Financial Mangement

(FIN

306)

Risk and Return

Chapter 8
Dr. Ishtiaq Ahmad
Department Of Banking and Finance

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Page 1

Lecture Outline
What is Return
What is Risk
Relationship Between Risk and
Return
How to calculate Return
Historical Return and Risk A Case
Study
Microsoft Vs. Walgreens
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(Financial)

Return

The gain or loss of a security in a particular

period, the return consists of the income and the
capital gains relative on an investment. It is
usually quoted as a percentage.
Performance analysis of an investment requires
investors to measure returns over time.
Return and risk being intricately related, return
measurement helps in the understanding of
investment risk.

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(Financial)

Risk

Uncertainty of outcome ???

Risk can be defined as a measure of the uncertainty in a
set of potential outcomes for an event in which there is a
chance of some loss.

Risky = Potential for loss exists

It is important to measure and analyze the risk
potential of an investment, so as to make an
informed decision.
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The

Risk-and-Return Trade-off
Investments must be analyzed in
terms of, both, their return potential as
well as their riskiness or variability.
Historically, its been proven that
higher returns are accompanied by
higher risks.

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8-5
Page 5

Dollar Profits and Percentage Returns

Dollar Profit or Loss = Ending value + Distributions - Original Cost

Rate of return =

Dollar Profit or Loss

Original Cost

Holding Period Return (HPR) =

Profit/Loss
Cost

HPR = Ending price + Distributions - Beginning price

Beginning price

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Dollar Profits and Percentage Returns

Example

Calculating dollar and percentage returns?

Joe bought some gold coins for $1,000 and sold them 4 months later for $1,200.
Jane on the other hand bought 100 shares of a stock for $10 and sold those 2 years later for
$12 per share after receiving $0.50 per share as dividends for the year.
Calculate the dollar profit and percent return earned by each investor over their respective
holding periods.

Solution:
Joes Dollar Profit
Joes HPR

= Ending value Original cost

= $1,200 - $1,000 = $200
= Dollar profit / Original cost
= $200/$1,000 =

20%

Janes Dollar Profit = (Ending value +Distributions) - Original Cost

= $12 x 100 + $0.50 x 100 - $10 x 100
= ($1,200 + $50) - $1,000
= $250.00
Janes HPR

= $250.00/$1,000 = 25%

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Returns at same Footings (annualized)

Example

Calculating APR and EAR?

Joe bought some gold coins for $1,000 and sold them 4 months later for $1,200.
Jane on the other hand bought 100 shares of a stock for $10 and sold those 2 years later for $12 per share after
receiving $0.50 per share as dividends for the year.
Calculate the dollar profit and percent return earned by each investor over their respective holding periods.

Solution:
Joes HPR = 20%

APR= HPR/n= 0.20/0.33= 60%

EAR = (1+HPR)^1/n -1= (1+0.20)^ 1/0.33 -1 = 74%

Janes HPR = 25%

APR= HPR/n= 0.25/2= 12.5%

EAR = (1+HPR)^1/n -1 = (1+0.25)^

-1 =

11.8%
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Historical Return and Risk A Case Study

Microsoft Vs. Walgreens

Rate of return for both companies are given from
2007 to 2012
Based on the Risk and return analysis in which
stock you will like to invest????/

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Variance and Standard Deviation as a Measure of Risk

Variance and standard deviation are measures of

dispersion
Helps researchers determine how spread out or
clustered together a set of numbers or outcomes is
around their mean or average value.
The larger the variance, the greater is the variability and
hence the riskiness of a set of values.

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Historical Return and Risk A Case Study cont.

Microsoft Vs. Walgreens
Percent

Decimal

Year

Microsoft

Wallgreen

Microsoft

Wallgreen

2012

8.4%

15.7%

0.084

0.157

2011

-4.6%

16.9%

-0.046

0.169

2010

-6.6%

-19.4%

-0.066

-0.194

2009

59.5%

50.9%

0.595

0.509

2008

-44.1%

-34.1%

-0.441

-0.341

2007

20.6%

-16.3%

0.206

-0.163

Sum

33.2%

13.7%

0.332

0.137

Average

5.5%

2.3%

5.53%

2.28%

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Historical Return and Risk A Case Study cont.

Microsoft

Year

2012
2011
2010
2009
2008
2007
Sum
Variance=
Sum/(n-1)

8.4%
Return
-4.6%
-6.6%
59.5%
-44.1%
20.6%

Deviati
on
Deviatio Square
5.5%
d 8.4%
Minus Average 2.9%
n
5.5%
-10.1% 102.0%
5.5%
-12.1% 146.4%
5.5%
54.0% 2916.0%
5.5%
-49.6% 2460.2%
5.5%
15.1%
228.0%

Standard
Deviation SQRT (variance)
Coefficien
t
of
variance

Wallgreen

5861%
sq
5861%/(61)
1172%

15.7%
Return
16.9%
-19.4%
50.9%
-34.1%
-16.3%

34%

34/5.5
6.2

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Minus

Averag
2.3%
e
2.3%
2.3%
2.3%
2.3%
2.3%

Deviati
on
Deviati Square
13.4%
d 180.0%
on
14.6% 213.6%
-21.7% 470.2%
48.6% 2363.6%
-36.4% 1323.7%
-18.6% 345.3%

4896.5
% sq
4896%/(61)
979%
31%

31/2.3
13.5

Page 12

Investment Rules
Investment rule number 1:
If faced with 2 investment choices having the same expected returns,
select the one with the lower expected risk.
Investment rule number 2:
If two investment choices have similar risk profiles, select the one with
the higher expected return.
To maximize return and minimize risk, it would be ideal to select an investment that has
a higher expected return and a lower expected risk than the other alternatives.
Realistically, higher expected returns are accompanied by greater variances and the
choice is not that clear cut. The investors tolerance for and attitude

towards risk matters.

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Investment Rules

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