Chapter Two: Risk and Return

2. Introduction

Investment decisions are backed by various motives. Some people make investment to acquire
control and enjoy prestige associated with it, some to display their wealth, and some just for the
sake of putting their excess money in some places. But most people invest their limited resource
with an aim to get certain benefits in the future. These future benefits are the returns you get on
the investment. Return is the driving force behind investment. In the case of a fixed income
security like a debenture, the returns you get are in the form of periodic interest payments and
repayment of principal at the end of the maturity period. Similarly, in the case of an equity share,
the returns are in the form of dividends and the price appreciation of the share.

On the other hand, risk is about the variability of expected returns. From the perspective of
financial analysis, risk is the possibility that the actual cash flow will be different from forecasted
cash flows (returns) of an investment. Therefore, if an investment’s returns are known for
certainty the security is called a risk free security. An example on this regard is Government
treasury securities. This is because it is quite sure that there is no chance that the government will
fail to redeem these securities at maturity or that the treasury will default on any interest payment
owed.

With regard to investment in financial securities, there are always some levels of uncertainty
associated with future holding period returns. Such uncertainty is commonly known as the risk of
the investment. Then the question will be what causes the uncertainty (or volatility) of an
investment’s returns? The answer depends on the nature of the investment, the performance of
the economy, and other factors.

2.1 The concept of risk

In its simplest form, risk is the possibility of loss or injury, and/or the possibility of not getting
the expected return. The difference between expected return and actual return is called risk of the
investment. Investments can be represented as high-risk, medium-risk and low-risk investments.
In addition, risks can be categorized in to systematic risks and unsystematic risks based on the
controllability of factors that causes uncertainty of returns.

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Systematic risks

The systematic risk is caused by factors external to the particular company and uncontrollable by
the company. Systematic risk affects the market as a whole. It refers to that portion of the total
variability of the return caused by common factors affecting the prices of all securities alike
through economic, political and social factors.

Unsystematic risks

Unsystematic risk is caused by factors that are specific, unique and related to the particular
industry or company. It refers to portion of the total variability of the return caused due to unique
factors, relating to that firm or industry. It includes factors like management failure, labor strikes,
raw material scarcity, etc.
Sources of Risk

Sources of risks that potentially leads to deviation of actual results with expected results are
discussed below:

a) Interest rate risk

Interest rate risk is the variation in the single period rates of return caused by the fluctuations in
the market interest rate. Most commonly, the interest rate risk affects the debt securities like
bonds and debentures.

b) Market risk

Market risk is the possibility of incurring a loss due to factors that affect the overall performance
of the financial market in which he or she is involved. Market risk is also known as systematic
risk and it cannot be eliminated through diversification, though it can be hedged against in other
way.

c) Purchasing power risk

It refers to the variation in investor expected return caused by Inflation. It is another type of
systematic risk and cannot be diversified away.

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 d) Business risk

Every company operates with in a particular operating environment; and it comprises both
internal environment within the firm and external environment outside the firm. Business risk is
thus a function of the operating conditions faced by a company and is the variability in operating
income caused by the operating conditions of the company.

e) Financial risk

It refers to the variability of the income to the equity capital due to the debt capital. Financial risk
in a company is associated with the capital structure of the company. The debt in the capital
structure creates fixed payments in the form of interest. This creates more variability in the
earning per share available to equity shareholders. This variability of return is called financial
risk and it is a type of unsystematic risk.

f) Liquidity risk

An investment which is easily and quickly saleable or marketable without loss of money is said
to possess liquidity. Thus, liquidity risk is an element of financial risk in which an investor might
not be able to sell his or her financial securities quickly and without significant loss in value.

g) Exchange rate risk

Exchange rate is the rate at which a currency can be traded in exchange for another currency.
Thus, exchange rate risk is the risk of changes in an exchange rate or in the foreign exchange
value of a currency. Currency risk occurs in three forms: transaction exposure (short-term),
economic exposure (effect on present value of longer-term cash flows) and translation exposure
(book gains or losses). When we came to investment in financial securities, exchange rate risk is
the uncertainty of returns to an investor who acquires securities denominated in a currency
different from his or her own. The likelihood of incurring this risk is becoming greater as
investors buy and sells assets around the world, as opposed to only assets within their own
countries.

h) Country risk

It is also called political risk. It is the uncertainty of returns caused by the possibility of a major

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change in the political or economic environment of a country. It includes political instability,
macro-economic crises, natural disaster and the likes. Individuals who invest in countries that have
unstable political or economic systems must add a country risk premium when determining their
required rates of return.

2.2 Concept of Return

Return is the benefit associated with an investment, and represents rewards for making an
investment. Investments are made with the primary objective of obtaining a return. Thus, return
is the driving force behind every commercial investment. Many investments have two
components of measurable return. Return on investment may be received in the form of regular
income (yield) such as dividend or interest, and income from capital appreciation (capital gain)
on the investment such as the difference between the sales price and the purchase price of the
security.

Return = Yield (Dividend, Interest) + Capital Appreciation

 Yields: - represent regular income paid for the investors in the form of dividend for
equity instrument holders and interest for debt instrument holders.
 Capital appreciation: - represent the difference between price of the instrument at the
end period and at the time of investment.
2.3 Measurement of risk and return

Selection of securities for investment requires estimation and evaluation of the expected risk-
return trade-offs for the available investment alternatives. Therefore, you must understand how
to measure the rate of return and the risk involved in an investment alternative accurately. To
meet this need, we will examine ways to quantify return and risk. The discussion will consider
how to measure both historical and expected rates of return and risk.

2.3.1 Measures of Historical Rates of Return

When we invest, we defer current consumption in order to add to our wealth so that we can
consume more in the future. Therefore, when we talk about a return on an investment, we are
concerned with the change in wealth resulting from this investment. This change in wealth can

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be either due to cash inflows, such as interest or dividends, or caused by a change in the price of
the asset (positive or negative). Let’s see some measures of historical returns as they are starting
point to estimate expected (future) rates of return of the investment.

Holding Period Return (HPR)

The period during which you own an investment is called its holding period, and the return for
that period is called the Holding Period Return (HPR).

For example, if you commit $200 to an investment at the beginning of the year and you get back
$220 at the end of the year, what is your return during one year holding period?

Holding Period Return (HPR) will always be zero or greater—that is, it can never be a negative
value. A value greater than 1.0 reflects an increase in your wealth, which means that you
received a positive rate of return during the period. A value less than 1.0 means that you suffered
a decline in wealth, which indicates that you had a negative return during the period. An HPR of
zero indicates that you lost all your money. In the above example, the HPR is 1.10 which is
above the threshold 1 and profitable.

Holding Period Yields (HPY)

Although HPR helps us express the change in value of an investment, investors generally
evaluate returns in percentage terms on an annual basis. This conversion to annual percentage
rates makes it easier to directly compare alternative investments that have markedly different
characteristics. The first step in converting an HPR to an annual percentage rate is to derive a
percentage return, referred to as the holding period yield (HPY). The HPY is equal to the HPR
minus 1.

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For the above example:

Annual Holding Period Return (Annual HPR)

It is expression of return on annual bases. It can be calculated by using overall Holding Period
Return (HPR) as follows;

Where: n = number of years the investment is held

Example 2: Consider an investment that cost $250 initially and it worth $350 after being held
for two years. Overall HPR, Annual HPR and Annual HPY of the investment are calculated as
follows;

Note that we made some implicit assumptions when converting the HPY to an annual basis. This
annualized holding period yield computation assumes a constant annual yield for each year. In
the two-year investment, we assumed an 18.32 percent rate of return each year, compounded.

If you experience a decline in your wealth value from $500 to $400, the computation is as
follows:

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Consider an investment that cost $1,000 initially and it worth $750 after being held for two
years. A multiple year loss over two years would be computed as follows:

In contrast, consider an investment of $100 held for only six months that earned a return of $112:

In the annualized partial year HPR, we assumed that the return is compounded for the whole
year. That is, we assumed that the rate of return earned during the first part of the year is likewise
earned on the value at the end of the first six months. The 12 percent rate of return for the initial
six months compounds to 25.44 percent for the full year. Because of the uncertainty of being
able to earn the same return in the future six months, institutions will typically not compound
partial year results.

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Remember one final point: The ending value of the investment can be the result of a positive or
negative change in price for the investment alone (for example, a stock going from $20 a share to
$22 a share), income from the investment alone, or a combination of price change and income. In
most cases, ending value includes the value of everything related to the investment.

Computing Mean Historical Returns

Now that we have calculated the HPY for a single investment for a single year, we want to
consider mean rates of return for a single investment and for a portfolio of investments. Over a
number of years, a single investment will likely give high rates of return during some years and
low rates of return, or possibly negative rates of return, during others. Alternatively, you might
want to evaluate a portfolio of investments that might include similar investments (for example,
all stocks or all bonds) or a combination of investments (for example, stocks, bonds, and real
estate). In this instance, you would calculate the mean rate of return for this portfolio of
investments for an individual year or for a number of years. Single Investment given a set of
annual rates of return (HPYs) for an individual investment, there are two summary measures of
return performance. The first is the arithmetic means return, the second the geometric mean
return. To find the arithmetic mean (AM), the sum (∑) of annual HPYs should be divided by the
number of years (n) as follows:

AM =∑annual HPY/n

Where:

∑HPY = the sum of annual holding period yields

An alternative computation, the Geometric Mean (GM), is the nth root of the product of the
HPRs for n years.

Where:
π=¿ Product of the annual holding period returns as follows:
( HPR1) × (HPR2) ... (HPRn)

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Investors are typically concerned with long-term performance when comparing alternative
investments. GM is considered a superior measure of the long-term mean rate of return because
it indicates the compound annual rate of return based on the ending value of the investment
versus its beginning value.

Although the arithmetic average provides a good indication of the expected rate of return for an
investment during a future individual year, it is biased upward if you are attempting to measure
an asset’s long-term performance.

When rates of return are the same for all years, the GM will be equal to the AM. If the rates of
return vary over the years, the GM will always be lower than the AM. The difference between
the two mean values will depend on the year-to-year changes in the rates of return. Larger annual
changes in the rates of return—that is, more volatility—will result in a greater difference
between the alternative mean values.

An awareness of both methods of computing mean rates of return is important because published
accounts of investment performance or descriptions of financial research will use both the AM
and the GM as measures of average historical returns.

Example: To illustrate these alternatives, consider an investment with the following data and
calculate AM and GM of the investment.

Year Beginning value Ending value HPR HPY

1 100 115 1.15 0.15

2 115 138 1.0954 0.0954

3 138 110.4 0.928 -0.072

Arithmetic Mean (AM) return;

= (0.15+0.0954-0.072) / 3

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 = 0.0578

= 5.78%

Geometric Mean (GM) return;

= (1.15 * 1.0954 * 0.0928)(1/3) – 1

= 0.0534

= 5.34%

Arithmetic Mean of 5.78% represents constant level of return expected in the next three years
on simple interest basis. Whereas geometric mean of 5.34% represent compounding level of
return in the next three years.

2.3.2 Measuring Expected Rates of Return

In the prior section, we examined historical rates of return and it could be a good starting point to
project the future. An investor who is evaluating a future investment alternative expects or
anticipates a certain rate of return. The investor might say that he or she expects the investment
will provide a rate of return of 10 percent, but this is actually the investor’s most likely estimate,
also referred to as a point estimate.

Pressed further, the investor would probably acknowledge the uncertainty of this point estimate
return and admit the possibility that, under certain conditions, the annual rate of return on this
investment might go as low as –10 percent or as high as 25 percent. The point is, the
specification of a larger range of possible returns from an investment reflects the investor’s
uncertainty regarding what the actual return will be. Therefore, a larger range of expected returns
makes the investment riskier.

An investor determines how certain the expected rate of return on an investment is by analyzing
estimates of expected returns. To do this, the investor assigns probability values to all possible
returns. These probability values range from zero, which means no chance of the return, to one,
which indicates complete certainty that the investment will provide the specified rate of return.
These probabilities are typically subjective estimates based on the historical performance of the
investment or similar investments modified by the investor’s expectations for the future.

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As an example, an investor may know that about 30 percent of the time the rate of return on this
particular investment was 10 percent. Using this information along with future expectations
regarding the economy, one can derive an estimate of what might happen in the future. The
expected return from an investment is defined as:

Let us begin our analysis of the effect of risk with an example of perfect certainty wherein the
investor is absolutely certain of a return of 5 percent.

Perfect certainty allows only one possible return, and the probability of receiving that return is
1.0. Few investments provide certain returns. In the case of perfect certainty, there is only one
value for PiRi:

E(Ri) = (1.0)(0.05) = 0.05

In an alternative scenario, suppose an investor believed an investment could provide several

different rates of return depending on different possible economic conditions. As an example, in
a strong economic environment with high corporate profits and little or no inflation, the investor
might expect the rate of return on common stocks during the next year to reach as high as 20
percent. In contrast, if there is an economic decline with a higher-than-average rate of inflation,
the investor might expect the rate of return on common stocks during the next year to be –20
percent. Finally, with no major change in the economic environment, the rate of return during the
next year would probably approach the long-run average of 10 percent.

The investor might estimate probabilities for each of these economic scenarios based on past
experience and the current outlook as follows:

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The computation of the expected rate of return [E(Ri)] is as follows:

Problem

Assume that the probability of getting 12 % return from your investment is 25%, probability of
getting 20 % return from your investment is 35% and the remaining probability is earning 8%
return. Calculate your estimated average return.

2.3.3 Measuring the expected Risk of Return

We have shown that we can calculate the expected rate of return and evaluate the uncertainty, or
risk, of an investment by identifying the range of possible returns from that investment and
assigning each possible return a weight based on the probability that it will occur. Although the
graphs help us visualize the dispersion of possible returns, most investors want to quantify this
dispersion using statistical techniques. These statistical measures allow you to compare the
return and risk measures for alternative investments directly. Two possible measures of risk
(uncertainty) have received support in theoretical work on portfolio theory: the variance and the
standard deviation of the estimated distribution of expected returns.

In this section, we demonstrate how variance and standard deviation measure the dispersion of
possible rates of return around the expected rate of return. We will work with the examples
discussed earlier.

Variance

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Variance describes how much a random variable differs from its expected value. The larger the
variance for an expected rates of return, the greater the dispersion of expected returns and the
greater the uncertainty, or risk, of the investment. The formula for variance is as follows:

The variance for the perfect-certainty example of the above Expected Rates of Return discussion
would be:

Note that in perfect certainty, there is no variance of return because there is no deviation from
expectations, and therefore no risk or uncertainty.

On the other hand, the variance for the second example of the above Expected Rates of Return
discussion would be;

Standard Deviation

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It is also the measure of the amount of variation or dispersion of a set of values. Standard
deviation is preferred measure of risk than variance because it is expressed in the same unit as
the data itself. The standard deviation is the square root of the variance:

For the second example, the standard deviation would be:

Therefore, when describing this example, you would contend that you expect a return of 7
percent, but the standard deviation of your expectations is 11.87 percent.

Coefficient of Variance: A Relative Measure of Risk

In some cases, an unadjusted variance or standard deviation can be misleading. If conditions for
two or more investment alternatives are not similar—that is, if there are major differences in the
expected rates of return—it is necessary to use a measure of relative variability to indicate risk
per unit of expected return. A widely used relative measure of risk is the coefficient of variation
(CV);

The CV for the preceding example would be:

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This measure of relative variability and risk is used by financial analysts to compare alternative
investments with widely different rates of return and standard deviations of returns. As an
illustration, consider the following two investments:

Coefficient of Variance of the two investments would be;

Comparing absolute measures of risk, investment B appears to be riskier because it has a

standard deviation of 7 percent versus 5 percent for investment A. In contrast, the CV figures
show that investment B has less relative variability or lower risk per unit of expected return
because it has a substantially higher expected rate of return.

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