CHAPTER 5

OVERVIEW
OF RISK
AND
RETURN
 INTRODUCTION
• Morgan Stanley's Chief Executive, James Gorman,
expressed concerns over the firm's revenue growth in weak
markets in 2016.

• The firm faced challenges in fixed-income markets and

underwriting due to sliding commodity and oil prices,
concerns about the Chinese economy, and uncertainty about
US interest rates.

• Morgan Stanley's return on equity (ROE) was 6.2%, below its

target of 9% to 11% by the end of 2017.

• Gorman emphasized the need for aggressive cost-cutting

measures to improve shareholder return.

• Morgan Stanley is a global financial services firm with offices

worldwide, including a Southeast Asia hub in Singapore.
Chief Executive James Gorman
• They provide financial advice, capital management, and
investment banking services to governments, institutions, and
individuals globally.
The following are the Investors should go through in making an
investment decision:

1. Set objectives.
2. Identify available resources.
3. Evaluate various investment alternatives-stocks, bonds, mutual
funds, pension funds, T-notes and T-bonds, T-bills, CPs, security
derivatives, MMMFs, CDs, precious metals, futures, options, and the
like.
4. Choose or identify the investment alternative that will provide the
best return and at the same time, serve or attain their objectives.
CONCEPT
OF
RISK
Risks refer to chances that the outcome of an event is unfavorable or
undesirable.
Risk is a chance of possibility (of danger, loss, injury, and the like. It is
the uncertainty of the expected outcome. It is the consequence or the stake
of doing things. It is oftentimes associated with the game of chance.

Returns on the other hand, refer to yields or earnings on an investment.

Generally, the higher the risks, the higher the required returns on an
investment.
Investment risks force investors to evaluate the return
and risk characteristics of each investment alternative
before making a decision. Investors, however, differ in
their attitudes toward risks. Some like taking risks, while
others exert efforts to avoid or minimize risk.

Risk averse investors include a premium for risk in the

return that they desire in their investments, that is, they
use an adjusted rate of return as their discount rate or
desired yield.
The risk for short-term investments like 3-month
time deposits, bonds purchased 6 months before
maturity, 1-year T-bills, and other money market
instruments is very minimal since the outcome is more
certain due to the shortness of the period or term
involved.

Risks for long-term investments, which mature in

more than a year, are more likely to be present due to
the length of their term. This is attributed to the
different kinds of risks.
Risks are further classified as systematic and unsystematic risk (Fabozzi
and Modigliani 2009):

1. Systematic risk also called undiversifiable risk

or market risk. Systematic risk results from the
general market and economic conditions that
cannot be diversified away.

2. Unsystematic risk sometimes called diversifable

risk, residual risk, or company, specific risk. This is
the risk that is unique to a company such as a
strike, the outcome of unfavorable litigation, or a
natural catastrophe.
Measurement of Risk

" If it can't be measured, it can't be managed "

 Different Standards of Risks
● BS 25999- Risk is an average effect by summing the combined effect
of each possible consequence weighted but the associated likelihood of
each consequence.

● ISO 27005- Risk estimation is the process to assign values to the

probability and consequences of a risk.

● NFPA 1600- Risk assessment categories threats, hazards, or perils by

both their relative frequency and severity.
 Structured Sequence of Activities
• Establish the risk management context

• Quantitatively or Qualitatively assess relevant risks, taking into account the information
assets, threats, existing controls and vulnerabilities to determine the likelihood of incidents
or incident scenario and the predicted business consequences if they were to occur to
determine a level of risk.

• Treat, retain, avoid and/or share the risks appropriately using those levels of risk to
prioritize them;

• Keep stakeholders informed throughout the process, and;

• Monitor and review risks, risk treatments, obligations, and criteria on an ongoing basis,
identifying and responding appropriately to significant changes.
METHODS ON MEASUREMENT OF RISK
1. Loss of Principal and/or Interest Payments
- The crudest yet most conservative measurement of risk is the total sum
of money invested or loaned. The worst possible outcome is that the entire
investment becomes worthless or that the borrower defaults.

2. Probability
- A refinement is the introduction of probabilities to the analysis. The
mathematical theory of probability deals with patterns that occur in random events.
- Probability is a set of all possible outcomers like an 80% probability of
success and a 20% probability of failure.
3. Volatility and Variability

• Volatility is a basic measure for risks associated with a financial market's instrument. It
represents an asset's price fluctuation and is accounted as the difference between maximum and
minimum prices within trading session, trading day, month, and the like. The wider range of
fluctuations ( higher volatility ) means higher trading risk involved. Standard deviation is the typical
statistic used to measure volatility.

• Variability is the extent

to which data points in a
statistical distribution or
data set diverge from the
average or mean value.
 4 Commonly Used Measure of Variability
• Range- is the highest data minus the
lowest data
• Mean- is also known as the arithmetic
average, which is the result when you
add up all the numbers, then divide by
how many numbers there are.
• Variance- is a measure of how close the
scores in the data set are, to the middle of
the distribution.
• Standard Deviation- is a measure of
how spread out numbers are. The square
root of the variance
4. Assessments of Counterparty Risk
• Counterparty Risks- which includes default risk, is the risk that the other
party to a transaction, such as another firm in the financial services industry, will
prove unable to fulfill its obligation on time.
• Assessments of Counterparty Risk- often are made based on the analysis of
companies financial strengths provided by rating agencies.

5. The Role of Actuaries

• Actuaries are most associated with analyzing mortality tables on behalf of
life insurance companies and any venture which involves measurement of risk.
• Actuarial Science as it is often called, is an application of advance statistical
techniques to huge data sets which themselves have high degrees of measurement
accuracy.
CONCEPT OF RETURNS
● Returns are the revenues, earnings, yields, proceeds, income, or profit from
some Undertakings made, like financial investment, capital investment, and
business operation They are measured based on the net cash flow realized or
expected to be realized from an Investment or based on the net income from
business operations.

● Net cash flows refer to the Difference between the cash flows received from
an investment and the cash flows expended On an investment.
• Net income from an investment refers to the difference between revenues from
An investment and the expenses spent on an investment. They are normally
translated In the form of percentages, which are called rates of rates of return.
• Rate of return is used to compare The outcomes of different investments. It is
also used to measure historical performance, determining future investment
and estimating cost of capital for capital investment decision. It show the
return made on an investment.
Returns, when talking about investments in financial securities, can be in the form of Income or price
appreciation, which is a capital gain or both. For example. For an investment in A bond of P1,000 with a maturity
period of 10 years, paying P40 interest every 6 months, the Income on the bond would be equal to P80 a year,
which is equivalent to 8% of the face value Of the bond (P80/P1,000). If, at any time during the life of the bond,
the bond sells at 110 (P1.000 x 110% = P1,100), the investor will not only earn the P80/year interest on the bond
But also the increase in price from P1,000 to P1,100 or P100 gain should he decide to sell The bond prior to
maturity. The same is true for an investment in stocks. The only difference is That, in stocks, income is in the
form of dividends declared by the issuing corporation is instead Of interest.

In the foregoing example, the computation of the interest rate would be:

R =I/P
Where
R = Interest rate
I = Interest received
P = Principal or cost of investment
R =P80/P1,000 =8%
 The increase in value or capital gain, which is the growth (g) in the investment would be:

G = (CP- P)/P
where
CP = Current price
P = Principal or cost of investment
P1,100-P1,000 / P1,000 = P100/P1,000 = 10%

Therefore, the rate of return (ROR).

R+g
8% + 10%
18%
 RISK AND RETURN
are inter related because the return from an investment should equate the risk involved.
As stated earlier ,the risk- averse investors, before making investment in a risky
asset requires as higher return than the risk- free asset
 Risk is the possibility that actual return will deviate or differ from what
is expected. The actual return can go up or down depending on the
market. Taking risks in involves knowledge of expected return, terminal
value, present value, and rate of return. Expected return are the future
cash flows associated with the investment. Terminal value is the maturity
value of an investment. Present values are the discounted value of the
future return. Rate of return is the ratio of the net cash flows and the
principal or initial investment.

Return is the profit or earnings and rate of return is the percentage of

profit or earnings on a particular investment, which is why it is often
termed ROI or return of investment.
METHODS OF CALCULATING RATES OF
RETURN
Example:
The market value of the stocks of Bright Corporation at the beginning of year 1 is 120
per share; at the beginning of year 2 is P130. It declares dividend of 20 per share. What is
the holding period return from the said investment?
2. Average rate of return - measures the return across months or years

a. Arithmetic average – an unweighted average of the returns which formula is:

AR = ( RoR)n/n
where
AR = Average rate of return
n = number of intervals
RoR = holding period return for each months or each day

For the month of January, return is computed as ( February value- January value)/January value :
₱122 – ₱120 = ₱2 /120 =.01667 = 1.667%

Then, for the month of February, return is computed as (March value - February value)/February value:

₱120 – ₱122 = (₱2) / ₱122 = (.01639) = (1.639%).

Note: return for February is negative because the value of return for march is less than the value of
return for February
For the succeeding months, the same procedure will be followed. To compute for the average rate of return, the sum of the calculated
returns for each month Is divided by the number of intervals which is 12. In our example, the computed average of return is.68% for the
12-month period. The average rate of return for the first 5 months would be .83%, computed as
[(1.67%- 1.64% +1.67%+ 0.82%+1.63%)/5).
c. INTERNAL RATE RETURN (IRR) YIELD TO MATURITY.
In computing for the IRR of the investment present value of the expected cash
flow is taken into account.We have to used the present value table( present value of
1.00 per year for each of n year)if the future returns all the same if they are not the same
we have to used the the discount table( present value of 1.00 to be received after n
years) Internal rate of return is a metric used in capital budgeting measuring the
profitability of potential investment.
Internal rate of return a discount rate that makes the net present value of all cash
flows from a particular investment equal to zero.Nat present value is the difference
between present value of future cash inflows and the present value of the investment or
the principal.If the NPV is is positive the investment is accepted if negative the
investment is rejected.
However, this method will require trial and error and interpolation. Yield to maturity is the IRR for
bonds. Since it will require trial and error, the computation can start with finding the estimated yield to
maturity (Mejorada 1999). The approximate yield to maturity (YM) would be:

where
C=Coupon/Interest payment
F = Face value
P = Price or principal
n = Years to maturity
Example: A 10-year, 8% bond of P10,000 each was purchased at 9,800. What is the yield to
maturity of the bond?

The yield to maturity (YM) or the IRR is between 8% and 9%. To compute for the exact YTM, compute the
present value using the said rates which should equal to the initial value of the investment which is 9,800.00.
The 642 is the difference between 10,000 and 9,358 and the 200 is the difference between 10,000 and
9,800. Dividing the differences with the first difference as the denominator and the second difference as
the numerator, we get .31, which we add to the 8% (in as much, we are getting the rate between 8% and
9%). This helps us arrive at 8.31%, the exact rate of interest.
Trial and Error
What we need to do is to try different rates until we find the rate that
will make the price of the bond equal to the present value of the
interest payments plus present value of the principal upon maturity. If
the bond in trading below far ( at a discount ), we can assume the YM (
discount rate ) to be above the nominal rate on the bond and vice versa.
 EXPECTED RETURN
VARIANCE AND
STANDARD DEVATION OF
PORTFOLIO
“when you make a decision, you take risks”
Two (2) types of return:

1. expected returns, which is what you expected to get on your

investment, and

2. unexpected returns, which are gains or losses caused by

unforeseen events.

Expected return is calculated by using the following formula:

Variance
Portfolio Variance
PORTFOLIO
VARIABLE
 The expected mean for the
forecasted sales is; (0.15)*(17.0) + (0.25)*(15.0) + (0.25)*(14.0)+(0.35)*(12.0)
= 2.55 + 3.75 + 3.5 + 4.2
= ₱14 million
Calculating a variance starts by computing the difference
in each potential sales outcome. From ₱14 million mean value, we obtain and then the square the difference.
lio variance

A portfolio collection of financial assets or investments such as stocks, bonds, and cash.
- It is a measure of the risk of a portfolio , a combination of the return variance and co
variance of each security , and its proportion in that portfolio.

Covariance
- Provides diversification reducing the overall volatility for a portfolio.
- It is a statistical measure of how two assets move in relation to each other.
Modern Portfolio theory (MPT) or mean variance analysis is a mathematical framework
for assembling a portfolio of assets such that the expected return is maximize for a given
level of risk defined as a variance.

Portfolio variance
- is calculated by multiplying the squared weight of each security by its corresponding
variance and adding two times the weighted average weight multiplied by the
covariance of all individual security pairs expressed in the following formula for a
simple two asset portfolio:
Standard deviation -is calculated as the squared root of variance. It derives
from the variance , a measure of the dispersion of a set of data from its mean.
STANDARD
DEVIATION
Standard deviation (óx) can be defined in
two ways:
● 1. Standard deviation is calculated as the square root of variance. It
derives from the variance, a measure of the dispersion of a set data from
its mean. The more spread apart the data, the higher the deviation.
● 2. In finance, standard deviation is also known as historical volatility and
used by investors as a guage for the amount of expected volatility. It is
applied to the annual rate of return of an investment to measure the
investment's volatility. For example, a volatile stock will have a high
standard deviation while a stable due to chip stock will have a lower
standard deviation. The more volatile an investment, the higher the
standard deviation. A large dispersion tells us how much the fund's return
is deviating from the expected normal returns.
Example 1: Standard deviation (ó) is found by taking
the square root of variance.

(170)½ = 13.04%

We used two-asset portfolio to illustrate this principle,

but most portfolios contain far more than two assets.
This formula for variance becomes more complicated
for multi-asset portfolios. All terms in a variance matrix
need to be added to the calculation.
Example 2: Given the following data for Newco's stock, calculate
the stock's variance and standard deviation. The expected return
based on the data is 14%.

Scenario Probability Return Expected

Return

Worst Case 10% 10% 0.01

Base Case 80% 14% 0. 112

Best Case 10% 18% 0. 018

 The standard deviation of Newco's stock is simply the square
root of the variance, which is 0.0173 or 1.73%.

The adage "Don't put all your eggs in one basket" holds true
when it comes to investment. It only means that one should not
place his entire investible fund in one kind of investment security
because if it fails, then he loses. This is why choosing the
composition of one's portfolio is critical in investment decision -
making. The larger the the portfolio's variance, the higher the
required risk premium on the portfolio. Therefore, on the average,
the larger will be the required risk premium on each asset (Levy
1999).
STRUCTURE OF RATES OF RETURN
The interest rates on various securities or investments are
determined by factors such as length of time to maturity, credit
or default risk, and liquidity.

The difference in interest rates arising from differences in length

of time to maturity or term of the security is called the term
structure of interest rates.

The difference in interest rates arising from the credit or default

risk is termed default risk or credit risk structure of interest
rates. It is the relationship between the return or yield on debt
securities and the risk that the issuer may default on its obligations
to pay the interest or the principal.
 Default risk premium is the difference between the
interest on the debt security of a specific issuer and the
interest on a government treasury security with the same
maturity comparison with a government security is made
because government securities are default free.

The yield curve is a graphical representation of the term

structure of interest rates at a particular point in time.
Constructing the yield curve involves measuring the length
of time to maturity or the term of the instrument on the
horizontal axis or x-axis and the yield to maturity or interest
rate on the vertical axis or y-axis.
As shown in figure 16a, the ascending or upward-sloping yield
curve means that the longer the maturity of the security, the
higher the interest rate, which is the general trend. This curve is
formed when interest rates are lowest on short-term securities
and it rises at a diminishing rate until the rates begin to level out
on longer maturities. This is the yield curve most commonly
observed (Kidwell et al. 2013)
 A flat yield curve, as shown in Figure 16b, means that interest rates are
the same across the maturity spectrum, that is, among different maturities
that may happen occasionally. This means that the YM is virtually
unaffected by the term to maturity. They are not common, but do occur
from time to time.

A downward-sloping or inverted yield curve, as shown in Figure 16c,

means that short-term rates are higher than long-term rates which can
happen under certain market conditions. This means that yields decline as
maturity increases.

The different yield curves are in response to securities' or asset holders'

regard for securities of different maturities as perfect substitutes for each
other, as imperfect substitutes, or as no substitutes at all
(Hadjimichalakises 1995).
TERM STRUCTURE OF INTEREST RATES

The term of a loan (also called term-to-maturity) is the length of

time the principal matures. It is the period from the time the loan
s acquired up to its maturity date. The relationship between
security’s yield to maturity (YM) and the term-to-maturity is
known as the term structure of interest rates. The term structure
can be graphically shown by plotting the YM and the maturity for
equivalent-grade securities at a point in time, giving as the yield
curve that e have studied under structure of rates of return. It is
important to note that for yield curves to be meaningful , other
factors that affect interest rates, such as default risk, tax
treatment, and marketability must be held constant (Kidwell et, al.
2013).
An important aspect of the term structure of interest rates
is the distinction and the relationship between spot rates
and forward rates.

Spot interest rates - are the current interest rates that

apply to current or outstanding loans of any term or
duration, that is, wether the loan is short-term or
long-term.
Forward interest rates - are for loans of any term or
duration, but to be executed at some future time.
Assume a one year security to be sold two years from today. If the one-year
security bears interest at 6% and will be sold to an interested buyer two years
from today at 8%, the 8% is the forward interest rate, while the 6% is the spot
interest rate or the current rate. A long-term loan can be broken down into a
series of renewable short-term loans. The 2-year loan can be thought of as
short-term 1-year loan and another 1-year loan each of which can can be
renewed or “rolled over” with principal and the earned interest for the
succeeding year. Renewing the loan, such that the new principal is the sum
of the original principal and the interest, is what “rolled over” means. If the
principal is P1,000 and the interest is P100, the principal for the next year
when the loan is rolled over becomes P1,100. This is how compounding is
done. The interest earned lus the principal at the beginning of the period
becomes the principal for the next period.
Assuming that the current rate is 4% and the next year rate is 6%. The rule s
that e long-term rate is the average f its implicit forward rate. The following
formula adapted from Thomas (1997) shows how to calculate the implicit
forward rate: R1 and R2 , are the yields (interest rates) available today on 1-
and 2-year securities, respectively. The implicit forward rate is the hypothetical
1-year rate which, if it prevails a year from now, would make the two
investments produce the same average return over the 2-year period.
Calculating he implicit forward rate by transposing our formula above:
This means that the 1-year forward rate that would make the investor indifferent
between the two investments is 8%. Indifference means it will not affect the
decision of the investor, that is, the investor is neutral or impartial relative to the
difference between the two investments. The investor can take either of the two
investments and still be satisfied with the return. I case of compounding, that
is, the principal and the interest earned are reinvested each year the formula ill
be as follows:
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