Chapter 2

Risk and Return

Return
A return is the ultimate objective
for any investor
Generally, return is the benefit
associated with an investment
When investors buy a stock or a
bond, their return comes in two
forms:
(1)a dividend or interest payment,
and
(2)a capital gain or a capital loss.
Returns

Dollar Returns
Dividends
the sum of the cash received
and the change in value of
Ending market
the asset, in dollars. value

Time 0 1
Percentage Returns
the sum of the cash received
and the change in value of the
Initial
asset divided by the original
investment
investment.
Returns
Dollar Return = Dividend + Change in Market Value

dollar return
Percentage return =
beginning market val
ue

dividend + change in market val ue

=
beginning market val ue

= dividend yield + capital gains yield

 Returns: Example
Suppose you bought 100 shares of
National Cement S.Co. a year ago at
birr 25 per share. Over the last year, you
received birr 20 in dividends on your
100 shares (birr 20= 20 cents per share
100 shares). At the end of the year, the
stock sells for birr 30.

Required: How much is the dollar and

percentage return on each shares did you
earn?
Holding-Period Returns
The holding period return is the
return that an investor would get
when holding an investment over a
period of n years, when the return
during year i is given as ri:
holding period return = Rh
Rh = (1 + r1 ) (1 + r2 ) (1 + rn ) 1
Holding Period Return: Example
Suppose your investment provides the following
returns over a four-year period:

Year Return Your holding period return =

1 10% = (1 + r1 ) (1 + r2 ) (1 + r3 ) (1 + r4 ) 1
2 -5%
3 20% = (1.10) (.95) (1.20) (1.15) 1
4 15% = .4421 = 44.21%
Average Return:
An investor who held this investment have realized
an annual return of 9.58% on average:
Year Return Geometric average return =
1 10% (1 + rg ) 4 = (1 + r1 ) (1 + r2 ) (1 + r3 ) (1 + r4 )
2 -5%
3 20% rg = 4 (1.10) (.95) (1.20) (1.15) 1
4 15% = .095844 = 9.58%
So, the investor earn a return of 9.58% on his
money for four years, realizing a holding period
return of 44.21% 1.4421 = (1.095844) 4
Average Return
Note that the geometric average is not the
same thing as the arithmetic average:

Year Return
r1 + r2 + r3 + r4
1 10% Arithmetic average return =
2 -5%
4
10% 5% + 20% + 15%
3 20% = = 10%
4 15% 4
Expected rate of return
It is the most likely return on a given asset for a
specified future time period.
It is the sum of all possible rates of returns for
the same investment weighted by probabilities
Expected return is computed as:
n
re =
i =1
p ir i
Example: Refer to the following
information about stock 1 and 2 to
calculate expected return of each stock. .
Risk
Risk is defined as a chance that the actual
outcome from an investment will differ from the
expected outcome.
Risk is the possibility that actual cash flows
differ from expected cash flows.
The more variable the possible outcomes that
can occur, the greater the risk.
Risk is associated with the dispersion in the
likely outcome.
Measuring Stand-Alone Risk
The most common statistical indicator of an
assets risk is the standard deviation.
Standard deviation () measures the dispersion
around the expected value.
n
= ( p (ri r )2
i =1
i e

The smaller the standard deviation, the

tighter the probability distribution, and,
accordingly, the lower the riskiness of the stock.
Measuring Stand-Alone Risk:
Coefficient of variation
It is a measure of relative dispersion used in
comparing the risk of assets with differing
expected returns.
The coefficient of variation shows the risk per
unit of return.
It enables us to compare investment alternatives

CV =
re
Where, re is expected value of return.
 Coefficient of Variation: Example
You are asked to rank the following set of
investments according to their risk return
profile.

Security Return Standard

Deviation
A 6% 7%

B 10% 13%

C 18% 20%

15
 Coefficient of Variation: Solution

Security Return Standard Coefficient of

Deviation Variation

A 6% 7% 7
= 1.17
6
B 10% 13% 13
= 1.3
Most Risk 10
C 18% 20% 20
= 1.1
Least Risk 18

16
Example:
The following data shows the returns and probabilities of
returns for two stocks (A & B) under different possible
economic conditions. Calculate the expected returns,
standard deviations and coefficient of variation of each
stock.
Econ Probabi Stock A Stock B
condition lity

Pessimistic 0.30 13 % 7%
Most likely 0.50 15 15
Optimistic 0.20 17 23
 18

Relationship Between Risk and Return

Required Rate of Return =
Risk-free Rate of Return + Risk Premium

Risk-free Rate: rate of return on securities that

are free of default risk, such as T-bills.

Risk Premium: expected reward the investor

expects to earn for assuming risk
 19

Risk-Free Rate of Return

Risk-free Rate of Return (rf) =
Real Rate of Return + Exp. Inflation Premium

Real Rate of Return: the reward for deferring

consumption. Time value of money

Expected Inflation Premium: compensates

investors for the loss of purchasing power due to
inflation
Systematic and unsystematic risks
Systematic risk
Influences a large number of assets.
Have market wide effects
Affect nearly all companies to some degree.
Can not be eliminated by diversification
Unsystematic risk
Affects a single asset or a small group of assets.
These risks are unique to individual companies or
assets
unique or asset-specific risks.
Can be diversified
 21

Systematic Risk is Relevant

Systematic, or non-diversifiable, risk is caused
by factors affecting the entire market
interest rate changes
changes in purchasing power
change in business outlook

Unsystematic, or diversifiable, risk is caused by

factors unique to the firm
strikes
regulations
managements capabilities
The Systematic Risk Principle
The systematic risk principle states that
the reward for bearing risk depends only
on the systematic risk of an investment.
Since unsystematic risk can be eliminated at
virtually no cost, there is no reward for bearing
it.
The required rate of return on an asset
depends only on that assets systematic
risk.
Systematic risk principle 23

The market will not

compensate us for risk that
can be diversified away.

Unique Risk Systematic Risk

(measured with Beta)

The market will compensate us for

systematic risk the risk that
cannot be diversified away
 24

Systematic Risk is Measured by Beta

Beta is a measure of the volatility of a securitys

return compared to the volatility of the return
on the Market Portfolio
A beta tells us how much systematic risk a
particular asset has relative to an average asset.

Covariance j,Market
Security j = VarianceMarket
Security Market Line (SML)
The reward-to-risk ratio for Asset ,i,is the ratio
of its risk premium (E(Ri) - Rf) to its beta ( bi ).
In a well-functioning market, reward-to-risk
ratio is the same for every asset.
As a result, when asset expected returns are
plotted against asset betas, all assets plot on the
same straight line, called the security market
line (SML).
Securities Market Line (SML) 10-26

Ri = RF + i (RM RF )
Expected return

RM

RF
1.0 b
 27

Market Risk Premium

The reward for bearing risk
Equal to (Rm Rf)
Equal to the slope of security market line (SML)

Will increase or decrease with

uncertainties about the future economic outlook
the degree of risk aversion of investors
Capital Asset Pricing Model (CAPM)
Model Developed by William Sharp

A formula that shows the relation ship b/n

expected rate of return and risk

CAPM predicts what an expected rate of return

for the investor should be, given expected rate of
return in the market and systematic risk of the
investment
CAPM
Assumptions
1. Investors are price takers and they cannot
influence the market individually;
2. There is risk free rate at which an investors
may either lend (invest) or borrow money.
3. Investors are risk-averse,
4. Taxes and transaction costs are irrelevant.
5. Information is freely and instantly available to
all investors.
CAPM
10-30

From the SML, the expected

return on Asset ,i, can be written
as:
R i = RF + i ( R M RF )

Market Risk Premium

This formula is called the Capital Asset Pricing

Model (CAPM)
CAPM 10-31

The expected return on a risky asset thus has three

components.
1. The first is the pure time value of money (Rf)
2. The second is the market risk premium [E(RM)
-Rf], and
3. The third is the beta for that asset, (i).

Ri = RF + i (RM RF )
Expected
return on a Risk-free Beta of the Market risk
= rate + security premium
security
CAPMexamples
Q1. A stock has a beta of 1.5, the expected return on
the market is 14 percent, and the risk-free rate is 5
percent. What must the expected return on this
stock be?
Q2. A stock has an expected return of 13 percent, the
risk-free rate is 5 percent, and the market risk
premium is 7 percent. What must the beta of this
stock be?
Q3. A stock has an expected return of 10 percent, its
beta is 0.9, and the risk-free rate is 6 percent. What
must the expected return on the market be?
Summary and Conclusions 10-33

The systematic risk of a security is measured by beta of the

security which computed as:

Cov(Ri , RM )
bi =
s 2 (RM )
The CAPM states that the expected return on a security is
positively related to the securitys beta:

Ri = RF + i (RM RF )