RISK AND RETURN

1.1 Return
Return is an income received on an investment plus any change in market
price, usually expressed as a percentage of the beginning market price of
the investment. The return from holding an investment over some period –
say, a year – is simply any cash payments received due to ownership, plus the
change in market price, divided by the beginning price.
In other words, it is a reward from holding an investment for some period-say, a
year. It is simply any cash payments received due to ownership, plus the change
in market price, divided by the beginning price.
Arithmetically, returns can be calculated as follows:
Return=

X 100

For common stock we can define one-period return as

where R is the actual (expected) return when t refers to a particular

time period in the past (future); Dt is the cash dividend at the end
of time period t; Pt is the stock‟s price at time period t; and Pt−1 is
the stock‟s price at time period t−1. Note that this formula can be
used to determine both actual one-period returns

You might, for example, buy for ₦100 a security that would pay
₦7 in cash to you and be worth ₦106 one year later. The return
would be (₦7 + ₦6)/$100 = 13%. Thus return comes to you from
two sources: income plus any price appreciation (or loss in price).
 Example: If you made an investment in the shares of a company in 2005 which
were selling for N50 per unit and decided to sell the shares at the rate of N60
per unit, what is your rate of return?

Return= EPp - BPp X 100

BPp

Return= N60 - N50 x 100= 20%

N50

1.2. Risk
Risk simply means the variability of returns from those that are
expected. Most people would be willing to accept our definition of
return without much difficulty. Not everyone, however, would
agree on how to define risk, let alone how to measure it. To begin
to get a handle on risk, let‟s first consider a couple of examples.
Assume that you buy a Federal Government Treasury note (T-
note), with exactly one year remaining until final maturity, to yield
8 percent. If you hold it for the full year, you will realize the
government-guaranteed 8 percent return on your investment – not
more, not less. Now, buy a share of common stock in any company
and hold it for one year. The cash dividend that you anticipate
receiving may or may not materialize as expected. And, what is
more, the year-end price of the stock might be much lower than
expected – maybe even less than you started with. Thus your actual
return on this investment may differ substantially from your
expected return. If we define risk as the variability of returns from
those that are expected, the T-note would be a risk-free security
whereas the common stock would be a risky security. The greater
the variability, the riskier the security is said to be.

Every investment decision is guided by an assessment of risk and the return

expected. Financial managers generally prefer having higher returns and lower
risks on their investments. Because of this desire, they try at any point in time to
strike a balance between risk and expected return. The higher the level of risk
associated with a given investment, the higher the expected return. That is to say,
there is a trade-off between risk and expected return. But that does not prevent one
from investing in risky assets over the long term in the hope of benefiting from this
trade-off.

The Risk-averse financial managers (those afraid of risks) tend to invest in less
risky stocks while the Risk-seekers or lovers invest in highly risky securities
because of their desire for higher returns. This explains why some investors
speculate on higher risks ventures, but the rational investor will always try to
determine the level of risk associated with a given investment before he commits
his funds into it.

1.3 Using Probability Distributions to Measure Risk

Probability distribution is a set of possible values that a random
variable can assume and their associated probabilities of
occurrence. As we have just noted, for all except risk-free
securities, the return we expect may be different from the return
we receive. For risky securities, the actual rate of return can be
viewed as a random variable subject to a probability distribution.
This probability distribution can be summarized in terms of two
parameters of the distribution: (1) the expected return and (2) the
standard deviation.
1.3.1 Expected return
Expected return is the weighted average of possible returns, with the
weights being the probabilities of occurrence.
The expected return, R is
R
where Ri is the return for the ith possibility, Pi is the probability of
that return occurring, and n is the total number of possibilities.
Thus the expected return is simply a weighted average of the
possible returns, with the weights being the probabilities of
occurrence.
To complete the two parameter description of our return
distribution, we need a measure of the dispersion, or variability,
around our expected return. The conventional measure of
dispersion is the standard deviation which is the measure of the
variability of a distribution around its mean.
It is the square root of the variance. The greater the standard
deviation of returns, the greater the variability of returns, and the
greater the risk of the investment. The standard deviation, σ, can
be expressed mathematically as:
Example
Let us look at two companies A and B, whose returns and associated probabilities
are as follows:
COMPANY A COMPANY B
r P r P
6 0.1 4 0.1
7 0.25 6 0.2
8 0.3 8 0.4
9 0.25 10 0.2
10 0.1 12 0.1

If (r) represents the required rate of return from each investment and (p) is the
associated probability of a given return occurring, we can, therefore, estimate
the level of risks of the two companies A and B above as follows:

Solution
COMPANY A
R p (R)(P) ( R1 – R ) ( R1 – R )2 ( R1 – R )2 p

6 0.1 0.6 -2 4 0.4

7 0.25 1.75 -1 1 0.25

8 0.3 2.4 0 0 0

9 0.25 2.25 1 1 0.25

10 0.1 1 2 4 0.4
∑(R)(P) or R=8.00 ∑( R1 – R )2 p =1.3

Variance (σ) = ∑( R1 – R )2p =1.3

Standard Deviation ( σ ) = √∑( R1 – R )2p
(σ ) = =1.14
 COMPANY B
R p (R)(P) ( R1 – R ) ( R1 – R )2 ( R1 – R )2 p

4 0.1 0.4 -4 16 1.6

6 0.2 1.2 -2 4 0.8

8 0.4 3.2 0 0 0

10 0.2 2 2 4 0.8

12 0.1 1.2 4 16 1.6

∑(R)(P) or R = 8.00 ∑( R1 – R )2 p =4.8

Variance (σ ) = ∑( R1 – R )2p =4.8

Standard Deviation ( σ ) = √∑( R1 – R )2p
(σ) =2.19 = 2.2
Decision: Because the Expected Return from either investment is the same, the
Investor will prefer Company A because its risk is lower than that of Company
B.
However, if the Expected Returns were different, Speculator will not mind
shouldering higher risks for higher returns.
CLASS WORK
Use the probability distribution of the possible one-year returns to
calculate expected return and standard deviation of return.
Possible Probability of
Return (Ri) occurrence
(Pi)

-0.10 0.05
-0.02 0.10
0.04 0.20
0.09 0.30
0.14 0.20
0.29 0.10
0.28 0.05
1.4 Systematic and Unsystematic Risks:
Risks can be grouped into two component parts, systematic and unsystematic risks
1. Systematic Risks: These are risks caused by factors external to the business,
and therefore cannot be controlled by the business or the investor. These
risks affect the entire market and neither the company nor the investor can
prevent their occurrence. Systematic risks can be sub-divided into;
 Market Risk: This is a risk that arises due to changes in the market
behaviour of the capital. The market may experience a decline in the
prices of stocks due to factors such as unstable political climate,
government policy changes, war, economic meltdown, religious and
other ethnic crises. A stock market situation where the prices of stocks
are continuously rising for a given period is called the Bull market, and
the market situation where the prices of stocks are continuously
declining is called the Bear market. In Nigeria, we have experienced
the Bull market from the late 90s up to around 2005. The bearish
market began from around 2006.

 Interest Rate Risk: The rise or fall in interest rates affects the
availability of funds in the hand of the investors, especially the
Speculators. If the cost of borrowing is low, people will borrow money
from the banks to invest in stocks with the expectation of making
higher returns. High cost of borrowing, on the other hand, implies low
money in the hand of investors for stock purchases. The decline in the
purchase of stocks will inadvertently lead to a decline in their prices.
Fluctuation in interest rates does not only affect the investors or the
stock market, it also affects the companies who carry out their activities
with borrowed funds.
  Purchasing Power Risk: Generally, inflation in the economy leads to
reduction in purchasing power of consumers, and variations in the
expected returns from investments are caused by loss in purchasing
power. The increase in the cost of raw materials, labour and equipment
will lead to increase in the cost of production and hence, increase in the
prices of goods and services. If the manufacturer cannot pass on the
increased costs to the consumer, it means there will be a reduction in
the profitability of the business. Reduction in profitability leads to
lower returns.

2. Unsystematic Risks: These are risks which are unique and peculiar to the
business, and can, therefore, be controlled by the business. Unsystematic
risks can arise due to managerial inefficiency, poor machinery, liquidity
(finance) problem, disruption in the production system, labour problems,
unavailability of raw materials, change in consumer preference, etc.
Unsystematic risk can be broadly classified into:
a. Business Risk: an aspect of the unsystematic risks which is caused by the
business operating environment.
b. Financial Risk: an aspect of the unsystematic risk caused by the variability of
income due to the capital structure of the company. The capital structure of the
company consists of equity and borrowed funds. The presence of debt funds in the
capital structure of the company can affect the payments of dividend to be made to
equity holders.

Regardless of whether a risk is systematic or unsystematic, the possible risks

that can occur in the business environments may include Finance risk, Capital
risk, Country risk, Default risk, Delivery risk, Economic risk, Exchange rate
risk, Interest rate risk, Liquidity risk, Operations risk, Payment system risk,
Political risk, Refinancing risk, Reinvestment risk, Settlement risk, Sovereign
risk, and Underwriting risk, etc
1.5 Attitude Toward Risk
The finance manager should know how risks are measured and how to cope
with dynamism of investment and financing through the capital market.
It is worthy of note that, if a business organization uses excessive debt to
finance growth, investors may perceive it as risky. The value of a firm share
may shrink or decline. In the same vein, investors may not like the decision of
a highly profitable, growing firm to distribute dividend. They may like the firm
to plough back the profits into more lucrative and prospective opportunities
(investments) that would enhance futuristic prospects of high capital gains.
These types of operations in capital markets are where investors
continually assess the capability of the finance manager, after
all investments involve risk and return.
In selecting securities form available investment options, the finance manager
tries to match alternative investments with the specific needs of the firm, after
taking into account such considerations as safety, convenience, yield, and
maturity.

In short, the composition of the firm‟s investment portfolio is determined

while keeping in mind the trade-off that exists between risk and return.
1.6 Risk-Return Trade-off
Investment decisions involve varying degree of risk. If an Investor makes an
investment in government securities, the risk of the investment is minimal because
the likelihood of default on the investment might not be there. However, the rate
of return (interest) on such securities will be smaller due to the low level of risks
involved. Generally, we can expect lower returns and lower risks on government
securities, and higher returns with higher risks on the shares of private companies.
Risk and Return move in the same direction (direct relationship). The greater the
risk, the greater the return. The relationship between risk and return can be
expressed by the following equation:
 Return = Risk free rate + Risk Premium.
Risk-free rate is the rate applicable to government securities, while the Risk
premium is the additional risk over and above the risk-free rate which is added
to the risk-free rate to get the expected return. Therefore, in government
securities, return = risk-free rate, while in other investments, Return = Risk-free
rate + Risk Premium.