Risk and

Return
(Single asset and Portfolio)

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Learning Objectives:
 Measurement of Historical Risk and Return of Single Asset

 Measurement of Expected Risk and Return of Single Asset

 Measurement of Historical Risk and Return of Portfolio

 Measurement of Expected Risk and Return of Portfolio

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Financial Products
 Fixed deposits
 Shares / stocks

Why do returns differ??

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 Sharpe Ratio = Return /
Risk

 Risk drives the return on

assets (investments)

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 Defining
Defining Return
Return
Income received on an investment plus
any change in market price, usually
expressed as a percent of the beginning
market price of the investment.

Dt + (Pt – Pt - 1 )
R=
Pt - 1
 Return
Return Example
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. What return
was earned over the past year?
 Return
Return Example
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. What return
was earned over the past year?

$1.00 + ($9.50 – $10.00 )

R= = 5%
$10.00
 Defining
Defining Risk
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 & RETURN
 The concept of risk and return analysis is
integral to the process of investing and finance.

 All financial decisions involve some risk.

 One may expect to get a return of 15% per

annum in his investment but the risk of "not able
to achieve 15% return" will always be there.

 Return is simply a reward for investing, as all

investing involves some risk.
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 RISK & RETURN
 The objective of risk and return analysis is
to maximize the return by creating a balance of
risk.

 For example, in case of working capital

management, the less inventory you keep, the
higher the expected return as less of your
money is locked as asset. But ??

 In case of an investment in shares/stocks, I as

an investor accept to get a better return than
fixed deposits. But ?? 10
 RISK & RETURN
 Risk denotes deviation of actual return
from the estimated return

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RISK & RETURN

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 RISK

 Systematic Risk / Market Risk

(general economic factors)

 Unsystematic Risk / Specific Risk

(company specific)

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 Total
Total Risk
Risk =
= Systematic
Systematic
Risk
Risk ++ Unsystematic
Unsystematic
Risk
Risk
Total Risk = Systematic Risk +
Unsystematic Risk
Systematic Risk is the variability of return on
stocks or portfolios associated with changes
in return on the market as a whole.
Unsystematic Risk is the variability of return
on stocks or portfolios not explained by
general market movements. It is avoidable
through diversification.
 Total
Total Risk
Risk =
= Systematic
Systematic
Risk
Risk ++ Unsystematic
Unsystematic
Risk
Risk
Factors such as changes in the nation’s

STD DEV OF PORTFOLIO RETURN

economy, tax reform by the Congress,
or a change in the world situation.

Unsystematic risk
Total
Risk
Systematic risk

NUMBER OF SECURITIES IN THE PORTFOLIO

 Total
Total Risk
Risk =
= Systematic
Systematic
Risk
Risk ++ Unsystematic
Unsystematic
Risk
Risk
Factors unique to a particular company

STD DEV OF PORTFOLIO RETURN

or industry. For example, the death of a
key executive or loss of a governmental
defense contract.

Unsystematic risk
Total
Risk
Systematic risk

NUMBER OF SECURITIES IN THE PORTFOLIO

 Measurement of RISK & RETURN

 In the investing world, there are a

number of highly technical,
sophisticated metrics that are used
to measure investment risk-return.

 The most commonly used of these

indicators include alpha, beta, r-
squared, standard deviation and the
Sharpe ratio.
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Return on a Single Asset

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Return on a Single Asset

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Return on a Single Asset

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Return on a Single Asset

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Return on a Single Asset

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 Computing Historical Return of Single Asset
The total return on an investment for an given period is
given,

Total Return =

R=
where , R is the total return over the period
C = cash payment received during the period
= ending price of the investment
= Beginning Price of the investment

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 Computing Historical Return of Single Asset
Splitting of total return into two
components i.e. Current yield and
capital/ gains/loss yield

R= = +

Where, = Current Return/Yield

(dividend)
= Capital Return/Yield (capital gain/loss) 24
 Computing Historical Return of Single Asset

Example:
Consider the following information for an
equity stock:
Price at the beginning of the year = Rs.60
Dividend paid at the end of the year = Rs.
2.40
Price at the end of the year : Rs. 69
Calculate the total return, Current yield and
Capital Yield from the investment.
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 Computing Historical Return of Single Asset

Solution:
Price at the beginning of the year = Rs.60
Dividend paid at the end of the year = Rs.
2.40
Price at the end of the year : Rs. 69
total return=
Current yield=
Capital yield=

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Average Annual Returns

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Average Annual Returns

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Average Annual Returns

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Average Annual Returns

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 Average Annual Returns

(a)Arithmetic mean of realised returns for each year

during the given period.

Arithmetic Mean() =
Arithmetic mean is the appropriate measure when you
want to know the central tendency of a series of
returns.

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 Average Annual Returns

Suppose you invest Rs 1 today in a company’s share

for five years.
Rate of returns are 18%, 9%, 0%, -10%, 14%
What is the worth of you shares?
You hold share for five years and assuming dividends of
each year are reinvested in shares.

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 Average Annual Returns

This compound rate of return is the Geometric mean return

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 Average Annual Returns

Ifyou hold your Rs 1 investment in HUL share’s for 11

years

Your 11 years holding return would be: 169%

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 Average Annual Returns
(b)Geometric mean of realised returns for each
year during the given period.
Geometric Mean(GM) = - 1
Geometric mean is the appropriate measure when
you want to know the average compound rate of
growth over a period of time.
For example, cumulative ending wealth generated
by an investment of Rs.1 =
Geometric mean is always less than arithmetic
mean, except when all the return values being
considered are equal.
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 Average Annual Returns
(b)Geometric mean of realised returns for each
year during the given period.
The difference between arithmetic and
geometric mean depends upon the variability
of the distribution.
Greater the variability, greater the difference
between the two means
 = -
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 Average Annual Returns
Example:
Calculate the arithmetic mean return and geometric
mean return , compound growth rate, and cumulative
ending wealth for $1000 investment in stock A.
annual returns from stock A over the five year period
is given below. Year Total Return (%)
1 19.0
2 14.0
3 22.0
4 -12.0
5 5.0
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 Average Annual Returns
Solution:
arithmetic mean return =
geometric mean return =
compound growth rate =
cumulative ending wealth =

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 Variance of Returns
Used to know the variability of returns
Most commonly used measure of variability is
variance or the standard deviation (i.e. square root
of variance)
The variance and standard deviation of a historical
return series:

Variance = =

Standard deviation = = σ

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 Variance of Returns
Example:
Consider the returns from a stock over a 6-year
period. Calculate the variance and standard deviation
of returns from a stock.
Period Return (%)
1 15
2 12
3 20
4 -10
5 14
6 9
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 Variance of Returns
Solution:
variance =
standard deviation =

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 Expected Return of a Single Asset
The expected rate of return is the weighted
average of all possible returns multiplied by
their respective probabilities.

E(R) =

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 Expected Risk of a Single Asset
 Risk refers to the dispersion of variable. It is
commonly measured by variance or the
standard deviation.
 The variance of the probability distribution is
the sum of the squares of the deviations of
actual returns from the expected returns,
weighted by the associated probabilities.
Variance = =
Risk = = {
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 Expected Risk of a Single Asset
 The standard deviation is most appropriate
measure of risk, since it easily tractable and
if the variable is normally distributed, its
mean and standard deviation contain all the
information about its probability distribution
function.

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 Expected Risk of a Single Asset
Example:
The probability distributions of the all the possible
returns on the Bharat foods stock and Oriental
shipping stocks is given below. Calculate the
expected return and risk associated with each
investment. Rate of Return (%)
State of the Probability of
Bharat Foods Oriental shop
economy occurrence
Boom 0.30 16 40
Normal 0.50 11 10
Recession 0.20 6 -20

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 Expected Risk of a Single Asset
Solution:

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 Portfolio
 Portfolio is a bundle or a combination of
individual assets of securities.

 Portfolio theory is a theory on how risk-

averse investors can construct portfolios to
maximize expected return based on a given
level of market risk.

 We can extend the portfolio theory to derive

a framework for valuing risky assets.
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Portfolio

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Portfolio

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 Expected Return on Portfolio
The Expected return on portfolio is simply the weighted
average of the expected returns on the assets
comprising the portfolio.

when portfolio consists of two securities, its expected

return is given by,

E(Rp) = w1 E(R1) + (1-w1) E(R2)

when portfolio consists of more than two securities, its

expected return is given by,

E(Rp) = w1 E(R1) + w2 E(R2) + w3 E(R3) +……… 50

 Expected Return on Portfolio
Example:
let’s assume the portfolio is comprised of
investments in three assets – X, Y, and Z. $2,000 is
invested in X, $5,000 is invested in Y, and $3,000 is
invested in Z. Assume that the expected returns for
X, Y, and Z have been calculated and found to be
15%, 10%, and 20%, respectively. Based on the
respective investments in each component asset, the
E(Rp) = w1portfolio’s expected
E(R1) + w2 E(R return is?
2) + w3 E(R3) = 0.2(15%) + 0.5(10%) + 0.3(20%) = 14%

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 Expected Return on Portfolio
Example:
Consider the portfolio consisting of five securities
with the following expected returns:
E(R1)= 10%, E(R2)=12%, E(R3)=15%, E(R4)=18% and
E(R5) = 20 % . The portfolio proportions invested in
these securities are 0.1 , 0.2, 0.3, 0.2 and 0.2
respectively. Determine the expected return of
portfolio.

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 Expected Return on Portfolio
Solution:
Expected portfolio return is:
E(R1)= 10%, E(R2)=12%, E(R3)=15%, E(R4)=18% and
E(R5) = 20%, portfolio proportions invested in these
securities are 0.1, 0.2, 0.3, 0.2 and 0.2.

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 Expected Return on Portfolio
Example:
You have $10000 to invest in stock portfolio. Your
choices are stock X with expected return of 12.7%
and stock Y with expeted return of 9.1%. If your goal
is to create portfolio with expected return of 11.2 %
how much money will you invest in stock X and stock
Y?

E(Rp) = w1 E(R1) + (1-w1) E(R2)

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 Expected Risk on Portfolio
Risk in an investment portfolio can be defined as the
possibility that the actual return from your total investment
will be less than the expected return

Variance = =
Risk = = {

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Expected Risk on Portfolio

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Expected Risk on Portfolio

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 Diversification & Portfolio Risk
Example:
Suppose you have Rs. 1,00,000 to invest and you want to
invest it equally it two stocks, A and B. The returns on these
two stocks depends on the state of economy. The fives states
of economy and the corresponding probability along with
possible returns are given in the table. Calculate the expected
return and risk (standard deviation) on stock A, B and the
portfolio consisting of A and B in equal proportions.
State of the Return on Return on Return on
Probability
economy Stock A (%) Stock B (%) Portfolio (%)
1 0.20 15 -5 5
2 0.20 -5 15 5
3 0.20 5 25 15
4 0.20 35 5 20
5 0.20 25 35 30
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 Diversification & Portfolio Risk
Solution:

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