Chapter 3

Risk and Return Management

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2.1 Measurement of Risk and Return
• Risk and return are the two most important
attributes of an investment
• Return is the net reward generated from an
investment. It is a gain or loss made from an
investment.
• Generally historical return can be calculated
using the following formula

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 Risk and Return
• Risk is the variability of return because of
different uncertainties.
• Probabilities are used to evaluate the risk
involved in a return.
• Expected rate of return is the weighted average
of possible returns from a given investment.
Mathematically it is given by:

Where

Pi= Probability, ri= return at each state of nature 3

 Risk and Return
• Research has shown that the two are linked in the capital
markets and that generally, higher returns can only be
achieved by taking on greater risk.
• Risk isn’t just the potential loss of return, it is the potential
loss of the entire investment itself (loss of both principal
and interest).
• Consequently, taking on additional risk in search of higher
returns is a decision that should not be taken lightly.

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 Different Types of Risks
• Controllable Risks (Unsystematic Risks)
1. Operating risk
2. Liquidity risk
3. Credit Risk
• Uncontrollable Risks ( systematic Risks)
1. Market risk
2. Interest rate risk
3. Inflation risk
4. Political risk
5. Exchange rate risk
6. Legal Risk
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 Measuring risk
1. The standard deviation is an absolute measure
of risk. The smaller the standard deviation, the
lower the risk of the investment and vice versa.

2. Coefficient of variation is a relative measure of

risk computed simply by dividing the standard
deviation for a security by expected value:

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 Example 1
Consider the possible rates of return that you
might earn next year on a $ 50,000
investment in stock A or on a $50,000
investment in stock B, depending up on the
states of the economy: recession, normal, and
prosperity. Calculate
1. The expected return of stock A and B
2. The standard deviation of stock A and B
3. The coefficient of variation of stock A and B
4. Which one is more risky?

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State of Return of Return Probabilit
Economy stock A of y
Stock B
Recession -5% 10% 0.2
Normal 20% 15% 0.6
Prosperity 40% 20% 0.2

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2.2 Risk Diversification and Portfolio Management

• It is risky to hold a single financial asset in

isolation
• It is better to hold a group of securities in
order to minimize risk
• This group of assets held to gather are called
portfolio
• The portfolio return is the weighted average of
the returns of the securities
rp = w1r1 +w2r2 + … wnrn 9
 Portfolio Risk of two asset
1. Portfolio risk is not the weighted average of the
standard deviation
2. Portfolio risk can be minimized by diversification
3. The degree to which risk is minimized depends on
[8-15] the correlation between the two assets combined

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 By combining two perfectly negative correlated securities,
the overall portfolio risk can be completely eliminated
Returns
If returns of A and B are
%
20% perfectly negatively correlated,
a two-asset portfolio made up of
equal parts of Stock A and B
would be riskless. There would
15% be no variability
of the portfolios returns over
time.

10%

Returns on Stock A
Returns on Stock B
5%
Returns on Portfolio

Time 0 1 2

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 Combining two perfectly positive correlated
assets does not help to reduce risk
Returns
If returns of A and B are
%
20% perfectly positively correlated, a
two-asset portfolio made up of
equal parts of Stock A and B
would be risky. There would be
15% no diversification (reduction of
portfolio risk).

10%
Returns on Stock A
Returns on Stock B
5%
Returns on Portfolio

Time 0 1 2

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 Can we Diversify all Risks
Answer : No
Securities consists of two components of risk

1. Diversifiable risk ( Controllable or unsystematic risk)

This risk is part of security risk that can be controlled
through diversification. This type of risk is unique to a
given security
– Operating risk
– Liquidity risk
– Default risk

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2. Non Diversifiable risk(Non controllable or
systematic risk
– This risk results from forces outside of the firms’
control and is therefore not unique to the given
security.
– It is due to factors affecting all assets such as energy
prices, interest rates, inflation, business cycles .
– This type of risk is measured by the beta coefficient
• Inflation risk
• Interest rate risk
• Market risk
Total Risk = Systematic Risk + Unsystematic Risk

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s
Unsystematic
Risk
Total
Risk

Systematic
Risk

No. of assets

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 Example 2
A portfolio consists of assets A and B. The
return, the standard deviation, and Weight of
each of these securities is given below.

Asset Weight Return Standard

deviation
A 1/3 18% 20%
B 2/3 9% 10%

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Calculate :

1. The expected return on the portfolio

R= 0.12 or 12%
2.3 Capital Asset pricing Model (CAPM)

The capital asset pricing model is a model that

relates the risk measured by beta to the level
of expected rate of return on a security.

Where
r=required rate of return
rf = risk free rate (eg. rate of t-bill)
rm = market rate of return
β = an index of non diversifiable risk 18
• CAPM was discovered by William F. Sharpe
( 1934 – present)
• He is the 1990 noble prize winner economist
 Example 3
Assuming that the risk free rate is 8% and the
market rate is 12%, calculate the rate of return
for specific security if the beta coefficient has
the following values.
1. β=0
2. β = 0.5
3. β =1.0
4. β =1.5
5. β =2.0

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 What is Beta(β)?

β is a measure of the security volatility relative to the average

security in the market. It is given by the following formula

Where:
–M = rm – rf
–K = ri – rf
–n= number of years

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 Interpreting b
• if b = 0
– asset is risk free
• if b = 1
– asset risk = market risk
• if b > 1
– asset is riskier than market index
 b<1
– asset is less risky than market index

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 Example 4
Compute the beta coefficient using the
following data for stock x and the market
portfolio. Assume that the risk free rate is 6%.
Year Rate of return Market rate
2001 -5 10
2002 4 8
2003 7 12
2004 10 20
2005 12 15
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