Module 2: ESTIMATING RISK AND RETURN ON ASSETS

Learning Objectives

After studying this chapter, you should be able to:

1. Understand the basic risk and return concept and relationship.

2. Know how to apply probability and probability distribution in determining the expected rate of return on an
investment.
3. Understand how to measure the variability of a probability distribution using standard deviation.
4. Explain the meaning of coefficient of variable as a tool to measure risk.
5. Know how to analyze the risk- return relationship in a portfolio of assets.
6. Understand how portfolio risk is affected by diversification of investment.

INTRODUCTION

In previous chapter, the primary goal of the firm and therefore its financial manager is stated to be shareholder
wealth maximization. The finance manager’s task is to make financial decisions that maximize the price of the
firm’s equity shares (common stock), given legal and other constraints. Each of these financial decisions has certain
risk- return characteristics that affect share prices. This chapter explores the meaning of risk and return and how they
can be measured.

BASIC RIISK AND RETURN CONCEPT

Risk is the variability of an asset’s future returns. Risk refers also to the chance that some unfavorable event will
occur. Risk is present whenever future outcomes are not completely certain or predictable. From an investor’s
viewpoint, the uncertainty of, or variability in, an asset’s future return creates risk. Thus, if an asset’s actual return
but the investor should also recognize that actual rate of return could range from, say +1,000%-100%. Because there
is a significant danger of actually earnings considerably less than the expected return, the stock would be described
as relatively risky.

RISK- RETURN RELATIONSHIP.

Investment risk, then is related to the probability of actually earning less than the expected return- the greater the
chance of low or negative returns, the riskier the investment. Very low risk investments also provide a very low
return. Investors take on higher risk investments in expectation of earning higher returns. Likewise, businesses also
take on risky capital investments only if they expect to earn a higher returns that at least cover their costs, including
investors’ required return. Both investors and business sentiments create a positive relationship between risk and
expected return. Of course taking risk also means that the investor does not get a guarantee that the investment will
be recouped. In the short run, higher risk investments often significantly underperform lower risk investments.
Companies and investors should expect higher risk investments to earn a higher returns only over the long- term
(many years). In addition, not all forms of risk are rewarded.

An investor can be use historical information to characterize past returns and risks, to be able to diversify investment
to eliminate some risk and expect the highest return possible for desired risk level.

PROBABILITY AND PROBABILITY DISTRIBUTION

Probability is the percentage chance that an event will occur. Probabilities range between 0 and 1.0. For example, a
senatorial candidates states, “There is a 40 percent chance that I will lose the election and a 60 percent chance that I
shall win”. If all possible events or outcomes are listed, and the probability is assigned to each event, the listing is
called a probability distribution. For the election forecast, the following probability distribution could be set up.

Outcome Probability
Win 0.6 60%
Lose 0.4 40%
1.0 100%

The possible outcomes are listed in Column 1 while the probabilities of these outcomes, expressed both as decimals
and percentages, are given in Column 2. Notice that the probabilities must sum to 1.0 or 100 percent.

Probabilities can also be assigned to the possible outcomes (or returns) from an investment. If we multiply each
possible outcome by its probability of occurrence, we shall have the weighted average of outcomes and adding them
will give us the expected value or expected rate of return on an investment. This is the weighted average of all
possible returns from an investment, with the weights being the probability of each return.

A probability distribution may be objective or subjective. In reality, probability distribution often combine both
objective and subjective probabilities.

1. An objective probability distribution is generally based on past outcomes of similar events.

2. A subjective probability distribution is based on opinions or “educated guesses” about the likelihood that
an event will have a particular future outcomes.

A probability distribution maybe discrete or continuous.

1. A discrete probability distribution is an arrangement of the probabilities associated with the values of a
variable that can assume a limited or finite number of values (outcomes).
2. A continuous probability distribution is an arrangement of probabilities associated with the values of a
variable that can assume an infinite number of possible values (outcomes).

The flatter or less peaked the probability distribution of expected future returns, the higher the risk of the project.
The range of a probability distribution is the difference between the highest and lowest possible outcome. A flat
probability distribution has a wider range than a peaked distribution.

To illustrate, assume that two investment prospects are available to Mr. Martin who has Php 100,000 investible
funds. He is considering the following:

a. Investment in X’OR Products, Inc., a manufacturer and distributor of computer terminals and equipment
for a rapidly growing data transmission industry; or
b. Investment in Zamboanga Electric Company which supplies an essential service.

The rate of return probability distributions for the two companies are as follows:

X’OR PRODUCTS, INC.

Probability Rate of Expected

State of the of this State Return Rate of
Economy Occurring (%) Return (%)
Boom 0.3 100 30
Normal 0.4 15 6
Recession 0.3 (70) (21)
Expected Value of Outcome 15%
 ZAMBOANGA ELECTRIC COMPANY

Probability Rate of Expected

State of the of this State Return Rate of
Economy Occurring (%) Return (%)
Boom 0.3 20 6
Normal 0.4 15 6
Recession 0.3 10 3
Expected Value of Outcome 15%

The above tables are known as a payoff matrix. We can graph the rates of return to obtain a picture of this variability
of possible outcomes bar charts. The height of each bar signifies the probability that a given outcome will occur. The
range or probable returns for X’OR Products is from + 100 to – 70 percent, with an expected return of 15 percent.
The expected return for Zamboanga Electric is also 15 percent, but its range is much narrower.

A. X'OR Products, Inc.

Probability of Occurrence

0.4    
       
       
       
  0.3      
             
             
             
      0.2        
             
             
             
      0.1        
             
             
             
                       
-
Rate
7 1 10
of
0 5 0
Retur
n
(%)
Expected Rate of Return
 B. Zamboanga Electric Company

Probability of Occurrence

0.4    
     
     
     
0.3      
               
             
             
0.2            
               
             
             
0.1            
               
             
             
                   
  1 1 2
Rate of
0 5 0
Return
(%)
Expected Rate of Return

Figure 2.1. Probability Distribution of X’OR Products, Inc.

And Zamboanga Electric Company

EXPECTED PORTFOLIO RETURNS

The expected portfolio return (Fp) is the weighted average of the expected returns from the individual assets in the
portfolio.

The formula for the expected portfolio return follows:

rp = ∑ni=1 wi ri

Where: wi = proportion of portfolio invested in asset, i

ri = expected return on asset, i
n = number of assets in the portfolio

Illustration Case 2-1. Calculation of Expected Portfolio Returns

Nokus Properties is evaluating two opportunities, each having the same initial investment. The project’s risk and
return characteristics are shown below:
 Project E Project F
Expected return 0.10 0.20
Proportion invested in each project 0.50 0.50

Using the formula above, the expected return of a portfolio combining Project E and Project F is:

rp = (0.5) (0.10) + (0.5) (0.20) = 0.15 or 15%

STANDARD DEVIATION

Standard deviation, (pronounced “sigma”), is a statistical measure of the variability of a probability distribution
around its expected value. The standard deviation can be used as a measure of the amount of absolute risk associated
with an outcome. Absolute risk does not consider the relationship of the variability of outcomes to its expected
value. Standard deviation also measures the tightness of a probability distribution. A tight probability distribution is
one in which the set of possible returns is close to the expected value of returns. If a probability distribution is tight,
then the range or difference between the highest and lowest value in the distribution will be relatively small. Thus,
the smaller the standard deviation, the tighter the probability distribution, the smaller the range of returns, and the
lower the risk.

Standard deviation is an appropriate risk measure of the variability if the probability distribution is reasonably
symmetrical. A symmetrical distribution is one in which each of the half of the distribution is a mirror image of the
other half. A skewed distribution is a distribution which is not symmetric. When comparing different investments
using standard deviation, the size of the initial investments and the expected value of their probability distributions
should also be equal in order to making meaningful risk comparisons. Unless these conditions are met, use of the
standard deviation may be misleading.

The standard deviation is calculated as follows:

1. Compute the expected value (r)

2. Subtract the expected value from each possible return to obtain the deviations (ri - r)
3. Square each deviation (ri - r)2
4. Multiply each squared deviation by its probability of occurrence, pi (ri – r)2, and then add. The result is
called the variance (σ2), which is the standard deviation squared.
5. Take the square root of the variance to get the standard deviation.

Where: pi = probability of occurrence

ri = return or value of outcome
n = total number of possible outcomes

Illustrative Case 2-2. Computation of Standard Deviation for X’OR Products, Inc.

Use the data for X’OR Corporation. The standard deviation is computed using the steps enumerated above.

1. The expected rate of return as previously computed is 15% (k).

(2) (3) (4)

Ki – k (ki – k)2 (ki – k)2 pi
100% - 15% = 85% 7,225% (7,225%) (0.3) = 2,167.5%
15% - 15% = 0% 0 (0) (0.4) = 0%
-70% - 15% = -85% 7,225% (7,225%) (0.3) = 2,167.5%
 Variance

(5) Standard Deviation = √4,445 = 65.84%

The standard deviation is a probability- weighted average deviation from the expected value and it provides an idea
of how far above or below the expected value from the actual value is likely to be. X’OR’s standard deviation is
65.84% and using the same procedures, we find the Zamboanga’s standard deviation to be 3.87%.

The larger standard deviation of X’OR Products indicates a greater variation in returns, thus a greater chance that the
expected return will not be realized. Therefore, X’OR Products would be considered a riskier investment than
Zamboanga Electric according to this measure of risk. If a probability distribution is normal, the actual return will be
within + 1, standard deviation of the expected 68.26 percent of the time. The following diagram, illustrates this
point.

Notes:

1. The area under the normal curve equals 1.0 or 100% percent. Thus, the areas under any pair of normal
curves drawn on the same scale, whether they are peaked or flat must be equal.
2. Half of the area under the normal curve is to the left of the mean, indicating that there is a 50 percent
probability that the actual outcome will be less than the mean, and half is to the right of k, indicating a 50
percent probability that it will be greater than the mean.
 3. Of the area under the curve, 68.26 percent is within + 1σ of the mean, indicating that the probability is
68.26 percent that the actual outcome will be within the range k - 1σ to k + 1σ.

To illustrate:

Standard Range of Actual Return

Deviation Probability (15% + 65.84%)
+1 68.26% -50.84% 80.84%
+2 65.46% -116.68% 146.68%
+3 99.74% 182.52% 212.52%

4. Procedures exist for finding the probability of other ranges. These procedures are covered in statistics
courses.
5. For a normal distribution, the larger the value of σ, the greater the probability that the actual outcome will
vary widely from, and hence perhaps be far below, the expected, or most likely, outcome. Since the
probability of having the actual result turn out to be far below the expected result is one definition of risk,
and since σ measures this probability, we can use σ as a measure of risk. This definition may not be a good
one, however, if we are dealing with an asset held in a diversified portfolio. This point is covered later in
the chapter.

Illustrative Case 2-3. Calculation of Expected Portfolio Returns

Suppose the following projections are available for three alternative investments in equity shares (stock).

Probability Rate of Return if State Occurs

State of State of Stock -Stock -Stock
Economy -Economy A B C

Boom .40 10% 15% 20%

Recession .60 8% 4% 0%

Required:

1. What would be the expected return on a portfolio with equal amounts invested in each of the three stocks
(Portfolio 1)?
2. What would be the expected return if half of the portfolio were in (1) with the remainder equally divided
between B and C (Portfolio 2)?

Solution:

1. Expected Return on Portfolio 1 (A=1/3; B= 1/3; C= 1/3)

a. Portfolio Expected Return (Boom)\

= (1/3) (10%) + (1/3) (15%) + (1/3) (20%)
= 3.33% + 5% + 6.67%
= 15%

b. Portfolio Expected Return (Recession)

= (1/3) (8%) + (1/3) (4%) + (1/3) (0)
= 2.67% + 1.33%
 = 4%

Expected return on the Portfolio = (.40) (15%) + (.60) (4%)

= 6% + 2.4%
= 8.4%

2. Expected Return on Portfolio 2 (A = 50%; B = 25%; and C = 25%)

a. Portfolio Expected Return (Boom)

= (.50 x 10%) + (.25 x 15%) + (.25 x 20%)
= 13.75%

b. Portfolio Expected Return (Recession)

= (.50 x 8%) + (.25% x 4%) + (.25 x 0)
= 5%

Expected return on the Portfolio = (.40 x 13.75%) + (.60 x 5%)

= 5.5% + 3%
= 8.5%

Illustrative Case 22- 4. Calculation of Portfolio Standard Deviation

Using the data in Illustrative Case 22-3, the portfolio standard deviation for Portfolio 1 and Portfolio 2 are computed
as follows:

Standard deviation- Portfolio 1

σ = √ .40 x (15% - 8.4%)2 + .60 x (4% - 8.4%)2

= √.40 (0.004356) + .60 (.001936)
= √ .002905
= 5.4%

Standard deviation- Portfolio 2

σ = √ .40 x (13.75% - 8.5%)2 + .60 x (5% - 8.5%)2

= √ .40 (.002756) + .60 (.001225)
= √ .0018375
= 4.3%

COEFICCIENT OF VARIATION

Another useful measure of risk is the coefficient of variation (CV). Coefficient of variation is the standardized
measure of the risk per unit of return; calculated as the standard deviation divided by the expected return.

The coefficient of variation is computed for X’OR Products, Inc. and Zamboanga Electric Company as follows:

For X’OR Products, Inc. = 65.84% = 4.39

15%
 For Zamboanga Electric Company = 3.87% = .26
15%

The coefficient of variation provides a more meaningful basis for comparison when the expected returns on two or
more alternatives are not the same. Based on the above computations, X’OR Products is almost 17% riskier than
Zamboanga Electric.

PORTFOLIO RISK (σp)

Portfolio risk is the variability of returns of the portfolio as a whole. The riskiness of a portfolio may be less than the
riskiness of any individual assets contained in the portfolio because of diversification.

Diversification is investing in more than one type of asset in order to reduce risk. It could also be investment in
several different assets of the same type but this would be less effective. Diversification reduces risk by combining
assets such as, securities with different risk- return characteristics.

The amount of risk reduction achieved through diversification depends on the correlation of the individual assets’
returns with one another. This could be measured by computing for the correlation coefficient (p or rho). This is a
relative statistical measure of correlation in the degree and direction of change between two variables. It ranges from
+ 1.0 to – 1.0

Generally:

 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 of each other.

Risk reduction is achieved through diversification whenever the returns of the assets combined in a portfolio are not
perfectly positively correlated. In other words, greater benefits are achieved with less positive or more negative
correlation among asset returns.

Portfolio risk is measured by the portfolio standard deviation. Unlike the expected portfolio return, the portfolio
standard deviation is only the weighted average of the standard deviation from the individual assets when the two
assets returns are perfectly positively correlated. Otherwise, the portfolio standard deviation is a function of the risk
of the individual assets, their weights in the portfolio and the correlations among the individual assets’ returns.

The following formula could be used to solve for the standard deviation of portfolio returns for a two- asset
portfolio:

σp = √ w1 2 σ1 + w2 2 σ2 + w1 w2 p1,2 σ1 σ2

where: w1 = proportion invested in asset 1

w1 = proportion invested in asset 2
σ1 = standard deviation of asset 1
σ2 = standard deviation of asset 2
p1,2 = correlation coefficient between asset 1 and asset 2
Illustrative Case 2-5. Calculation of Portfolio Standard Deviation for Two Assets

Using the data in the Illustrative Case 2-1, the portfolio standard deviations are:

For p1,2 = + 1.0:

σp = √ (0.5)2 (0.08)2 + (0.5)2 (0.08)2 + (2) (0.5) (0.5) (1.0) (0.08) (0.08)
= √ 0.0016 + 0.0016 + 0.0032
= √ 0.0064
= 0.08

Risk is not reduced through diversification when the assets combined have perfectly positively correlated returns.
The portfolio standard deviation of 0.08 in this situation is the same as the weighted average of the standard
deviations of the individual assets.

For p1,2 = + 0.2:

σp = √ (0.5)2 (0.08)2 + (0.5)2 (0.08)2 + (2) (0.5) (0.5) (0.2) (0.08) (0.08)
= √ 0.0016 + 0.0016 + 0.00064
= √ 0.00384
= 0.062

Risk reduction does occur through diversification when the assets combined are not perfectly positively correlated.
With a low positive correlation of 0.2, the portfolio risk is reduced from 0.08 to 0.062

The following table shows the extent of risk reduction through diversification when there are different degrees of
correlation between Project E and Project F.

Risk Reduction through Diversification for a

Portfolio Containing Project E and Project F at
Various Degrees of Correlation

Correlation Coefficient (p) Portfolio Risk

+ 1.0 0.080
+ 0.5 0.069
+ 0.0 0.057
- 0.5 0.040
- 1.0 0.000

Computing the portfolio standard deviation becomes more complex as the size of the portfolio increases. These
methods are complex and require numerous calculations and hence are not demonstrated here. There are however
computer software that can be facilitate the computations.

RISK PREFERENCES

Decision makers want to be compensated for the risk associated with an investment. The greater the risk, the more
the demanded return. The actual amount of compensation demanded, which is called the required rate of return, is
influenced by the individual decision maker’s attitude towards risk. Thus, the decision makers have different
required rate of return for the same investment because their risk preferences differ.
Decision makers may be classified into one of the following groups: risk averse, risk neutral, or risk takers.

1. Risk-averse investors are those that require higher rates of return on higher- risk securities. They are
unwilling to pay an amount as much as the expected value of an uncertain investment. Risk aversion does
not imply complete avoidance of risk. In a market dominated by risk- averse investors, riskier securities
must have expected returns as estimated by the average investor, than less risky securities, for if this
situation does not hold, stock prices will change in the market to force it to occur. Risk- averse investors are
willing to accept greater risk provided the return is sufficiently high. Most investors in stocks and bonds are
risk averse.
2. Risk- neutral decision makers are willing to pay more than the expected value.

Illustrative Case 2.6. Risk- Averse, Risk Neutral and Risk- Taker Decision Makers

The following data are available for Projects A and B.

Rate of Return if State Occurs

State of the Economy Probability Project A Project B

1. Weak 0.2 Php 800 Php 200

2. Moderate 0.6 1,000 1,000
3. Strong 0.2 1,200 1,800

Expected Value (r) 1,000 1,000

Standard Deviation (σ) 126 506
Coefficient of Variation (cv) 0.13 0.52

A risk- averse investor would select Project A because it involves the same expected return as Project B but has less
risk. A risk- neutral investor would be indifferent between the two investments. A risk- taker would prefer Project
B. Although the expected value of each project is equal, Project B has a greater potential return or more risk. That is,
with a strong economy the maximum return for Project B is Php 1,800 compared with only Php 1,200 for Project A.
The risk- averse investor would be unwilling to pay Project B’s expected value of Php 1,000. A risk- neutral
investor would be willing to pay exactly Php 1,000 and a risk- taker would be willing to pay more than the expected
value.

RISK AND RETURN PORTFOLIO

Until this point, risk- return analysis has focused on both a single asset and a portfolio or collection of two or more
assets. Portfolio theory involves a selection of efficient portfolios. An efficient portfolio provides the highest return
for a given level of risk or the least risk for a given level of return. While portfolio theory originated in the context
of financial assets such as investment in equity shares, the general concepts also apply to physical assets such as the
capital budgeting projects.

Source: Financial Management – PRINCIPLES AND APPLICATIONS VOLUME 2 2015 EDITION

Author: Ma. Elenita Balatbat Cabrera BBA, MBA, CPA, CMA