CHAPTER THREE

RISK ANALYSIS: SINGLE INVESTMENT

3.1. RETURN

Investments are made to earn a return. To earn the return, the investor must accept the
possibility of loss. Portfolio theory is concerned with risk and return. Its purpose is to
determine the combination of risk and return that allows the investor to achieve the highest
return for a given level of risk.

The word return is often modified by an adjective, including the expected return, the
required return, and the realized return. The expected return is the anticipated flow of
income and/or price appreciation. An investment may offer a return from either of two
sources. The first source is the flow of income that may be generated by the investment. A
savings account generates interest income. The second source of return is capital
appreciation. If an investor buys stock and its price subsequently increases, the investor
receives a capital gain. All investments offer the investor potential income and/or capital
appreciation. Some investments, like the savings account, offer only income, whereas other
investments, such as an investment in land, may offer only capital appreciation.

It is important to realize that this return is anticipated. The yield that is achieved on the
investment is not known until after the investment is sold and converted to cash. It is
important to differentiate between the expected return, the required return, and the realized
return. The expected return is the incentive for accepting risk, and it must be compared with
the investor’s required return, which is the return necessary to induce the investor to bear
the risk associated with a particular investment. The required return includes (1) what the
investor may earn on alternative investments, such as the risk-free return available on
Treasury bills, and (2) a premium for bearing risk that includes compensation for the
expected rate of inflation and for fluctuations in security prices. Since the required return
includes a measure of risk, the discussion of the required return must be postponed until the
measurement of risk is covered.

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The realized return is the return actually earned on an investment and is essentially the sum
of the flow of income generated by the asset and the capital gain. The realized return may,
and often does, differ from the expected and required returns.

Example:
1. On February 1, you bought 100 shares of stock in the Francesca Corporation for $34 a
share and a year later you sold it for $39 a share. During the year, you received a cash
dividend of $1.50 a share.
Required: Compute
I. Total dividend income
II. Total capital gain
III. Total return
IV. Dividend yield
V. Capital gain yield
VI. Total rate of return(yield)
2. On August 15, you purchased 100 shares of stock in the Cara Cotton Company at $65
a share and a year later you sold it for $61 a share. During the year, you received
dividends of $3 a share.
Required:
I. Total dividend income
II. Total capital gain
III. Total return
IV. Dividend yield
V. Capital gain yield
VI. Total rate of return(yield)
3. At the beginning of last year, you invested $4,000 in 80 shares of the Chang
Corporation. During the year, Chang paid dividends of $5 per share. At the end of the
year, you sold the 80 shares for $59 a share. Compute your total HPY on these shares
and indicate how much was due to the price change and how much was due to the
dividend income.

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3.1.1 EXPECTED RETURN EXPRESSED AS A PROBABILITY

Probability theory measures or indicates the likelihood of something occurring. If you are
certain that something will happen, the probability is 100 percent. The sum of all the
probabilities of the possible outcomes is 100 percent. The expected value (the anticipated
outcome) is the sum of each outcome multiplied by the probability of occurrence. Each of the
expected returns is weighted by the probability of occurrence.

Whenever we are expecting about the future the concept of probability comes into being. A
probability distribution indicates the percentage of chance of occurrence of each possible
outcome. An objective determination basically relies on past occurrence of similar outcomes
while subjective one is solely dependent on opinions made based on perception. So the
expected value of an investment then can be calculated based on the probability that a
particular outcome will occur. Then it can be said that, the expected value is a statistical
measure of the mean or average value of the possible outcomes. In other words, it is the
weighted average of possible outcomes, with the weight being the probabilities of
occurrences

Algebraically,

n
ER=  RiPj
i 1

Where ER= the expected return,

Ri is expected outcome in ith case,

n is the possible outcomes and

Pi is the probability that the ith outcome will occur.

Example: Suppose an investor is considering an investment of 200,000 in the stock of XYZ

co or ABC co. hoping to gain dividend and selling it at appreciated price after one year. Over
the year it is presumed that the economy will be 20% at boom, 60% at normal and 20% at
recession. What is the expected return from the investment given the following rate of returns
in various economic conditions?

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Economic Probabilities Return of Return Expected Expected
conditions XYZ of ABC return of XYZ return of ABC

Boom 0.2 10% -4% 2% -0.8%

Normal 0.6 11% 20% 6.6% 12%

Recessions 0.2 26% 40% 5.2% 8%

ER 13.8% 19.2%

3.2. Risk Analysis

 It is the possibility that actual future returns will deviate from expected returns
 It is the variability of returns
 It is a chance of unfavorable event to occur
 Risk is concerned with the uncertainty that the realized return will not equal the
expected return

From the perspective of financial analysis then, it is the possibility that the actual cash flow
will be different from forecasted cash flows (returns). Therefore if an investment’s returns are
known for certainty the security is called a risk free security. An example on this regard is
Government treasury securities. This is basically because virtually there is no chance that the
government will fail to redeem these securities at maturity or that the treasury will default on
any interest payment owed.

When it comes to investments, there are always some levels of uncertainty associated with
future holding period returns. Such uncertainty is commonly known as the risk of the
investment. Then the question will be what causes the uncertainty (or volatility) of an
investment’s returns? The answer depends on the nature of the investment, the performance
of the economy, and other factors. In other words, when you “dissect” the uncertainty of an
investment’s return, you will realize that it is made up of different components. The
following are some of the components:
(a) Business risk: This is the uncertainty regarding the earnings (or profitability) of a
firm as a result of changes in demand, input prices, and technological obsolescence.

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 (b) Default risk: This is the uncertainty regarding an issuing firm’s ability to pay interest,
principal, etc. on its debt instruments.
(c) Inflation risk: This is the uncertainty over future rates of inflation. If the return from
an investment is barely keeping up with the rate of inflation, an investor’s purchasing
power will be eroded as time goes on. In other words, the investor will receive a lesser
amount of purchasing power than what was originally invested because the cost of
buying everything has gone up. Inflation risk is also known as purchasing power risk.
(d) Market risk: This represents the changes in an investment’s price (or market value)
as a result of an event that affects the entire market. An example is the impact of a
market correction or a market crash on an investment’s return.
(e) Interest rate risk: This represents the fluctuation in the value of an investment when
market interest rate changes. This has a big impact on interest-paying investments
because as market interest rate rises (falls), an investor’s money is tied up in a bond
that pay less (more) than the going rate, and hence the value of the investor’s bond
decreases (increases).
(f) Liquidity risk: This is the risk of not being able to sell an investment immediately
with a reasonable price.
(g) Political risk: This is caused by changes in the political environment that affect an
investment’s market value. Political risk can be classified as either domestic or
foreign political risk. An example of domestic political risk is a change in the tax
laws, and an example of foreign political risk is a change in a foreign government’s
policy regarding capital outflow.

(h) Exchange rate risk: This is the uncertainty regarding the changes in exchange rates
that might affect the value of an investment. Exchange rate uncertainty has an impact
on both domestic and foreign investments.

3.2.1 Measurement of risk

Expected returns are insufficient for decision making. The risk aspect should also be
considered. The most popular measure of risk is the variance or standard deviation of the
probability distribution of possible returns. Variance is usually denoted by δ2and is calculated
by the following formula

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 n
δ2 =  ( Ri  ER)2 * Pi
i 1

A risk of an investment can be measured in absolute term using standard deviations and
variance or in relative terms using coefficient of variation.

Standard deviation: An absolute measure of risk: It is the statistical measure of the

dispersion of possible outcomes about expected value. It is the square root of the weighted
average square deviations of possible outcomes from the expected value. It is used to
measure the variability of returns for an investment and therefore an indication of risk. The
largest the standard deviation, the more the variability of returns and therefore the riskier the
investment is. A standard deviation of Zero indicates no variability and thus no risk involved.
A standard deviation is useful to evaluate investments of expected returns.

Variance and standard deviation are measures of how actual values differ from the expected
values for a given series of values. In this case, we want to measure how rates of return differ
from the mean value of a series. There are other measures of dispersion, but variance and
standard deviation are the best known because they are used in statistics and probability
theory.
n
SD =  ( Ri  ER)2 * Pi
i 1

Let us calculate the standard deviation of ABC and XYZ Company based on the above
example.

A. Variances of ABC Company

Economic conditions Pi Ri ER (Ri-ER)2 (Ri-ER)2 * Pi

Boom 0.2 10% 13.8% 14.4 2.888

Normal 0.6 1I% 13.8% 7.84 4.704

Recessions 0.2 26% 13.8% 148.84 29.768

Variance of ABC 37.36

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 B. Variances of XYZ Company

Economic conditions Pi Ri ER (Ri-ER)2 (Ri-ER)2 * Pi

Boom 0.2 -4% 19.2% 538.24 107.648

Normal 0.6 20% 19.2% 0.64 0.384

Recessions 0.2 40% 19.2% 432.64 86.528

Variance XYZ 194.56

C. Standard deviation of XYZ co

SD = var iance 37.36 = 6.11

D. Standard deviation of ABC co

SD = var iance = 194.56 =13.95

Coefficient of variation: A relative measure of risk

This is a relative measurement. It measures the standard deviation in relation to expected

return. It measures the risk per unit of expected return. So as the coefficient of variation
increases, so does the risk of an asset. In some instances, you might want to compare the
dispersion of two different series. The variance and standard deviation are absolute measures
of dispersion. That is, they can be influenced by the magnitude of the original numbers. To
compare series with very different values, you need a relative measure of dispersion. A
measure of relative dispersion is the coefficient of variation,
Coefficient of variation= SD/ ER
Which one of the securities is high risky?
XYZ coefficient of variation = 6.11/13.8=0.44
ABC coefficient of variation =13.95/19.2=0.73
 Since the coefficient of variation of ABC is greater than XYZ it is more risky

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