Chapter 08

The Return & Risk

Books: L J Gitman

Prepared By:
Nusrat Nargis
Assistant Professor of Finance
Department of Business Administration
 Defining Return

Return: Percentage form of earnings from an

investment or asset including normal income and
capital gain or loss is called return.
Income received on an investment plus any change in
market price, usually expressed as a percent of the
beginning market price of the investment.

Dt + (Pt - Pt-1)
R=
Pt-1
 Return Components

• Returns consist of two elements:

– Periodic cash flows such as interest or dividends (income
return)
• “Yield” measures relate income return to a price for the security

– Price appreciation or depreciation (capital gain or loss)

• The change in price of the asset

• Total Return =Yield +Price Change

 6-3
 Return Example
The stock price for Stock A was $10 per share 1
year ago. The stock is currently trading at $9.50
per share and shareholders just received a $1
dividend. What return was earned over the past
year?

$1.00 + ($9.50 - $10.00 )

R= = 5%
$10.00
 Return

Return may be the following three types:

1. Risk-free rate of return – rate of return can be earned by making

investment in government securities of a country is known as risk-free
rate of return.

2. Nominal rate of return – rate of return calculated by ignoring existing

level of inflation is known as nominal rate of return.

3. Real rate of return - rate of return determined by considering/adjusting

existing level of inflation is known as real rate of return.
 Defining
Defining Risk
Risk

The variability of returns from those that are

expected.
What rate of return do you expect on your
investment (savings) this year?
What rate will you actually earn?
Does it matter if it is a bank CD or a share of
stock?
 Risk Sources
• Interest Rate Risk
• Financial Risk
– Affects income return
– Tied to debt financing
• Market Risk
– Overall market effects • Liquidity Risk
• Inflation Risk – Marketability with-out sale
– Purchasing power variability prices
• Business Risk-risk related to overall business
• Country Risk
activities of a particular business enterprise that
is mostly out of control of that business – Political stability
enterprise.

 6-7
 Measures of risk

Measures of risk

1. Return Calculation

2. Standard Deviation – absolute measurement of total risk

3. Coefficient of Variation - relative measurement of total risk

 Risk Preferences

1. Risk Indifference

2. Risk Averse

3. Risk Seeking
Determining
Determining Expected
Expected Return
Return (Discrete
(Discrete Dist.)
Dist.)

n
R=
i=1
( R i )( P i )

R is the expected return for the asset,

Ri is the return for the ith possibility,
Pi is the probability of that return occurring,
n is the total number of possibilities.
How
How to
to Determine
Determine the
the Expected
Expected Return
Return and
and Standard
Standard Deviation
Deviation

Stock of Apex
Ri Pi (Ri)(Pi)
The
-.15 .10 -.015 expected
-.03 .20 -.006 return, R,
.09 .40 .036 for Stock
Apex is .09
.21 .20 .042
or 9%
.33 .10 .033
Sum 1.00 .090
 Determining
Determining Standard
Standard Deviation
Deviation (Risk
(Risk Measure)
Measure)

n
 =  ( Ri - R )2( Pi )
i=1

Deviation , is a statistical
Standard Deviation,
measure of the variability of a distribution around
its mean.
It is the square root of variance.
Note, this is for a discrete distribution.
How
How to
to Determine
Determine the
the Expected
Expected Return
Return and
and Standard
Standard Deviation
Deviation

Stock BW
Ri Pi (Ri)(Pi) (Ri - R )2(Pi)
-.15 .10 -.015 .00576
-.03 .20 -.006 .00288
.09 .40 .036 .00000
.21 .20 .042 .00288
.33 .10 .033 .00576
Sum 1.00 .090 .01728
Determining
Determining Standard
Standard Deviation
Deviation
(Risk
(Risk Measure)
Measure)

n
= i=1 ( Ri - R )2( Pi )

 = .01728

 = .1315 or 13.15%
 Coefficient of Variation

The ratio of the standard deviation of a

distribution to the mean of that distribution.
It is a measure of RELATIVE risk.
CV =  / R
CV of BW = .1315 / .09 = 1.46
 Determining Expected Return
(Continuous Dist.)
n
R =  ( Ri ) / ( n )
i=1
R is the expected return for the asset,
Ri is the return for the ith observation,
n is the total number of observations.
 Determining Standard
Deviation (Risk Measure)
n
 = i=1
 ( Ri - R )2
(n)

Note, this is for a continuous distribution where

the distribution is for a population. R represents
the population mean in this example.
 Example
Calculation of Risk-Return (Historical Data)

Year Return (%) Dev. (Ri-E(R)) Dev. Square

2004 20 7 49
2005 5 -8 64
2006 -5 -18 324
2007 15 2 4
2008 30 17 289
Mean Return= 13% Sum of Dev sq= 730
Stand.Deviation2   730/(5-1)= 182.5
Stand.Deviation=   Square root (182.5) 13.5%
 Example
Calculation of Risk-Return (Probability Distribution)

Probability Return (Ri) Exp. Value Deviation Deviation

Weather (Pi) (%) (Pi*Ri) (Ri-E(R)) Square Dev sq* Pi
(25-13.25) (11.25)2 (138*.25)
Rain 0.25 25 6.25 =11.75 =138.0625 =34.52
(14-13.25) (0.75)2 (.56*.5)
Moderate 0.5 14 7 =0.75 =0.5625 =0.28
(0-13.25) (-13.25)2 (175*.25)
Dry 0.25 0 0 =-13.25 =175.5625 =43.89

    E(R)= 13.25%   Stand Dev2= 78.69

    Risk= 8.87%   Stand Dev 8.87

 Risk-return relationship i.e.
Security Market Line (SML)

Return [E(R)]

SML

E(Rj)

E(Rm)

Rf=5%

Systematic Risk (Beta)

βm=1 βj=1.9
 Total Risk = Systematic Risk +
Unsystematic Risk
Total Risk = Systematic Risk +
Unsystematic Risk
Systematic Risk is the variability of return on stocks
or portfolios associated with changes in return on
the market as a whole.
Unsystematic Risk is the variability of return on
stocks or portfolios not explained by general market
movements. It is avoidable through diversification.
 Total Risk = Systematic Risk +
STD DEV OF PORTFOLIO RETURN Unsystematic Risk

Factors such as changes in nation’s economy, tax reform

by the NBR, or a change in the world situation.

 Unsystematic risk
Total
Risk

 Systematic risk


 NUMBER OF SECURITIES IN THE PORTFOLIO

 Total Risk = Systematic Risk +
STD DEV OF PORTFOLIO RETURN Unsystematic Risk
Factors unique to a particular company or industry. For
example, the death of a key executive or loss of a
governmental defense contract.

 Unsystematic risk
Total
Risk

 Systematic risk


 NUMBER OF SECURITIES IN THE PORTFOLIO