Risk and Return

Basic return concepts

Basic risk concepts
Stand-alone risk

What are investment returns?

Investment returns measure the
financial results of an investment.
Returns may be historical or
prospective (expected/anticipated).
Return and Risk are part of any
decision (not only investments)

RISK FREE RATES OF RETURN

Risk is defined as the actual or potential variability of

returns from an investment project or portfolio.

Risk-free rate of returns is the expected return from a

financial asset with the lowest default risk or credit
risk in the market.
Treasury

Bills are often considered the risk-free financial

assets. Why?

Risk-free

rate of return sets a floor (minium required

return) under all other returns in the market.

RISK FREE RATES, INTEREST RATES

AND INFLATION

HOLDING PERIOD RETURN

Return for holding an investment for one period (i.e. period of

days, months, years, etc.)

When there is no cash flow during the holding period, then:

P1 - P0
HPR =
P0
P1 = Ending Value of Investment (Ending Investment)
P0 = Beginning Value of Investment (Initial Investment)
HPR = Holding Period Return (as a percentage of Initial Investment)
5

Return in Dollars = Ending Investment Initial Investment

HOLDING PERIOD RETURN

When there is a cash flow in addition to the ending price

(such as the payment of a dividend), the Holding Period
Return formula is:

HPR =

P1+Cash Flow
P0

- P0

HOLDING PERIOD RETURN: EXAMPLE

You bought a stock one year ago for $10. Today, it is worth $12.
Yesterday, you received a $1 dividend. What is your holding
period return?

HPR =

P1+Cash Flow
P0

12 1 10

10
0.30 or 30%

- P0

COMPUTING RETURN (HOLDING

PERIOD)

HOLDING PERIOD RETURN: EXAMPLE

HPR = ($21.9 mill - $ 20.0 mill)/$ 20.0 mill

HPR = 9.5%

RETURNS

Ex Post Returns (After the fact)

Return

that an investor actually realizes

Ex Ante Returns (Before the fact)

Return

that an investor expects to earn

10

COMPUTING EX-POST RETURNS

11

ANALYZING EXPECTED RETURN

Expected Return (
r):
As

future or expected returns are not known with certainty, we

assume that exist a diversity of possible scenarios or events (in the
economy that give rise to a possible return) and each of them
associated with a probability of occurrence.

Expected

return is a weighted average of the individual possible

returns (rj), with weights being the probability of occurrence (pj).

rp
j1

12

Assume the Following

Investment Alternatives
Economy

Prob.

T-Bill

ABC Inc.

RST Ltd.

XYZ Co.

Recession

0.10

2.0%

-22.0%

28.0%

10.0%

Below avg.

0.20

2.0

-2.0

14.7

-10.0

1.0

Average

0.40

2.0

20.0

0.0

7.0

15.0

Above avg.

0.20

2.0

35.0

-10.0

45.0

29.0

Boom

0.10

2.0

50.0

-20.0

30.0

43.0

1.00

Market
-13.0%

What is unique about

the T-bill return?

The T-bill will return 2% regardless

of the state of the economy.
Is the T-bill riskless? Explain.

Do the returns of Alta Inds. and Repo

Men move with or counter to the
economy?
ABC Inc. moves with the economy, so it
is positively correlated with the
economy. This is the typical situation.
RST Ltd. moves counter to the economy.
Such negative correlation is unusual.

Calculate the expected rate of return

on each alternative.
^
r = expected rate of return.

r =

rP .
i i

i=1

^
rABC = 0.10(-22%) + 0.20(-2%)
+ 0.40(20%) + 0.20(35%)
+ 0.10(50%) = 17.4%.

ABC Inc.
Market
XYZ Ltd.
T-bill
RST Co.

^
r
17.4%
15.0
13.8
2.0
1.7

ABC Inc. has the highest rate of return.

Does that make it best?
Do we need any information about risk?

What is risk and how to measure it?

Returns are not known with certainty as future is
uncertain. So we computed and expected return
but there is always a risk.
We need information about how much the
expected return can fluctuate in the future.
Risk is how much the expected return can
fluctuate, then we can get a return higher or
lower than the expected return.

What is risk?
To measure and visualize the dispersion of possible returns
(risk) we need an indicator
Two possible indicators of risk are the variance and the
standard deviation of the expected returns.
Variance and standard deviation measure the dispersion of
possible rates of return around the expected rate of return.

What is risk?
The formula for variance is as follows:

The larger the variance for an expected rate of return, the

greater the dispersion of expected returns and the greater the
uncertainty, or risk, of the investment.
Note that, in condition of full certainty, there is no variance of
return because there is no deviation from expectations and,
therefore, no risk or uncertainty

What is risk?
And, the standard deviation is the square root of the variance

Standard deviation
Variance

Pi .

i 1

Probability distribution
Stock X

Stock Y

-20

15

50

Rate of
return (%)

Which stock is riskier? Why?

What is the standard deviation

of returns for each alternative?

r
i
Pi .

i 1

ABC Inc.:
= ((-22 - 17.4)20.10 + (-2 - 17.4)20.20
+ (20 - 17.4)20.40 + (35 - 17.4)20.20
+ (50 - 17.4)20.10)1/2 = 20.0%.
T-bills = 0.0%.
ABC = 20.0%.

RST =
XYZ =
Market =

13.4%.
18.8%.
15.3%.

 Standard deviation measures the stand-alone risk of an

investment.
The larger the standard deviation, the higher the probability
that returns will be far below (or above) the expected return.
Coefficient of variation is an alternative measure of standalone risk.

Expected Return versus Risk

Security
ABC Inc.
Market
XYZ Ltd.
T-bills
RST Co.

Expected
return
17.4%
15.0
13.8
2.0
1.7

Risk (
20.0%
15.3
18.8
0.0
13.4

Risk of a Single Asset:

Coefficient of Variation
The coefficient of variation, CV, is a measure of relative dispersion that
is useful in comparing the risks of assets with differing expected returns.

A higher coefficient of variation means that an investment has more

volatility relative to its expected return.

Risk of a Single Asset:

Coefficient of Variation (cont.)
A and B are financial assets with returns of 15%
each and a standard deviation of 1.41% and
5.66% respectively, Calculate the coefficients of
variation yields the following:
CVA = 1.41% 15% = 0.094
CVB = 5.66% 15% = 0.377

Coefficient of Variation

Security

Expected
Return R)

Risk

CV
R

ABC Inc.
Market

17.4%
15.0

20.0%
15.3

1.1
1.0

XYZ Ltd.
T-bills
RST Co.

13.8
8.0
1.7

18.8
0.0
13.4

1.4
0.0
7.9

Bonds: Returns, Risk and Spread

Historical Returns for Asset Classes (1900-2011)

Historical Returns and Standard Deviations for Asset Classes

(19002011)

U.S. Financial Markets Domestic Investment

Returns
The graph shows the value of $1 investment made

in each of these asset categories (small stocks,

large stocks, government bonds, treasury bills) in
1926 and held until the end of 2008.
We observe a clear relationship between risk and

return. Small stocks have the highest annual return

but higher returns are associated with much
greater risk.

33

FIN3000, Liuren Wu

Historical risk-return relation

We observe a clear relationship between risk and return. Small

stocks have the highest annual return but higher returns are
associated with much greater risk.

Annual

Small
Stocks

Large
Stocks

Governm
ent
Bonds

Treasu
ry Bills

Return

11.7%

9.6%

5.7%

3.7%

S.D.
34.1% have
21.4%
8.5%
The
riskier investments
historically
realized0.9%
higher returns.
The historical returns of the higher-risk investment classes have

higher standard deviations

34

FIN3000, Liuren Wu

Risk of a Single Asset:

Risk Assessment
A probability distribution is a model that relates probabilities to the
associated possible outcomes. For investment the outcomes are the possible
returns.
Probability is the chance that a given outcome (return) will occur.

2012 Pearson Prentice Hall. All rights reserved.

8-35

Expected Returns
Normal Probability Distributions

Bell-Shaped Curve

Risk of a Single Asset:

Standard Deviation (cont.)
Assuming that the probability distributions of returns for common stocks and
government bonds are normal, we can summarize that (you are asked to complete by
using historical information historical for the US market):

68% of the possible outcomes would have a return ranging between (1 and
for stocks and between and . for bonds
95% of the possible return outcomes would range between (2 .. and for
stocks and between . and . for bonds
Note that the greater risk of stocks is clearly reflected in their much wider range of
possible returns for each level of confidence (68% or 95%).

2012 Pearson Prentice Hall. All rights reserved.

8-38