Risk and Return

Zoom Session 4
Reference:

Chapter 8 of Brigham, E.F. and Houston, J.F., 2015.

13th Edition. Fundamentals of financial management.
Cengage
 Objectives:
01 The concept risk

02 The concept of expected rate of return in finance

03 Stand-alone risk and return

04 Using historical data to measure risk and return

05 Correlation

06 Portfolio return and risk

Investors like returns and dislike risk
 Risk
Risk is defined in Webster’s as “a hazard; a peril; exposure to loss or
injury.” Thus, risk refers to the chance that some unfavorable event
will occur.
An asset’s risk can be analyzed in two ways:
(1) on a stand-alone basis
(2) on a portfolio basis
No investment should be undertaken unless the expected rate of
return is high enough to compensate the investor for the perceived
risk of the investment
 Risk Aversion
• Most investors are risk averse.
• In a market dominated by risk-averse investors, riskier securities
must have higher expected returns, as estimated by the marginal
investor, than less risky securities.
• If this situation does not exist, buying and selling in the market
will force it to occur.
 Investment Returns
Suppose you buy 10 shares of a stock for $1,000. The stock pays no
dividends, but at the end of one year, you sell the stock for $1,100.
What is the return on your $1,000 investment?
Dollar return = Amount received - Amount invested
= $1,100 - $1,000 =100
 Investment Returns
• Investors receive their returns from shares in the form of dividends and
capital gains/ losses.
• The formula for calculating the annual return on a share is:
 Return Example 1
DGKC paid Rs. 5 per share during the year 2019. The value of DGKC at th
e beginning of year was Rs. 100. The share value has increased during the
year and stands at Rs. 117 at the end of the year. Calculate Annual return o
f DGKC company?
 Return Example 1
DGKC paid Rs. 5 per share during the year 2019. The value of DGKC at th
e beginning of year was Rs. 100. The share value has increased during the
year and stands at Rs. 117 at the end of the year. Calculate Annual return o
f DGKC company?

Annual Return = 5 + (117-100) / 100 = 0.22 or 22%

 Return Example 2

Q: 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 di
vidend. What return was earned over the past year?
 Return Example 2

Q: 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 di
vidend. What return was earned over the past year?

$1.00 + ($9.50 - $10.00 )

R= = 5%
$10.00
Unit 2.2
 Example-3
Example-3 Solution demonstrated in Excel sheet

Demand for the Probability of this Martin Products U.S Water

company`s products demand Rate of Return Rate of Return
  P R R
Strong 0.3 80% 15%
Normal 0.4 10% 10%
Weak 0.3 -60% 5%

Q: Calculate expected rate of return of these two products?

Example
 Expected Returns

• Expected returns are based on the probabilities of possible outcomes.

• The “expected” return does not even have to be a possible return.

n
E ( R)   pi Ri
i 1
 Example 4: Expected Return
You have predicted the following returns for stocks PSO and Shell in three possible state
s of nature. What are the expected returns?

– State Probability PSO Shell

– Boom 0.3 0.15 0.25
– Normal 0.5 0.10 0.20
– Recession ??? 0.02 0.01
 Example 4: Expected Return
You have predicted the following returns for stocks PSO and Shell in three possible state
s of nature. What are the expected returns?

– State Probability PSO Shell

– Boom 0.3 0.15 0.25
– Normal 0.5 0.10 0.20
– Recession ??? 0.02 0.01

R(PSO) = .3(.15) + .5(.10) + .2(.02) = .099 = 9.99%

R(Shell) = .3(.25) + .5(.20) + .2(.01) = .177 = 17.7%
 Risk calculations
For risk, the measure is standard deviation, the symbol for which is σ , pronounced
“sigma.” The smaller the standard deviation, the tighter the probability distribution,
and, accordingly, the less risky the stock
A statistical measure of the variability of a set of observations
1. Calculate the expected rate of return:

2. Subtract the expected rate of return from each possible outcome

 Risk calculations
3. Square each deviation, then multiply the result by the probability
of occurrence for its related outcome and then sum to obtain the
variance

4. Find the square root of the variance to obtain the standard

deviation
 Example-5
Example-5 Solution demonstrated in Excel sheet

Demand for the Probability of this Martin Products U.S Water

company`s products demand Expected Return Expected Return
  P R R
Strong 0.3 100% 20%
Normal 0.4 15% 15%
Weak 0.3 -70% 10%
How to Determine the Expected Return and Standard Deviation

Stock UBL
Ri Pi (Ri)(Pi) (Ri - R )2(Pi)
-0.15 .10
-0.03 .20
0.09 .40
0.21 .20
0.33 .10
Sum 1.00
How to Determine the Expected Return and Standard Deviation

Stock UBL
Ri Pi (Ri)(Pi) (Ri - R )2(Pi)
-0.15 .10 -.015
-0.03 .20 -.006
0.09 .40 0.36
0.21 .20 .042
0.33 .10 .033
Sum 1.00 .090
How to Determine the Expected Return and Standard Deviation

Stock UBL
Ri Pi (Ri)(Pi) (Ri - R )2(Pi)
-0.15 .10 -.015 .00576
-0.03 .20 -.006 .00288
0.09 .40 0.36 .00000
0.21 .20 .042 .00288
0.33 .10 .033 .00576
Sum 1.00 .090 .01728
Determining
Determining Standard
Standard Deviation
Deviation (Risk
(Risk Measure)
Measure)

n
s= S
i=1
( R i - R )2
( P i )

s= .01728

s= .1315 or 13.15%
Using historical data to measure return & risk
 Example- 6

Year Rate of Return

1999 15%
2000 -5%
2001 20%

What is the average return and risk?

 Measuring stand alone risk

The coefficient of variation shows the risk per unit of return

the coefficient of variation for Martin is 65.84/15 = 4.39 and

that for Water is 3.87/15 = 0.26. Thus, Martin is about 17
times riskier than U.S. Water based on this criterion.
 Practice Question 7
Solution in Excel Sheet
Stocks X and Y have the following probability distributions of expected future returns:
Calculate the expected rate of return for Stock Y (rX = 12%).
Probability X Y
0.1 -10% -35%
0.2 2% 0%
0.4 12% 20%
0.2 20% 25%
0.1 38% 45%
Calculate the standard deviation of expected returns for stock X, SD of stock y=20.35%
Now calculate the coefficient of variation for Stock Y.
Unit 2.3
 Expected return of Portfolio
The expected return on a portfolio is simply the weighted average of the
expected returns on the individual assets in the portfolio, with the weights
being the fraction of the total portfolio invested in each asset.
 Example-8
Example Solution demonstrated in Excel sheet

Stock Expected Return Dollar Invested

Microsoft 12.00% 25000
IBM 11.50% 25000
GE 10.00% 25000
Exxon 9.50% 25000
10.75% 100000

What is the portfolio’s return?

Unit 2.4
 Correlation
• The tendency of two variables to move together is called
correlation, and the correlation coefficient measures this
tendency.
• The symbol for the correlation coefficient is the Greek letter
rho, ρ (pronounced roe)
• The estimate of correlation from a sample of historical data is
often called “R.”
Rate of Return
for two Perfectly
Negatively
correlated
stocks

When stocks are

perfectly negatively
correlated (-1.0), all
risk can be
diversified away
Rate of Return
for two Perfectly
Positively
correlated
stocks

When stocks are

perfectly positively
correlated ( 1.0),
diversification does
no good whatsoever
Rate of Return
for two Partially
correlated stocks

Past studies have

estimated that on
average the
correlation
coefficient for the
monthly returns on
two randomly
selected stocks is
about 0.3.
Unit 2.5
 Risk of a Portfolio
• Therefore, it is impossible to form completely riskless stock portfolios.
Diversification can reduce risk but not eliminate it.
• As a rule, the risk of a portfolio will decline as the number of stocks in
the portfolio increases.
• If we added enough partially correlated stocks, could we eliminate risk?
• In general, the answer is no, but the extent to which adding stocks to a
portfolio reduces its risk depends on the degree of correlation among
the stocks
• The smaller the positive correlation coefficients, the lower the risk in a
large portfolio.
 Diversifiable Risk
• Diversifiable risk is caused by such random events as lawsuits,
strikes, successful and unsuccessful marketing programs, the
winning or losing of a major contract, and other events that are
unique to a particular firm.
• Because these events are random, their effects on a portfolio can
be eliminated by diversification—bad events in one firm will be
offset by good events in another
 Market Risk

• Market risk, on the other hand, stems from factors that

systematically affect most firms: war, inflation, recessions, and
high interest rates. Since most stocks are negatively affected by
these factors,
• Market risk cannot be eliminated by diversification.
THANK YOU!!