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CH 3 - Risk and Return

Risk is the uncertainty of investment returns. It can be measured through standard deviation and coefficient of variation. Standard deviation measures absolute variability of returns, while coefficient of variation measures risk relative to expected return. The document provides examples to calculate expected return, standard deviation, variance and coefficient of variation for two companies XYZ and ABC based on different economic conditions and rates of return. ABC is found to have higher risk than XYZ based on its larger coefficient of variation, indicating more variability in returns relative to expected return.

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ALEMU TADESSE
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86 views26 pages

CH 3 - Risk and Return

Risk is the uncertainty of investment returns. It can be measured through standard deviation and coefficient of variation. Standard deviation measures absolute variability of returns, while coefficient of variation measures risk relative to expected return. The document provides examples to calculate expected return, standard deviation, variance and coefficient of variation for two companies XYZ and ABC based on different economic conditions and rates of return. ABC is found to have higher risk than XYZ based on its larger coefficient of variation, indicating more variability in returns relative to expected return.

Uploaded by

ALEMU TADESSE
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPT, PDF, TXT or read online on Scribd
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Chapter Three

Risk and Return


Risk and Return
• Return: Benefit associated with an Investment
• It is defined as the total gain or loss
experienced on an investment over a given
period of time.
• It does have two components: an income
component and a capital gain or loss
component.
• For example a stock does provide a dividend to
its shareholders during holding period and
capital gain or loss at time of sales.
• Absolute(dollar return)= Periodic income+
Capital gain
• %return= Periodic income+ Capital gain/Initial
value of an investment
• For stock investment,
%return=Dividend/Purchase price+ Capital
gain/purchase price=Dividend yield+ capital
gain rate

3
Measuring Return
Historical rate of return/ Holding period
return

 represents the return an investor received for holding


an investment for a certain period of time.

• The formula for determining the HPR is as follows:

Periodic income + Capital gain/loss


HPR= Purchase price

04-2014 4
Cont’d….
• The stock price for Stock A was Br.10 per
share 1 year ago. The stock is currently
trading at Br.9.50 per share and shareholders
just received a Br.1 dividend.
dividend What return
was earned over the past year?
Average rate of return

• Determine the investment returns over


multiple periods.
• There are two different measures for average
returns:
(a) arithmetic average, and
 (b) geometric average--------Widely used and
applied when values are given in percentage.

6
arithmetic average
• It is a rate of return calculated for a longer
period of time.
• It is the sum of various one period returns
divided by the number of periods.
• Average return (AR)=∑ Rt /n
• Where, n= number of periods,
Rt = returns of individual periods.

7
Cont’d
• ABC co. reported a return of 10%, 12%, 14%,
8% and 6% returns form year 2000 to 2004
respectively. What is the average return of
ABC co?
• AR= 1/5(10+12+14+8+6) =50/5 = 10%

8
Geometric average return

• Geometric Average = [(1+R1) (1+R2) ---+---


(1+Rt)] 1/t -1
• Following the above example average return
will be:
= [(1.10) (1.12) (1.14) (1.08) (1.06)]1/5 - 1 =
(1.60785) 1/5 -1= 1.0996-1= 9.96%

9
Calculating Expected rate of Return

• An investor determines how certain the expected


rate of return on an investment by analyzing
estimates of expected returns.
• To do this, the investor assigns probability
values to all possible returns.

11/24/23 Chapter Two: Risk and Return of A Single Investment 10


cont..

• These probability values range from zero, which


means no chance of return, to one, which indicates
complete certainty that the investment will provide
the specified rate of the return.
• These probabilities are typically subjective
estimates based on the historical performance of the
investment
11/24/23 Chapter Two: Risk and Return of A Single Investment 11
cont..

• The sum of the possible returns multiplied by the


corresponding probability of the return occurring
• The expected return from an investment is defined as;
Expected Return =∑ (probability of return) x
(possible return)
E(Ri) = ∑ (Pi) (Ri)
Example1: The return on securities A and B are given
below:
11/24/23 Chapter One: Risk and Return of A Single Investment 12
CONT..

Probability Security A(%) Security B (%)

0.5 4 0

0.4 2 3

0.1 0 1

11/24/23 Chapter Two: Risk and Return of A Single Investment 13


CONT..

• Required:

• Calculate the expected rate of return for both security, and

1) Make a decision based on the rate of returns of these two securities

Solution:

E(Ri) = ∑ (Pi) (Ri)

E(Ri) A = P1R1 +P2R2+P3R3

= 0.5x4+0.4x2+0.1x0 = 2.8%

E(Ri) B = P1R1 +P2R2+P3R3

= 0.5x0+0.4x3+0.1x1 = 1.3%

Decision: On the basis of return, security A is preferable as its return is higher


11/24/23 Chapter Two: Risk and Return of A Single Investment 14
• Example: Suppose an investor is considering
an investment of 200,000 in the stock of XYZ
co or ABC co. hoping to gain dividend and
selling it at appreciated price after one year.
Over the year it is presumed that the economy
will be 20% at boom, 60% at normal and 20%
at recession. What is the expected return from
the investment given the following rate of
returns in various economic conditions?
15
Economic Probabilities Possible return of XYZ Possible return of ABC
conditions

Boom 0.2 10% -4%

Normal 0.6 11% 20%

Recessions 0.2 26% 40%

16
Defining Risk
• Risk: the chance of financial loss or more
formally, the variability of return associated with
a given asset – uncertainty.

Uncertainty and Risk of Investment


• Unknown outcomes in the future is called
uncertainty.
• When it can be quantified then it is called Risk.
17
• Risk can be:
 systematic and
 unsystematic
• Major sources of uncertainty of investment:
 Business risk
 Financial(leverage) risk
 Liquidity Risk
 Exchange rate risk
 Country Risk

18
Measuring Risk

A risk of an investment can be measured in


absolute term using standard deviations and
variance or in relative terms using coefficient of
variation.

11/24/23 Chapter Two: Risk and Return of A Single Investment 19


Standard deviation: An absolute
measure of risk

Standard deviation- measures the dispersion


around the expected value – the most likely
value.
It is the statistical measure of the dispersion of
possible outcomes about expected value.
It is the square root of the weighted average
square deviations of possible outcomes from the
expected value.
11/24/23 Chapter Two: Risk and Return of A Single Investment 20
Cont’d….
 It is used to measure the variability of returns from an
investment and therefore an indication of risk.
 The largest the standard deviation, the more the
variability of returns and therefore the riskier the
investment is.
 A standard deviation of Zero indicates no variability
and thus no risk involved.
 A standard deviation is useful to evaluate
investments, which have approximately equaled in
expected returns.

21
Determining Standard
Deviation (Risk Measure)
n
 =  ( Ri - ER )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.
•The risk of a single risky asset is calculated as its
standard deviation.
Variance of XYZ Company
Economic Pi Ri ER (Ri-ER)2 (Ri-ER)2 * Pi
conditions

Boom 0.2 10% 13.8% 14.4 2.888

Normal 0.6 1I% 13.8% 7.84 4.704

Recessions 0.2 26% 13.8% 148.84 29.768

Variance 37.36

23
Variance of ABC Company
Economic Pi Ri ER (Ri-ER)2 (Ri-ER)2 * Pi
conditions

Boom 0.2 -4% 19.2% 538.24 107.648

Normal 0.6 20% 19.2% 0.64 0.384

Recessions 0.2 40% 19.2% 432.64 86.528

Variance 194.56

24
Cont’d….
Standard deviation of XYZ co
 =√variance= √37.36 = 6.11
Standard deviation of ABC co
= √variance= √194.56 =13.95

25
Coefficient of variation: A relative measure of risk

• It measures the standard deviation in relation to


expected return.
• It measures the risk per unit of expected return.
• As the coefficient of variation increases, so does the
risk of an asset.
• Coefficient of variation= / ER
• Which one of the securities is highly risky?
• XYZ coefficient of variation = 6.11/13.8=0.44
• ABC coefficient of variation =13.95/19.2=0.73
 the coefficient of variation of ABC is greater than XYZ
means ABC is more risky than XYZ.

26

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