2.

Return and Risk

Alok Kumar

09/04/08 2. Return and Risk 1

 What we did in last class…

09/04/08 2. Return and Risk 2

 We covered in last class

• Why people invest?

• What they want from their investment?

• Where all they can invest and what parameters they

adopt to invest?

09/04/08 2. Return and Risk 3

 Investment

Return
Risk
• Historical • Historical

HPR
Variance and Standard
Deviation
(Holding Period
Return)
Coefficient of Variance

HPY • Expected
(Holding Period Yield)
Variance and Standard
Deviation
• Expected

Coefficient of Variance
09/04/08 2. Return and Risk 4
 How do we measure return?
• HPR - When we invest, we defer current consumption in order to add our wealth so
that we can consume more in future, hence return is change in wealth resulting from
investment. If you commit Rs 1000 at the beginning of the period and you get back
Rs 1200 at the end of the period, return is Holding Period Return (HPR) calculated as
follows

HPR = (Ending Value of Investment)/(beginning value of Investment) = 1200/1000 = 1.20

• HPY – conversion to percentage return, we calculate this as follows,

HPY = HPR-1 = 1.20-1.00 = 0.20 = 20%

• Annual HPR = (HPR)1/n = (1.2) ½, = 1.0954, if n is 2 years.

• Annual HPY = Annual HPR – 1 = 1.0954 – 1 = 0.0954 = 9.54%

09/04/08 2. Return and Risk 5

 Computing Mean Historical Return

Over a number of years, a single investments will likely to give

high rates of return during some years and low rates of return, or
possibly negative rates of return, during others. We can
summarised the returns by computing the mean annual rate of
return for this investment over some period of time.

There are two measures of mean, Arithmetic Mean and Geometric
Mean.

Arithmetic Mean = ∑HPY/n

Geometric Mean = [{(HPR1) X (HPR2) X (HPR3)}1/n -1]

09/04/08 2. Return and Risk 6

 How AM is different to GM

Beginning Ending
Year Value Value HPR HPY
1 1000 1150 1.15 0.15
2 1150 1380 1.2 0.2
3 1380 1104 0.8 -0.2

AM = [(0.15) + (0.20) + (-0.20)]/3 = 5%

GM = [(1.15) X (1.20) X (0.80)] 1/3 – 1 = 3.35%

09/04/08 2. Return and Risk 7

 How AM is different to GM

Beginning Ending
Year Value Value HPR HPY
1 100 200 2.0 1.0
2 200 100 0.5 -0.5

AM = [(1.0) + (-0.50)]/2 = 0.50/2 = 0.25 = 25%

GM = [(2.0) X (0.50)] 1/2 – 1 = 0.00%

09/04/08 2. Return and Risk 8

 How do we Calculate Expected Return
Expected Return = ∑RiPi,
• where i varies from 0 to n
• R denotes return from the security in i outcome
• P denotes probability of occurrence of i outcome

Economy Growth Probability of Occurrence

Deep Recession 5%
Mild Recession 20%
Average Economy 50%
Mild Boom 20%
Strong Boom 5%

09/04/08 2. Return and Risk 9

 How do we Calculate Expected Return
Economy Probability of Corporate Equity Equity
Growth Occurrence T-Bills Bonds A B
Deep
Recession 5% 8% 12% -3% -2%

Mild Recession 20% 8% 10% 6% 9%

Average
Economy 50% 8% 9% 11% 12%
Mild Boom 20% 8% 8.50% 14% 15%

Strong Boom 5% 8% 8% 19% 26%

100%
Expected Rate
of Return 8.00% 9.20% 10.30% 12.00%
09/04/08 2. Return and Risk 10
 Probability Distribution of Return

Probability Distribution of Equity "A"

60%
50%
P r oba bility

40%
30% Series1
20%
10%
0%
-13.300% -4.300% 0.700% 3.700% 8.700%
Series1 5% 20% 50% 20% 5%
Dispersion from Expected Return

09/04/08 2. Return and Risk 11

 Probability Distribution of Return

09/04/08 2. Return and Risk 12

 So there is a risk of earning more
than one return or uncertainty in
return

09/04/08 2. Return and Risk 13

 What is Risk

Webster define it as a hazard; as a peril ; as a
exposure to loss or injury.

Chinese definition –

Means its a threat but at the same time its an

opportunity

So what is in practice risk means to us?

09/04/08 2. Return and Risk 14
 What is Risk

Actual return can vary from our expected return,
i.e. we can earn either more than our expected
return or less than our expected return or no
deviation from our expected return.

Risk relates to the probability of earning a return

less than the expected return, and probability
distribution provide the foundation for risk
measurement.

09/04/08 2. Return and Risk 15

 Risk Measures for Historical Returns

Variance – is a measure of the dispersion of actual outcomes
around the mean, larger the variance, the greater the
dispersion.
Variance = ∑(HPYi – AM)2 / (n)
where i varies from 1 to n.
Variance is measured in the same units as the outcomes.

Standard Deviation – larger the S.D, the greater the dispersion

and hence greater the risk.

Coefficient of Variation – risk per unit of return,

= S.D/Mean Return

09/04/08 2. Return and Risk 16

 Risk Measurement for Expected Return

Variance – is a measure of the
dispersion of possible outcomes
around the expected value, larger
the variance, the greater the
dispersion.
Variance = ∑(ki – k)2 (Pi)
where i varies from 1 to n.
Variance is measured in the same
units as the outcomes.
09/04/08 2. Return and Risk 17

Standard Deviation – larger the S.D,

 Return and Risk Measurement

Expected Return or Risk Corporate

Measure T-Bills Bonds Equity A Equity B

Expected return 8% 9.20% 10.30% 12.00%

Variance 0% 0.71% 19.31% 23.20%

Standard Deviation 0% 0.84% 4.39% 4.82%

Coefficient of Variation 0% 0.09% 0.43% 0.40%

Semi variance 0.00% 0.19% 12.54% 11.60%

09/04/08 2. Return and Risk 18

 Things to look Measuring Risk

• Variance and Standard Deviation

The spread of the actual returns around the expected return; The greater the
deviation of the actual returns from expected returns, the greater the variance

• Skewness
The biasness towards positive or negative returns;

• Kurtosis
The shape of the tails of the distribution ; fatter tails lead to higher kurtosis

09/04/08 2. Return and Risk 19

 Skewness and Kurtosis

09/04/08 2. Return and Risk 20

 So How Return and Risk should
be related…..next class

09/04/08 2. Return and Risk 21

 End of Lecture 2
Thank You!!!

09/04/08 2. Return and Risk 22