Risk and Return

Chapter Objectives
• Discuss the concepts of average and expected rates of return.
• Define and measure risk for individual assets.
• Show the steps in the calculation of standard deviation and
variance of returns.
• Compute historical average return of securities and market
premium.
• Determine Expected Returns and Variances
• Calculating Coefficient of Variation
• Portfolio Risk and Return
• Systematic and Unsystematic
• Risk Diversification
• CAPM
 Introduction
An investment is the current commitment of
dollars for a period of time in order to derive
future payments that will compensate the
investor for
• the time the funds are committed,
• the expected rate of inflation, and
• the uncertainty of the future payments
 Holding Period Return
• If you commit GHȼ200 to an investment at the beginning
of the year and you get back GHȼ220 at the end of the
year, what is your return for the period? The period
during which you own an investment is called its holding
period, and the return for that period is the holding
period return (HPR). In this example, the HPR is 1.10,
calculated as follows

• However, investors generally evaluate returns in

percentage terms on an annual basis which is called
holding period yield (HPY): HPY = HPR – 1
 Return on a Stand Alone Asset
• Total return = Dividend + Capital gain
Rate of return  Dividend yield  Capital gain yield
DIV1 P1  P0 DIV1   P1  P0 
R1   
P0 P0 P0

• Year-to-Year Total Returns on HLL Share

160.00 149.70
T ota l R e tu r n (% )

140.00
120.00
100.00 92.33

80.00 70.54

60.00 49.52 52.64

36.13
40.00 22.71
16.52 12.95
20.00 7.29
0.00
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

Year
 Return on a Stand Alone Asset
• What is the return on an investment that costs
GHȼ1,000 and is sold after 1 year for GHȼ1,100?
• Ghana Return
GHȼ Received - GHȼ Invested
GHȼ1,100 - GHȼ1,000 = GHȼ100.
• Percentage return
Return/Amount Invested
100/1,000 = 0.10 = 10%.
 Average Rate of Return
• The average rate of return is the sum of the
various one-period rates of return divided by
the number of period.
• Formula for the average rate of return is as
follows: 1 1 n
R = [ R1  R 2    R n ]   Rt
n t =1 n

• The rate of return can be calculated for a

single asset or a portfolio of assets.
 Risk
Risk is the uncertainty that an investment will earn its
expected rate of return. Also, risk refers to the
chance that some unfavorable event will occur. The
greater the chance of a return far below the
expected return, the greater the risk.
• An asset’s risk can be analyzed in two ways:
1. on a stand-alone basis, where the asset is considered
in isolation, and
2. on a portfolio basis, where the asset is held as one of
a number of assets in a portfolio.
 Risk for a Stand Alone Asset
• Thus, an asset’s stand-alone risk is the risk an
investor would face if he or she held only this
one asset.

• Two possible measures of risk (uncertainty)

have received support in theoretical work on
portfolio theory: the variance and the standard
deviation of the estimated distribution of
expected returns
 Risk of Rates of Return: Variance and
Standard Deviation
• Formulae for calculating variance and
standard deviation:
Standard deviation = Variance

1 n
 
2
 
2

n  1 t 1
Rt  R
 Risk of Rates of Return: Variance and
Standard Deviation
• ABC Ltd, a company traded on the GSE made
the following returns over a ten-year period.
Year Returns
2000 0.1
2001 0.32
2002 0.12
2003 0.25
2004 0.23
2005 0.09
2006 0.11
2007 0.42
2008 -0.12
2009 0.15
 Calculate the average return and the risk of ABC
 Risk of Rates of Return: Variance and
Standard Deviation
• Average return = 0.167
Year Returns (R-Rbar)(R-Rbar)^2
2000 0.1 -0.067 0.0045
2001 0.32 0.153 0.0234
2002 0.12 -0.047 0.0022
2003 0.25 0.083 0.0069 0.0219
2004 0.23 0.063 0.0040
2005 0.09 -0.077 0.0059
2006 0.11 -0.057 0.0032 0.148
2007 0.42 0.253 0.0640
2008 -0.12 -0.287 0.0824
2009 0.15 -0.017 0.0003
Risk of Rates of Return: Variance and
Standard Deviation
• Standard deviation measures the stand-alone
risk of an investment.

• The larger the standard deviation, the higher

the probability that returns will be far below
the expected return and therefore the higher
the risk
 Expected Return Vrs Risk
• Although the analysis of historical
performance is useful, selecting investments
for your portfolio requires you to predict the
rates of return you expect to prevail. An
investor who is evaluating a future investment
alternative expects or anticipates a certain
rate of return. This may be a point estimate or
range.
 Expected Return Vrs Risk
• An investor determines how certain the expected rate of
return on an investment is by analyzing estimates of
expected returns. To do this, the investor assigns
probability values to all possible returns.
• These probability values range from zero, which means no
chance of the return, to one, which indicates complete
certainty that the investment will provide the specified rate
of return.
• These probabilities are typically subjective estimates based
on the historical performance of the investment or similar
investments modified by the investor’s expectations for the
future.
 Expected Return Vrs Risk
• The expected return from an investment is
defined as
 Expected Return Vrs Risk
• Below are forecasts of the various economic
conditions in Ghana with the likely returns for
Zee Ltd.

Calculate the expected return for Zee Ltd

 Expected Return Vrs Risk

Economic Conditions Prob Returns (P*R)

Strong Economy 0.15 0.2 0.03
Waek Economy 0.15 -0.2 -0.03
Normal Economy 0.7 0.1 0.07
Expected return= 0.07
 Expected Return Vrs Risk
• We can then calculate the variance and
standard deviation of the returns as follows;
 Expected Return Vrs Risk
• We can calculate the variance and standard
deviation for Zee Ltd as;
Economic Conditions Prob Returns (P*R) R- E(R) [R-E(R )]^2P[R-E(R )]^2
Strong Economy 0.15 0.2 0.03 0.13 0.0169 0.002535
Waek Economy 0.15 -0.2 -0.03 -0.27 0.0729 0.010935
Normal Economy 0.7 0.1 0.07 0.03 0.0009 0.00063
Variance =0.0141
𝑺𝒕𝒂𝒏𝒅𝒂𝒓𝒅 𝑫𝒆𝒗 = ξ 𝟎. 𝟎𝟏𝟒𝟏 = 0.1187
 Relative Measure of Risk
• In some cases, an unadjusted variance or standard
deviation can be misleading. If conditions for two
or more investment alternatives are not similar—
that is if there are major differences in the
expected rates of return—it is necessary to use a
measure of relative variability to indicate risk per
unit of expected return. A widely used relative
measure of risk is the coefficient of variation (CV),
calculated as follows:
 Relative Measure of Risk

The CV for the preceding example would be;

 Relative Measure of Risk
Consider the following two investments;
Stock A Stock B
Expected Return 0.07 0.12
Standard Deviation 0.05 0.07
Expected Return : Incorporating Probabilities
in Estimates
• The expected rate of return [E (R)] is the sum
of the product of each outcome (return) and
its associated probability:
RETURNS UNDER VARIOUS ECONOMIC CONDITIONS
Economic Conditions Share Price Dividend Dividend Yield Capital Gain Return
(1) (2) (3) (4) (5) (6) = (4) + (5)
High growth 305.50 4.00 0.015 0.169 0.185
Expansion 285.50 3.25 0.012 0.093 0.105
Stagnation 261.25 2.50 0.010 0.000 0.010
Decline 243.50 2.00 0.008 – 0.068 – 0.060

RETURNS AND PROBABILITIES

Economic Conditions Rate of Return (%) Probability Expected Rate of Return (%)
(1) (2) (3) (4) = (2)  (3)
Growth 18.5 0.25 4.63
Expansion 10.5 0.25 2.62
Stagnation 1.0 0.25 0.25
Decline – 6.0 0.25 – 1.50
1.00 6.00
 Expected Risk and Preference
• A risk-averse investor will choose among investments
with the equal rates of return, the investment with
lowest standard deviation. Similarly, if investments
have equal risk (standard deviations), the investor
would prefer the one with higher return.
• A risk-neutral investor does not consider risk, and
would always prefer investments with higher returns.
• A risk-seeking investor likes investments with higher
risk irrespective of the rates of return. In reality, most
(if not all) investors are risk-averse.
 Review Question 1
• Cronox Industries and Zealous Incorporated share
prices and dividends are shown below for the
period 1995 – 2000.
  Cronox Industries Zealous Incorporated

Year Stock price Dividend (GH¢) Stock price Dividend(GH¢)

2010 7.62 0.85 55.75 2.00

2011 12 0.90 60.00 2.25

2012 10.75 0.95 57.25 2.50

2013 17 1.00 48.75 2.75

2014 15.75 1.06 52.30 2.90

2015 17.25 1.15 48.75 3.00

 Review Question 1
• Use the data given to calculate annual returns for Cronox, and Zealous.
• Compute average return (Arithmetic Average) over the five year period (2006-
2010)
• Calculate the risk (standard deviation of returns) for both Cronox and Zealous.
• Calculate the coefficient of variation for both companies
• Compare the two companies in terms of risk and returns.
• Calculate the correlation coefficient between the two stock
• Calculate the portfolio risk and return assuming the assets are equally weighted.
• Assuming Kweku invested GH¢20,000 in the stocks of Cronox Industries and GH
¢30,000 in that of Zealous Incorporated with a correlation coefficient between
the two firms of 0.8, what is the portfolio risk and return?