RISK & RETURN

SHENAL RAJAKARUNANAYAKE
DEPARTMENT OF INDUSTRIAL MANAGEMENT
FACULTY OF BUSINESS
UNIVERSITY OF MORATUWA
Return
Income received on an investment.
Any change in market price that is usually
expressed as a percentage of the beginning
market price.
It comprises of two components.
1. Yield
2. Capital gains
Return (Cont’d)
Yield
Periodic cash flows/income on the
investment is called as Yield. This
could either be interest from bonds or
dividends from shares.
Capital Gains
The appreciation in the price of an
asset is called as CAPITAL GAINS.
Total Return
Total Return = Yield + Price change

TR = {Dt + (Pt – Pt-1)}/ Pt-1

Thumindu purchased a stock at LKR 500 and its value has

increased to LKR 650. He received a dividend of LKR 300.
Calculate the total return received by Thumindu.
Total Return (Cont’d)
The percentage return can be expressed as the sum of the dividend yield
and percentage capital gain.
Dividend Yield is the dividend expressed as a percentage of the stock
price at the beginning of the year.
Dividend Yield = { Dividend / Initial Share Price} * %
Percentage Capital Gain
◦ = { Capital Gain / Initial Share Price } *%
 S

Expected Return E ( R)  P
s 1
s Rs

Investors cannot be sure of the amount of return that

he\she is going to receive.
The expected return is an estimate of the future
outcome of any security.
Although the Expected Return is an estimate of an
investor’s expectations of the future, it can be
estimated using either ex ante (forward looking) or
ex post (historical) data.
If the expected return is equal to or greater than the
required return, purchase the security.
 S
E ( R)   Ps R s
Ex Ante Expected Return s 1
Calculations are based on probabilities of the future states of nature and
the expected return in each state of nature. Sum over all states of nature,
the product of the probability of a state of nature and the return projected
in that state.
State Ps Rs Ps * Rs
Good 30% 20% 0.3(0.2)
Average 50% 15% +0.5(0.15)
Poor 20% -4% +0.2(-0.04)
S
E ( R)   Ps R s 12.70%
s 1
Ex post expected return
Calculations are based on historical data. Add the historical
returns and then divide by the number of observations.
Year Rt
2002 15%
2003 20%
2004 9%
2005 10%
2006 5%
T 
E ( R )    Rt   T 11.80%
 t 1 
Relative Return
The difference between absolute return achieved by the
investment and the return achieved by the benchmark.
The return on a stock is 8% over a given period of time. If the
designated benchmark return is 20%, what is the relative
return?

RR = AR - BR
Inflation Adjusted Return

{ (1 + Return) / (1 + Inflation Rate) } – 1

Return on investment is 7%, inflation rate is 3%. What is the

Real Return earned by an investor?
Risk

Risk is the variability between the expected

and actual rate of returns.
01. Systematic Risk
02. Unsystematic Risk
Systematic Risk
Systematic risk, also known as "market risk"
or "un-diversifiable risk“.
It is the uncertainty inherent to the entire
market or entire market segment.
This is also referred to as volatility where it
consists of the day-to-day fluctuations in a
stock's price.
Unsystematic Risk
This is the type of uncertainty that comes
with the company or industry you invest in.
Unsystematic risk can be reduced through
diversification.
Unsystematic risk, also known as
"specific risk," "diversifiable risk" or
"residual risk,"
Interest Rate Risk
Interest rate risk is the chance that an
unexpected change in interest rates will
negatively affect the value of an investment.
This affects the value of bonds more directly than
stocks.
Market Risk
This refers to the variability in returns
resulting from fluctuations in the overall
market conditions.
This is the risk of loss due to the factors
that affect an entire market or asset class.
Market risk is also known as
undiversifiable risk because it affects all
asset classes and is unpredictable.
Financial Risk
Financial risk is the type of specific risk that
encompasses the many types of risks related to a
company's capital structure, financing and the
finance industry.
Types of financial risks
Credit risk
Liquidity risk
Foreign investment risk
Equity risk & Currency Risk
Measurement of Risk
Standard Deviation
This is the tool for assessing risk associated with a particular
investment.
This measures the dispersion or variability around a mean/
expected value.
Test Your Knowledge
Outcomes Return of Probability Return on Probability
Stock Stock
X Y
01 20 0.25 12 0.25
02 25 0.50 20 0.50

03 30 0.25 28 0.25

Calculate the Std. Deviation of X & Y

Test Your Knowledge
Stock A Stock B
Expected Return 20 20
Standard 1.21 5.68
Deviation

As an investor, what are your thoughts?

Coefficient of Variation { S.D / Exp Mean }
The coefficient of variation (COV) can determine the volatility
of an investment.
When used in the stock market, it helps to determine the
amount of volatility in comparison to the expected return rate
of an investment.
COV is a measure of relative risk.
It explains the risk associated with each unit of money invested.
Test Your Knowledge
Stock A Stock B

Expected Value 25 45
(Mean)
Standard 4 5
Deviation

Which stock is riskier?

Risk Diversification
Risk can be accepted, mitigated, avoided or diversified.
Only Unsystematic risk can be diversified. Not the systematic
risk.
Since systematic risk can not be diversified, investors should
be adequately compensated.
This depends on level of risk and it can be measured via Capital
Asset Pricing Model.
Capital Asset Pricing Model
This describes the relationship between
systematic risk and expected return for
assets, particularly stocks.
CAPM is widely used throughout finance for
the pricing of risky securities, generating
expected returns for assets given the risk of
those assets and calculating costs of capital.
Capital Asset Pricing Model
William Sharpe says : The return on an individual stock or portfolio of
stocks should be equal to its cost of capital.

The result should give an investor the required return or discount

rate they can use to find the value of an asset.
Capital Asset Pricing Model (Cont’d)
Investors expect to be compensated for risk and the time value of money.
The risk-free rate in the CAPM formula accounts for the time value of
money.
 The
risk-free rate also represents the interest an investor would expect
from an absolutely risk-free investment over a specified period of time.
The other components of the CAPM formula account for the investor
taking on additional risk.
 Capital Asset Pricing Model (Cont’d)
A market portfolio is a theoretical bundle of investments that includes
every type of asset available in the world financial market, with each asset
weighted in proportion to its total presence in the market.
The expected return of a market portfolio is identical to the expected
return of the market as a whole.
The beta of a potential investment is a measure of how much risk the
investment will add to a portfolio that looks like the market.
A stock’s beta is then multiplied by the market risk premium, which is the
return expected from the market above the risk-free rate.
Characteristic Line
A regression line drawn summarizing a
particular security's rate of return and
returns on market portfolio.
Slope of CL is ‘Beta’. It represents
systematic risk.
Beta measures change in excess return
on the stock over the change in excess
return on the market portfolio.
Characteristic Line (Cont’d)
The characteristic line is created by plotting a security's return at various
points in time.

The y-axis on the chart measures the excess return of the security. Excess
return is measured against the risk-free rate of return.

The x-axis on the chart measures the market's return in excess of the risk
free rate.
Characteristic Line (Cont’d)
If B = 1 Risk associated with the individual stock is same as the risk
associated with the market portfolio
If B > 1 Risk associated with the individual stock is greater than the
risk associated with the market portfolio. That means more
unavoidable risk is associated with the individual stock.
(Aggressive Investment)
If B < 1 Risk associated with the individual stock is less than the risk
associated with the market portfolio. That means security is less risky
(Defensive Investment)
Test Your Knowledge
Rf = 6%
Market rate = 13%
Beta = 1.25
Calculate the Expected return,

Greater the Beta = Greater the Systematic Risk

= Greater the Expected Return
Security Market Line

This describes the linear

relationship between the Expected
Return & the Systematic Risk as
measured by Beta
This is even called as graphical
representation of CAPM model.
Expected Return for 2 Assets
Expected return for 2 assets, is calculated as the weighted average of
the likely profits of the assets in the portfolio, weighted by the likely
profits of each asset class
E(R) = w1R1 + w2Rq + ...+ wnRn
For a simple portfolio of two mutual funds, one investing in stocks and
the other in bonds, if we expect the stock fund to return 10% and the
bond fund to return 6% and our allocation is 50% to each asset class
Expected return (portfolio) = (0.1)*(0.5) + (0.06)*(0.5) = 0.08, or 8%
 Portfolio Variance
The variance of a portfolio's return is a function of the variance of the
component assets as well as the covariance between each of them.
Covariance is a measure of the degree to which returns on two risky assets
move in tandem.
A positive covariance means that asset returns move together. A negative
covariance means returns move inversely.

Portfolio Variance = w2A*σ2(RA) + w2B*σ2(RB) + 2*(wA)*(wB)*Cov(RA, RB)

TYK
Stock A is worth Rs. 50,000 & has a std. deviation of 20%
Stock B is worth Rs. 100,000 & has a std. deviation of 10%
The covariance between two assets is 0.85
Weightage 33.3% (A) & 66.7% (B)
Calculate Variance & Std. Deviation