Return and Risk

Two major concern of an investor, while choosing a security as an investment, are the expected return from holding the security and the risk that the realized return may fall short of the expected return. Expected return:- expected return is the return investors anticipate from holding a security over some future period. It is relevant before the asset is actually acquired. It may or may not occur. Realized return is the return that holder of the security actually earn after holding the security. It may be more or less than the expected return.

 when return is calculated with probability than it is known as Expected return. Expected return or Return from security is generally calculated as a percentage and usually it is per annum. For Actual return we never use probability. Standard deviation represents as absolute measure of total risk. Higher the SD greater is the risk and vice versa. SD can be either in percentage or rupees depending upon the basic data.

Return on a single asset

1. Total return = Dividend + Capital gain 2. Rate of return= Div1+ (P1-P0) P0 3. Average Rate of Return 4. Variance 5. Standard Deviation 6. Expected Rate or Return 7. Expected Variance 8. Expected Standard Deviation

Problems
1. The following are the return on the share of Reliable Company for the past five years. calculate the average rate of return for the five years. Also calculate the standard deviation and variance of the returns for the Year 1 2 3 4 5 period.
Return (%) 5.3 16.6 -7.3 15.0 19.8

Problems
2. An asset has the following possible returns with associated probabilities. Calculate the expected rate of return and standard deviation of that rate of return.
Possible return 20% 18% 8% 0% -6%

Probability

0.10

0.45

0.30

0.05

0.10

Problems
3. Star company system limited has forecasted returns on its share with the following probability distribution. Calculate the expected return, variance and standard deviation of return of Star.
Return (%) -20 -10 -5 5 10 18 20 30

Probability 0.05 0.05

0.10 0.10

0.15

0.25

0.25

0.05

4. Securities X and Y have the following characteristics: You are required to calculate the expected return and standard deviation of return for each security. Which security would you select for investment and why?
Security A
Return (%) 30 20 10 5 -10 probability 0.10 0.20 0.40 0.20 0.10

Security B
Return (%) -20 10 20 30 40 Probability 0.05 0.25 0.30 0.30 0.10

5. The following information is available in respect of the return from the security X under different economic conditions. Find out the expected return of the security and the risk associated with that.
Economic condition Return (%) Probability Good 20 0.1 Average 16 0.4 Bad 10 0.3 Poor 3 0.2

6. A stock costing Rs. 120 pays no dividend the possible prices that the stock might sell at the end of the year with respective probabilities are: Required 1). Calculate the expected return 2). Calculate standard deviation.
Price 115 120 125 130 135 140

Probability 0.1

0.1

0.2

0.3

0.2

0.1

Risk and Return Portfolio Theory

Portfolio Return: two asset case E(Rp)= ( Wi x Pi ) Or W x E(Rx) + (1-W) x E(Ry) W= proportion of investment in asset X and (1-W) is the remaining investment in asset Y.

Portfolio Risk: Two Asset Case

The portfolio variance or Standard deviation depends on the co-movement of returns on two assets. Covariance of return on two assets measures their co-movement. Three steps are involved in the calculation of covariance between two assets. Step 1: determine the expected return on assets Step 2: determine the deviation of possible returns from the expected return for each asset. Step3: determine the sum of the product of each deviation of returns of two assets and respective probabilities .

Covariancexy = {Rx- E(Rx)} { Ry- E(Ry)} x P

Or CoVxy = x x y x Corxy
Corxy is the correlation between return of X and Y.

Corxy = COV xy x x y Variance and Standard Deviation of a two assets portfolio 2 = a+b+2abr a= w1 1, b=w22, r= correlation If r=1 p = a+b If r= -1 p = a-b If r= 0 p = a2 + b2

7. Mr. X is presently concerned with the investment of Rs.

1,00,000. he has two securities A and B for this purpose. The relevant information in respect of these two securities is as follows: He has decided to consider only five portfolios of A and B as follows I. All fund invested in A II. 50% of funds in each of A&B III. 75% of funds in A and 25% of B IV. 25% of funds in A and &75% in B V. All funds invested in B
Security Expected return Standard deviation of return A 12% 10% B 20% 18%

Coefficient of correlation r between A and B : 0.15

Find out a) Expected return under different portfolios. b) Risk factor associated with these portfolios c) Which portfolio is best for him from the point of risk? d) Which portfolio is best for him from the point of return?

8. Europium Ltd has been specially formed to undertake two investment opportunities. The risk and return characteristics of the two project are shown below. Europium plans to invest 80% of its available funds in project X and 20% in Y. the directors believe that the r between is +1. you are required to determine (i). The expected return on a portfolio. (ii). The SD of return from each of the two stocks
X Expected return 12% Y 20%

Risk

3%

75

9.Consider the following information of two stocks X and Y: You are required to determine: 1. The expected return on a portfolio containing X and Y in proportion of 60% and 40% respectively. 2. The SD of return from each of the two stocks. 3. The covariance of return of two stocks. 4. r between return of two stocks. 5. The risk of portfolio containing 60% of X and 40% of Y Year Return X (%) Return Y(%)
2008 2009 12 18 10 16

10.Security X and Y have the following characteristics. You are required to calculate a). The Expected return and SD of return for each security and b). The expected return and SD of the return for the portfolio of X and Y, combined with equal weights.
Security X Return (%) 30 20 10 5 -10 Probability 0.10 0.20 0.40 0.20 0.10 -20 10 20 30 40 Security Y Return (%) Probability 0.05 0.25 0.30 0.30 0.10

11. The historical rates of return of two securities over the past ten years are given. Calculate the covariance and the correlation coefficient of the two securities.
Year Return of S1 Return of S2 1 12 20 2 8 22 3 7 24 4 14 18 5 16 15 6 15 20 7 18 24 8 20 25 9 16 22 10 22 20

12. The distribution of return of security F and the market portfolio P is given below. You are required to calculate the expected return of Security F and the market portfolio P, the covariance between the market portfolio and security and beta for the security.
Probability Return %

F
0.30 0.40 0.30 30 20 0

P
-10 20 30

13. Given below is information of market rates of return and data from two companies A and B. Determine beta coefficient of the shares of company A and company B.
Year Market % Company A % Company B % 2002 12.0 13.0 11.0 2003 11.0 11.5 10.5 2004 9.0 9.8 9.5

14.The rate of return on the security of company A and market portfolio for 10 periods are given below: what is the beta of the security X?
Period 1 2 3 4 5 6 7 8 9 10

Return of Sec X(%) 20 22

25

21

18

-5

17

19

-7

20

Return of Market Portfolio (%)

22 20

18

16

20

-6

11

15. (a) calculate the market sensitivity index ( ) and the expected return on the investment from the following data: Standard deviation of the asset 2.5%; market standard deviation 2%; risk free rate of return 13%; expected return on market portfolio 15%; correlation coefficient of portfolio with market 0.8. (b) What will be the expected return on the portfolio if is 0.5 and risk free rate of return is 10%.

16. An investor is seeking the price to pay for a security whose standard deviation is 3%. The correlation coefficient for the security with the market is 0.8 and the market standard deviation is 2.2%. The return from government securities is 5.2% and from the market portfolio is 9.8%. The investor knows that by calculating the required return he can then determine the price to pay for the security. What is the required return on security?

17. Mr. Aggarwal recently attended an investors meet in Mumbai where in he came across some brokers who advised him measure the systematic risk of shares being using beta before finally investing money in the same. Mr. Aggarwal picked the old financial newspapers and prepared the following table containg the data of equity shares prices of Infotech Ltd, Cantaxy Ltd and S&P CNX Nifty, collected on the last trading day of the month for the last 13 months. Calculate Beta for Infotech Ltd and Cantaxy Ltd. Use S&P CNX Nifty data as a proxy for market portfolio and comment.
Date Share price of Infotech Ltd Share price of Cantaxy S&P CNX Nifty Feb 115 28 976 Mar 125 26 985 Apr 140 21 991 May 167 20 1035 June 189 20 July 177 15 Aug 142 19 977 Sept 121 21 965 Oct 102 32 956 Nov 94 29 951 Dec Jan Feb 102 126 149 31 28 39

1049 989

957 962 975