Chapter-2

Risk and Return Analysis

Lecture presentation
 Chapter Flow
 Introduction and Defining Return
 Holding period return and yield
 Historical and Expected returns (Measurement)
 Risk and sources of risks
 Types of risks
 Measurement of risks
 Management of risks
 Attitudes of investors toward risk
 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
6-4
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%.
Definition of returns

 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.

Dt + (Pt - Pt-1 )
R=
Pt-1
 Returns 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.
Ex: X purchased a share at $200 a year ago and sold it now for
$220 and received $20 as a dividend during the period of holding
that security with him then the holding period returns are
Ending Value of Investment  current income recieved
HPR 
Beginning Value of Investment
$220  20
  1.20
$200
Measures of Historical Rates of Return
Holding Period Yield
HPY = HPR - 1
1.20 - 1 = 0.20 = 20%
Measures of Historical Rates of Return

Annual Holding Period Return

Annual HPR = HPR 1/n

where n = number of years investment is held

Annual Holding Period Yield

Annual HPY = Annual HPR - 1
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
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Determining
Determining Expected
Expected Return
Return
(Discrete
(Discrete Dist.)
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.
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.
 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?
Risk Sources
 Interest Rate Risk  Financial Risk
 Affects income return  Tied to debt financing
 Market Risk  Liquidity Risk
 Overall market effects  Marketability with-out
 Inflation Risk sale prices
 Purchasing power
 Exchange Rate Risk
variability  Country Risk
 Business Risk  Political stability

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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

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Measurement 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 is an alternative
measure of stand-alone risk.
 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.
 How
How to
to Determine
Determine the
the Expected
Expected
Return
Return and
and Standard
Standard Deviation
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

Deviation , is a statistical measure of

Standard Deviation,
the variability of a distribution around its mean.
It is the square root of variance.
Note, this is for a discrete distribution.
 How
How to
to Determine
Determine the
the Expected
Expected
Return
Return and
and Standard
Standard Deviation
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
 ( Ri - R )2( Pi )
 = i=1

 = .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.
 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.
 Raleigh 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.
Raleigh 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.
 Summary
 Returns
 Historical and expected returns
 Risks
 Sources of risk
 Measurement of risk
 Risk Attitude

Massachusetts Finance Institute 29