Chapter 3 Risk-Return Analysis 53

e expected return 1S greater at 20.56%, the range of returns is 18% (i.e. 30% - 12%)and the standard deviation is
rer at 4.31%. The investment carries lesser risk in terms of lowvariation in return.
stration 3-7 The possible returns and associated probabilities of Securities Xand Yare given below:
Security X Security Y
obability Return % Return %
Probability
0.05 6 0.10 5
0.15 0.20 8
10
0.40 15 0.30 12
0.25 18 0.25 15
0.10 20 0.10 18
0.05 24 0.05 20
alculate the expected return and standard deviation of Security X and Y.

alculation of Expected Return and Standard Deviation of Security X

ProbabilitytReturn % ( P x R)t n (R-X) (R-R)2xP
(P) (R)
0.05 6 0.30 -9.5 ilclr,4.5125
0.15 10 1.50 -5.5 4.5375
0.40
0.25 18 4.50 2.5
T 0.10 20 t 2.000 10 4.5 2.0250
0.05 24
8.5 3.6125
1.00 X= 15.5 Z(R -R)²P = 16.35
Expected Return of Security X(R) = 15.5%
Standard Deviation of Security X
G = 16.35
16.35 = 4.04%

Calculation of Expected Return and Standard Deviation of Security Ý

Probability
(P)
Return %
(R) o) A
(PxR) (R -R) (R-RY² xP
sigisv/
0.10 5 -0.50 -7.25
0.20 8 5.2563
1.60 -4.25
0.30 12 3.60 3.6125
0.25 -0.25
15 3.75 800 0.0188
2.75
0.10 18 1.80 0E,0
1.8906
0.05 5.75
20 3.3063
1.00
7.75
1.00 R 3.0031
12.25valaise in k
E(R-X2p = 17.0876
Expected Return of Security Y (R) = 12.25%
Standard Deviation of Security Y
= 17.0876
o= 17.0876 = 4.134%
Analysis -Security
- Ahas higher expected return andlower leyel of
 118
INVESTMENT MANAGEMENT
ILLUSTRATIONS

lllustration 5.1: The return from security Z can be provided in different time periods:
What would be the average expected risk and return of the security.
Time perlod - 2006 Return Probability
Jan 0.25 0.10
Feb 0.15 0.40
Mar 0.10 0.30
April 0.05 0.20

Solutlon: The expected risk and return of the security can be measured in terms of standard deviation and welchtod
average return.
Colunn 1 2 3 4 (2 X 3) Col. 3 (Col. 2 - Avg. 0.125)2
Time period Return Probablllty Avg. Return
Jan 0.25 0.1 0.025 0.1 (0.25 - 0.125) 2 = 0.0015625
Feb 0.15 0.4 0.060 0.4 (0.15 0.125) 2 = 0.00025
Mar 0.10 0.3 0.030 0.3 (0.10 - 0.125) 2 = 0.0001875
April 0.05 0.2 0.010 0.2 (0.05 - 0.125) 2 = 0,001125
Total 0.125 0.003125
Step 1: Average return = 0.125 or 12.5%
Step 2: Probability = (Return Average)2
Step 3: Risk = VO.003125 = 5.59%
IMustration 5.2: The return on two securities X' and 2' are given below select the security according to risk and
eturn:

Return on Security X' Return on Security 2' Probability

(%) (%)
5 1 0.5
4 3 0.4
3 0.1

Solution:
(1) Return RP, + R,P, + RgP3
(ii) Security 'X' = 5 >X 0.5 + 4 x 0.4 + 0 X 0.1
= 2.5 + 1.6 + 0
= 4.1
Security '2 = 1 x 0.5 + 3 x O.4 + 3 x 0.1
= 05 + 1 2 + 0.3
 119

P,(R, - Er)2
Er)2
Security (R, - 0.405
= 0.81 0.004
(5 - 4.1)2 = 0.01
RISK P
1.681
0.5 (4 - 4.1)2
= 16.81 2.09
5 0.4 (0 - 4.1)2
4 0.1

Total - Er)2
Er)2
P,(R,
(b) Security 2' Security (R, - 0.5
P; = 1 0.4
(1 - 2.0)2 0.1
1
0.5 (3 - 2.0)2 = 1
1 0.4 2.0)2 = 1.0
3
(3 -
0.1
3
Total

Risk
= 1.44
Security X = 2.09 for risk will prefer
security X.
1.0 appetite
Security 2' = 1.0 = who has an probabilities.
risk is also high. An individual are their rates of return and
higher but securities. The following
Security XReturn is choose from 2
Investor has to
Illustration 5.3: An P
Probability
Return %
Return %
Probability 0.1
13
0.1 0.2
20 16
0.4 0.3
16 22
0.3 0.4
10 25
0.2
3

security Q or P? The securities are

(a) Which is the better securities will show which security is the best.
and risk of the
Solution: An analysis of return
named C and P
Analysis of Security Q
Average Return Prob. (Return - Average)?
R P
(3) (4)
(1) (2) 0.00064
0.020 0.1 (0.20 - 0.12)2
0.20 0.10 0.00064
0.064 0.4 (0.16 - 0.12)2 =

0.16 0.40 0.00012

0.030 0.3 (0.10 - 0.12)2
0.10 0.30
0.2 (0.03 0.12)2 0.00162
0.03 0.20 0.006
= 0.00302
Total 0.120

Step 1:
Expected return = 0.120 or 12%
and risk 9' VO.00302 = 0.054 or 5.4%
 119

R P,(R, - Er)2
P Security (R, - Er)2
5 0.405
4 0.5 (5 - 4.1)2 = 0 .81
0.004
0 0.4 (4 - 4.1)2 = 0.01
0.1 (0 4.1)2 = 16.81 1.681
Total 2.09
(b) Security Z

Pi Security (R, - Er)2 P,(R, - Er)?

0.5 (1 - 2.0)2 = 1 0.5
3
0.4 (3 - 2.0)2 = 1 0.4
3
0.1 (3 - 2.0)2 = 1 0.1
Total
1.0
Risk

Security X = J2.09 = 1.44

Security 2 = J1.0 = 1.0
Security X Return is higher but risk is also hiah. An individual who has an appetite for risk will prefer
security X
Illustration 5.3: An Investor has to choose from 2 securities. The followina are their rates of return and
probabilities.
Q P
Return %
Probability Return % Probability
20 0.1 13 0.1
16 0.4 16 0.2
10 0.3 22 0.3
3 0.2 25 0.4
(a) Which is the better security Q or P?
Solution: An analysis of return and risk of the securities will show which security is the best.
named Q and P The securities ar

Analysis of Security Q
R P Average Return Prob. (Return Average)2
(1) (2) (3) (4)
0.20 0.10 0.020 0.1 (0.20 - 0.12)2 0.00064
0.16 0.40 0.064 0.4 (0.16 0.12)2 0.00064
0.10 0.30 0.030 0.3 (0.10 0.12)2 0.00012
0.03 0.20 0.006 0.2 (0.03 - 0.12)2 0.00162
Total 0.120 0.00302
Step 1:
Expected return= 0.120 or 12%
and risk '0' - 0 00802 = 0.054 or 5.4%o
 120
e Expected
andreturn

risk
y
0'
808
'P'
0.211or
as 21.1% 0.25 0.22 0.16 0.13
(1)
it
is
he0.0425
4.25% or
t.
Total

0.4 0.3 0.2 0.1 P

(2)
is Analysis
Securityof
Average
Return
0.211 0.1000.0660.0320.013 (3)

P
s

0.4 0.30.1(0.13
(0.160.2 - -
Prob.
(0.25(0.22
(Return
- -
0.211)2
0.211)2 0.211)2
0.211)2 (4)
-
Average)2
0.001808
0.000608
0.000024 =
= =0.000656 =
0.000520
 securities?
these

turn
xpected
Average Solution: eXpected
Illustration retur
The

is
37%

and
5.5:
Return
return 0.45 0.40 0.35 0.30 0.25 Securities Find
risk
is 5 4 3 2 1 risk
8% =
0.37 and
the or return
Total
37% Prob.
stor
0.25 0.15 0.40 0.15 0.05 of
and the
uld risk following
Return
Prob. X Return %
or
nue 45 40 35 30 25
tandard0.3700 0.1125
0.06000.14000.04500.0125 5
securities.
with
eviation
this
Give
lio.
isTotal 0.25 0.15 0.40 0.15 0.05 an
'0'
(0.45(0.40 (0.35 (0.30 (0.25 P analysis.
= (Return Probability
.00335 0.25 0.15 0.40 0.15 0.05
-
0.37)20.37)0.37)20.37)20.37)2 Should
-
Avg.)"
0.00335
5.78%
= 0.0016
= = 0.00016
0.000135 0.000735 = =
= =0.00072 the
investor

koc.
RISK
121
INustratlon 5.6: The market price of a share is A 155. Following information is available
Jidends and market price after one about market condition,
year (year-end). Find the expected return of the share and the variability of the return.
Market Condition Probablllty Market Prlce Divldend (A)
Bullish 0.25 200 15
Stable 0.50 160 10
Bearish 0.25 5
150
Solution:
The expected return of the equity share may be as
follows:
Market
Probability Total Return = Market Price Net Return
Condition Market Price + Dividend of Share
Bullish 0.25 200 + 15 = 215 155 60
Stable 0.50 160 + 10 = 170 155 15
Bearish 0.25 150 +5 = 155 155
Expected return = (60 X 0.25) + (15 x 0.50) + (0 x 0.25)
= 15 7.5 + 0 = 22.5%
The variability of returns will be studied in terms of standard deviation.
2 = 0.25(60 - 22.5)2 + 0.50(15 - 22.5)2 + 0.25(0 - 22.5)2
= 0.25 x 1406.25 + 0.50 × 56.25 + 0.25 x 506.25
= 351.562 + 28.125 + 126.562

J506.249 = 22.49% Ans.

Illustration 5.7: Calculate Risk and Return for the following:
Monthly Return (x-)?
3.17 -4.71 22.18
-14.63 13.09 171.35
3.27 -4.81 23.14
-3.27 1.73 2.99
-15.77 14.23 202.49
-4.15 2.61 6.81
2.36 -3.09 15.21
-7.33 5.82 33.87
-10.9 9.44 89.11
26.47 -28.01 784.56
8.01 -9.05 90.25
-5.62 4.08 16.65
-18.39 0.07 1458.61

Average: = -18.39/12 = - 1.53

EX-% |1458.61
=11.51
N-1 12-1
Company A
(ri) (Pi) (Pi) (ri)
6.00 0.10 0.60
7.00 0.25 1.75
8.00 0.30 2.40
9.00 0.25 2.25
10.00 0.10 1.00
8.00
 INVESTMENT MANAGEMENT
122
Company B
(Pi) (ri)
(PI)
(ri) 0.40
0.10 1.20
4.00 0.20
6.00 3.20
0.40 2.00
8.00 0.20
10.00 1.20
0.10
12.00 8.00

In the example given about the expected means are the same in both the companies. The A company's return varies
standard do:es
from 4% to 12%. To find out the variation, the
from 6% to 10% while the B companv's return varies
technique is applied.
N
o=Plr-E(r))'
Vi=l

Variance o²- jPr-Ej

Hence o=/Variance(o)
For Company A
ri P! ri - E(r) ri - (E(r)]2 P1[ri - (E()]2
6 0.1 -2 4 0.4
0.25 -1 1 0.25
0.3 0
9 0.25 1 1 0.25
10 0.1 2 4 0.4
1.3
N
o'=}Plr-El)
ViEl
= 1.30 =1.14
For Company b
P! ri - E(r)
4
ri - (E(r)]2 P1 [ri - [E(r)]"
0.1 -4
6 16 1.60
0.2 -2
8 4 0.80
0.4
10 0.2 0.00
2 4
12 0.1 0.80
16 1.60
N 4.80
o'-Er-E) -/4.80 =2.19
haracteristic Regression Line (CRL)
The
e market characteristic
index return regression line or CRL is a simple
to mneasure its linear regression model against
diversifiable and
undiversifable risks. The
estimated for a particular stock
B =
model is:
Return of the ith stock
a = Intercept
B, = Slope of the
ith stock
R = Return of the
matket index
 CorporateFinance
Principlesof
DivisionOne
52
614 102.33
= 10.12%
Variance (o') 6
/102.33
=/Variance anticipated returns and
Vo' Aluminium Ltd., its
Deepak
equity shares of 20 30
Illustration 3-5 Mr.
Kishore invested in 15
given below: 10 0.05
associated probabilities are -10
5 0.30
-15 0.25
Return % 0.15 deviation.
0.05 0.10 standard
terms of
Probability and risk in
of return
required to calculate the expected rate Standard Deviation
You are Risk in terms of (R - R)² xp
Calculation of Expected
Return and (R - R)²
(R -X)
(Px R)
Return Probability 1.5125
(P) 30.25
(R) -5.5
-0.75 0.25 0.0250
-15 0.05
-1.00
-0.5 3.0375
-10 0.10 20.25
0.75 -4.5
5 0.15 0.25 0.0625
2.50 0.5
10 0.25 9.0750
30.25
0.30 4.50 5.5
15
110.25 11.0250
20 0.10 2.00 10.5
20.5 420.25 21.0125
30 0.05 1.50
1.00 R=9.5% E(R-R)?P = 45.75
Expected Return (R)= E(Px R ) =9.5%
Standard Deviation =
E(R-R)? P =45.75 = 6.764 i i t ) i
The risk in the above illustration, can be measured by taking the range of 459% i.e. 30% -
deviation of 6.764. The investment carries greater risk in terms of high variation in return. (-)15%] and standard
Illustration 3-6 The probabilities and associated returns of Agri Gold Ltd.
aregiven below:
Return % 12 15 18 20 24 26
Probability 0.05 0.10 0.24 0.26
30
0.18 0.12
Calculate the standard deviation. 0.05

Return
(R) Probability (P x R)
(P) (R- R)
12
0.05
(R - R)² x P
15 0.60
0.10 -8,56
18 1.50
0.24 3.664
20 -5.56
0.26 4.32 3.091
24
0.18 5.20 -2.56
26 1.573
4.32 -0.56
30 0.12 0.082
0.05 3.12 3.44
2.130
1.00 1.50 5.44 3.551
Expected Return (R) = 2(Px R) X= 20.56% 9.44 4.456
= 20.56%
Standard Deviation = E(R- X)?P E(R-R)P = 18.547
=18.547 = 4.31%