Topic 5

Risk and Return I

The trade-off between
risk and return
Chapter 6
MPF753 Finance T3 2015
Department of Finance
1
Note that pages mark with * are originally prepared by Dr Mong Shan Ee and
currently adopted/modified by Dr Tunyarputt Kiaterittinun and those mark
with (^) are prepared by Dr Tunyarputt Kiaterittinun
Recap Topic 4
Preferred share valuation
Ordinary share valuation
Dividend discount models, free cash flow
approach, book value, liquidation value,
comparable multiples
Investment banking functions
Long term financing [Initial public offering
(IPO), Seasoned equity offering (SEO), Rights
Offering, Private placements]
2
Learning outcomes
After studying this topic, you will be able to
Calculate Investments total return in dollar
and percentage terms.
Measure return and risk of a financial asset
Distinguish between systematic and
unsystematic risk
Describe the concept of diversification and
the link between systematic risk and return
3
 Risk and Return Defined
Risk
Websters dictionary, risk is exposing to danger or hazard.
The Chinese refers to risk as a mix of
danger and opportunity.
Risk measures the uncertainty that an
investor is willing to take to realize a gain
from an investment
Return
Return is a measure of earnings on an investment

In finance, risk generally refers to the probability that an actual 4^

return on an investment will be lower than the expected return.
Understanding risks and returns
Risk represents the cost of investing whereas
return earned on investments represents the
benefit of investing.
A trade-off always arises between expected risk
and expected return.
But not all risks are compensated.
Risk is neither good nor bad.
Business should invest in a good risk-return trade-
off investment.
5
Figure 6.1 The trade-off between
risk and return

6
Total returns
Total return: the total gain or loss experienced
on an investment over a given period of time.

Income stream from the investment

Components
of the total
return Capital gain or loss due to changes
in asset prices

Total return can be expressed either in dollar

terms or in percentage terms.
7
Dollar returns
Total dollar return = income + capital gain or loss

For shares,

Income = Dividend per share

Capital gain or loss per share
= (Ending share price Beginning share price)

Total dollar return Divt 1 Pt 1 Pt

8^
 Example: Dollar returns
Dividend per share (Ending price - Beginning price)

Total dollar return = income + capital gain or loss

Terrell bought 100 Dollar return

shares of Micro-Orb
shares for $25. = [$1 + ($30-$25)] x (100 shares)
A year later: = ($1 + $5) x (100 shares)
Dividend = $1/share
Sold for $30/share = $600

Owen bought 50 Garcia Dollar return

Ltd shares for $15.
= [$0 + ($25-$15)] x (50 shares)
A year later: 9*
No dividends paid = ($10) x (50 shares)
Sold for $25/share
= $500
Percentage returns
Terrells dollar return exceeded Owens by $100. Can we say that
Terrell was better off?

No, because Terrell and Owens initial investments were different:

Terrell spent $2500 in initial investment while Owen spent $750.

total dollar return

Total percentage return
initial investment

Divt 1 Pt 1 Pt
Total percentage return
Pt
10
 Example: Percentage returns
Use the same example

total dollar return

Total percentage return
initial investment

Terrell' s percentage return

$1 $5100shs
$600 / $2500 24%
$25 100shs

Owen' s percentage return

$0 $10 50shs
$500 / $750 66.67%
$15 50shs

In percentage terms, Owens investment 11

performed better than Terrells did.
Example: Percentage returns
Metropolis Limited paid a one-time special dividend of
$3.08 on 15 November 2010.
Suppose you bought a Metropolis share for $28.08 on
1 November 2010 and sold it immediately after the
dividend was paid for $27.39.
What was your realised return from holding the share?

1 Nov 15 Nov

12
Calculate the percentage return:
t t+1

Pt = $28.08 Pt+1 = $27.39

Dt+1 = $3.08

total dollar return

Total percentage return
initial investment

Divt 1 Pt 1 Pt
Total percentage return
Pt

3.08 27.39 28.08

13
Rt 1 8.51%
28.08
Dividend yield & Capital gain yield
total dollar return
Total percentage return
initial investment

Income Capital gain/loss

14*

Dividend yield Capital gain yield

 total dollar return
Total percentage return
initial investment

Total percentage return Dividend yield Capital gain yield

Divt+1
Dividend yield =
Pt
Pt+1 - Pt 15
Capital gain yield =
Pt
Example: Calculate the dividend yield & capital gain yield:
t t+1

Pt = $28.08 Pt+1 = $27.39

Dt+1 = $3.08

Divt+1 3.08
Dividend yield = = = 10.97%
Pt 28.08

Pt+1 - Pt 27.39 -28.08

Capital gain yield = = = -2.46%
Pt 28.08
16
Total yield = 10.97% + (- 2.46%) = 8.51%
Returns
Total dollar return = income + capital gain or loss
Total dollar return Divt 1 Pt 1 Pt
total dollar return
Total percentage return
initial investment
Divt 1 Pt 1 Pt
Total percentage return
Pt
Total percentage return Dividend yield Capital gain yield
Divt 1 Pt 1 Pt
Total percentage return
Pt Pt
17^
R1 R2 RN N
Average return R R N
N t 1
 Risk
Risk can be measured using the standard deviation of an
investments returns
Standard deviation is a measure of the dispersion of
possible outcomes
The greater the standard deviation, the greater the risk
Sydney Melbourne
0.2 Investment 0.5 Investment
=9% = 3%
0.4
0.15
Probability

0.3
0.1
0.2
0.05
0.1
0 0
18
-10 -5 0 5 10 15 20 25 30 4 8 12

return (%) return (%)

 Risk and Return for Australian Shares &
Bonds from 1974 to 2009

19

Source: RBA cited in Parino et al. (2011), Fundamentals of Corporate Finance.

Figure 6.6 The relationship between average
(nominal) return and standard deviation 19002010

20

Investors who want higher returns have to take more risk.

 The variability of equity returns
Risk premium: the additional return that an investment
must offer, relative to some alternative, because it is
more risky than the alternative.
Asset classes with greater volatility pay higher average
returns.
Average return on shares is more than double the
average return on bonds, but on average shares are
also twice as volatile. Therefore, on an average, shares
carry a bigger risk premium as compared to bonds.

Example: If the return on ordinary shares = 10%, risk free rate

= 4%, what is risk premium? 21*
Rate of return = Risk free rate + Risk premium
Risk premium = 10% - 4% =6%
Measure risk
N

t
( R R ) 2

Variance 2 t 1
N 1

Standard deviation a statistical measure of volatility

(expressible in percentage terms)

Standard deviation ( ) Variance

22
 Annual Returns on the Australian
All Ordinaries Index 2004-08
The arithmetic average return provides an estimate of the
return in any given year. Calculate the standard deviation
of these returns.

23
 Calculating historical volatility
N

t
( R R ) 2

Variance 2 t 1
N 1
R R
t R R
t
2

24*
Variance = 0.353064/(5-1) =0.0883
Standard deviation = variance = 0.0883 = 0.2972 = 29.72%
Which security would you invest in?

Which investment has a better risk-return

trade off? 25
 Coefficient of variation
The ratio of the standard deviation of a distribution to
the mean of that distribution.
A standardized measure that shows the amount of
risk per unit of return.
The coefficient of variation allows the comparison of
different investments.

S tan dard Deviation

CV
Expected Re turn E ( R) 26
Example:
Expected Standard
Return Deviation
Rio 8.1% 11.14%
BHP 9.9% 13.16%

Without the Coefficient of Variation information, which

security would you invest in?

With the Coefficient of Variation information, which

security would you invest in?
27^
 Correlation between 2 assets
Negative correlation: Returns tend to
move in opposite directions
Perfect negative correlation
- Risk is minimised

Positive correlation: Returns tend to

move in the same directions.

Perfect positive correlation

- Risk is not minimised

If returns on two assets are not positively correlated, combining

these assets in the same portfolio may reduce the portfolios risk. 28^
Figure 6.7 Annual Returns on Coca-Cola and
Archer Daniels Midland

29
The two shares did not always move in sync.
The net effect is that the portfolio is less volatile than either share
held in isolation.
 Risk and diversification
A portfolio is a collection of single investments.
Diversification: By investing in two or more assets whose
returns do not always move in the same direction at the same
time (negative correlation), investors can reduce risk of
investments or portfolio

Standard Coeff. of
Return Deviation Variation
Stock A 9.0% 13.15% 1.46
Stock B 8.0% 10.65% 1.33
Portfolio (A&B) 8.64% 10.91% 1.26
30
The portfolio has the lowest coefficient of variation due to
diversification.
 The limits of diversification
If returns do not all change the same way, increasing
number of shares in a portfolio will reduce standard
deviation of portfolio returns even further.
Diversification reduces portfolio volatility, but only up to a
point. Portfolio of all shares still has a volatility of roughly
20%.

31
 Risk that can be diversified away is called
diversifiable, unsystematic, or unique risk
Risk that cannot be diversified away is called
non-diversifiable, or systematic risk
With complete diversification, all unique risk is
eliminated from portfolio; investor still faces
systematic risk

32
Figure 6.8 The relationship between portfolio
SD and the number of stocks in the portfolio
Total risk = Systematic risk + Unsystematic risk

CAN be
eliminated by
diversification

CANNOT be
eliminated by
diversification
33
AgainWhy systematic risk is all that matters

Total Risk = Systematic Risk + Unsystematic Risk

Standard deviation is a measure of total risk
Unsystematic risk can be diversified away.
Only systematic risk is rewarded in asset markets

34
Example: Systematic risk
Which one of the following is an example of
systematic risk?
1. Investors panic causing security prices
around the globe to fall precipitously.
2. A flood washes away a firm's warehouse
3. A city imposes an additional one percent
sales tax on all processed food products.
4. A toymaker has to recall its top-selling toy.
5. Corn prices increase due to increased 35
demand for alternative fuels.
 6.4 Risk and return revisited
For the various asset classes, a trade-off arises
between total risk and return.
Fig.6.1 Fig.6.6

36
Does this trade-off hold for individual securities?
Figure 6.9 Average returns and standard
deviations for 10 shares, 19932010

37

No obvious pattern here!

6.4 Risk and return revisited
The trade-off between standard deviation
and average returns that holds for asset
classes does not hold for individual shares!
Total risk is measured by standard deviation,
which contains both systematic and
unsystematic risk.
Because investors can eliminate
unsystematic risk through diversification,
the market rewards only systematic risk!
38
NOT COVERED IN CH.6
Section 6-2a Nominal and Real Returns on Shares,
Bonds and Bills

39
End of Week 5 lecture

Read Chapter 6 (relevant sections only) and revise

todays lecture slides and your notes
Remember to do your scheduled Aplia homework
Keep working on your Assignment Part 2
Prepare Chapter 7 for next week

40