Chapter 4 RISK AND RETURN

Two Sides of the Investment Coin

Outline
Return Risk Measuring Historical Return

Measuring Historical Risk

Measuring Expected (Ex Ante) Return and Risk

Return
Return is the primary motivating force that drives investment.
The return of an investment consists of two components: Current return Capital return

Risk
Risk refers to the possibility that the actual outcome of an
investment will deviate from its expected outcome. The three major sources of risk are : business risk, interest rate risk, and market risk. Modern portfolio theory looks at risk from a different perspective. It divides total risk as follows.

=
Total risk Unique risk

+
Market risk

Measuring Historical Return

Total Return

C + (PE - PB) R
Return Relative C + PE Return Relative = PB Cumulative Wealth index CWIn = WI0 (1+R1) (1+R2) (1+Rn)

= PB

Arithmetic Mean Return n Ri R = t =1 n Geometric Mean Return GM = [ (1+R1) (1+R2) (1+Rn)] 1/n - 1

1+Geometric Mean

1+Arithmetic Mean

Standard Deviation

The choice between A.M. And G.M. A.M more appropriate measure of average performance over single period G.M is a better measure of growth in wealth over time 1 + Nominal Return Real Return = 1 + Inflation Rate -1

Arithmetic Vs. Geometric Mean

Capm additive model capm expected equity risk premium must be derived by arithmetic, not geometric, subtraction The a.M rate of return, which, when compounded over multiple periods gives the mean of the prob. Distrns of ending wealth
1.69 1.30 1 0.90 Year 1 0.81 Year 2 1.17

A.M=0.5x30%-0.5x10%=10% G.M=[(1.30)(0.90)]1/2 1 =8.2% The expected value, or probability - weighted average of all possible outcomes is equal to: (0.25) x 1.69 + (0.5) x 1.17 + (0.25) x 0.81 = 1.21 Now the rate that must be compounded up to achieve a terminal wealth of 1.21 after 2 years is 10% (the a.m not .. gm) in the investment markets, where returns are described by a prob. Distrn, the a.M. Is the measure that accounts for uncertainty, and is the appropriate one for estimating discount rates and cost of capital

Computation of Arithmetic and Geometric Mean of Annual Returns Provide by S&P CN X Nifty
Date Dec24, 1990* Dec 24, 1991 Dec 24, 1992 Dec 24, 1993 Dec 23, 1994 Dec 29, 1995 Dec 31, 1996 Dec 31, 1997 Dec 31, 1998 Dec 30, 1999 Nifty 330.86 558.63 761.31 1042.59 1182.28 908.53 899.1 1079.4 884.25 1480.45 Annual Return 68.84 36.28 36.95 13.40 -23.15 -1.04 20.05 -18.08 67.42 Date Dec 29, 2000 Dec 31, 2001 Dec 31, 2002 Dec 31, 2003 Dec 31, 2004 Dec 30, 2005 Dec 29, 2006 Dec 31, 2007 Dec 31, 2008 Dec 31, 2009 Dec 31, 2010 Dec 30, 2011 Nifty 1263.55 1059.05 1093.5 1879.75 2080.5 2836.55 3966.4 6138.6 2959.15 5201 6134.5 4624.3 Annual Return -14.65 -16.18 3.25 71.90 10.68 36.34 39.83 54.77 -51.79 75.76 17.95 -24.62

*These dates correspond to the last trading day of the year.

The return for 1991 is (558.63/330.86) 1 = 68.84%. The returns for the other years have been calculated the same way. Given the annual returns during this period, we can calculate the arithmetic mean and geometric mean:

Arithmetic mean = (68.84 + . + 75.76 + 17.95 -24.62) / 21 = 19.23 percent Geometric mean = (1.6884 X 1.3826 X 0.4821 x 1.7576)1/21 1 = (13.98)1/21-1 = 13.38 percent.

Choice Between Geometric Mean and Arithmetic Mean

When you look at historical returns, you can easily understand the

reason for the difference between geometric average and arithmetic

average. The former measures the actual rate of return earned per year on average, compounded annually; the latter measures the rate of return earned in a typical year. So, you should use the measure that is appropriate to the question you have in mind.

Forecasting the Future on the Basis of the Past-1

A somewhat difficult question relates to forecasting the future. If you have estimates of both the geometric and arithmetic average returns, then which one should you choose? The former is perhaps too low for shorter periods whereas the latter is perhaps too high for longer periods. Marshal Blume has suggested a simple formula for combining the two averages. Suppose you have calculated geometric and arithmetic average returns from N years of past data and you want to use these inputs, to forecast a T-year average return, R(T), where T<N. Heres is how you do it with the Blume formula:

T-1 R(T) = N-1 X Geometric average +

N-T X Arithmetic average N-1

Forecasting the Future on the Basis of the Past-2

To illustrate, suppose that from 20 years of data on annual returns, you find that the geometric and arithmetic average returns are 12 percent and 15 percent respectively. You want to forecast 1 year, 5 year, and 10 year average return forecasts. According to the Blume formula, the average return forecasts are as follows:
11 R(1) = X 12% + 20 1 X 15% = 15%

20 1
51 R(5) = 20 1 X 12% +

20 - 1
20 5 X 15% = 14.37% 20 - 1

10 1
R(10) = 20 1 20 1 R(20) = X 12% + X 12% +

20 10
X 15% = 13.58% 20 - 1 20 20 X 15% = 12%

20 1

20 - 1

Global Equity Returns

A study titled Triumph of the Optimists: 101 Years of Global Investment Returns authored by P. Marsh and M. Staunton and published by Princeton University Press in 2002 found that in the first half of the 20th century the arithmetic average annual real return on the world equity index was 5.1 percent, whereas it was 8.4 percent over the period 1950 2002. What explains larger equity returns in the second half of the 20th century compared to the first half. P. Marsh and M. Staunton attribute it to the following factors: 1. Unprecedented growth in productivity and efficiency, thanks to rapid technological changes. 2. Enhancement in the quality of management and corporate governance. 3. Reduced transaction and monitoring costs. 4. Decline in inflation rates. 5. Fall in the required rate of return, thanks to diminished business and investment risks.

Measuring Historical Risk

Period 1 2 3 4 5 6

n (Ri - R)2 t =1
=

1/2

n -1
Return Ri 15 12 20 -10 14 9 Ri = 60 R = 10 2 = (Ri - R)2 = 109.2 n -1 Deviation (Ri - R) 5 2 10 -20 4 -1 Square of Deviation (Ri - R)2 25 4 100 400 16 1 (Ri - R)2 = 546

= [109.2]1/2 = 10.4

Critique & Defence Of

Variance (And S.D.)
Critique 1. Variance considers all deviations, negative as well as positive 2. When the probability distribution is not symmetrical around its expected value, variance alone does not suffice. In addition, the skewness of the distribution should be considered.

Defence 1. If a variable is normally distributed and capture all information 2. If utility of money quadratic function expected utility .. f (, ) 3. Standard deviation analytically more easily tractable.

Risk and Returns of Financial Assets

In The U.S. Over 75 Years (1926-2000)

In general, investors are risk-averse. Hence risky investments must offer higher expected returns than less risky investments
Portfolio Treasury bills Government bonds Corporate bonds Average Annual Rate of Return (%) 3.9 5.7 6.0 Standard Deviation (%) 3.2 9.4 8.7

Common stocks (S&P 500)

Small-firm common stock

13.0
17.3

20.2
33.4

Risk Premiums
Equity risk premium

Bond horizon premium

Bond default premium

Measuring Expected (Ex Ante)

Return And Risk
Expected rate of return E (R) = n i=1 pi Ri

Standard deviation of return = [ pi (Ri - E(R) )2]1/2 Bharat Foods Stock i. State of the Economy 1. Boom 2. Normal 3. Recession pi Ri piRi Ri-E(R) (Ri-E(R))2 pi(Ri-E(R))2

0.30 16 4.8 4.5 20.25 6.075 0.50 11 5.5 -0.5 0.25 0.125 0.20 6 1.2 -5.5 30.25 6.050 E(R ) = piRi = 11.5 pi(Ri E(R))2 =12.25 = [pi(Ri-E(R))2]1/2 = (12.25)1/2 = 3.5%

Normal Distribution

68.3%

95.4% 2 S.D. 1 S.D.

Expected return

+1 S.D.

+2 S.D.

Possible return

Summing Up
For earning returns investors have to almost invariably bear some risk. While investors like returns they abhor risk. Investment decisions therefore involve a trade off between risk and return.

The total return on an investment for a given period is :

R =

C + (PE PB)
PB

The return relative is defined as: C + PE PB

Return relative =

The cumulative wealth index captures the cumulative effect of total returns. It is calculated as follows:

CWIn = WI0 (1 + R1) (1+ R2) (1+ Rn)

The arithmetic mean of a series of returns is defined as: n Ri i=1 R = n

The geometric mean of a series of returns is defined as:

GM = [1+ R1) (1+ R2).(1+ Rn) ]1/n 1

The arithmetic mean is a more appropriate measure of average performance over a single period. The geometric mean is a better measure of growth in wealth over time.

The real return is defined as: 1+ Nominal return

-1
1+ Inflation rate

The most commonly used measures of risk in finance are variance or its square root the standard deviation. The standard deviation of a historical series of returns is calculated as follows: n (Ri R) 2 t=1 n-1
1/2

Risk premium may be defined as the additional return investors expect to get for assuming additional risk. contd

There are three well known risk premiums: equity risk premium, bond horizon premium, and bond default premium.

The expected rate of return on a stock is:

n E(R) = piRi i=1 The standard deviation of return is: 2 = ( pi (Ri E(R)2 )
1/2