Risk and Return

⚫ Risk & Return

⚫ Analysis of Risk
⚫ Mean Variance Model
⚫ Capital Asset Pricing Model
 Return
• Outcome of an effort.
• Investment return
– The financial outcome from an investment.
– Typically measured as a percentage of the total amount
of money invested.
 Risk
• Chance of unfavourable event/s.

• Investment risk
– Possibility of earning return less than expected return.
– Greater the probability of negative or low return, higher
the investment risk.
 Using Probability Distribution to
Measure Return
• Probability distribution
– A set of outcomes with probability of occurrence
attached to each outcome
• Measure the probability of the occurrence of
different states of economy.
– Deep recession, Mild recession, Average, Mild boom,
Strong boom.
• Calculate Expected Return.
Λ n
k =  k iPi
i=1
 Measuring Return

State of Economy Probability of Return

Occurrence
Deep recession 0.05 -2%
Mild recession 0.20 9%
Average economy 0.50 12%
Mild boom 0.20 15%
Strong boom 0.05 26%
Expected Return
=
-2%x0.05+9%x0.20+12%x0.50+15%x0.20+26%x0.05
=12%
 Types of Risk
• Stand-alone Risk
– When all your money is invested in one business activity.

⚫ Portfolio Risk
• When your money is invested in different business
activities
 Stand-alone Risk
⚫ Unsystematic/diversifia • Systematic/Non-
ble diversifiable
• Controllable – Uncontrollable.
• Diversifiable – Non-diversifiable.
• Company/industry- – Economy-specific
specific • e.g., inflation, recession,
•lawsuits, strikes, war, flood, etc.
unsuccessful marketing
programmes,
technological changes,
etc.
 Managing Investment Risk

• The important issue is the overall aggregate risk of

the portfolio
– Investment that combines portfolio risk and
unsystematic risk
– so losses (lower return) on some investments are
partially or fully recovered by the gains (higher return)
on some other investments.
– This is Portfolio Management
 Analysing Stand-alone Risk
• Variance:
– Dispersion of possible outcomes around the expected
value, i.e., the expected rate of return.

– The larger the variance, the greater the dispersion and

hence higher the risk.

2
n
 ^

Var =   k i − k  Pi
i=1  
Analysing Stand-alone Risk

• Standard deviation:

σ = VAR

n 2
 ^
  k i − k  Pi
i=1  

⚫ Standard deviation
= [0.05(-2-12)2 + 0.20(9-12)2 + 0.50(12-12)2 + 0.20(15-
12)2 +0.05(26-12)2]
= +4.8%
Analysing Stand-alone Risk

• Two conclusions drawn from standard deviation.

i. The larger the standard deviation, the higher the

stand-alone risk.

ii. For normally distributed outcomes

▪ 68.3% of all outcomes will fall within one SD
▪ 95% within 2SD
▪ 99.7% (almost all) within 3SD
Analysing Stand-alone Risk

• Example:
– Stock Y has an expected return of 30% and a standard
deviation of 5%. What will happen to actual return if it
deviates from the expected return by(i) 1 standard
deviation, (ii) 2 standard deviation, (iii) 3 standard
deviation?

• Ans.

i. The actual return will be reduced to 30% - 1 X 5% = 25%

ii. The actual return will be reduced to 30% - 2 X 5% = 20%
iii. The actual return will be reduced to 30% - 3 X 5% = 15%
Analysing Stand-alone Risk

• Coefficient of variation: CV
– measures the risk per unit of return.
σ
CV = ^
k

Example: Project X has a 30% expected return with a

10% standard deviation. Project Y has a 10% expected
return with a 5% standard deviation. How do you
compare the decision between investment in these two
projects?
Analysing Stand-alone Risk

Actual Return
• Project X: • Project Y

•For 10% - 5%
30% - 10%
dispersion of = 5%
1SD =20%

•For 10% - 10%

dispersion of 30% - 20%
2SD = 10% = 0%

•For
30% - 30% 10% - 15%
dispersion of
3SD = 0% = -5%
Analysing Stand-alone Risk

Actual Return

• Project X: • Project Y
Coefficient of
Variation 10/30 5/10
= 33% = 50%

Project Y therefore, has higher risk per unit of return than

project X. It can be argued that project Y is riskier than project
x despite having a lower standard deviation than project X.
 Subjective vs. Objective
Probability Distributions.
• Subjective probability distribution
– Probabilities assigned to different outcomes
– vastly subjective based on the experience of the
financial analyst.
• Objective probability distribution
– Applied to historical data provided.
i. Historical data are available.
ii. There is a good reason to expect that the future will behave
like the past.
 Subjective vs. Objective Probability Distributions.


kt
Average expected return = k avg =
i=1
n

n
(k i − k avg ) 2

Variance = i=1
n −1

Standard deviation = σ = VAR

σ
Coefficient of Variation =
k avg
 Portfolio Risk & Return
Mean-variance Model
Conceptualisation with the 2-asset portfolio

• Portfolio return
Λ n
k p =  w iki
i=1

• Portfolio risk

σ p = w 2A σ2A + w 2Bσ2B + 2w A w Bσ A σ BrAB

Portfolio Risk & Return: Mean-variance Model

EXAMPLE:
kA = 10% σA= 2% wA = 0.6
rAB=0.6
kB = 15% σB= 2.5% wB = 0.4

• Portfolio return:
Λ
k p = 0.6 10% + 0.4 15%
= 12%
⚫ Portfolio risk:

σp = (0.6 2
 2%2 + 0.42  2.5%2 + 2  0.6  0.4  2%  2.5% 0.6 )
= 3.88
= 1.97%
 Test Your Learning
• Fill up the blanks.
1. While walking down the road, you are carrying
Tk.20,000 equally distributed among your four pockets
equally. This is an example of ___________.
2. Due to the ongoing crisis caused by the Covid 19
pandemic, global trade, commerce, and investment
have been suffering immensely. This is an example of
______________.
3. The measure that you have to use to determine the
relative risk associated with investment in multiple
assets is the _____________.
 Test Your Learning
4. The relationship between changes between the return
on stock X and stock Y is measured by _____________.
5. A 3 standard deviation decline in return would imply
that the return will not ____________ further.
6. Your return from investment in MNO Company is likely
to fall significantly because some of the key executives
left the organisation. This is an example of
_____________.
7. “The higher the risk, the higher the compensation for
taking the risk,” this known as ______________.
 End of Session 1
• Be back with session 2 in 20 minutes.