Chapter 7: Return and Risk

Financial Analysis and Control

Prepared By:
Dr. H. M. Mosarof Hossain
Professor
Department of Finance
University of Dhaka
[email protected]
[email protected]

1
 Return
 Return: Percentage form of earnings from an
investment or asset including normal income
and capital gain or loss is called return. Return
may be the following three types:
1. Real risk-free return: The rate of return will be
earned without facing inflation and risk
problems is known as real risk-free return.
2. Risk-free rate of return – rate of return can be
earned by making investment in government
securities of a country is known as risk-free
rate of return.
 Return
3. Real rate of return - rate of return
determined by considering/adjusting
existing level of inflation or without facing
inflation problem but facing risk problems
is known as real rate of return.
4. Nominal rate of return – rate of return
calculated by ignoring existing level of
inflation and risks or by facing both
inflation and risk problems is known as
nominal rate of return.
 Risk
 Risk is the concept of fluctuations. This fluctuations can be
(i) a deviation of the actual return from the expected return,
or
(ii) a deviation of average return from the year to year
return. Higher the fluctuations, higher is the risk.

 Types of risk:
i. Systematic risk – risk that can not be avoided or
minimized and that is out of control of an individual or a
business enterprise.
ii. Unsystematic risk - risk that can not be avoided but can
be minimized by making intellectual decision and that is
to some extent under the control of an individual or a
business enterprise.
 Risk
iii. Business risk – risk related to overall business activities of a
particular business enterprise that is mostly out of control of
that business enterprise.
iv. Financial risk - risk related to using of fund from debt sources
for forming and running business operations or making
investments by a particular party that is under the control of
that party.

Measures of risk:
i. Standard Deviation – absolute measurement of total risk
ii. Coefficient of Variation - relative measurement of total risk
iii. Beta Coefficient - absolute measurement of systematic risk
iv. Covariance -is a measure of how much two random variables
change together
Correlation coefficient-is a measure of the strength and direction
of the linear relationship between two variables
 Formula for calculating of Risk-Return

Expected Return E ( R) R 
 R
 ( R * P )
i
i i
n

Risk  
 i
( R  R ) 2

( For time series data)

n 1
Risk    i i
( P ) ( R  R ) 2
( for probabilit y distribution)
 Example #1: Calculation of Risk-Return
(Historical Data)
Year Return (%) Dev. (Ri-E(R)) Dev. Square
1 20 7 49
2 5 -8 64
3 -5 -18 324
4 15 2 4
5 30 17 289
Mean Return= 13% Sum of Dev sq= 730
Standard
Deviation2 730/(5-1)= 182.5
Standard
Deviation= Square root (182.5) 13.5%
 Example # 2: Calculation of Risk-Return
(Probability Distribution)
Expected
Probability Return (Ri) Value Deviation Deviation
(Pi) (%) (Pi*Ri) (Ri-E(R)) Square Dev sq* Pi
(25-13.25) (11.25)2 (138*.25)
0.25 25 6.25 =11.75 =138.0625 =34.52
(14-13.25) (0.75)2 (.56*.5)
0.5 14 7 =0.75 =0.5625 =0.28
(0-13.25) (-13.25)2 (175*.25)
0.25 0 0 =-13.25 =175.5625 =43.89
Stand
E(R)= 13.25% Dev2= 78.69
Risk= 8.87% Stand Dev 8.87
 03. Wylie Electronics is considering an investment
in a new improved chip-making machine. The
company estimates that there is a 20% chance of a
30% loss, a 25% chance of a 6% loss, a 30%
chance of a 25% return and a 25% chance of a
40% return. Requirements:
 What is the expected return from this investment?
 What is the level of risk?
(a) E(R) = ∑ Pi*Ri
= P*R + P*R +P*R +P*R
=0.20*(0.30)+0.25*(0.06)+0.30*0.25+0.25*0.40
= 0.10 =10%

(b) σ = √ {∑ Pi [ Ri – E(R)]2}
= √ {P [R -E(R )] 2+ P [R -E(R )] 2+ P [R -E(R )] 2+
P [R -E(R )] 2}
= √ {0.20[-0.30-0.10] 2 + 0.25[-0.06-0.10] 2 +
0.30[0.25-0.10] 2 + 0.25[0.40-0.10] 2}= 26.01%
04: Year Rates of return
2016 6%
2017 9%
2018 7%
2019 12%

E(R) = (6% + 9% + 7% + 12%)/4 = 8.5%

σ == √ [{(0.06 - 0.085)2 + (0.09 - 0.085)2 + (0.07-
0.085)2 + (0.12 - 0.085)2 }/4]
= 0.0229 = 2.29%
 Risk-return relationship i.e.
Security Market Line (SML)

Capital asset pricing model (CAPM): The model

determines expected rate of return from an investment based
on risk-free rate of return and level of systematic risk that is
applied as discount rate for calculating intrinsic value of the
investment or asset that is used for ultimate investment
decision making is known as capital asset pricing model. It is
a set of predictions concerning equilibrium expected return on
risky assets. This was introduced by William Sharpe, Jhon
Lintner and Jan Mossin in 1964. The model is as follows:

E(R) = Rf + (Rm – Rf)β, here E(R) = Expected rate of return.

Rf = Risk-free rate, Rm = Market rate, β = Beta coefficient i.e.
level of systematic risk.
 Risk-return relationship i.e.
Security Market Line (SML)
Return [E(R)]

SML

E(Rj)

E(Rm)

Rf=5%

Systematic Risk (Beta)

βm=1 βj=1.9
Comments on beta
 If beta = 1.0, the security is just as risky as the
average stock.
 If beta > 1.0, the security is riskier than average.
 If beta < 1.0, the security is less risky than
average.
 Most stocks have betas in the range of 0.5 to
1.5.
 Risk premium
The rate of return can be earned by making
investment in risk-free asset is called risk free
rate of return and the rate of return can be
earned by making investment in risky asset is
called nominal risky rate of return. Generally
the nominal risky rate of return is higher that
risk-free rate of return. The increased
required rate of return over risk-free rate of
return is called risk premium.
 Sources of risk premium
1. Business risk- related to normal business
operations.
2. Financial risk- related to capital structure or
financing decision.
3. Liquidity risk- related to convert the investment into
cash easily and quickly.
4. Foreign exchange rate risk- related to increase or
decrease foreign exchange rate.
5. Country risk- related to mainly overall political
situation of the country.
 Determinants of required rate of return
1. The real risk-free rate: The rate of return can be
earned by making investment in risk-free sector
in absence of inflation is known as real risk-free
rate. The government sector of any country is
considered as risk-free sector.
2. Inflation premium: The rate of return can be
earned for compensating the loss for prevailing is
known as inflation premium.
 Determinants of required rate of return:

3. Expected risk premium: The additional rate

of return to be required for compensating
additional level of risk for making
investment in risky asset or for doing risky
business.
4. Conditions in the capital market: The impact
of the existing monetary and fiscal policies
of the government applicable within the
country and the probable change of these.
Example # 05: Mr A has available fund Tk.500000 for
making investment. He is planning to invest
Tk.150000 in project X and Tk.350000 in project
Y. The information related to these two projects is
given in the following table with correlation
coefficient is 0.80 (Po = initial price, P1=ending
price, D1 or I1 ordinary income):
 Asset X Asset Y
Current Expected Probability Dividend Current Expected Probability Dividend
price(Po) price (P1) (Pi) % income price(Po) price (P1) (Pi) % income
(D1) (I1)
120 130 20 15 950 960 35 100
110 35 970 25
115 15 940 40
125 30
Returns of asset X Prob. Returns of asset Y Prob
(%) (%)
Return (R) = (P1-P0+D1)/P0 Return (R) = (P1-P0+I1)/P0
R1 20 R1 35
=(130-120+15)/120=0.2083 35 =(960-950+100)/950=0.115 25
R2 8
15 40
=(110-120+15)/120=0.0417 R2
30
R3 =(970-950+100)/950=0.126
=(115-120+15)/120=0.0833 3
R4 R3
=(125-120+15)/120=0.1667 =(940-950+100)/950=0.094
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Expected Return: E(Rx)= ∑ Pi Ri
= P1R1+ P2R2+ P3R3+ P4R4
= .20*.2083+.35*0.0417+0.15*0.0833+.30*0.1667
= 0.01188=11.88%

Risk: σx = √ {∑ Pi [ Ri – E(Rx)]2}
= √{ P1 [ R1 – E(Rx)]2 + P2[ R2 – E(Rx)]2 + P3 [ R3 –
E(Rx)]2 + P4 [ R4 – E(Rx)]2 }
= √ {0.20 (0.2083-0.1188)2 + 0.35 (0.0417-0.1188)2 + 0.20
(0.0833-0.1188)2 + 0.20 (0.1667-0.1818)2}
= 0.0675=6.75%
Expected Return of Y: E(Ry) = ∑ Pi Ri
= P1R1+ P2R2+ P3R3
= 0.35*0.1158+.25*0.1263+0.40*0.0947= 11%
Risk:σy = √ {∑ Pi [ Ri – E(Ry)]2}
= √{ P1 [ R1 – E(Ry)]2 + P2[ R2 – E(Ry)]2 + P3
[ R3 – E(Ry)]2 +}
= √ {0.35 (0.1158-0.11)2 + 0.25 (0.1263-0.11)2 +
0.40 (0.0947-0.11)2 }
= 0.0131=1.31%