BUSINESS FINANCE/

FINANCIAL MARKETS & INSTITUTIONS

[B Sc (Hons) in Management]

SEMINAR 4
Risk & Return

1. Risk vs Return Calculation

• Historical (past)
• Expectation (future)
2. Rate of Return
• Return (%) = [(income) + (capital gain/loss)]
initial investment
• Bonds vs Shares
• The higher the risk, the higher the return required to
attract investors
• Return of Single Asset vs Portfolio of Assets
Example (Expected Return)

State of Probability Return

economy P A B

Recession 0.20 4% -10%

Normal 0.50 8% 18%
Boom 0.30 14% 30%

Expected return R is just a weighted average

E(r) = P(r1) x r1 + P(r2) x r2 + … + P(rs) x rs
Example (Expected Returni)

State of Probability Return

economy P A B

Recession 0.20 4% -10%

Normal 0.50 8% 18%
Boom 0.30 14% 30%

Company A
E(rA) =
Company B
E(rB) =
Example (Expected Returnp)
Calculating Expected Return on a Portfolio of A & B

ASSET Return E(ri) weight

A 9% 0.6
B 16% 0.4
S5

Risk & Return

1. Risk
• Investment risk depends on dispersion or spread
of possible outcomes
• Individual asset vs Portfolio of assets
• Variance/Standard Deviation
• Covariance/Correlation
Uncertainty in the distribution of
possible outcomes

Company 1 Company 2

0.5 0.2
0.2
0.4
0.15
0.15
0.3
0.1
0.1
0.2
0.05
0.05
0.1
0 00
4 89 12 -5
-10 -3 04 5 10
11 16 15
19 20
22 25
25 30
30
return (%) return
return (%)
(%)
Example (Expected Riski)

σ Α = Σ ( ri – E(rA) )2 P( ri )
i =1

Company A

( 4% - 9% )2 ( 0.2 ) = 5.0
( 8% - 9% )2 ( 0.5 ) = 0.5
( 14% - 9% )2 ( 0.3 ) = 7.5
Variance = σ2 = 13.0
Standard deviation = √13.0% = 3.61%
Example (Expected Riski)

σ Β = Σ ( ri – E(rB) )2 P( ri )
i =1

Company B
( -10% - 16% )2 ( 0.2 ) = 135.2
( 14% - 16% )2 ( 0.5 ) = 2.0
( 30% - 16% )2 ( 0.3 ) = 58.8
Variance = σ2 = 196.0
Standard deviation = √196.0 = 14.0%
Example (summary)

Share A Share B

Expected return

Standard deviation 3.61% 14.0%

S5

Risk & Return

1. Risk
• Investment risk depends on dispersion or spread
of possible outcomes
• Individual asset vs Portfolio of assets
• Variance/Standard Deviation
• Covariance/Correlation
Risk & Return

Covariance/Correlation vs Portfolio Risk

The riskiness of a portfolio depends on

➙ the measure of risk of each asset in the portfolio (σ)

➙ the weight of each asset (w)

➙ the measure of "co-movement" between returns of

portfolio assets is called the covariance = cov(x,y)

in a portfolio, pairs of assets that DO NOT move

together can have huge diversification benefits
 Correlation
PERFECTLY POSITIVELY CORRELATED RETURNS
R

A
B

PERFECTLY NEGATIVELY CORRELATED RETURNS

R

ZERO CORRELATION B
R
A

t
Example (Expected Riskp)
Taking into account correlation between each pair of assets in the
portfolio

ASSET Std deviation σ weight

A 3.61% 0.6 ρ x,y = 0.3
B 14% 0.4

σ p2 =

σp =
S5

Risk & Return

1. Risk
• Investment risk depends on dispersion or spread of
possible outcomes
• Individual asset vs Portfolio of assets
• Variance/Standard Deviation
• Covariance/Correlation
• Minimum Variance Portfolio
• Let x be weight in A and (1-x) be weight in B
• x = [(σB)² - ρABσAσB] / [(σA)² + (σB)² - 2ρABσAσB]
• Where ρ = -1, x = σB / (σA+ σB)