RISK AND

RETURN
TOPIC # 5
Ajay Pandey
IIM Ahmedabad
RISK AND RETURN
 Intuitively we think of risk as something or an event which is undesirable and hence to be
avoided. In the context of economic decisions, wherein the outcomes are not certain, we need
to characterize risk more sharply.
 Besides characterizing risk, and if possible measuring it, we also need to reflect on how risk
affects choices and decision made by the people and economic agents.
 Again intuitively, we may think that people and economic agents would like to avoid risks, but
there is no reason to believe that everyone would react to any given risk identically and this
idea needs to be incorporated in any analysis we do and choices which we make.
 So we start with the characterization of risk and its measures used in the context of investing
in financial assets before we look at the preferences of economic agents while dealing with
risks.
CHARACTERIZING RISK
 According to Oxford English Dictionary, Risk means-

“(Exposure to) the possibility of loss, injury, or other adverse or unwelcome circumstance; a
chance or situation involving such a possibility”
 The ISO Guide 73:2009 defines risk as “effect of uncertainty on objectives”.
 In finance- “risk is the possibility that the actual return on an investment will be different from its expected
return” (Farlex Financial Dictionary), which means deviation from expected returns.
 As you have already learned; in mathematics and statistics, expected value of a variable is given by the mean
and deviation is a measure of difference between the observed value of a variable and some other value, often
that variable's mean. The probability-weighted squared sum of deviation is variance and the square-root of
variance is standard deviation.
 While intuitively only downside (returns below expected value) seems as a risk, it does not matter if the
distribution is symmetrical around mean or expected value.
 Further, you also know that in case of a Normal or Gaussian distribution, only mean and variance exist.
Hence if the returns are normally distributed, we can only focus on mean and variance.
DAILY STOCK RETURN
DISTRIBUTION
DAILY STOCK RETURN
DISTRIBUTION….
DAILY STOCK INDEX RETURN
DISTRIBUTION….
ANNUAL STOCK INDEX
RETURN DISTRIBUTION….
VAR (VALUE-AT-RISK) AND
RETURN DISTRIBUTION
 If the returns were truly normally distributed, then the risk could be perfectly measured by
variance or standard deviation. In fact, then we could also estimate the probability of loss
/lower than expected return precisely. More generally if we knew the distribution of returns,
we could estimate the probability that the returns will be below any arbitrary level.
 The idea has been applied and is called Value-at- Risk or VaR. It is based on the assumption
that we know the return distribution either based on historical experience or through
estimation.
 The fact is that the stock returns are not normally distributed. They exhibit fat tails and more
mass in the middle. Such distributions are called leptokurtic.
 For this course, we will continue to pretend that only mean and variance of return matters, all
other characteristics of return distribution (such as skewness, kurtosis etc.) are minor
inconveniences with very little first-order effect for analysis and understanding. In practice,
one may have to extend and incorporate further nuances depending upon the context.
RISK AND RISK-AVERSION
 Having explored idea, definition and characterization of risk, we need to specify as to why
anyone cares for risk and what are the consequences of such preferences?
 Leaving aside non-economic risks such as risk to life, limb and liberty; do people care about
economic risks?
 To formalize the idea, let us assume that a typical person is offered two choices- (a) to receive
100 $/INR for sure, or (b) a payoff of 0 $/INR with probability 0.5 and 200 $/INR with
probability 0.5. Most people prefer (a) given such a choice and can be called risk-averse.
 More formally, anyone who avoids playing a “fair bet” is risk-averse. A fair bet is one which
has expected payoff of zero. A risk-averse person has to be induced to participate in playing a
fair bet by paying him/her some amount. The amount is a compensation for taking the risk.
 Such a person’s utility is a concave function of wealth as depicted in next slide.
UTILITY FUNCTION OF A
RISK-AVERSE AGENT
UTILITY FUNCTION OF A
RISK-AVERSE AGENT
 Here, the investor/economic agent’s objective is to maximize expected utility rather than to maximize
the expected outcome.
 As we saw in the previous slide, the utility function is increasing in wealth monotonically, i.e., U’(W) >
0.
 Also, the utility function is increasing in wealth at a decreasing rate. i.e., U’’(W) < 0.
 The vertical distance between the dotted line representing the expected utility of the $50000 (with
probability 0.5) and $150,000 (with probability 0.5) and solid graph representing utility of $100,000 is
the amount required for the person to assume the risk of getting 50/50 $50,000 or $150,000 as compared
to certain $100,000. More formally, U (E (Ŵ)) > E (U (Ŵ)) or the utility of expected outcome is more
than the expected utility of outcomes.
 Further, the absolute risk-aversion of a person (Arrow-Pratt measure) is defined as-

RA = - U’’ (W) / U' (W)

 Higher risk-aversion of an individual requires higher compensation to assume a given risk.
SUMMARY
 To summarize, we can model economic agents as expected utility maximizers exhibiting risk-
aversion (concave utility function in wealth) and requiring compensation (to overcome the
difference in expected utility vis-à-vis utility of expected value/outcome) to assume any given
risk.
 Further recall that a first approximation, we can characterize the risk of investing in financial
assets as the variance (or standard deviation) of asset return.
 The return on invested wealth determines the level of wealth at the end of the investment
period and hence maximizing expected wealth end-of-the-period is same as maximizing
expected return.
 The first two statements imply that any risk-averse investor would prefer higher return for any
given level of risk (as measured by std. dev.), and would prefer lower risk for any given level
of expected return.
DOES RISK-TAKING GETS
REWARDED?
Any Questions?