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Risk is the chance an outcome different than expected would

occur.
Riskiness of asset is based on the riskiness of cash flow. (CF)
Assets are categorized as Financial Asset and Real Assets.
The focus of this chapter is Financial Asset especially Stock.
An asset’s risk can be analyzed in two ways: (1) on a stand-alone
basis, where the asset is considered by itself, and (2) on a portfolio
basis, where the asset is held as one of a number of assets in a
portfolio.
In a portfolio context, a stock’s risk can be divided into two
components (a) a diversifiable risk which can be diversified away is of
little concerned to diversified investor (b) market risk which reflects
the risk of a general stock market decline which cannot be eliminated
by diversification. Hence this risk is of concern for rational investor.
A stock with high market risk must offer relatively higher expected
return to attract investors. Investors will not buy risky assets until
they are compensated with higher return. 2
If investors, on average, think a stock’s expected return is too
low to compensate for its risk, they will start selling it, driving
down its price and boosting its expected return. Conversely, if the
expected return on a stock is more than enough to compensate for
the risk, people will start buying it, raising its price and thus
lowering its expected return. The stock will be in equilibrium, with
neither buying nor selling pressure, when its expected return is
exactly sufficient to compensate for its risk.

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Stand-Alone Risk: The risk an investor would face if he or she held only
one asset.
Statistical measures of stand-alone risk

Probability Distributions: Listings of possible outcomes or events with a

probability (chance of occurrence) assigned to each outcome.
Expected Rate of Return: The rate of return expected to be realized
from an investment which is the weighted average of the probability
distribution of possible results.

Where, P = Probability associated with

return of ‘i’ stock and ri = Possible Returns 5
Ex: 1
Ex: 2

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Example: 3

= 0.2 X 1.1 + 0.5 X 0.22 + 0.3 X(-0.6) = 0.15 = 15%

QS 1: The table below provides a probability distribution for the

returns on stocks of Square Textiles. Calculate expected rate of return
for this stock.

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Measuring stand-alone risk: Standard Deviation
The standard deviation, , is a measure of how far the actual return is
likely to deviate from the expected return. The tighter the probability
distribution of expected future returns, the smaller the risk of a given
investment.

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Stand-alone Risk contains both ( Market Risk + Diversifiable Risk)
Standard Deviation (σ ) = Square root of Variance (σ2)

Where, ri = Possible return

= Expected return
Pi = Probability
An investment with lower standard deviation is less risky and an
investment with a higher standard deviation is highly risky.

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Example: Martin Products Standard Deviation (Stand-alone risk calculation)

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QS 2: Calculate Beximco Pharma’s Stock’s Expected Return and Stand-
alone Risk.

Expected Return= = 0.2 X 1.1 + 0.5 X 0.22 + 0.3 X(-0.6) = 0.15 = 15%

2 2 2
=√(1.1- 0.15) X 0.2 + (0.22 - 0.15) X 0.5 + (-0.75 - 0.15) X 0.3
=√(0.1805 + 0.00245 + 0.16875)
=√0.3517
= 0.593
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= 59.3%
QS 3: Calculate US Water’s Stock’s Expected Return and Stand-alone
Risk.

Historical or Realized Rates of Return

QS 4: Calculate Historical or Realized return and SD of Return of a
particular Stock X based on the given historical return from 2011 to 14.

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Historical or Realized Rates of Return

= [0.30 + (0.10)+ (0.19) +0.40]/4 = 0.41/4=0.103 = 10.3%

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QS 5: Calculate Square Pharma’s Stock’s Expected Return and Stand-
alone Risk.

Measuring Stand-alone Risk: The Coefficient Of Variation

Coefficient of Variation (CV): The standardized measure of the risk per
unit of return; calculated as the standard deviation divided by the
expected return. The coefficient of variation shows the risk per unit of
return, and it provides a more meaningful risk measure when the
expected returns on two alternatives are not the same.

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U.S. Water and Martin Products stock’s have the same expected return,
i.e. 10% the coefficient of variation is not necessary in this case. In this
example, the firm with the larger standard deviation, Martin, must also
have the larger coefficient of variation.

Thus, Martin is about 14 times riskier than U.S. Water on the basis of
this criterion.
QS 6: Calculate Square CV of ABC and XYZ Stock

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