.
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Adjusting Returns
Adjustment for Exchange Rate
• To calculate the return to a local investor (RLC) from an investment

in an asset in foreign country, we can use the following equation:
S C 
R LC   FC, t 1 * FC, t 1   1
 SFC, t C FC, t 
• In the above expression, SFC,t is the value of foreign asset in foreign

currency at time t and CFC,t is the exchange rate of foreign currency
at time t.
Adjusting Returns
• Consider a U.S. investor who invested in UAE Telecom at 175.86

Dhs when the value of the dirham stated in dollars was $0.29.
• One year later, UAE Telecom is selling at 195.24 Dhs. The dirham is
now at $0.27. What is the total return in dollars?
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Adjusting Returns
• The return for the U.S. investor after adjusting for exchange rate is
be computed as follows:
S C 
R LC   FC,t 1 * FC, t 1   1
 SFC,t C FC, t 
195.24 Dhs $0.27 
R LC   *   1  3.36%
175.86 Dhs $0.29 
Risk and Return

Measures of Historic Risk and Historic Return
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• Following measures of risk and return can be computed on the

time series data:
• Holding Period Return
• Arithmetic Average Return
• Geometric Average Return
• Dollar-Weighted Return
• Excess Return
• Standard Deviation of Returns
• Coefficient of Variation

Holding-Period Return
• Assume that you invested in a stock at the start of a year. The

realized rate of return (also known as the holding-period return,
HPR) on your investment is defined as follows:
D1  P1  P0 
HPR 
P0
• In the above equation, D1 is dividend paid during the holding

period, P0 and P1 are starting-period and end-period prices,
respectively.
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Holding-Period Return
• The equation of HPR can be modified as follows:

D1  P1  P0  D1 P1  P0 
HPR   
P0 P0 P0
• The component of return that is due to dividends is called the

dividend yield.
• The component of return that is due to change in price is called
the capital gain/loss yield.

Holding-Period Return: Example 1
• At the start of the year, the fund was selling for $100 per share.
Suppose that it is the end of a year and the price per share is $110.
Also suppose that the cash dividend over the year amount to $4.
What is the HPR?
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• The HPR is given as follows:

$4  $110  $100
HPR   0.14
$100

• At the beginning of the year, Apple stock traded for $90.75 per
share, and Wal-Mart was valued at $55.33. During the year, Apple
paid no dividends, but Wal-Mart shareholders received dividends
of $1.09 per share. At the end of the year, Apple stock was worth
$210.73 and Wal-Mart sold for $52.84. What is the HPR for both
stocks?
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• We can calculate the HPR for each stock as follows:

• HRPApple = [$0 + ($210.73 – $90.75)] / $90.75
= 132.20%
• HRPWal-Mart = [$1.09 + ($52.84 – $55.33)] / $55.33
= –2.50%

Arithmetic Average Return
• In historical data, we treat each observation as an equally likely

scenario. So if there are n observations, the probability of each
observation is 1/n. The expected return is estimated by the
arithmetic average of the sample rates of return:
1 n
E(r)   rs
n s1
• In the above expression, E(r) is the arithmetic average return and

rs is the return of observation ‘s’.
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Arithmetic Average Return: Example 1
• Compute the arithmetic average of the following returns:

Arithmetic Average Return: Example 1
• The arithmetic average of the returns is as follows:

• E(r) = (1/5)*[(-0.1189) + (-0.2210) + 0.2869 + 0.1088 + 0.0491] = 0.0210
• Above value can also be obtained as follows:
• E(r) = [0.2*(-0.1189)] + [0.2*(-0.2210)] + [0.2*0.2869 ] + [0.2* 0.1088] +
[0.2* 0.0491] = 0.0210
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Geometric Average Return
• The arithmetic average provides an unbiased estimate of the

expected future return. However, it does not tell us much about the
actual performance of an asset over the past sample period.

• As an example, consider that returns generated by ADA

Corporation over the period of last 2 years were -50% for the first
year and +100% for the second year. The arithmetic average
return will be 25% [=(-50% + 100%)/2].
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• Arithmetic average return does not tell us much about the growth
rate for investor’s investment in ADA Corporation. In order to find
the growth rate for investor’s investment, we need to compute the
geometric average.

• Geometric average is the annual return that would compound

over the period to the same terminal value as obtained from
the sequence of actual returns in the time series.
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• In our case, if we invested $1 in ADA Corporation, the final

investment would have been the following:
• Final Value of Investment = $1*(1 - 0.50)*(1 + 1) = $1
• The annual return (g) that result in above final value is given as
follows:
• (1 + g)2 = $1*(1 - 0.50)*(1 + 1) = $1
• Solving above equation yields g = 0%.

• Above example can be generalized as follows:
g  (1  r1 ) * (1  r2 ) * ... * (1  r n )  1
1/n
• Each return has an equal weight in the geometric average. For this
reason, the geometric average is referred to as a time-weighted
average.
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Geometric Average Return: Example 1
• Assume that annual returns of S&P500 for the first five years of
1970s were as follows:
• Y1970 = 3.51%
• Y1971 = 14.12%
• Y1972 = 18.72%
• Y1973 = -14.50%
• Y1974 = -26.03%
• What annual geometric average did S&P500 generate for these
years?

Geometric Average Return: Example 1
• The geometric average is computed as follows:

1/5
(1  0.0351) * (1  0.1412) * (1  0.1872) 
g  -1
* (1 - 0.1450) * (1 - 0.2603) 
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• The difference between geometric average and arithmetic average

depends on the variance of returns (σ2).
• E(Geometric Average) = E(Arithmetic Average) – 0.5σ2
• Above equation indicates that greater the volatility of returns,
greater the difference between geometric average and arithmetic
average.

Divergence…
• Arithmetic and geometric averages can be used to compute risk

premium. However, there can be dramatic differences between the
two methods.
• Arithmetic mean is a better predictor of risk premium in the next period.
• Geometric mean is considered to be a better predictor of risk premium in
the long-run.
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Dollar-Weighted Return
• Dollar-weighted return is the internal rate of return (IRR) of the

investment.

Dollar-Weighted Return: Example 1
• Assume that you bought a stock for $50 two years back. At the end
of first year, you received a dividend of $2. You also purchased
another share of the same stock for $53 at the end of first year.
• At the end of second year, you sold each share for $54. You also
received $2 dividend per share at the end of second year. What is
the dollar-weighted return?
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• Total cash outlays from this investment are as follows:

• Using the discounted cash flow (DCF) approach, we can solve for
the average return over the 2 years by equating the present values
of the cash inflows and outflows:
53 2 4 108
NPV  0  -50    
1  r  1  r  1  r  1  r 2
2
 r  7.117%
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Standard Deviation of Returns
• Using the historical data with n observations, we can estimate

variance (σ2) as follows:
1 n
σ2   rs  E(r)2
n s 1
• In the above expression, E(r) is the average return and rs is the
return of observation ‘s’.

• Standard deviation is the square root of variance.
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Standard Deviation of Returns: Example 1
• Suppose a series generated the following sequence of returns.

Compute the variance and standard deviation of the series.
Month-1 40%
Month-2 10%
Month-3 10%
Month-4 – 20%

• Average return for the series is given as follow:

1
E(r)  * 40%  10%  10%  20%
4
 E(r)  10%
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• Variance can be calculated as follows:

Rate of Expected Deviation from Expected Squared Deviation
Return Return Return
+40% +10% +30 (+30)² = 900
+10% +10% 0 (0)² = 0
+10% +10% 0 (0)² = 0
-20% +10% -30 (-30)² = 900
1
σ 2  * 900  0  0  900
4
 σ  450
2

• Standard deviation can be calculated as follows:

• σ = √450 =
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Divergence…
• We would like to mention that variance estimate from previous

equation is biased. The reason is that we have taken deviations
from the sample arithmetic average, instead of true average.
Therefore, we have introduced an estimation error. This is
sometimes called a degrees of freedom bias.

Divergence…
• We can eliminate the degrees of freedom bias by multiplying the

variance by the factor n /( n - 1).
 n  1 n
2 
σ2   
 n  1  n
 r
s 1
s  E(r)  

1  n
2 
σ2    rs  E(r)  
n  1  s 1 
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Divergence…
• For large observations, this bias is relatively small. Therefore, we

can safely ignore it and can use ‘n’ in the denominator.

• If returns are normally distributed, as is shown in the next figure,

we can obtain useful information about future returns from
historic returns and standard deviations.
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• The previous figure indicates that:

• There is 68.26% of chance that future return will be -1σ and +1σ around
the mean.
the mean.
the mean.
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• The continuously compounded annual return on a stock is

normally distributed with a mean of 20% and standard deviation
of 30%. With 95.44% confidence, we should expect its actual
return in any particular year to be between which pair of values?
• -40.0% and 80.0%
• -30.0% and 80.0%
• -20.6% and 60.6%
• -10.4% and 50.4%

• With probability 0.9544, the value of a normally distributed

variable will fall within two standard deviations of the mean; that
is, between –40% and 80%.
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Divergence…
• There may be arguments that past risk is not a good indicator of

future risk. As indicated in the next figure, the relative riskiness of
equities and bonds has changed over time.
• Until the 1960s, the annual returns on common stocks were about
four times more volatile than those on bonds. Since then, common
shares have only been twice as variable as bonds.

Divergence…
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Coefficient of Variation
• While comparing risk of an investment, it is advisable to interpret

standard deviation in the context of the average return of the data.
In order to do so, we standardize standard deviation by average
return.
• Coefficient of Variation allows us to determine how much risk we
are assuming in comparison to the amount of return we expect
from our investment.

• The coefficient of variance (CV) is the ratio of standard deviation

of returns (σ) to average returns [E(r)]:
• CV = σ / E(r)
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• It is important to use the coefficient of variation while comparing

risk because standard deviation (and the variance) suffers from
the scale problem.
• The scale problem refers to the fact that the size of standard
deviation is a function of the magnitude of returns used to
calculate the standard deviation. Higher is the magnitude of
returns, higher is the standard deviation. Therefore, the standard
deviation may give an incorrect impression of the riskiness of an
investment.

• In order to illustrate the scale problem, consider the following

data. Is XYZ twice as risky as ABC?
Potential Returns
Prob ABC XYZ
10% -12% -24%
15% -5% -10%
50% 2% 4%
15% 9% 18%
10% 16% 32%
E(r) 2.0% 4.0%
Variance 0.00539 0.02156
Std. Dev. 7.34% 14.68%
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• The answer is: No.

• The coefficient of variation (CV) provides a scale-free measure of

the riskiness of a security.
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• For previous example, the coefficient of variation (CV) for XYZ and
ABC are identical, indicating that they have exactly the same
degree of riskiness.
• The CV of both investments is 2.724796.

Coefficient of Variation: Example 1
• Mr. ADA is reviewing stocks for inclusion in his investment

portfolio. The stock he wishes to analyze is OF Corporation. One of
his key concerns is risk. As a rule, he will invest only in stocks with
a coefficient of variation below 0.75.
• His analysis shows that average return of OF Corporation is
10.50% and associated standard deviation is 4.51%. Should he
invest?
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Coefficient of Variation: Example 1
• Coefficient of variance is the ratio of standard deviation and

expected return.
4.51%
CV   0.4295
10.50%
• Mr. ADA should accept this investment.

Excess Return
• The difference between the actual rate of return on a risky asset

and the risk-free rate is called the excess return. The standard
deviation of the excess return is a measure of its risk.
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Risk and Return

References
References
• Bodie, Z., Kane, A., and Marcus, A.J., (2014). Investments (Chapter
5). 10th Edition, McGraw-Hill/Irwin.
43

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2/5/2024

• What are returns?

Risk and Return

• A return, in its simplest terms, is the money made or lost on an

• In order to compute return, consider a zero-coupon bond with a

• The returns can be computed as follows:

• One commonly quoted measure of return is the Annual

• In this case, there are 2 compounding periods. Therefore, ARR is

• If there are n compounding periods in a year, the length of each

• From the above expression for T, we can compute the value of n as

• In this case, there are 1/25 compounding periods.

Risk and Return

• Previous example shows that long-term securities offer higher

• Different types of adjustments should be made in returns to obtain

• In order to correctly compare returns of securities with different

• We can relate EAR to the total return over a holding period of

• Compute the EAR for the following returns:

• The EAR for a security with 0.5 year maturity is computed as

• The EAR for a security with 25 years maturity is computed as

• There is a link between EAR and APR. From our previous

• The equation for EAR can be expressed as follows:

• Therefore, the exact relationship will be as follows:

• The returns obtained in the previous examples are not adjusted

• Consider a U.S. investor who invested in UAE Telecom at 175.86

• The inflation adjusted return (rR) can be computed as follows:

• Sometimes, investors hold assets in other countries. The returns

• To calculate the return to a local investor (RLC) from an investment

• In the above expression, SFC,t is the value of foreign asset in foreign

• Consider a U.S. investor who invested in UAE Telecom at 175.86

Risk and Return

Measures of Historic Risk and Historic Return

• Following measures of risk and return can be computed on the

Measures of Historic Risk and Historic Return

• Assume that you invested in a stock at the start of a year. The

• In the above equation, D1 is dividend paid during the holding

Measures of Historic Risk and Historic Return

• The equation of HPR can be modified as follows:

• The component of return that is due to dividends is called the

Measures of Historic Risk and Historic Return

Measures of Historic Risk and Historic Return

• The HPR is given as follows:

Measures of Historic Risk and Historic Return

Measures of Historic Risk and Historic Return

• We can calculate the HPR for each stock as follows:

Measures of Historic Risk and Historic Return

• In historical data, we treat each observation as an equally likely

• In the above expression, E(r) is the arithmetic average return and

Measures of Historic Risk and Historic Return

• Compute the arithmetic average of the following returns:

Measures of Historic Risk and Historic Return

• The arithmetic average of the returns is as follows:

Measures of Historic Risk and Historic Return

• The arithmetic average provides an unbiased estimate of the

Measures of Historic Risk and Historic Return

• As an example, consider that returns generated by ADA

Measures of Historic Risk and Historic Return

Measures of Historic Risk and Historic Return

• Geometric average is the annual return that would compound

Measures of Historic Risk and Historic Return

• In our case, if we invested $1 in ADA Corporation, the final

Measures of Historic Risk and Historic Return

• Above example can be generalized as follows:

Measures of Historic Risk and Historic Return

Measures of Historic Risk and Historic Return