DFI501: FINANCIAL

MANAGEMENT

TOPIC TWO: RISK AND

RETURN

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 References
• Copeland, T. E., & Weston, J. F., & Shstri, K., ( 2011).
Financial Theory and Corporate Policy ( 4 th Ed.). Pearson
Education

• Higgins, R. C., (2012). Analysis for Financial Management

( 10th Ed.). Mc Graw Hill: International Edition

• Prasana , C., (2003). Financial Management: Theory and

Practice (5th Ed.). Mc Graw Hill

• Ross,S.A., Westerfield, R. W., & Jaffe J., (2007). Corporate

finance ( 7th Ed.). Mc Graw Hill
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 References
• Anthony, M., & Biggs, N. ( 2004). Mathematics for Economics and
finance: Methods and Modeling.
 
• Arnold, A., & Kumar, M. (2008). Corporate Financial Management
(3rd Ed.). Pearson Education.

• Berk, J., & Demerzo, P. ( 2011). Corporate Finance: The core (2 nd

Ed.). Pearson Education.

• Brigham, E. F., & Ehrhardt, M. C. (2005). Financial Management:

Theory and Practice ( 11th Ed.). Thomson: South Western.

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• “ Believe me! The secret of reaping the
greatest fruitfulness and the greatest
enjoyment from life is to live dangerously”
Friedrich Wilhelm Nietzsche

• The world is a risky Place…..

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 Basic facts and The Coverage

No Pain No gain

Return is a function of Risk

Risk aversion

The types of risk:

Measuring risk and expected return for a single asset and a

portfolio
Trade-Off between Risk and Return

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 Introduction
• Investment decisions are influenced by various
motives, but most investors, however , are
largely guided by the motive of earning a return
on their investment.

• Investment decisions invariably involve a trade-

off between risk and return.
• Risk is present in virtually in every decision.
Assessing risk and incorporating the same in the
final decision is an integral part of financial
analysis.
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 Risk aversion
• Most people try to avoid risk as possible. Risk
aversion is therefore the tendency to avoid
additional risk

• Risk – averse people will avoid risk if they can,

unless they receive additional compensation for
assuming that risk

• In finance, the added compensation is higher

expected rate of return
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 TYPES OF RISKS FIRMS ENCOUNTER

Risk Emanates from several sources

a) Business Risk

b) Financial Risk

c) Portfolio Risk

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 Business risk

• The uncertainty a company has with

regard to its operating income( EBIT).

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 Financial risk

It is the additional volatility of firm’s operating

income caused by the decisions of the firm to
finance its operations by debt ( fixed interest
expense)

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 Descriptions of risk and return

• People will invest in riskier assets only if they expect to

receive higher returns.

• A key feature of project appraisal is its orientation to the

future. Management rarely have precise forecast regarding
the future return to be earned from an investment. Usually,
the best that can be done is to make an estimate of the
range of the possible future inflows and outflows.

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 Descriptions of risk and return……….

• Two types of expectations individuals may

have about the future:
1. Certainty
2. Uncertainty

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 Certainty

Under these conditions , future outcomes can be

expected to have only one value i.e there is not a
variety of possible future orientations ( Only
One Will Occur)

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 Risk and Uncertainty
• Risk describes a situation where there is not
just one possible outcome, but an array of
potential returns. The possibility that the
actual will be different from the expected

• Risk thus exist whenever there is more than

one possible outcome to an event and the
occurrence of any is not known with
certainty. In analyzing risk, we should
consider all outcomes

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• Broadly, two aspects to investment risk: The
dispersion of an investment’s possible
returns and the correlation of these returns
with those available on other assets

• We assume that we know the probability

(ies) of each of the possible futures, which
can be estimated on the basis of objective or
subjective probabilities
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• Each possible has some likelihood of
occurring We summarize the information
with a probability distribution.

• If all possible outcomes / events are listed ,

and if a probability is assigned to each event,
the listing is called probability distribution

• Note: Risk and Return can be measured for

a single Asset and a portfolio.
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 Holding period & Expected return
• Return basically represents the reward for
undertaking investment. And since investing is
about returns ( after allowing for risk) ,
measurement of realized returns and estimating
future returns is necessary.

• Holding period represents income received on an

investment plus any change in Market Prices ,
usually expressed as percentage of the beginning
market price of the investment.

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 An Example:
The stock price for the stock of a
company was Sh. 10 one year ago . The
stock is currently trading at Sh. 9 and the
shareholders just received Sh. 1.5
dividend.
What return was earned over the past
year?

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 Expected return

• This is the weighted average of the possible

returns, where the weights correspond to the
probabilities;

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 Measuring risk: Variance & Standard
Deviation
• TOTAL RISK = Unique risk + Market Risk
• The unique Risk of a security represent that
portion of total risk which stems from firm-
specific factors and it is diversifiable
• Market Risk represents that portion of its risk
Which is attributable to economy-wide factors
e.g inflation, interest rates etc. Investors Cannot
avoid the risk arising from them however
diversified their portfolios may be.
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• Two common measures of Risk of a probability
distribution are its Variance and Standard
Deviation.

• Another Measure is the Coefficient of

Variation

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 Variance and standard deviation and
Coefficient of variation
• Variance is the expected squared deviations from the
mean ( expected return in our case).

• The standard Deviation is a statistical measure of

the variability of a distribution around its mean. It is
the square root of the Variance

• Coefficient of Variation (CV) is a measure of relative

risk. It shows risk per unit of return, and it provides a
more meaningful basis for comparison when the
expected returns for two alternatives are not the same.
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 Portfolio theory
• NOTE:
For an individual ( in regard to making investments) the unit of
analysis is a portfolio.

READ ON:
• Expected return of a portfolio
• Covariance
• Correlation Coefficient
• Variance and Standard deviation of portfolio
• Constructing an efficient portfolio using mean variance
dominance rule

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 Expected return of a Portfolio Theory

• We describe a portfolio by its portfolio weights, the

fraction of the total investment in the portfolio held in
each individual return

• Xi= Value of Investment in i

total value of a portfolio

• The E(Rp) is simply the weighted average of the returns

of the individual assets forming the portfolio, using the
portfolio weights
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 Volatility of a portfolio: A stock portfolio

• Combining stocks in portfolio eliminates some of

their risk through diversification. The amount of
risk that remains depends on the degree to which
the stocks are exposed to common risks

COVARIANCE:
• Is the expected product of the deviations of two
returns from their mean
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 n  
cov   ( R x  R) * ( R y  R) P
i 1 i


CV    R
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CORRELATION:
• Used to quantify the strength of
relationship between two stocks returns
and it is defined as;

• Correlation = COV( Rx, Ry)/SDx*Sdy

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 Linking risk and return
• Return = f ( Risk)

• This risk – return trade-off is fundamental to

much of finance.

• This relationship/the link can be demonstrated

using the Equilibrium Asset Pricing Models e.g
Capital Asset Pricing Model ( CAPM)
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 CAPM
Return=risk free rate + ( average return on
Market-Risk free rate)* Beta

Beta is a measure of Market risk

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 conclusion

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

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END

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