Some statistical concepts

&
Risk and Rates of Return
Ref:
Financial Management: Eugene F. Brigham, Louis C.
Gapenski
& Michael C.
Ehrhardt.
Modern Investment Theory- R. A Haugen
5-1

Investment returns
The rate of return on an investment can be
calculated as follows:
(Amount received Amount invested)

Return =

________________________
Amount invested

For example, if $1,000 is invested and $1,100 is

returned after one year, the rate of return for
this investment is:
($1,100 - $1,000) / $1,000 = 10%.
5-2

What is investment risk?

Two types of investment risk

Stand-alone risk
Portfolio risk

Investment risk is related to the

probability of earning a low or negative
actual return.
The greater the chance of lower than
expected or negative returns, the
riskier the investment.
5-3

Probability distributions

A listing of all possible outcomes, and the

probability of each occurrence.
Can be shown graphically.
Firm X

Firm Y
-70

15

Expected Rate of Return

100

Rate of
Return (%)

5-4

Why is the T-bill return

independent of the economy? Do
T-bills promise a completely riskfree return?
T-bills
will return the promised 8%,

regardless of the economy.

No, T-bills do not provide a risk-free return,
as they are still exposed to inflation.
Although, very little unexpected inflation is
likely to occur over such a short period of
time.
T-bills are also risky in terms of
reinvestment rate risk.
T-bills are risk-free in the default sense of
the word.

5-5

Return: Calculating the expected

return for each alternative
^

k expectedrateof return
^

k ki Pi
i1

kHT (-22.%) (0.1) (-2%) (0.2)

(20%) (0.4) (35%) (0.2)
(50%) (0.1) 17.4%
5-6

Risk: Calculating the standard

deviation for each alternative
Standarddeviation
Variance 2
n

(ki k) Pi
i1

5-7

Standard deviation
calculation

i1

(ki k)2 Pi

(8.0 - 8.0) (0.1) (8.0 - 8.0) (0.2)

T bills (8.0 - 8.0)2 (0.4) (8.0 - 8.0)2 (0.2)
2
(8.0 - 8.0) (0.1)

T bills 0.0%
HT 20.0%

Coll 13.4%
USR 18.8%
M 15.3%
5-8

Comparing standard
deviations
Prob.

T - bill
USR
HT

13.8

17.4

Rate of Return (%)

5-9

Comments on standard
deviation as a measure of
risk

Standard deviation (i) measures total, or

stand-alone, risk.
The larger i is, the lower the probability
that actual returns will be closer to
expected returns.
Larger i is associated with a wider
probability distribution of returns.
Difficult to compare standard deviations,
because return has not been accounted
for.
5-10

Comparing risk and return

Security

Expected
return

Risk,

8.0%

0.0%

HT

17.4%

20.0%

Coll

1.7%

13.4%

USR

13.8%

18.8%

Market

15.0%

15.3%

T-bills

5-11

Coefficient of Variation
(CV)
A standardized measure of dispersion
about the expected value, that shows
the risk per unit of return.

Stddev
CV
^
Mean k

5-12

Risk rankings,
by coefficient of variation
CV
T-bill
0.000
HT 1.149
Coll.
7.882
USR
1.362
Market 1.020

Collections has the highest degree of risk

per unit of return.
HT, despite having the highest standard
deviation of returns, has a relatively
5-13
average CV.

Illustrating the CV as a
measure of relative risk
Prob.

Rate of Return (%)

A = B , but A is riskier because of a larger

probability of losses. In other words, the same
amount of risk (as measured by ) for less returns.
5-14

Covariance & Correlation

Month

Stock A

Stock B

.04

.02

-.02

.03

.08

.06

-.04

-.04

.04

.08

Covariance tells us about the direction

of relationship and it is unbounded.
Covariance between A & B is .0017
5-15

Covariance & Correlation

The correlation coefficient can be

thought as a standardized
covariance. It ranges between +1 to
-1

5-16

Correlation pattern 1
rB

rB

rA

Perfect positive correlation

17

rA

Perfect negative correlation

5-17

Correlation pattern 2
rB

rB

}
rA

Imperfect positive correlation

18

rA

Zero correlation

5-18

The relationship between

a stock and the market
portfolio

The market portfolio contains

every single risky security in the
international economic system and
it contains each asset in proportion
to the total market value of that
asset relative to the total value of
all other asset.
5-19

Characteristic line, Beta

and residual variance

The relationship between return a stock

and the return of the market portfolio is
described by stocks characteristic line.
Since it is a straight line it can be
described by slope and intercept
The slope of that line is beta.
Measures a stocks market risk, and shows
a stocks volatility relative to the market.
Indicates how risky a stock is if the stock
is held in a well-diversified portfolio.
5-20

Calculating betas

Run a regression of past returns of

a security against past returns on
the market.
The slope of the regression line
(sometimes called the securitys
characteristic line) is defined as the
beta coefficient for the security.
5-21

Illustrating the calculation of

beta
_

ki

20
15

Year
1
2
3

10

kM
15%
-5
12

ki
18%
-10
16

-5

0
-5
-10

10

15

20

_
kM

Regression line:
^
ki = -2.59 + 1.44 ^
kM
5-22

A stocks residual variance gives

us an indication of the propensity
of a stocks return to deviate from
its characteristic line.
The stock which is perfectly
correlated with the market has
residual variance equal to zero.
5-23

For formula follow

Modern Investment Theory- R. A

Haugen

5-24