Return

Return can be defined as the benefits received from

an investment.
On an investment you can get benefits in two ways:
Risk and Return – Annual return in form of interest or dividend and,
– Capital gain (increase in value of investment)
Sanjeev Bajaj So the total returns can be put like this
Reader – Finance Area Return = Annual income +
(Selling Price– Purchase Price)
Or
Return = Amount received – amount invested

Return Return
The rate of return on an investment can be calculated as Rate of return can also be calculated with following
follows: formula:
(Amount received – Amount invested) Annual Income + (Ending Price – Beginning Price)
Return = __________________________ Return = __________________________________
Amount invested Beginning Price

For example, if Rs. 1,000 is invested and Rs. 1,100 is
returned after one year, the rate of return for this
investment is: (1,100 - 1,000) / 1,000 = 10%.
Rate of return is also called Yield which can be divided
into:
– Current Yield = Annual Income / Beginning Price
– Capital Gains Yield = (Ending Price – Beginning Price)
Beginning Price

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 Return
Return can be classified into following categories:
– Historical Return:
•The returns received on an investment in the past.
– Expected return:
• The weighted average of all the possible returns,
weighted by the probability that each return will occur.
– Required return:
•The minimum return necessary to attract an investor
to purchase or hold a security,
•Considers the opportunity cost of funds.
Expected Return
An investor might say that a given asset will be
expected to yield a 10% return. This is however a
point estimate.
Pressed further, the investor will admit that the
asset could possibly provide a return of -10%
under certain conditions or as high as 25%.
The uncertainty in the actual range of possible
returns is indeed a form of risk.

Expected Return Expected Return

By studying historical returns, relative performance In order to find the Probability of Possible
of similar investments, the investor can subjectively expected return the Return Return
determine the probabilities of achieving each of the following formula is used: 30% 10%
possible returns. 10% -10%
Lost yet? We can illustrate with an example. 60% 25%
Say that the investor believes that with a 30%
Expected Return = ∑ (Probability of Return x Possible Return)
probability, a given asset will have a 10% return. A
-10% return is determined to happen with a 10% For our example:
probability. The 25% return can occur with a 60%
probability. Expected Return = (0.30)(10%) + (0.10)(-10%) + (0.60)(25%)
= 17%

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 Probability Distributions
Probability Distributions is a listing of all possible
outcomes, and the probability of each occurrence.
Probability distributions are often presented
graphically as in these examples
Probability Distributions
For many reasons, we usually assume that the
underlying distribution of returns is normal
The normal distribution is a bell-shaped curve with
finite variance and mean

Firm X

Firm Y
Rate of
-70 0 15 100 Return (%)
Potential Outcomes Potential Outcomes

Expected Rate of Return

So Why is Expected Return What is Risk?

Important?
Risk is potential variability in future cash flows.
Expected Return is the most basic form of risk
It is also known as uncertainty in the distribution of
analysis.
possible outcomes.
An asset with perfect certainty of return will have
A risky situation is one which has some probability
only one possible return. This is rare.
of loss or unexpected results.
The challenge is to determine proper probability
The higher the probability of loss or unexpected
weights in order to calculate an expected return
results, the greater the risk.
value that accurately captures the risk associated
with an asset’s returns. The riskiness of an investment can be judged by
describing the probability distribution of its possible
All other things being equal, we assume that people
returns.
prefer higher expected returns.

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 How Do We Measure Risk? Why Standard Deviation?
By calculating the investment’s standard deviation Standard deviation is most commonly used as
of returns. measure of risk in financial analysis. Why?
Standard deviation is a measure of the dispersion of Because:
possible outcomes. – If a variable is normally distributed, its mean and SD
The greater the standard deviation, the greater the contain all the information about its probability
uncertainty, and, therefore, the greater the risk. distribution.
– If the utility of money is represented by a quadratic
Less Risky function, then the expected utility is a function of
mean and SD.
Riskier
– Standard deviation is analytically more tractable.

Calculating the Standard Deviation of Calculating the Standard Deviation of

Expected Returns Expected Returns
Following formula is used to calculate standard Suppose that a particular investment has the
deviation of expected returns: following probability distribution:
– 25% chance of -5% return
σ = Standard deviation
– 50% chance of 5% return
σ= Variance = σ2 – 25% chance of 15% return
This investment has an expected return of 5%
n
σ= ∑ (k − k̂ ) P
i=1
i
2
i E ( Ri ) = 0.25(−0.05) + 0.50(0.05) + 0.25(0.15) = 0.05

σi2 = 0.25( −0.05 − 0.05) 2 + 0.50(0.05 − 0.05) 2 + 0.25(0.15 − 0.05) = .005

Where k is expected return and k^ is average expected σi = 0.25(−0.05 − 0.05) 2 + 0.50(0.05 − 0.05) 2 + 0.25(0.15 − 0.05) = 0.071
return and P is the probability of an outcome.

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 Calculating Standard Deviation for Example 1
Historical Returns
variance: The average squared deviation between Year Actual Average Deviation from the Squared Deviation
Return Return Mean
actual returns and the average return (σ2)
standard deviation: square root of variance 1 .15 .105 .045 .002025

– the average deviation between actual returns and 2 .09 .105 -.015 .000225
average returns
n 3 .06 .105 -.045 .002025
∑ (r − r )
i =1
i
2

variance = σ2 = n −1
4 .12 .105 .015 .000225

Totals .42 .00 .0045

standard dev. = σ = var
Variance = .0045 / (4-1) = .0015 Standard Deviation = .03873

Problem 1 Problem 2
Year Actual Avg. Deviation Squared
return return deviation Potential Returns
85 .3216
Prob ABC XYZ
10% -12% -24%
86 .1847
15% -5% -10%
50% 2% 4%
87 .0523
15% 9% 18%
10% 16% 32%
88 .1681
E(R) 2.0% 4.0%

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 Coefficient of Variation Coefficient of Variation
Sometimes Variance and Standard Deviation The Coefficient of Variation is usually calculated with
can be misleading. the following formula:
If conditions for two or more investment
alternatives are not similar then a measure of CV = Standard Deviation/ Expected Rate of Return
relative variability is needed. - or –
A widely used measure of relative variability is CV = Standard Deviation / Mean
the Coefficient of Variation (CV)

An Example of CV However….
Assume Stock A and Stock Using CV analysis, the results are different.
B have widely differing
rates of return and
CV of Stock A = 5% / 7% = 0.714
Stock A Stock B
standard deviations of CV of Stock B = 7% / 12% = 0.583
return. Expected
Return 7% 12%
Using standard deviation
analysis, Stock A seems to
The CV figure shows that Stock B has less relative
Standard
be less risky than Stock B. Deviation 5% 7% variability or lower risk per unit of expected return.

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 Conclusion
Use Standard Deviation to compare different assets
and choose the one with the least amount of risk
and the highest possible return.
Historical Standard Deviation can be used to look at
the past performance of an asset. Can also be used
to compare two or more assets.
The Coefficient of Variation should be used to
compare assets in different industries or widely
differing expected returns.
Determining the Required Return
The required rate of return for a particular
investment depends on several factors, each of
which depends on several other factors (i.e., it is
pretty complex!):
The two main factors for any investment are:
– The perceived riskiness of the investment
– The required returns on alternative investments
An alternative way to look at this is that the required
return is the sum of the RFR and a risk premium:
E( R i ) = RFR + Risk Pr emium
Investor Attitude Towards Risk
Risk aversion –
– assumes investors dislike risk and require higher
rates of return to encourage them to hold riskier
securities.
Risk premium –
– the difference between the return on a risky asset
and less risky asset, which serves as
compensation for investors to hold riskier
securities.
The Risk-free Rate of Return
The risk-free rate is the rate of interest that is earned for
simply delaying consumption
It is also referred to as the pure time value of money
The risk-free rate is determined by:
– The time preferences of individuals for consumption
•Relative ease or tightness in money market (supply &
demand)
•Expected inflation
– The long-run growth rate of the economy
•Long-run growth of labor force
•Long-run growth of hours worked
•Long-run growth of productivity
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 The Risk Premium The MPT View of Required Returns
The risk premium is the return required in excess of
Modern portfolio theory assumes that the required
the risk-free rate
return is a function of the RFR, the market risk
Theoretically, a risk premium could be assigned to premium, and an index of systematic risk:
every risk factor, but in practice this is impossible
Therefore, we can say that the risk premium is a
function of several major sources of risk:
(
E( R i ) = R f + β i E( R M ) − R f )
– Business risk
This model is known as the Capital Asset Pricing Model
– Financial leverage (CAPM).
– Liquidity risk It is also the equation for the Security Market Line (SML)
– Exchange rate risk

Risk and Return Graphically Classification of Risk

Systematic Risk
The Market Line – Risk factors that affect a large number of
assets
– Non-diversifiable risk
Rate of Return

– Market risk
– Includes such things as:
•changes in GDP
RFR
•interest rates
Risk β or σ
•war

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 Classification of Risk Portfolio and Diversification of Risk
Unsystematic Risk A portfolio is a collection of assets (stocks, bonds,
– Risk factors that affect a limited number of cars, houses, diamonds, etc)
assets When assets are combined into portfolios, their
– Unique risk unsystematic risks tend to cancel out, leaving only
– Company-specific risk systematic variability.
– Diversifiable risk Portfolio diversification is the investment in several
– Includes such things as: different asset classes or sectors.
•labor strikes The risk-return trade-off for a portfolio is measured
•part shortages by the portfolio expected return and standard
•management character issues deviation
Diversification is not just holding a lot of assets.

Total Risk Illustrating Diversification Effects of a

Stock Portfolio
Total risk = systematic risk + unsystematic risk
The standard deviation of returns is a measure of σp (%) Company-Specific Risk
total risk. 35
For well diversified portfolios, unsystematic risk is Stand-Alone Risk, σp
very small.
Consequently, the total risk for a diversified portfolio
20
is essentially equivalent to the systematic risk.
Market Risk

0
10 20 30 40 2,000+
No. of Stocks in Portfolio

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Expected Return of a Portfolio
The expected return of a portfolio is a weighted
average of the expected returns of its components:
N The riskiness of a portfolio depends on both the
E ( RP ) = ∑ wi Ri
i =1

Note: wi is the proportion of the portfolio that
is invested in security I, and Ri is the expected
return for security I.
Portfolio Risk
The standard deviation of a portfolio is not a
weighted average of the standard deviations of the
individual securities.
riskiness of the securities, and the way that they
move together over time (correlation)
This is because the riskiness of one asset may tend
to be canceled by that of another asset
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 Portfolio Construction:
Portfolio Expected Return
Risk and Return
Economy Prob. Stock 1 Stock 2 Portfolio
Assume a two-stock portfolio is created with Rs. (50:50)
50,000 invested in both Stock 1 and Stock 2. Recession 0.1 -22.0% 28.0% 3.0%

Below avg 0.2 -2.0% 14.7% 6.4%

Expected return of a portfolio is a weighted average
of each of the component assets of the portfolio. Average 0.4 20.0% 0.0% 10.0%

Above avg 0.2 35.0% -10.0% 12.5%

Standard deviation is a little more tricky and requires
Boom 0.1 50.0% -20.0% 15.0%
that a new probability distribution for the portfolio
returns be devised. ^
k p = 0.10 (3.0%) + 0.20 (6.4%) + 0.40 (10.0%)
+ 0.20 (12.5%) + 0.10 (15.0%) = 9.6%

Calculating Portfolio Standard Comments on Portfolio Risk

Deviation and CV Measures
1
 0.10 (3.0 - 9.6) 2  2 σp = 3.3% is much lower than the σi of either
 + 0.20 (6.4 - 9.6) 2  stock (σ1 = 20.0%; σ2. = 13.4%).
 
σ p =  + 0.40 (10.0 - 9.6) 2  = 3.3% σp = 3.3% is lower than the weighted average of
 + 0.20 (12.5 - 9.6) 2  stock 1 and stock 2’s σ (16.7%).
 
 + 0.10 (15.0 - 9.6)
2
 ∴ Portfolio provides average return of component
stocks, but lower than average risk.
3.3% Why? Negative correlation between stocks.
CVp = = 0.34
9.6%

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 General comments about risk Returns distribution for two perfectly
negatively correlated stocks (ρ = -1.0)
Most stocks are positively correlated with the
market (ρk,m ≈ 0.65).
σ ≈ 35% for an average stock. Stock W Stock M Portfolio WM
Combining stocks in a portfolio generally lowers 25 25 25
risk.
15 15 15

0 0 0

-10 -10 -10

Returns distribution for two perfectly The Correlation Coefficient

positively correlated stocks (ρ = 1.0)
The correlation coefficient can range from
-1.00 to +1.00 and describes how the returns move
Stock M Stock M’ Portfolio MM’ together through time.
25 25 25
Perfect Positive Correlation Perfect Negative Correlation
(r = 1) (r = -1)
15 15 15 Stock 1 Stock 3
Returns (%)

Returns (%)
0 0 0

Stock 2 Stock 4
-10 -10 -10
Time Time

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The Portfolio Standard Deviation An Example:
Perfect Positive Correlation
The portfolio standard deviation can be thought
of as a weighted average of the individual Potential Returns
State of Economy Probability ABC XYZ 50/50 Portfolio
standard deviations plus terms that account for Recession 25% 2% 2% 2%
the co-movement of returns Moderate Growth 50% 8% 8% 8%
Boom 25% 14% 14% 14%
For a two-security portfolio: Expected Return 8% 8% 8%
Standard Deviation 4.24% 4.24% 4.24%
Correlation 1.00
σ P = w12 σ 12 + w22 σ 22 + 2r1,2 σ 1σ 2 w1w2

.5 2 ( 0.0424 ) + .5 2 ( 0.0424 ) + 2 (1.00 )( 0.0424 )( 0.0424 )( 0.5)( 0.5) = 0.0424

2 2
σP =

An Example: An Example: Zero Correlation

Perfect Negative Correlation

Potential Returns Potential Returns

State of Economy Probability ABC XYZ 50/50 Portfolio State of Economy Probability ABC XYZ 50/50 Portfolio
Recession 25% 2% 14% 8% Recession 25% 2% 2% 2%
Moderate Growth 50% 8% 8% 8% Moderate Growth 50% 8% 2% 5%
Boom 25% 14% 2% 8% Boom 25% 14% 2% 8%
Expected Return 8% 8% 8% Expected Return 8% 2% 5%
Standard Deviation 4.24% 4.24% 0.00% Standard Deviation 4.24% 0.00% 2.12%
Correlation -1.00 Correlation 0.00

.5 2 ( 0.0424 ) + .5 2 ( 0.0424 ) + 2 ( − 1.00 )( 0.0424 )( 0.0424 )( 0.5)( 0.5) = 0.00

2 2
σP =
σP = .5 2 ( 0.0424 ) + .5 2 ( 0.0424 ) + 2 ( 0)( 0.0424 )( 0.0424 )( 0.5)( 0.5) = 0.0212
2 2

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