Risk and Rates of

Return
Return
• Sources:
 Flow of income
 Capital appreciation
Computation:
Return = Selling price + dividends received (if any) – amount invested
Amount invested

Return = Selling price + dividends received (if any) – amount invested -1

Amount invested
Example:
Suppose Brownie Corporation invested in a time deposit amounting to
p1,000,000 for 3 months. The deposit earns interest at 12% p.a. What is the
return on investment?
Answer:
Interest = P1,000,000 x 12% x 3/12 = P30,000

Return = P30,000/P1,000,000
= 3%

The return on investment obtained from the time deposit is 3%.

Example:
Suppose SGT bought 100 shares of stocks for P50,000. The shares paid
dividends amounting to P10 per share at the end of the year. Upon receipt of the
dividends, SGT sold the stocks at P55,000.00. What is the return on investment?
Answer

Return = Selling price + dividends received (if any) – amount invested

Amount invested

Return = P55,000+ (P10 x 100 sh) – P50,000

P50,000

=12%
Probability Distribution
Probability
 The occurrence or non-occurrence of an event.
 Used to compute the expected overall return of a portfolio
Expected Return
The return made after the probabilities of occurrence, the state of the economy,
and the individual’s expected outcomes are considered.
Example:
XYZ Corporation plans to invest in Stock A. The firm expects that the possible
returns are dependent on the state of the economy. Determine the expected return
on their planned investment

State of the Economy Possible Returns Probability Distributions

Recession 10% 0.20
Normal 15% 0.60
Prosperity 20% 0.20
Portfolio
• A collection of investments which are all owned by single individual or a firm.
• Includes stocks, bonds, mutual funds, commodity, real estate, bank deposits,
and other fixed income securities
Example:
ABC Corporation plans to invest in three stocks. Listed below are the expected
returns for each investment.

Stocks Individual expected Amount invested

returns (%)
FLI 10 P20,000
PA 15 50,000
WEB 18 30,000

What is the portfolio expected return?

Answer
Stocks Amount invested Weight
FLI P20,000 20
PA 50,000 50
WEB 30,000 30

Portfolio expected return= 14.90%

Risk
• The exposure to uncertainty or danger resulting in changes in the expected
return n a given investment.
• Includes the possibility of losing some or all of the original investment.
Classifications of Risk
Systematic risk
• Sometimes called non-controllable or undiversifiable risk.
• Results from forces outside of the firm’s control and is, therefore, not unique to
a given security
Currency risk
• The risk that business operations or an investment’s value
will be affected by changes in the exchange rates

Equity risk
• The risk that the market value of the shares will increase or
decrease
Inflation risk
• The possibility that the value of the assets or income will
decrease as inflation “shrinks” the purchasing power of a
currency.
• Country risk
 Potential volatility of foreign stock or the potential default of foreign government
bond due to political and/or financial events in the given country

• Interest rate risk

 The possibility that the value of a security, particularly bonds, is reduced due to an
increase in the interest rate.

• Purchasing power risk

 The risk that inflation will “erode” the purchasing power of the portfolio of securities

• Event risk
 The uncertainty that an unexpected event will happen
Unsystematic risk
• Sometimes called controlled or diversifiable risk
• Represents the portion of a security’s risk that can be controlled through
diversification
• Principal risk
 The risk of losing the amount invested due to bankruptcy or default

• Credit risk
 Possibility that the bond issuer will delay the payment of the principal and interest.

• Liquidity risk
 The risk that arises from the difficulty in selling an asset
• Call risk
 The cash flow risk resulting from the possibility that a callable bond is redeemed
before maturity.

• Business risk
 The risk associated with the unique circumstances of a particular company, as they
might affect the price of that company’s securities.
 Caused by fluctuations n the earnings before interest and taxes
Measuring risk
Standard
deviation
• Widely used measure of volatility which
shows how much variation exists from
the average return of an investment
Steps in computing the standard
deviation

1 2 3 4 5

Multiply the expected Subtract the expected Square the difference Multiply the squared Square the result in step
individual return by the average return from the difference and multiply 4
probability distribution return the product by the
probability distribution
Example:
• Assume that Timbuktu Corporation is considering the possible rates of return it
might earn next year on a P100,000 investment on the stocks of FLI or a
P75,000 on those of WEB. The future returns depend on the state of the
economy with their corresponding probability distribution.

State of the Stock FLI Stock WEB

economy
Return Probability Return Probability

Recession -8.00% 0.15 -10.00% 0.20

Normal 15.00% 0.70 20.00% 0.80
Prosperity 35.00% 0.15 40.00% 0.20
Coefficient of Variation
• A statistical measure of the distribution of the data points in a data series
around the mean.

Standard deviation
Coefficient of variation =
Expected return
Portfolio Risk
• Associated with the total risks of the portfolio which consists of systematic and
unsystematic risks
 Stock A Holding Period Stock B Holding Period
70% Returns (30%) Returns
11-Jan-13 3.23 9.48
11-Feb-13 3.30 2.17% 9.40 -0.084%
11-Mar-13 3.27 -0.91% 9.50 1.06%
11-Apr-13 3.22 -1.53% 9.85 3.68%
11-May-13 3.45 7.14% 9.72 -1.32%
11-Jun-13 3.46 0.29% 9.80 0.82%
11-Jul-13 3.16 -8.67% 9.76 -0.41%
11-Aug-13 3.08 -2.53% 9.85 0.92%
11-Sep-13 3.03 -1.63% 10.20 3.55%
11-Oct-13 2.50 17.49% 10.45 2.45%
11-Nov-13 2.25 -10.00% 11.25 7.66%
11-Dec-13 2.00 -11.11% 11.50 2.22%
Average Return -4.02% 1.80%
Std. Dev 7.03% 2.56%