RISK AND RATES OF RETURN

A. Investment Returns and Risks

Risk is a measure of uncertainty surrounding the return that an investment will earn. More formally, the term
risk is used interchangeably with uncertainty to refer to the variability of returns associated with a given asset.

Investments whose returns are more uncertain are generally viewed as being riskier.

A return, also known as a financial return, in its simplest terms, is the money made or lost on an investment
over some period of time.

A rate of return (RoR) is the net gain or loss on an investment over a specified time period, expressed as a
percentage of the investment’s initial cost.

The concept of return provides investors with a convenient way to express the financial performance of an
investment.

Sample Problem No. 1 Returns on Investment

Suppose an investor brought 10 shares of stock for P1,000. The stock pays no dividends, but at
the end of one (1) year, the investor sells his stocks for P1,100. How much is the return on the
P1,000 investment? Answer: P100

*Return= Amount to be received-amount invested

Sample Problem No. 2 Required rate of return

The rate on the 1-year stock investment (from sample problem no. 1), when P1,100 is received
after one (1) year is: Answer: 10%

Rate of Return= Amount to be received – Amount invested

Amount invested

B. Stand-Alone Risk

Another definition of risk is that it is probability or threat of damage, injury, liability, loss, or any other negative
occurrence that is caused by external or internal vulnerabilities, and that may be avoided through preemptive
action.

Stand-Alone Basis- the asset is considered in isolation.

Part of a portfolio- a collection of assets

Stand-alone risk involves the risks created by a specific asset, division, or project. It measures the dangers
associated with a single facet of a company's operations or the risks from holding a specific asset.

Statistical Measures of Stand-Alone Risk

1. Probability Distributions- This is a listing of possible outcome or events with a probability assigned to
each outcome.
 Sample Problem No: 3

Mac Products Phil. Water

Economy Probability Rate of Product Probability Rate of Product
which of this Return if (4) (2) X of this Return if (4) (2) X
affects Demand this (3) Demand this (3)
demand Occurring demand Occurring demand
(1) (2) occurs (3) (5) occurs (3)
Strong 0.30 80% 0.30 15%
Normal 0.40 10% 0.40 10%
Weak 0.30 -60% 0.30 5%
1.00 Expected 1.00 Expected
Return Return

2. Expected Rates of Return (ř)-This is the rate of return expected to be realized from an investment.

Ř= P1r1 + P2r2 +… +Pnrn

Where:
Ř= expected return
P=probability of occurrence of the outcome
Rn=return for the nth outcome
N=number of outcomes considered

3. Standard Deviation- This is a statistical measure of the variability of a set of observations. It is the
most common statistical indicator of an asset’s risk; it measures the dispersion around the expected
value.

Sample Problem No. 4

Mac Products

Economy Probability of Rate of Deviation: Squared Squared

which affects this Demand Return if this Actual-10% Deviation (5) Deviation x
demand (1) Occurring (2) demand Expected Probability (6)
occurs (3) Return (4)
Strong 0.30 80% 70.00%
Normal 0.40 10% 0.00%
Weak 0.30 -60% -70.00%
1.00 ∑=Variance 0.2940
SD=Square root of variance: ợ 0.5422
SD expressed as percentage: 54.22%
Another approach:

N ri r ri-r (ri-r)2 P (ri-r)2 x P

Strong 80% 10% 70.00% 0.30
Norma l 10% 10% 0.00% 0.40
Weak -60% 10% -70.00% 0.30
1.00

Using the Average Return- The mean and standard deviation can be computed based on a subjected
probability distribution.

Sample Problem No. 5

Year Return Deviation from Squared Deviation

Average
(Return-Ave. Return)
2016 30%
2017 -10%
2018 -19%
2019 40%
Average Sum of squared deviations:
SS Devs/(N-1)=SS Devs/3
Standard Deviation= Square root of SS Dev/3

4. Coefficient of Variation (CV)-This is the standard deviation divided by the expected return. It 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.

5. Sharpe Ratio- This compares the asset’s realized excess return to its standard deviation over a
specified period. Subtracting the risk-free rate from the mean return allows an investor to better isolate
the profits associated with risk-taking activities. Generally, the greater the value of the Sharpe ratio, the
more attractive the risk-adjusted return.
6. Risk Aversion and Required Returns
Risk averse is the attitude toward risk in which investors would require an increase return as
compensation for an increase in risk. Risk-averse investors dislike risk and require higher rates of
return as an inducement to buy riskier securities.

Risk Neutral is the attitude toward risk in which investors choose the investment with the higher return
regardless of the its risk.

Risk seeking is the attitude toward risk in which investors prefer investments with greater risk even if
they have lower expected returns.

7. Risk Premium- It is the return in excess of the risk-free rate of return an investment is expected to
yield.
Sample Problem No. 6
S&P 500 generated a return of 8% the previous year, and the risk-free rate of the Treasury bill is 4%.
The premium is:

Seatwork:

1. Assuming you pay P500 for an investment that returns P600 in one (1) year, what is your annual
rate of return?

2. An investment has a 50% chance of producing a 20% return, a 25% chance of producing an 8%
return and a 25% chance of producing a -12% return. What is its expected return?

3. Historical returns for Stocks A and B over the past five (5) years are listed below. The risk-free rate
is 3%.

Years Stock A Stock B

1 20% 25%
2 30% 18%
3 -2% 50%
4 6% 10%
5 18% 21.5%

a. What are the coefficients of variation for Stocks A and B?

b. What are the Sharpe ratios for Stocks A and B?

c. Which stock has performed better on a risk-adjusted basis? Explain.