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Risk and Return For Print

This chapter discusses investment returns and risk. It defines returns as the financial results of an investment expressed in dollar or percentage terms. Returns have two components - income return from interest/dividends and capital gains/losses from price changes. Total return is the sum of these. Risk is the variability of returns from expected returns and can come from market, inflation, business and other sources. Expected return is calculated by weighting possible returns by their probabilities. Standard deviation measures the variability of returns around the expected value and is used to quantify risk.

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Tahir Desta
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27 views

Risk and Return For Print

This chapter discusses investment returns and risk. It defines returns as the financial results of an investment expressed in dollar or percentage terms. Returns have two components - income return from interest/dividends and capital gains/losses from price changes. Total return is the sum of these. Risk is the variability of returns from expected returns and can come from market, inflation, business and other sources. Expected return is calculated by weighting possible returns by their probabilities. Standard deviation measures the variability of returns around the expected value and is used to quantify risk.

Uploaded by

Tahir Desta
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Chapter 2

Risk and
Return
What are investment returns?
 Investment returns measure the financial results of an
investment.
 Returns may be historical or prospective (anticipated).
 Returns can be expressed in:
 Dollar terms.
 Percentage terms.
 Returns can be :
 Realised / historical returns
 Expected returns.
Return Components
 Returns consist of two elements:
 Periodic cash flows such as interest or
dividends (income return)
 “Yield” measures relate income return to
a price for the security
 Price appreciation or depreciation (capital
gain or loss)
 The change in price of the asset
 Total Return =Yield +Price Change
What is the return on an investment that costs
$1,000 and is sold after 1 year for $1,100?

 Dollar return:
$ Received - $ Invested
$1,100 - $1,000 = $100.
 Percentage return:

$ Return/$ Invested
$100/$1,000 = 0.10 = 10%.
Defining Return
Income received on an investment
plus any change in market price,
price
usually expressed as a percent of
the beginning market price of the
investment.
Where: Dt = Dividend, Pt =current price,
Pt-1 = original price, & R = return
Dt + (Pt - Pt-1 )
R=
Pt-1
Return Example
The stock price for Stock A was $10 per
share 1 year ago. The stock is currently
trading at $9.50 per share and shareholders
just received a $1 dividend.
dividend What return
was earned over the past year?
Return Example
The stock price for Stock A was $10 per
share 1 year ago. The stock is currently
trading at $9.50 per share and shareholders
just received a $1 dividend.
dividend What return
was earned over the past year?

$1.00 + ($9.50 - $10.00 )


R= = 5%
$10.00
Measures of Historical Rates of Return
Holding period returns:
Measures realized returns over a period of holding an
investment.
(Sale price  Purchase price)  Current income
HPR 
Purchase price
Capital gain/loss  Current income

Purchase price

Example: At the beginning of the year a stock was selling for


birr 40 per share and at a time Ato Abebe purchased 100
shares. Over the year the stock paid 5 per share and year-end
market price became 45. What is the return of Ato Abebe from
the investment?
Dividend = 5* 100= 500
Capital gain = (45-40) * 100 =500
Total return = 500+500 = 1000
Percentage of return
 Percentage of return: this is summarizing returns in
terms of percentage than absolute dollars. It
answers a question of how much do we get for each
dollar we invest. Following the previous example
 Dividend yield = Dt+1/Pt = 5/40= 12.5%
 Capital gain = (Pt+1 -Pt)/Pt = (45-40)/40 = 12.5%
 Total return = dividend yield + Capital gain = 12.5%
+12.5%= 25%
 Total percentage of return = (D t+1 + (Pt+1 -Pt))/ Pt
Measuring Returns
 For comparing performance over time or across
different securities
 Total Return is a percentage relating all cash
flows received during a given time period,
denoted CFt +(PE - PB), to the start of period
price, PB

CFt  (PE  PB )
TR 
PB

11
Defining Risk
The variability of returns from
those that are expected.
What rate of return do you expect on your
investment (savings) this year?
What rate will you actually earn?
Does it matter if it is a bank CD or a share
of stock?
What is investment risk?

 Typically, investment returns are not


known with certainty.
 Investment risk pertains to the
probability of earning a return less than
that expected.
 The greater the chance of a return far
below the expected return, the greater
the risk.
Risk Sources
 Interest Rate Risk  Financial Risk
 Affects income return  Tied to debt financing
 Market Risk  Liquidity Risk
 Overall market effects  Marketability with-out
sale prices
 Inflation Risk
 Purchasing power
 Exchange Rate Risk
variability  Country Risk
 Business Risk  Political stability
Risk Types
 Two general types:
 Systematic (general) risk
 Pervasive, affecting all securities, cannot be
avoided
 Interest rate or market or inflation risks
 Nonsystematic (specific) risk
 Unique characteristics specific to issuer
 Total Risk = General Risk + Specific Risk
Measurement of risk (absolute measure of risk)
 Standard deviation measures the stand-alone
(Total) risk of an investment.
 The larger the standard deviation, the higher
the probability that returns will be far below
the expected return.
 Coefficient of variation (a relative measure
of risk) is an alternative measure of stand-
alone risk. It measures the standard deviation
in relation to expected return. It measures the
risk per unit of expected return. So as the
coefficient of variation increases, so does the
risk of an asset.
Determining Expected
Return (Discrete Dist.)
n
R =  ( Ri )( Pi )
i=1

R is the expected return for the asset,


Ri is the return for the ith possibility,
Pi is the probability of that return
occurring,
n is the total number of possibilities.
Note: Continuous and discrete distribution
 A continuous distribution describes the
probabilities of the possible values of
a continuous random variable.
A continuous random variable is a random
variable with a set of possible values (known as
the range) that is infinite and uncountable.
 Unlike a continuous distribution, which has an
infinite number of outcomes, a discrete
distribution is characterized by a limited number
of possible observations.
How to Determine the Expected
Return and Standard Deviation

Stock BW
Ri Pi (Ri)(Pi)
The
-.15 .10 -.015 expected
-.03 .20 -.006 return, R,
.09 .40 .036 for Stock
BW is .09
.21 .20 .042
or 9%
.33 .10 .033
Sum 1.00 .090
Determining Standard
Deviation (Risk Measure)
n
=  ( Ri - R )2( Pi )
i=1

Standard Deviation,
Deviation , is a statistical
measure of the variability of a distribution
around its mean.
It is the square root of variance.
Note, this is for a discrete distribution.
How to Determine the Expected
Return and Standard Deviation

Stock BW
Ri Pi (Ri)(Pi) (Ri - R )2(Pi)
-.15 .10 -.015 .00576
-.03 .20 -.006 .00288
.09 .40 .036 .00000
.21 .20 .042 .00288
.33 .10 .033 .00576
Sum 1.00 .090 .01728
Determining Standard
Deviation (Risk Measure)
n
= 
i=1
( Ri - R ) 2
( P i )

= .01728

= .1315 or 13.15%
Coefficient of Variation
The ratio of the standard deviation of
a distribution to the mean of that
distribution.
It is a measure of RELATIVE risk.
CV =  / R
CV of BW = .1315 / .09 = 1.46
Determining Expected
Return (Continuous Dist.)
n
R =  ( Ri ) / ( n )
i=1

R is the expected return for the asset,


Ri is the return for the ith observation,
n is the total number of observations.
Determining Standard
Deviation (Risk Measure)
n
=  ( R i - R )2
i=1

(n)
Note, this is for a continuous
distribution where the distribution is
for a population. R represents the
population mean in this example.
Continuous Distribution
Problem
 Assume that the following list represents the
continuous distribution of population returns
for a particular investment (even though there
are only 10 returns).
 9.6%, -15.4%, 26.7%, -0.2%, 20.9%,
28.3%, -5.9%, 3.3%, 12.2%, 10.5%
 Calculate the Expected Return and
Standard Deviation for the population
assuming a continuous distribution.
Risk Attitudes
Certainty Equivalent (CE)
CE is the
amount of cash someone would
require with certainty at a point in
time to make the individual
indifferent between that certain
amount and an amount expected to
be received with risk at the same
point in time.
Risk Attitudes
Certainty equivalent > Expected value
Risk Preference
Certainty equivalent = Expected value
Risk Indifference
Certainty equivalent < Expected value
Risk Aversion
Most individuals are Risk Averse.
Averse
Risk Attitude Example
You have the choice between (1) a guaranteed
dollar reward or (2) a coin-flip gamble of
$100,000 (50% chance) or $0 (50% chance).
The expected value of the gamble is $50,000.
 Mary requires a guaranteed $25,000, or more, to
call off the gamble.
 Aron is just as happy to take $50,000 or take the
risky gamble.
 Shannon requires at least $52,000 to call off the
gamble.
Risk Attitude Example
What are the Risk Attitude tendencies of each?

Mary shows “risk aversion” because her


“certainty equivalent” < the expected value of
the gamble.
Aron exhibits “risk indifference” because her
“certainty equivalent” equals the expected value
of the gamble.
Shannon reveals a “risk preference” because
her “certainty equivalent” > the expected value
of the gamble.

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