Professor K.

Ozgur Demirtas
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RISK AND RETURN

A. Rates of return
Example 1. On Jan. 1, you paid $10,000 for 100 shares of a stock, which pays $10
per share in dividends annually (at the end of each year). A year later,
on Dec. 31, the market price of the stock reached $130. Find the
return on your investment?
you paid: $10,000
you could get: $13,000 + $1,000
your $ return = amount received - amount invested = $14,000-$10,000=$4,000
the rate return = $4,000 / $10,000 = 40%
amount received - amount invested dollar return
single period rate of return, r  
amount invested amount invested

Example 2. You are considering an investment, but want an estimate of how much
money you can make, i.e. you want to know the expected return on
your investment. What can you do?
Expected return: the average return you can expect to earn if you buy an asset at the
offered price.
You can look at what can happen under alternative scenarios:

Recession Normal Boom

Probability 0.3 0.5 0.2

Stock X 4% 5% 10%
Professor K. Ozgur Demirtas
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n
Expected rate of return, E (r )   Pi  ri where, Pi is the probability of the scenario i
i 1

ri is the return under scenario i

X: E (rx ) = (0.3)(4) + (0.5)(5) + (0.2)(10) = 5.7%

 Knowing the expected return (in this case, 5.7%) is not enough. The second
question we need to ask is whether this return is high enough, i.e., whether it
exceeds our benchmark return, which we will call the required return.

 How do we determine the fair return for any particular investment?

Look what you can earn on alternative investments.

Example 3. One alternative to buying stock X from example 2, is to invest the

money in stock Y. The distribution of the returns on this stock is as
follows.

Recession Normal Boom

Probability 0.3 0.5 0.2

Stock Y 12% 5% -3%

Which investment should you chose?

Y: E (rY ) = (0.3)(12) + (0.5)(5) + (0.2)(-3) = 5.5%
 E(rx) > E(ry) but is E(ry) an appropriate benchmark?
 Are there alternative benchmarks?
 We should control for relative riskiness of X and Y.
Professor K. Ozgur Demirtas
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B. Risk
 Risk = degree of variability of investment returns
 We could depict the return pattern from example 2 in the form of a probability
distribution:

probability

0.6

0.4

0.2

0
-4 -2 0 2 4 5 8 10 12 14
Rate of return (%)

 Compare to the probability distribution of returns on stock Y.

probability

0.6

0.4

0.2

0
-4 -2 2 5 8 12
Rate of return (%)

Proposition:
People usually prefer safer investments, unless the riskier ones provide
sufficiently higher return, i.e., investors require risk premiums from risky assets.
This is because investors are risk-averse.
required return, E(r) = rf + RP , where rf = risk-free rate

 Intuitively, expected return demanded by investors for a particular asset depends

on 2 things:

 The pure time value of money

Measured by risk-free rate, rf. This is the reward for merely waiting for your
money, without taking any risk.
Professor K. Ozgur Demirtas
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 The reward for bearing risk = risk premium

This is the reward for worrying, i.e. for bearing risk in addition to waiting
for your money.

Proposition:
The fair return is the same for investments of the same level of risk.

C. Measuring risk
 Asset risk is often measured as the variance of the asset’s returns.
 Variance measures the average degree of deviation from the average return.
 We can calculate the variance using return distribution data:
n
   Pi  (ri  E (r )) 2
2

i 1

Example 4.
Compute the variance stocks X and Y based on the probability distribution of their
returns:

Recession Normal Boom Expected

Probability 0.3 0.5 0.2

Stock X 4% 5% 10% 5.7%

Stock Y 12% 5% -3% 5.5%

2X = (0.3)(4 - 5.7)2 + (0.5)(5 - 5.7)2 + (0.2)(10 - 5.7)2 = 4.81

X =  2  4.81 = 2.19%

2Y = (0.3)(12 - 5.5)2 + (0.5)(5 - 5.5)2 + (0.2)(-3 - 5.5)2 = 27.26

Y =  2  27.26 = 5.22%
Professor K. Ozgur Demirtas
These materials are copyrighted. Copying, modifying or distributing without permission of the Professor is prohibited.

D. An Alternative Method to Estimate the Expected Return and the Variance

Example 5. Consider the following historical data:

Rate of Return

Stocks Bonds

year 1990 -5% 14%

year 1991 15% 8%
year 1992 25% 4%

1 n
expected return  arithmetic average return, E (r )  r   ri
n i 1

1 n
2  
n  1 i 1
(ri  r ) 2

 calculate the expected rate of returns

E (rs ) = (-5% + 15% + 25%) / 3 = 11.67%

E (rb ) = (14% + 8% + 4%) / 3 = 8.67%

 calculate the standard deviations

 2S = [(-5-11.67)2 + (15-11.67)2 + (25-11.67)2 ] / 2 = 233.33
S = 233.33 = 15.28%
  2
B = [(14-8.67)2 + (8-8.67)2 + (4-8.67)2 ] / 2 = 25.33
B = 2523
. = 5.03%

 which investment would you prefer?

Professor K. Ozgur Demirtas
These materials are copyrighted. Copying, modifying or distributing without permission of the Professor is prohibited.

In class, we will go much further. First we will analyze simple expectation and variance
operators. Then, we will examine the variance and expected return of a portfolio formed
by a riskless asset and a risky portfolio.

We will then plot the Capital Allocation Line (CAL) and discuss portfolios on that line.

So for now consider the following:

Suppose c and d are constants and X and Y are a random variables.

What can you say for the following operations?

E(cX)=?

Var(cX)=?

Std(cX)=?

E(cX+dY)=?

E(cX+d)=?

Var(cX+d)=?

Std (cX+d)=?

Var(c)=?

Std(c)=?

E(c)=?