Risk and Rates of Return

Mary Jane Abrea

Christine Joy Urgel
Risk
- It refers to the variability of an assets future return and to the
chance that some unfavorable event will occur.
Return
- It is the reward for investing.
Return on an investment is consist of the two following sources of income:
A. Periodic Cash Payments (Current Income)
B. Appreciation/Depreciation in market value (Capital Gains /losses)
Measuring Return

Holding Period Return (HPR) refers to the total return earned from
holding an investment for that period of time.

+ ( )
=

Example:Investment in Share Capital A & B over
one-year period

Share Capital Share Capital

A B
Purchase
100 100
(beg. of the year)
Cash dividend received
13 18
(during the year)
Sales Price
107 97
(end of the year)
 + ( )
=

13 + (107 100) 18 + (97 100)

( ) = ( ) =
100 100

13 + 7 18 3
= =
100 100

20 15
= =
100 100
= 20% = 15%
Thus, the return on investment of A is 20% and of B is 15%
Arithmetic and Geometric Average Returns

Arithmetic Return the arithmetic average of successive

one-period rates of return.

n = number of the time periods

= 1/ r = the single holding period return
in time t
Geometric Return a more accurate measure of the actual
return generated by an investment over multiple periods.

= 1+ 1+ 1+ 1
 Example: Arithmetic and Geometric Return

Time Periods
t=0 t=1 t=2
Price (end of season) 80 160 80
HPR - 100% -50%

100% + 50%
= = 25%
Note: 2
n=2
1 = 100% or 1 =
2
1 + 1 1 0.50 1 = 0
2 = -50% or -0.50
Expected Rate of Return

It uses probability to evaluate the expected return

Probability is the percentage chance that the event will occur.

=
 Example:Consider the possible rates of return depending on
the states of economy on a P50,000 investment in either share
A or share B

Share A Share B
Return ( ) Probabilty ( ) Return ( ) Probabilty ( )
State of economy State of economy
Recession -5% .2 Recession 10% .2
Normal 20% .6 Normal 15% .6
Prosperity 40% .2 Prosperity 20% .2

= 5% .2 + 20% .6 + 40% = 10% .2 + 15% .6 + 20% .2

= 19% = 15%
Measuring Risk

Standard Deviation - is a statistical measure of the variability of a

probability distribution around its expected value.

= ( ) 2
The standard deviation is calculated as follows:
1. Comepute the expect ()
2. Subtract the expected value from each possible return to obtain the
deviations ( )
3. Square each deviation ( ) 2
4. Multiply each squared deviation by its probability of occurrence,
( ) 2 , and then add.
5. Take the square root of the variance to get the standard deviation
 Example:

SHARE A (step 1) (step 2) (step 3) (step 4)

Probabilty ( )
Return ( ) ( ) ( ) 2 ( ) 2
-5% .2 -1% -24% 567% 115.2
20% .6 12% 1% 1% .6
40% .2 8% 21% 441% 88.2
=19%
2 =204

(step 5) :
2 =204
= 204
= 14.28%
SHARE B (step 1) (step 2) (step 3) (step 4)
Probabilty ( ) ( ) ( ) 2 ( ) 2
Return ( )
10% .2 2% -5% 25% 5
15% .6 9% 0% 0% 0
20% .2 4% 5% 25% 5
=15%
2 = 10

(step 5) :
2 =10
= 10
= 3.16%
Coefficient of Variation

It is used to compare securities with deffering expected returns.

The higher the coefficient, the more risky the security.
It is the standardized measure of the risk per unit of return

=
Share A Share B
19% 15%
14.28% 3.16%

14.28 3.16
= =
19 15
cv = 0.75 cv = 0.21
Risk Preferences

Risk Averse those that require higher rates of return on higher-risk

securities.

Risk-neutral are willing to pay the expected value

Risk-takers are willing to pay more than the expected value

 Share A Share B
Expected Value () 19% 15%
Standard Deviation () 14.28% 3.16%
Coefficient of Variation (cv) 0.75 0.21

A risk-averse investor would select Share A because it

involves higher expected return even it has higher risk.

A risk-neutral would be indifferent between the two

investments.

A risk-taker would prefer Share A because it has greater

potential return and more risk.
Types of Risk

Business Risk the risk that the business enterprise will have general
business problems. This kind of risk depends on changes in demand
input prices, and technological obsolescence.

Liquidity Risk the possibility that an asset may not be sold on short
notice for its market value.

Default Risk the risk that the issuing business enterprise is unable to
make interest payments or principal repayments on debt.

Market Risk risk associated with changes in share price resting from
broad swings in the share capital market as a whole.
 Interest Rate Risk fluctuations in the value of an asset as the
interest rates and conditions of the money and capital
market change.

Purchasing Power Risk the possibility that you will receive

lesser amount of purchasing power than was originally
invested.
Diversification

It is investing in more than one type of asset in order to reduce risk.

It could also be investment in several different asset.
Diversification reduces risk by combining assets with different risk-
return. (Diversified Portfolio)
Portfolio Return

- the weigthed average return of the individual sets in the portfolio

= 1 1 + 2 2 + =
=1

Asset Return ( ) Fraction ( )

A 18% 1/3 6%
B 9% 2/3 6%
=12%
Portfolio Risk

the variability of returns of the portfolio as a whole.

It is dependent on the correlation coefficients of its assets.

= 1 2 1 2 + 2 2 2 2 + 21,2 1 2 1 2

1 2 = standard deviations of assets A and B

1 2 = weights, or fractions, of total funds invested in assets A and B

1,2 = the correlation coefficient between assets A and B

Correllation Coefficient

It is the measure of the degree to which two variables move together.

- if p = 1.0, the two variables move in the same direction exactly to the
same degree and are perfectly positively correlated.

- if p = -1.0, the two variables move in opposite directions exactly the

same degree and are perfectly negatively correlated.

- if p = 0, the two variables are uncorrelated or independent to each

other.
Example:

Asset w
A 20% 1/3
B 10% 2/3

= 1 2 1 2 + 2 2 2 2 + 21,2 1 2 1 2

Assume the P = 1

= (1/3)2 (0.2)2 + (2/3)2 (0.1)2 + 2(1)(13)(23)(0.2)(0.1)

= 0.0089 + 0.0089
= 0.13
 Assume the P = 0

= (1/3)2 (0.2)2 + (2/3)2 (0.1)2 + 2(0)(13)(23)(0.2)(0.1)

= 0.0089

= 0.09

Assume the P = -1

= (1/3)2 (0.2)2 + (2/3)2 (0.1)2 + 2(1)(13)(23)(0.2)(0.1)

= 0.0089 0.0089

=0
Add a Slide Title - 4

References
Cabrera, M. B., CPA,BBA,MBA,CMA.
(2012). FInancial Management Principles and
Application (2012-2013 ed., Vol. Comprehensive).
Manila, Philippines: GIC ENTERPRISES & CO., INC.

Salvador, S. M., Ed.D,MBE,BSE,BSC, Baysa, G. T.,

Ed.D,MBE,CPA, Gamboa, D. L., Jr,DBA,MBA, & Fua-
Geronimo, E. C., DEM.MEM,CPA.
(2016). Fundamentals & Applications of Financial
Management. Allen Adrian Books Inc.