Managerial Finance

Risk & Return

MAHMUDUR RAHMAN (R-213212) 1

1. Risk & Expected Return of Single Project: Risk is the measure of the uncertainty surrounding
the return, which an investment will earn. More formally, the term risk is used interchangeably
with the uncertainty to refer to the variability of the returns associated with a given asset.
Investments whose returns are more uncertain, are generally viewed as being riskier. As for
example; a $1,000 government bond that guarantees its holder $5 interest after 30 days has no
risk, because there is no variability associated with the return. On the contrast, a $1,000
investment in a firm’s common stock, the value of which over the same 30 days may move up
or down a great deal, is very risky because of the high variability of its return.
When we are on the way to assess the risk on the basis of variability of return, we need to be
certain about the returns and how to measure it. The total return from an investment is the sum
of any cash distributions plus the change in the value of investment divided by the beginning
of period value.
 Expected Return in case of the past data where, a specific time period is given;
∑ 𝐑𝐢
̅=
𝐑
𝐧
In case of the assessing of risk and return, an important topic for the measurement is the
Probability Distribution. It does provide a more quantitative insight into an asset’s risk. It
generally express that, the probability of a given outcome is its chance of occurring. An
outcome with an 80% probability of occurrence would be expected to occur 8 out of 10 times
where, an outcome with a probability of 100% is certain to be occurred
 Expected Return in case of the future data where, probability amount is given;
̅ = ∑ 𝐑 𝐢 . 𝐏𝐢
𝐑

Standard Deviation ‘𝜎𝑟 ’, measures the dispersion of an investment’s return around from the
expected return. The expected return is the average return, that an investment is expected to
produce over time.
 Standard Deviation in case of the past data where, a specific time period is given;

̅ )𝟐
∑(𝐑 𝐢 − 𝐑
𝛔=√
𝐧−𝟏

 Standard Deviation in case of the future data where, a specific time period is given;

̅ )𝟐 × 𝐏𝐢
𝛔 = √∑(𝐑 𝐢 − 𝐑

The higher the standard deviation ‘σ’, the higher the amount of risk of that investment.

MAHMUDUR RAHMAN (R-213212) 2

 Coefficient of Variation (CV) is the measurement of relative dispersion, which is useful in
comparing the risks of assets with differing the expected returns. It shows actually the accurate
result about how much riskier or profitable the project or the investment by taking the standard
deviation and the return into consideration.
𝛔
𝐂𝐕 = × 𝟏𝟎𝟎
̅
𝐑
The higher the coefficient of variation, the lower the amount of risk of that investment.

In the all equations above;

̅ = 𝐄𝐱𝐩𝐞𝐜𝐭𝐞𝐝 𝐑𝐚𝐭𝐞 𝐨𝐟 𝐑𝐞𝐭𝐮𝐫𝐧
𝐑 𝛔 = 𝐒𝐭𝐚𝐧𝐝𝐚𝐫𝐝 𝐃𝐞𝐯𝐢𝐚𝐭𝐢𝐨𝐧 CV = Coefficient of Variance
𝐑 𝐢 = 𝐈𝐧𝐝𝐢𝐯𝐢𝐝𝐮𝐚𝐥 𝐑𝐞𝐭𝐮𝐫𝐧 𝐏𝐢 = 𝐑𝐞𝐭𝐮𝐫𝐧 𝐏𝐫𝐨𝐛𝐚𝐛𝐢𝐥𝐢𝐭𝐲 n = Number of Projects

2. Portfolio Risk & Return: In real world situations, the risk of any single investment would not
be viewed independently of other assets. New investments must be considered in light of their
impact on the risk and return of an investor’s portfolio of assets. The financial manager’s goal
is to create an efficient portfolio, which will provide the maximum return for a given level of
risk. We therefore need a way to measure the return and the standard deviation of a portfolio
of the assets.
Return on Portfolio is a weighted average of the returns on the individual assets from which
it is formed. We can use the following formula to measure the portfolio return;

𝐫 𝐏 = ∑ 𝐖𝐢 . 𝐑 𝐢

Standard Deviation in case of the portfolio investment, can be calculated by the following;

𝛔 𝐏 = ∑ 𝐖𝐢 . 𝛔𝐢

The higher the standard deviation ‘σ’, the higher the amount of risk of that investment.

Coefficient of Variation in case of the portfolio investment, can be calculated by the

following;
𝛔𝐏
𝐂𝐕 = × 𝟏𝟎𝟎
̅
𝐑
The higher the coefficient of variation, the lower the amount of risk of that investment.
Where;
𝐈𝐧𝐝𝐢𝐯𝐢𝐝𝐮𝐚𝐥 𝐈𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭 𝐀𝐦𝐨𝐮𝐧𝐭 ̅ = 𝐄𝐱𝐩𝐞𝐜𝐭𝐞𝐝 𝐑𝐞𝐭𝐮𝐫𝐧
𝐑 𝐫 𝐏 = 𝐏𝐨𝐫𝐭𝐟𝐨𝐥𝐢𝐨 𝐑𝐞𝐭𝐮𝐫𝐧
𝐖𝐢 =
𝐓𝐨𝐭𝐚𝐥 𝐈𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭
𝛔 𝐏 = 𝐏𝐨𝐫𝐭𝐟𝐨𝐥𝐢𝐨 𝐑𝐢𝐬𝐤 𝐂𝐕 = 𝐂𝐨𝐞𝐟𝐟𝐢𝐢𝐜𝐢𝐞𝐧𝐭 𝐨𝐟 𝐕𝐚𝐫𝐢𝐚𝐭𝐢𝐨𝐧

MAHMUDUR RAHMAN (R-213212) 3

3. Capital Assets Pricing Model (CAPM): Capital Asset Pricing Model (CAPM) describes the
relationship between the systematic risk and the expected return for the assets, particularly
stocks. CAPM is widely used throughout the finance for pricing the risky securities and
generating the expected returns for the assets, given the risk of those assets and cost of the
capital. The goal of the CAPM formula is to evaluate whether a stock is fairly valued when,
it’s risk and the time value of money are compared to its expected return are not. The real risk
of the security is the market risk, which can not be reduced through the diversification but, an
investor will always try to make the investments on those securities, which are covered with
the moderated risk. The higher the risk of a security, the greater the expected return will be
gained from that security. In this regard, the Capital Asset Pricing Model helps to calculate the
relationship between the expected return of a security and its relevant market risks. In the
Capital Asset Pricing Model, the higher the value of the market risk, the greater the amount of
the risk of the security and thus, the return will be also the higher.

𝐊 𝐬 = 𝐊 𝐫𝐟 + (𝐊 𝐦 − 𝐊 𝐫𝐟 )𝛃
Where;
𝐊 𝐬 = 𝐄𝐱𝐩𝐞𝐜𝐭𝐞𝐝 𝐑𝐚𝐭𝐞 𝐨𝐟 𝐑𝐞𝐭𝐮𝐫𝐧 𝐊 𝐫𝐟 = 𝐑𝐢𝐬𝐤 𝐅𝐫𝐞𝐞 𝐑𝐞𝐭𝐮𝐫𝐧 𝐊 𝐦 = 𝐌𝐚𝐫𝐤𝐞𝐭 𝐑𝐞𝐭𝐮𝐫𝐧
(𝐊 𝐦 − 𝐊 𝐫𝐟 ) = 𝐌𝐚𝐫𝐤𝐞𝐭 𝐏𝐫𝐞𝐦𝐢𝐮𝐦 𝛃 = 𝐌𝐚𝐫𝐤𝐞𝐭 𝐑𝐢𝐬𝐤

After completing this chapter one may achieve the following learning goals, which are
discussed below;
 Understanding the Meaning and Fundamentals of Risk, Return & Risk Preferences: Risk
is a measure of the uncertainty surrounding the return, that an investment will produce. The
total rate of return is the sum of cash distributions, such as; interest or dividends plus the
change in the asset’s value over a given period divided by the investment’s beginning of
period value. Investment returns may vary both over time and between different types of
the investments. Investors may be risk averse, risk neutral or risk seeking. Most financial
decision makers are risk averse. A risk averse decision maker requires a higher expected
return on a more risky investment alternative.
 Describing Procedures for Assessing and Measuring the Risk of a Single Asset: The risk
of a single asset is measured in much the same way as the risk of a portfolio of assets.
Scenario analysis and probability distributions can be used to assess risk. The range, the
standard deviation and the coefficient of variation can be used to measure the amount of
risk quantitatively.

MAHMUDUR RAHMAN (R-213212) 4

 Discussing the Measurement of Return & Standard Deviation for a Portfolio and Concept
of Correlation: Return of a portfolio is calculated as the weighted average of returns on the
individual assets from which it is formed. The portfolio standard deviation is found by
using the formula for the standard deviation of a single asset. Correlation also known as
the statistical relationship between any two series of numbers, can be positively correlated,
negatively correlated or uncorrelated. At the extremes, the series can be perfectly positively
correlated or perfectly negatively correlated.
 Understanding the Risk & Return Characteristics of a Portfolio in terms of Correlation
and Diversification and the Impact of International Assets on a Portfolio: Diversification
involves in combining the assets with lower correlation to reduce the risk of the portfolio.
The range of risk in a two-asset portfolio depends on the correlation between the two assets.
If they are perfectly positively correlated, the portfolio risk will be between the individual
assets’ risks. If they are perfectly negatively correlated, the portfolio risk will be between
the risk of the more risky asset and zero.
 Reviewing Two Types of Risk, Derivation and Role of Beta in Measuring the Relevant Risk
of Both a Security and a Portfolio: The total risk of a security consists of the non-
diversifiable and diversifiable risk. Diversifiable risk can be eliminated through the proper
diversification. On the other hand, non-diversifiable risk is the only relevant risk. Non-
diversifiable risk is measured by the beta coefficient, which is a relative measure of the
relationship between an asset’s return and the market return. Beta is derived by finding the
slope of the ‘Characteristic Line’, that best explains the historical relationship between the
asset’s return and the market return. The beta of a portfolio is a weighted average of the
beta of the individual assets that it includes.
 Explaining the Capital Asset Pricing Model (CAPM): CAPM is the relationship to the
Security Market Line (SML) and the major forces causing shifts in the SML. The CAPM
uses beta to relate an asset’s risk relative to the market to the asset’s required return. The
graphical depiction of the CAPM is SML, which shifts over time in response to the
changing inflationary expectations or the changes in investor risk aversion. Changes in
inflationary expectations result in parallel shifts in the SML. Increasing risk aversion
results in a steepening in the slope of the SML. Decreasing risk aversion reduces the slope
of the SML. Although it has some shortcomings, the CAPM provides a useful conceptual
framework for evaluating and linking the risk and return.

MAHMUDUR RAHMAN (R-213212) 5

 Mathematical Example
Problem 01: You have been asked for your advice in selecting a portfolio of assets and have
been given the following data:
Expected Return
Year
Asset A Asset B Asset C
2019 12% 16% 12%
2020 14% 14% 14%
2021 16% 12% 16%

You have been told that you can create two portfolios, one consisting of assets A & B and the
other consisting of assets A & C by investing equal proportions in each of the two component
assets.
Requirements:
a. What is the expected return for each assets over the 3 year period?
b. What is the standard deviation for each asset’s return?
c. What is the expected return for each of the two portfolios?
d. How would you characterize the correlations of returns of the two assets making up each
of the two portfolios identified in part c?
e. What is the standard deviation for each portfolio?
f. Which portfolio do you recommend and why?

Solution:

a. Given;
For the Asset A, the returns ‘R i ’ are;
2019 2020 2021
12% 14% 16%

We know;
Therefore;
Expected Rate of Return; 12% + 14% + 16%
̅A =
R
∑ Ri 3
̅=
R
n ̅ 𝐀 = 𝟏𝟒%.
∴ 𝐑

Therefore; Expected Rate of Return for Assets A is 14%.

MAHMUDUR RAHMAN (R-213212) 6

 Again;
For the Asset B, the returns ‘R i ’ are;
2019 2020 2021
16% 14% 12%

We know;
Therefore;
Expected Rate of Return; 16% + 14% + 12%
̅B =
R
∑ Ri 3
̅=
R
n ̅ 𝐁 = 𝟏𝟒%.
∴ 𝐑

Therefore; Expected Rate of Return for Assets B is 14%.

And;
For the Asset C, the returns ‘R i ’ are;
2019 2020 2021
12% 14% 16%

We know;
Therefore;
Expected Rate of Return; 12% + 14% + 16%
̅C =
R
∑ Ri 3
̅=
R
n ̅ 𝐂 = 𝟏𝟒%.
∴ 𝐑

Therefore; Expected Rate of Return for Assets C is 14%.

b. We have;
̅’ = 14%. &
Expected Rate of Return for Assets A ‘R
Returns for the Asset A, ‘R i ’ are;
2019 2020 2021
12% 14% 16%

We know; Therefore;
Standard Deviation; (12 − 14)2 + (14 − 14)2 + (16 − 14)2
σA = √
̅ )2 3−1
∑(R i − R
σA = √
n−1 ∴ 𝛔 𝐀 = 𝟐%.
Again;
Therefore; standard deviation for Asset A is 2%.
MAHMUDUR RAHMAN (R-213212) 7
 We have;
̅’ = 14%. &
Expected Rate of Return for Assets B ‘R
Returns for the Asset B, ‘R i ’ are;
2019 2020 2021
16% 14% 12%

We know; Therefore;
Standard Deviation; (16 − 14)2 + (14 − 14)2 + (12 − 14)2
σB = √
̅ )2 3−1
∑(R i − R
σB = √
n−1 ∴ 𝛔 𝐁 = 𝟐%.

Therefore; standard deviation for Asset B is 2%.

And;
We have;
̅’ = 14%. &
Expected Rate of Return for Assets C ‘R
Returns for the Asset C, ‘R i ’ are;
2019 2020 2021
12% 14% 16%

We know; Therefore;
Standard Deviation; (12 − 14)2 + (14 − 14)2 + (16 − 14)2
σC = √
̅ )2 3−1
∑(R i − R
σC = √
n−1 ∴ 𝛔 𝐂 = 𝟐%.

Therefore; standard deviation for Asset C is 2%.

c. Given;
Portfolio investment proportion; Wi = 50% = 0.50.
We know;
Portfolio Expected Rate of Return;

r P = ∑ Wi . R i

MAHMUDUR RAHMAN (R-213212) 8

 Therefore, we get;
Expected Return; 𝐫𝐏 = ∑ 𝐖𝐢 . 𝐑 𝐢
Year
Asset A Asset B Asset C
2019 12% × 0.50 = 6% 16% × 0.50 = 8% 12% × 0.50 = 6%
2020 14% × 0.50 = 7% 14% × 0.50 = 7% 14% × 0.50 =7%
2021 16% × 0.50 = 8% 12% × 0.50 = 6% 16% × 0.50 = 8%

Now;
We know;
Therefore;
Expected Rate of Return; 14% + 14% + 14%
̅ AB =
R
∑ Ri 3
̅=
R
n ̅ 𝐀𝐁 = 𝟏𝟒%.
∴ 𝐑

Therefore; portfolio Expected Rate of Return for Assets AB is 14%.

Again;
We know;
Therefore;
Expected Rate of Return; 12% + 14% + 16%
̅ AC =
R
∑ Ri 3
̅=
R
n ̅ 𝐀𝐂 = 𝟏𝟒%.
∴ 𝐑

Therefore; portfolio Expected Rate of Return for Assets AC is 14%.

d. In case of portfolio assets AB;

As the return on asset A has been increased by 2% in each year and in the meantime the
return on asset B has been declined by 2% in each year therefore, we may say there remains
Perfectly Negative Correlation between the portfolio asset AB. Moreover;
In case of portfolio assets AC;
As the return on asset A has been increased by 2% in each year and in the meantime the
return on asset C has been increased by 2% in each year therefore, we may say there
remains Perfectly Positive Correlation between the portfolio asset AC.

MAHMUDUR RAHMAN (R-213212) 9

e. We have;
̅ AB ’ = 14%. &
Expected Rate of Return for Portfolio Assets AB ‘R
Returns for the Portfolio Asset AB, ‘R i ’ are;
2019 2020 2021
14% 14% 14%

We know; Therefore;
Standard Deviation; (14 − 14)2 + (14 − 14)2 + (14 − 14)2
σ AB = √
̅ )2 3−1
∑(R i − R
σ AB = √
n−1 ∴ 𝛔 𝐀𝐁 = 𝟎%.

Therefore; standard deviation for Portfolio Asset AB is 0%.

Again we have;
̅ AC ’ = 14%. &
Expected Rate of Return for Portfolio Assets AC ‘R
Returns for the Portfolio Asset AC, ‘R i ’ are;
2019 2020 2021
12% 14% 16%

We know; Therefore;
Standard Deviation; (12 − 14)2 + (14 − 14)2 + (16 − 14)2
σ AC = √
̅ )2 3−1
∑(R i − R
σ AC = √
n−1 ∴ 𝛔 𝐀𝐂 = 𝟐%.

Therefore; standard deviation for Portfolio Asset AC is 2%.

f. As portfolio AB has the return 14% with 0% standard deviation where, portfolio AC has
the return 14% with 2% standard deviation therefore, I will recommend the portfolio AB
to make the investment.

MAHMUDUR RAHMAN (R-213212) 10

Problem 02: Currently under consideration is an investment with a beta ‘b’ of 1.50. At this
time, the risk free rate of return ‘R f ’ is 7% and the return on the market portfolio of assets ‘R m ’
is 10%. You believe that this investment will earn an annual rate of return of 11%.

Requirement:
a) Use the Capital Asset Pricing Model (CAPM) to find the required return on this investment.
b) If the return on the market portfolio were to increase by 10%, what would you expect to
happen to the investment’s return? What if the market return were to decline by 10%?
c) On the basis of your calculation in part a, would you recommend this investment? Why or
why not?
d) Assume that as a result of investors becoming less risk averse, the market return drops by
1% and now is 9%. What impact would this change have on your responses in parts c?

Solution:

a) We know;
Required Rate of Return;
K s = K rf + (K m − K rf )β
Given;
Return from the market portfolio; R m = 10% Risk free return rate; R f = 7% Beta = 1.5%

Therefore;
Required Rate of Return;
K s = 7% + (10% − 7%) × 1.5
∴ 𝐊 𝐬 = 𝟏𝟏. 𝟓%.
Therefore; required rate of return is 11.5%.

b) Let;
If the market return increase by 10% then, new market return will be (10% + 10%) = 20%.
Therefore, new portfolio market return; R m = 20%
Therefore;
New Required Rate of Return;
K s = 7% + (20% − 7%) × 1.5
∴ 𝐊 𝐬 = 𝟐𝟔. 𝟓%.
Therefore; required rate of return is 26.5% when market return increase by 10%.

MAHMUDUR RAHMAN (R-213212) 11

 Again;
If the market return decrease by 10% then, new market return will be (10% - 10%) = 0%.
Therefore, new portfolio market return; R m = 0%
Therefore;
New Required Rate of Return;
K s = 7% + (0% − 7%) × 1.5
∴ 𝐊 𝐬 = −𝟑. 𝟓%.
Therefore; required rate of return is -3.5% when market return decrease by 10%.

c) We have the expected rate of return 11% whereas, we are required to have the 11.5% rate
of return. As the expected rate of return is less than the required rate of return therefore,
we shall not invest on that project.

d) Let;
If the market return drops by 1% then, new market return will be (10% - 1%) = 9%.
Therefore, new portfolio market return; R m = 9%
Therefore;
New Required Rate of Return;
K s = 7% + (9% − 7%) × 1.5
∴ 𝐊 𝐬 = 𝟏𝟎%.
Therefore; new required rate of return is 10% when market return drops by 1%.

In that case, we have the expected rate of return 11% whereas, we are required to have the
10% rate of return. As the expected rate of return is greater than the required rate of return
therefore, we shall invest on that project.

MAHMUDUR RAHMAN (R-213212) 12