Risk and Return qos - “prcepin lis cape, side should be al to: Every investor aims to maximize return and vaand ho coneepl and components of rtums, minimize risk on her/his investment. To "ea dng prod retums achieve these goals, the investor should be able to correctly perceive what risk and return mean and how they arc measured. The main. purpose of this chapter is, therefore, to present the concepts and measurement of risk and return on an individual asset. This chapter, first, presents the concept of return along with its components. Then this chapter extends to a discussion on the different measures of investment return. Finally, this chapter presents the concept of risk, sources of risk, and techniques of measuring risk for a single asset by using variance, standard deviation, and coefficient of variation, "acs the concept and calculate of athmatic mean, mean and intemal rate of retum. 4 Utestand tho rlatinship between nominal and real tm. «slate the expected retum. «+ Usedtlerent measures to measure risk in investment, ———ee“reorrr”ersestw'reeor— ms nmtee) sonapters 193 Hence, ‘The expected return for Investment A, E(Ry) = 9% Standard deviation of returns of Investment A (o,) = [74 = 8.60% 1) =V74 = 8: For Investment B: Probability | . x a a Rexe IRe- E(R)} Pike ECR) ” ™% Be 968 a be 2 2 288 02 8 3 : a ao 1 8 128 aa 3 28 1568 Eki) = 3% aan 286 Hence, ‘The expected return for Investment B, E(Rs) = 13% Standard deviation of retums of Investment B (1) = 7256 = 17.20% b. Calculation of coefficient of variation: We know, covets . ER) For Investment A: 60 cva=832=0.9556 For Investment B: 17.20 CVe=g 7 15231 return as indicated by coefficient of variation is lower for The risk per unit of Jess volatile relative to its level of investment A. It implies that Investment A is return, so we prefer Investment A to B. Summary + Retum is reward for investing, wealth. Therefore, other things + Two components of return are cu cash periodically. Capital gain or loss end of period as compared to the beginning: «Total return is the total of current income anc capital in oF a percentage on beginning value of investment called a rate +The rae of return over a longer investment horizon can be annual return, geometric average return ‘and cash flow weighted average return. + The rate of return quoted for all investments 2°° nominal returns, They measure rupee amounts of changes in assets value but ignore the purchasing power. But the rel return considers purchasing Power, ~ Tt is the level of profit from an investme It increases the investor's ‘held constant, investors always prefer higher return to the lower one. ss, Current income is realized in vrcalts from the change in market value of investment at the rent income, and capital gain or lo Joss. The total rupee return expressed as of return or the holding period return. lized by using arithmetic average t offers a rate of return at least ‘The rate is called the required ym for the _—Ertrt—“—=i—isr™”™ alternative that it risk involved. sufficient to compensate for the level of investies is Tetum and it consists of real return, an expected inflation premium, and risk premét investment.Beginning investment . \ an investment Over singe ing 194 INVESTMENT ANALYSIS mn measures the total rate of return frome horizon. It compares total returns relative to size of the oe ier ine ae + Fora longer holding period, HPR is not appropriate as 008% ot eg, ‘Thus, internal rate of return or yield is used as an alternative IRR recognizes the conce, th from an investment with holding period of more than one year cma value of money. / a +The expected rate of return is defined as the wephed svenee of i sponding probability of cal . | on the level of returns but aso on the lv ider investment return and tisk together, i, 7 er .ce that an investment will fail to seer + Holding period retur Possible retums why, * An investment performance does not only depend « associated with it. Therefore, it is necessary to consi the risk is defined as variability in returns. It is the chan returns as expected. | * The risk — ‘can be measured by variance or standard cineyh and coetfcien 7 variation. The variance is average of the mean squared error terms. It measures the average dig, of returns on investment around the average or expected return of the investment, + Itis difficult to interpret variance because it is expressed in percent squared form. Standard devi, isan absolute measure of risk and calculated as the square root of variance. It is expressed inthe sng unis, as are the original data, hence is easier to comprehend and compare with expected retam t consider both return and risk, we calculate the coefficient of variation, which measures risk in tems per unit of return. Hi Illustrative Problems _—————————————————————— Wustration 5.1 Assume that you purchased a share of stock for Rs 50 one year ago, sold it today fy Fuge eum andra Rs 60, and during the year received dividend payments totaling Rs 270, Calclse ae the following: a, Current income, b. Capital gain or loss, c. Total rupee retum and te holding period return, Solution: Given: Beginning purchase price (Ps) = Rs 50 Cash dividend (C1) = Rs 2.70 Ending selling price (P,) = Rs 60 a, We have received a total dividend income of Rs 2.70 from the stock. Thus, Current income = Cash dividend = Rs 2.70 b. During one year of holding period, the stock price has been increased from Rs to Rs 60. Thus, capital gain for this period is: - Capital gain = Ending stock price ~ Beginning stock price =Rs60-Rs50= R510 Total rupee return is the total of current income and capital gain and is works out as follows: Total rupee return = Current income + Capital gain = Rs 270+ Rs 10=Rs 12.70 ‘The holding period return is the total rupee return expressed as a percentage beginning investment. It is worked-out as follows: pr = —Zolal rupee retuen195 RISK AND RETURN «chapter § Rs 121 =" Rs 50 = 0.254 or 25.40% al holding peri ‘Thus, annual holding period return on this stock investment is 25.4 percent- a Cato the total rupee return and tolal return in percentage for each year. ee the average ate of retum over the period 2011-2015? b icate the k ? OC ane level of return you would expect in 2016 and comment on Your & ee 8 btn return in rupees and as a percentage of your original investment if you purchased 100 shares ofthe investment atthe beginning of 2011 and sold it at the end of 20137 sation a. Calculation of total rupee return and total return in percentage for each year a) Markel price @ o G iL | canis | Total | Rateof Beginning) Ending | £0, return | return (3)-@) (+ eve) Rs 1.00 | Rs300 |” Rs325 Rs 25 Bs 3.50 11.67% Pal es — 25 3.70 11.38 130) 350) 330 -20 -070 200 ty 400 70 8.60 2606 175} _400|__ 450 50 675 1688 — Total by The average relurn over the period 2011-2015 is given by: A ou _ Total of, the annual rate of return. erage return ‘Number of years -oe8, 12.80% sxpected return to be the same as annual average return observed in past, Thus, we may expecta 12.80 percent retin) in SOTe.fiowever, we would expect to realize 1280 percent rate of return in 2016 only if past ends and events would continue to prevail in the faryre as well, 44. If we purchased 100 shares of the investment at the beginning of 2011 and sold it at therend of 2013, the foal return in rupees and as a percentage of our original investment is worked out as follows: Given: Boginning value of investment in 2011 = Rs30 * 100 shares = Rs 3,000 Ending value of investment in 2013 = R533 « 100 shares = Rs 3,300 2012 and 2013 Total current income for 2011, = (Rs1.0 + Rs 1.2+ Rs 1.3) * 100 shares = Rs 350 ‘A naive investor might estimate the © ‘Thus, ‘Total income in rupees = (Ending value ~ Beginning value) + Current income = (Rs 3,300 ~ Rs 3,000) + Rs 350 = Rs 650196 INVESTMENT ANAL ‘And, Percentage rate of return ysis Total Rs 650 "Rs 3,000 ce return Beginning value = 0.2167 or 21.67% Mlustration 5.3 You are provided the following information on year-end dividend per shar > year-end market price per share of Mechi Tea Company: “Tot ru, cidond nen ‘Year-end dividend per share Required: a. Annual rates of return, b. Dividend yield and capital gain yield for each year. Solution: a, Calculation of annual rales of return Pi-Pia+ Dr D Rr Return [n. mr ] > 200 = 210 - 200 +10 10 210 200 = 10% =210+11.5 ns 230 BOTA TS 15% = 230 + 26 6 250 BO B02. 20% 0 2s oR 0 | 0% 75 240 BO ZS*7S soy —__| b,_Caleulation of dividend yield and capital gain yield for each year Year Dividend Yield D/Pur Capital Gain Yield (Pi Piay/Pia 2011 10/200 = 5% (210 ~ 200)/200=5% 2012 11.50/210 = 5.48 (230-210) / 210= 952 2013 26/230 = 11.30 (250 - 230)/230 = 8.70 2014 0/250 =0 (225 - 250)/250=~ 10.00 2015 75/225 = 33:33 (240 — 225)/295 = 6.67 Mlustration $4 Consider two investments Stock A and Stock B. Stock A pays quarterly dividends o eee Rs 4 per share, and currently selling at Rs 300 per share. If you buy this stock, you expect to sell the stock at the end of first quarter at Rs 320, Stock B pay's quarterly dividends of Rs 9 per share and is trading at Rs 320 per share. If you buy this stock you expect to sell the stock in one year for Rs 380. Which stock will provide the better annualized holding period return? Ignore time value of money. Solution: Given: Stock A: Stock B: Quarterly dividend = Rs 4 Holding period = 3 months Beginning price = Rs 300 Ending price = Rs 320 Quarterly dividend = Rs 9 Holding period = 1 year Beginning price = Rs 320 Ending price = Rs 380: RISK AND RETURN Dee Calculation of holding period retu: mn: Folding period Dividend received 5 months, First quarter Second quarter ae ‘Third quarter : Fourth quarter z (1) Total cash income i Investment value Bsa (2) End of period 9 Beginning of period sO (4) Capital gain (loss) = (2) - 6) Total rupee return = (1) a na (6) Holding period return = (5)/(3 0. oot The holding period return of Stock A is for 3 months. So, we need convert it into annualized holding period return. Ignoring the time value of money, annual HPR of Stock A is four times of 8 percent. That is, ‘Annualized HPR for Stock A= 8% X 12/3 =32% ‘Annualized HPR for Stock B = 30% ‘Thus, Stock A provides better annui period return than Stock B. a8 ee 3: ga a8 2 =e ae At the be; ig of the year, Miss Shital decided to take Rs 100, wontons we bank and invest it in a portfolio of stock and bonds; Ks 40,000 S Common stocks and Rs 60,000 into corporate bonds. A year later S fond holding were worth Rs50,000 and Rs 46,000, respectively Di R22,000 in cash dividends was received on the stocks, and RS 6,000 in coupon payments was received on the bonds. The stock and bond income ‘was not reinvested in Shital's portfolio. a. What was the return on stock portfolio during the year? E What was the return on bond portfolio during the year? e What was the return on total portfolio during the year? Given: i Solution: Beginning investment Ending value Cash income, rock portfolio during the yeat a. HPRonst (Ending value - Beginning value) + Cash income HPR = Beginning value (Rs. 50,000. =Rsanom +Rs2,000 9.39 or,30% bb, HPRon bond portfolio during the Year Eosdng value= Beginning val) * Cash income HPR = Boginning value _(s.4,000 = Rs 60.900) 5 5°* = 0 + Rs 6,000 _ _ 9.1333 or -13.33% a portfolio during the yeat cc. HPR on tots | (Ending, value — Bey.nning, value) + Cash income HPR = Beginning value (gs. 96,000 = Rs 100,000) + Rs 8,000 _ 9.04 or 4% Rs 100,000198 INVESTMENT ANALYSIS oy Illustration 5. An investor purchased 1,000 shares of Nepal Bank Ltd. at Hs 200 per share in Tan 2001. The Bank declared and paid dividend of Rs 20 per share in 2001 and Rs a") reeset domes share in 2002. The investor sold the stock for Rs 190 per share after ils holding period. a. Calculate the two-year holding-period return, assuming that the received in 2001 was not reinvested. b. Calculate the two-year holding-period return, assuming that the g received in 2001 was reinvested at 10 percent. What is the anny, period return of this two-year HPR? Solution: Given: Beginning price (Po) = Rs 200 1B Price (P2) 's 190 ividend in 2001 (C1) = Rs 20 idend in 2002 (C2) =Rs30 4. Caleulation of two-year holding period return if dividend is not reinveseg Po Pa) + Ci + Cp Her = @2-Pd t+ Ge Po _ (Rs 190 -Rs 200) + Rs 20+ R530 _ a = Reabt .20 oF 20 }. Calculation of two-year holding period return if dividend is reinvested 1 percent (Po ~Po) + Ci (1+ 1) + Co HPR = Po (Rs 190 -Rs 200) + Rs 20 (1 + 0.10) + R530. _ - is 200 0.21 or 21% Where r= reinvestment rate of first year’s dividend = 0.10 ‘The annualized holding period return of the two-year LPR is given by: Annualized HPR = (1+ 2-year HPR)'/—1 (1.21)/2-1 = 1.10-1=0.10 or 10% Ulustration 5.7, A S-month maturity money market instruments are selling at Rs 49,000. ts Ine win HPR, APA and EAR 's Rs 50,000. If you buy this instruments; hold it over three months period and ths Telaize the face value, what is your rate of return over three month's holding pei!) What is the annual percentage rate on this investment? What is the effective onmal rate? Solution: Given: Beginning price (P) = Rs 49,000 Ending price (P,) = Rs 50,000 Number of compounding periods (m) = 4 The holding period return over three mont Pi-Po _Rs50,000- BPR =A = s50,000- Rs 49,000 eat = 0.0204 oF 2.04% ‘The annual percentage rate on this investment is: APR = HPR x m = 0.0204 » 4 = 0.0816 or 816% ‘The effecive annual rate is given by: war [1287 hs is given by:RISK AND RETURN acnepters 19° Alternatively, we can work-out: i out effective 5: ; ae ecm teas follows: Suppose the inte ee est rate on one-year callfcale of deposi is & percent. You eXPECE inflation to be 5 percent over the i i in interest? Whats the exact real ate? Wi aperna : oe Given: sol ‘Nominal interest rate (R) = 0.08 Inflation rate (IR) = 0.05 ‘The approximate real rate of interest is interest RR=R-IR=0.08 - 0.05 = 0.03 or 3% “aenby ‘The exact real rate of interest is given by: 1+R ; RR =74IR~ 218 = Tg” 1 = 0.0286 or 2.86% jon 59 ‘Consider the following two investments and associated holding period returns over ist a three years. Tolding period return (11PR) Stock A Stock B 10% 2% 10. 20 2B 30 ‘a. Whats the arithmetic mean HPR for Stock A? Stock B? b. Whatis the geometric mean HPR for Stock A? Stock B? ‘c. Which investment would you prefer? Why? Solution: a. Calculation of arithmetic mean IIPR: For Stock A: HPRoois + HPRoo15 + HPRoote n Raw. 1 ys + 13% H+ 10+ 13% yg, For Stock B: HPRans + HPRoos + HPRooig Re an - MED +08 a1 33% b. Calculation of the geometric mean TIPR: For Stock A: Rea =[(1+ HPRoon) (1+ HPRoos) (1 + HPRao)]*-1 = [(1 +0.) (#04) (1+ 0.13) = 1 = (1.3673)1~ 1 = 1.1099 ~ 1 = 0.1099 or 10.99% For Stock B: Roos = [(1 + HPReon) (1 + HPRoos) (1 + HPRao)]/°~1 = [(1-+0.28 (1-02) (1+ 039-1 = (1.2896)1/3 = 1 = 1.0885 ~ 1 = 0.0885 or 8.85% Tn HPR, Stock B has higher return performance. werage return does not consider the reinvestment In contrast, geometric mean HPR considers the we follow the geometric mean HPR to c. Considering arithmetic mea However, this measure of effect of the annual HPR compounding effect of reinvestment. S0,200 INVESTMENT ANALYSIS tMlustration Solution: investments. Accordi evaluate the return performance of these two invest According measure, Stock A has better return performance. Therefore, if we Assume Ot these two investments have equal risk, we tend to prefer Stock A as its Bom mean HPR is higher. ind history of Stock A are as follows: Beginning of year price Year-end dividegy Rs 100 Rs4 10 4 70 4 9% 4 An investor buys three shares of Stock A at the beginning of 2013, buys mai {wo shares at the beginning of 201, sells one share atthe beginning of ons, a sells all four remaining shares at the beginning of 2016. a. What are the arithmetic and geometric average rates of retu {0t he investor? b. What is the cash-flow weighted retum (or internal rate of return) for the investor? First, we work-out annual holdin; 'B Period return from this investment 35 follows: Dividend | E*ding | Beginning Year price’ | price rn = B= Bet (9 ©) 9 10 - 100 + 4 213 | Rsa | Rs110 | Rs 100 Ot oor <1 2014 4 90 110 Rae = -0.1455 or -14.55% 95 90 95-9044 90 = 9.10 oF 10% a The arithmetic average return forthe investor fs given bys HPRoois + HPRo1s + HPRoois Ray 14% - 14.55% 1% 14% es +10% 515% The geometric average return for the investor is given by: Rew. ={(1 + HPRoos) (+ HPRong) (1+ HPRop)]/n 1 = [+ 0.14) (1 0.1455) (1+ o.10)}13-1 = (L.0715)¥3 - 1 = 1.0233 ~ 1 = 0.0233 of 2.33% Hence, the arithmetic and geometric average returns for the investors are 315 Percent and 2.33 percent, respectively, >. Calculation of cash-flo w weighted return, First, we work-out the cas! (Internal rate of return): h flows as follows, = flow Jan 1, 2013 Buy 3 shares @ Rs 100 - (R30) (Year 0) Jan1,2014 | Collect cash dividend of Rs (Rs 220) | (R528) (Year) | 4 pershare on3 shares and buy 2 new shares @ Rs 110lustraton 5.11. soaps an Solution: RISK AND RETURN Collect cash dividen id of 4 pershareonSsharesang | S27" 85% sell 1 share @ Rs 99 Collect cash dividend of Rs Apershareondsharesand |” 8S? sell 4 shares @ Rs 95 , arl il Deed arbitrarily We choose 0 percent discount rate to calculate the total present Rall Present value at this discount rate is Rs 298, which is lower than jal investment cost of Rs 300, So, we reduce the discount rate and calculate total present value at negative 1 percent discount rate. As shown in the rai bebeerga the total present value at negative 1 percent is higher thar percent westment cost. It implies that IRR falls between negative 1 percent and © dof Cash year flows O% 1% : (Rs 208) 1 yo101 _){ (Rs 210.10) : a 1 10 1.023 “| 11223 3 396 1 396, 1.0306 408.12 Total present value (IPV) | _ Rs 298 Rs 310.25 Finally, we use these two rates as higher rate and lower rate to workout IRR as follows: Given: 5 TPVix= Rs 310.25 Ge ‘TPVaw = Rs 298 Va Thus, x y TPVin- CFs a IRR =LR + GRY TP * CR -LR) Y Rs 310.25 - Rs 300 =-1% + R¢310.25- Rs 298 * O% 1%) Rs 10.25 teks = -0.1683% Hence, this investment produces return or the internal rate of retur x 1% =~ 1% + 0.8367% 3 a negative 0.1633 percent cash-flow-weighted Suppose a fund begins wi Compute arithmetic, geometric, and cash-flow Weighted average returns. ‘The arithmetic average return for the investor is given by: _HPRi + HPR:+ HPRs n Aa —2EABE-AK og “The geometric average return for the investor is given by: Row. = [(1+HPR) (1+ HPR:) (1+ HPR)}v*=1202 INVESTMENT ANALYSIS = [(1 + 0,02) (1 + 0.08) (1 -0.04)]" -1 = (1.057536)" =1 = 1.0188 -1 = 0.0188 or 1.88% Hence, the arithmetic and geometric average returns for the investor, ay percent and 1.88 percent, respectively. a Calculation of cash-flow weighted return (Internal rate of return); First, we work-out the cash flows as follows. Month] Beginning ] Return Adiltional | Ending’ 7 Nao investment investment | investment | qa 1 Rs10 | 002*Rs Rs3 Rs 132 we 10=Rs 02 2 Rs132 | 0.08% Rs Rs5 R519256 | (res 3 Rs 19.256 Rs18.486 | Reta Now, arbitrarily we choose 1 percent discount rate to calculate the total p value. The total present valuc at this discount rate is Rs 10.0707 million, what higher than initial investment cost of Rs 10 million. So, we increase the discon rate and calculate total present value at 2 percent discount rate. As shown in, the following calculation, the total present value at 2 percent is lower than init investment cost. It implies that IRR falls between 1 percent and 2 percent, Tndof ] Cash] PVIF@ ™% | Pvire year flows wm | PY@™M% | ay, | Pam 7 (3) [09601 | (R25703) | 9807 | (RsaI 2 © 0.9803 | (4.9015) | 0.9612 | (480% 3 1sas6_| 09705 | 17.915 | 943 | tro Total present value (IPV) | Rs 10.0707 Rs 967 | Finally, we use these two rates as higher rate and lower rate lo workout IRR follows: Given: TPVix= Rs 10.0707 TPVim = Rs 9.6722 Thus, TPVin- Chi TPVin- TPVig * CHR LR) Rs 10.0707 - Rs 10 Rs 10.0707 - Rs 9.6722 * (2% - 1%) Rs 0,0707 Rs0.3985 * 1% = 1% 40.18% = 1.18% Hence, this investment produces a 1.18 percent cash-flow-weighted avert? return or the internal rate of return, IRR =LR+ =1ht =1%+gouon" Solution: RISK AND RETURN edu “Guppose your expectati ‘pectations regarding the stock market are as follows: State of the economy fiers Probability He Normal fa i Recession fa 03 ‘Compute the me Pi "an and standard deviation of the FPR on stocks. ‘The mean and the stand ae follows: ard deviation of the TPR on stocks are worked-o Sate ofthe | Prob) [Re] Pie] TRe Fito) yut as economy Boom 03 : 7 Normal oa 7 ue 3, Recession 03 16 a a EP IRs~ (RS)? © (Rs) = 540. uu% ‘The mean of the HPR on stocks, E(Rs) = 14% ‘The standard deviation of the HPR on stocks (0) = V=_ PIRs- E(RS)? 540 = 23.24% D million. A financial analyst sum follows The current value of a stock portfolio is Rs wmarizes the uncertainty about next year’s holding period return as Tnd-of-year values ‘Annual dividend millions) : Tigh growth 030 Rs35 Rs dO Normal growth | 045 a 4.00 No growth 020 15 4.00 Recession 0.05; 8 2.00 rns under each scenario? period returi sa and standard deviation of returns. ‘What are annual holding a. b, Calculate expected holding period retu ‘a. Annual holding period returns ‘under each scenario are given by: Business PB Po a Py-Po +Ci conditions HPR="—~py 35-23 +44 High growth | R835 Rs23 | Rs440 SB ons m-B+4 Normal growth | 27 B 4.00 2 = 0318 15-2344 No growth 3 | 3 4.00 Boa 8-242 . Recession 8 B 2.00 SB? 60565 | | cated holding period return ‘and standard deviation: Tasiness condition | Prob. ) |_ Ra. Px Ra] Re F(a) | PIRs-F(Ra) High growth 030 713 oz 0405 0.019) Normal growth 045 0.157 0.040 0.001 No growth 0.20 0.035 0.482 0.016 0.05 0028 0873 0.038 FARA) = E(Ra)] 0.2308 = 30.8% |_ oo — ‘on the stock portfolio, H(R.204 INVESTMENT ANALYSIS NCC Bank's stock and Nabil Mustration 5.14 Expected oun ad ik Solution: expected fulure returns: CC's return NABIL’s return, a. Calculate the expected rate of return for each bank's stock. b. Calculate the standard deviation of expected returns for each bank's stock, c. Inwhich stock you prefer to invest and why? 2. Calculation of expected rae of return for each bank’s stock [nce -E(Rwce)?* P Probability | Rwcc_| Ras Rycex P Roan =P Or 712.5% | - 20% -1.25% -200% 02 5 0 1.00 0.00 oa 10 15 4.00 6.00 02 5 30 5.00 6.00 o1 35 36 3.50 3.60 Expected return E(Rnce) = 12.25% E(Rwasn) = 136% b. Calculation of Standard Deviation for each stock’s return [Rwann -E(Rwamn) =P (25 - 12.25)? « 0.1 = 61.26 (6-12.25) « 0.2=1051 (10 - 12.25)? 0.4 = 208 (25 - 12.25)? x0.2=32.51 (35 ~ 12.25)? x 0.1 = 51.76 (-20- 13.6? «01 = 1129) (0-136)? x 02=36.99 (15 - 13.6)? 04-078 G0 - 13.6) « 0.2=53,79 (36-136)? « 0.1 =5018 ‘once? =158.07 Onanit? = 254.64 Standard deviation of NCC’s stock: once = Voxce? = 158.07 =1257% Standard deviation of Nabil’s stock: onata = Vos = 2548 = 15.94% © Calculation of coefficient of Variation Coefficient of variation of NCC stock return: once “ERxco) 1257 = Typ 7102 Coefficient of variation of Nabil stock return: Naw E(Rwamu) 15.94 “36 71172 CVwce CVn = We prefer to invest in NCC's because its coefficient of variation is lowerRISK AND RETURN Shocks P and Stock Q have the Tillowl setae following probability distribution of expected f0t™re Rate of Return State of Economy Stock P Stock Q Recession Average Booin ‘Which stock is more fit i nore profitable? Which stock is riskier in absolute term? Which stock is riskier in relative term? |. Which stock would you prefer? : Caleulation of expected ‘ a pee return, standard deviation and coefficient 0! aeoe f variation of gosto [Re-E(Re)] | PARP E (Rr) =15% 0 16 Expected rate of return on Stock P E (Rr) = EP. Re =10% Standard deviation of return on Stock P or =a =fi35 = 11.62% Coefficient of variation of return on Stock P or C¥r = FR) 11.62% oe = ee ficient of variation of return Calculation of expected return, standard deviation and coe ‘on Stock Q : State of | Prob. (P) FxRe] TRe- FORA | PiRO=ERall* Economy Recession | 03 | 9% “15% 20% 10 Average | 04 6 6 0 0 Boom 03. 35 105. 20 120 R= 15% og= 210 red rate of return on Stock Q Expect tga -* =Pi.RQ =15% Standard deviation of return on Stock Q 0 = aoe? = 240 = 15.49% Coefficient of variation of return on Stock Q oo nC) 15.49% 21.033 =" 15%206 investment anatysis y that of Stock Qj “The expected return of Stock P is 10 pecentend 7 — Qists “SS more profitable because of higher °xPe 62 percent and that of gy Stock P is 11 ‘i lock abel re ee ae ae absolute term because its standard doyigy* Q percent, Stoc! Stock P is 1.162 and thay oy hig, t of return from Font gett Of gO © The coefficient 7 aser in relative term because its coctticient ting a Wen beeen tock Q because coefficient of variation OF tsk per yyy ahi |. We would prefer Petey, nis heh Stock Q is lower. 5 hy a new investment lustration 5.16 ‘The Himalayan Herbal Company is evaluating aa wewprsunanérsk eturns are estimated as follows: ‘a, Whats the expected rate of return on this investment project? b. Calculate variance and standard deviation of returns. Solution: First, we work out the necessary inpuls as follows: a. The expected rate of return on the project is given by: ER) = 50 =p 7 125% b. The variance of the project return is: oe -2RacERaP 49 = 7 71633 ‘The standard deviation of the project return is: os =Vo = 1635 = 4.01% llustration 5.17, Stocks A and B have the following historical rolurne ‘Average retum and fk Stock A's returns Stock B's returnsaK Ava nTuRN senapter $207 Calculation of the expected returns Ra 18% 33% 15% 05% 2% Z(Ra) = 56.5% Expected retum on Stock A, Ry = 2a) 7 56. 5 113% Expected return on Stock B, Ry = 289 n 565% pte Calculation of variance and standard deviation: For Stock A: Year, Te 1991 18% 3 ee 33% 27 beat 15% 37 a4 05% -118 1995 a 157 ‘Total ‘Variance of returns of Stock A: a1 822 Standard deviation of returns for Stock A: eae = 322 = 20.79% of variation of returns from Stock A: on Coefficient os ow he 20.79% = Trax 7108 For Stock B: Year Re Te ECR) Tre ER 1991 14.5% 25.80 665.64 1992 21.8% 10.50 110.25, 1993 5% 19.20 368.64 1991 18% -18.90 397.21 195 253% 15.00 225.00 Total 172674 ‘Variance of returns of Stock B: [Rs ERD? ov ane208 IvesTMENT ANALYSIS 1726.74 Gere = 431.69 Standard deviation of returns for Stock B: os = vost =ViB1@ = 20.78% Coefficient of variation of returns from Stock B: Ce 20.78% "113% ° 14398 Both stocks are equally preferable as their risk relative to returns as indicatey coefficient of variations is equal. by Wustration 5.18 ‘The rate of return on Stock A and Stock B for past five years are as below: —— Return on Stock A. Calculate: a. The average return on Stock A and Stock B. b. The standard deviation of return on Stock A and Stock B. c. Which Stock would you prefer? Solution: First, we prepare the following table to generate required information - TRo- oy | Ra-BRO |e) 15% 1% 2% -10 a -B B -19 R 20 4 7 15 1 2 E(Ra) = 45% E(Ri) = 65% a, The average return on Stock A and Stock B x ER.) = 28a 45 = F-9% E(Rs) = $ =13% Thus, average return on Stock A and Stock B are 9 percent and 13 percent respectively. b. Standard deviation of return on Stock A and Stock B<5 209 RISK AND RETURN chi oe nl 730, =\f eq 7 VI825 = 13.51% ‘Thus, standard deviation of return on St 2 percent and T35T percent, respectively, jock A and Stock B are 14.32 Pe! .d Jower Fisk: ¢. We would prefer investing in Stock B because it has higher return a tA and Asset B: Return for Asset B 16% | Zonsider the following historical return data for Asse Return for Asset A u 16 a 3 1 6 10 2 12 wndard deviation for Asset A? dard deviation for Asset B? s return. ‘a What are the expected returns and sta b, What are the expected returns and stan calculate the coefficient of variation for each assets d. Which asset do you prefer? Why? 4g. Calculation of expected return and stand n for Asset A: TRa= lard di soltion: Ra Ra 64% 40.96 66 13.56 “1.6 2.56 j : 46 2116 4 1.96 86 73.96 1.96 Expected return for Asset « 46% ERs) =7q9 746% Standard deviation of returns for Asset A: on PERERA on ad 16a =\fq01 5 3*‘210 INVESTMENT ANALYSIS 2015 a Total a Expected return for Asset 85% ER) = 4g 785% Standard deviation of returns for Asset B: E{Ro - E(Re)? 7 a \F 0 7 857% Calculation of coefficient of variation: For Asset A: os = él On aR 3:33 wa For Asset B: ing value ‘Tota rupee return = Current income + Capital gain (r loss) Total rupee return Beginning value of ‘investment or Hp ~ Ending value Beginning value + Current income HPR: Beginning value Py = HPR= Capital gain yield = Pr=Py PoRISK AND RETURN, a1 = chapter § a yield” Po a 2 HPR ok sya. HPRe ci n . eee ea ecg raaea no 4 Cs +. + or FO GIR * + * CHIRK) prammeen Rae * ORT) ark [eT - ’ ‘ n ae Variance (0) LPR ERP jel n LIR-E@P e Variance (= Sandard deviation (0) = e= a Ae EQ ee Coefficient of variation (CV) “a Review Questions Sate whether following statements are T¥ 1. Curent income isthe income generated from increase in asset's P' Geometric mean return incorporates the reinvestment effect] Annual percentage rate is equal to effective annual rate in all cases. Two investments have the same amount of initial —_ outlays, every six-month and other gives Rs pts likely, 2 a : but one gives Rs 100 in income '50 in income every In this case both are equally212 \ 5 “A 6. 7. 4 8. 49. 10. 1. 412 INVESTMENT ANALYSIS Real return is always lower than nominal return if there is an inflation. Investment A yields 10 i is 7 percent but required return is 11 percent; Investment B yi required return is 8 percent, so we prefer investment B. eS Oe An investment offers Rs 50 income for c i ‘ ft rach quarter of the year. Its investment cost at : Rs 9,500 and ending value of investment is Rs 9,900. The total return on this investment hy A aad purchased one year ago for Rs 60 paid an annual cash dividend of Rs3 ang Lia sold for Rs 63, The holding period return on this investment is 10 percent haa inn, The coefficient of variation is a measure of relative risk. An investment has beginning as b g value of Rs 100,00, You buy this investment, After six-m for Rs 10,500 after receiving a cash income of Rs 600. Thus your holding period return isn You are considering purchasing a bond that pays annual interest of Rs50 per RS 1,000 of. ° ; ‘The bond matures in one year, when you will collect the par value and the interest Parva, can purchase this bond for Rs 950, your capital gain is Rs 100. Payment i, Given the following historical returns from Investment P and Q the Investment Q is beter. Year Investment P Investment Q 1 10% 17% 2 1 10 12 3 R and expected inflation premium of 3.7 percent, the approxing Given real rate of 6.2 percent nominal rate is 9.9 percent. Given the nominal rate of 13 percent and real rate of 9 percent the inflation rate is 22 percent 14. 15. Given the following expected returns and standard deviation of two securities, we accept Security 4 Security Expected return ‘Standard deviation A 10% 20% B 15 15, i Questions [What do you mean by return on an investment? How current income is different from capital st Explain with illustration. 2. What role do historical return data play in estimating expected return on investment? Whats ie underlying assumption in using historical data to provide an estimate of expected return? Exphin 3. What do you mean by holding period return? How do you measure returns over multiple periods! Explain. 4. Differentiate arithmetic mean return from the geometric mean return. Which of these two easus of average returns is better? Why? 5, What do you mean by IRR? In what condition it is more appropriate than HPR to measure the ett on investment? Explain. 6. What do you mean by expected return? How do you measure the expected return? Explain. ) 7, “Standard deviation is an absolute measure of total risk while coefficient of variation i a measure of risk”, In the light of this statement, explain the standard deviation and coc plain, why is it necessary to further qua variation as a measure of investment risk and also ex} in terms of coefficient of variation. How do you combine risk and return in investment decision process? Explain.a problem 53. ssi Problem 54. Const Problem 55, RISK AND RETURN scnapters 213 Rs 9,500. The bond pays Rs 300 six-month. You sell the bond after 18 ‘Months for Rs 10,000. Calculate: a, Current income b. Capital gain or loss ¢. Total return in rupees and holding period return, Consider two investments, ji Bond A and Bond B, with following income and price information. Interest received: First quarter Second quarter eo, Third quarter 300 Fourth quarter >] Investment value: End of year a Beginning of year 5,000 ‘a, Calculate the holding period return for each investment. b. Which bond would you prefer, assuming they are of equal risk? Explain. ‘An investor purchased 100 shares of common stock at Rs 20 per share one year ago. ‘The company declared and paid a dividend of Rs 2 per share during, the year. The investor sold the stock for Rs 21 per share after the one-year holding period. a. Calculate the rupee return from this investment. b. Calculate the HPR for this investment. ¢. Partition the HPR into its dividend and capital appreciation components. sita Khanal, a financial analyst for Dupex Limited, wishes to estimate the rate of return for two similar risk investments- ABC and XYZ. Sita’s research indicates that the immediate past returns will act as reasonable estimates of future returns. One year before, investment ABC had a market value of Rs 120,000 and investment XYZ, 7F Rs 155,000, During the year, investment ABC generated cash flow of Rs 15,000 sand investment XYZ generated cash flow of Rs 16,800. The current market values of ‘and XYZ are Rs 130,000 and Rs 185,000 respectively. investments ABC investment ABC and XYZ using a. Calculate the holding period rate of return on the most recent year’s data. b. If the two investments are equally risky, recommend? Why? which one should Mr. Thapa You are considering two investment alternatives: The first is a stock that pays quarterly dividends of Rs 5 per share and is trading at Rs 250 per share; you expect tb sell the stock in sixemonths for Rs 270, The second is a stock that pays quarterly dividends of Rs 6 per share and is trading at Rs 270 per share; you expest fo sell the slock in one year for Rs300. What are the annual IPRS on these two stocks? Ignoting risk, time value of money, which stock will provide the better return performance?~~ ‘214 INVESTMENT ANALYSIS Problem 5.6. HER on tock and Bond porto Problem 5.7, PR Wh teomwsiment ‘rearo Problem 5.8. HR, APR and EAR, Problem 5.9. PR, APA andEAR Problem 5.10. Noninl andra ate Mr. Siwakoti has Rs 150,000 for investment in a portfolio of stocks ang invests Rs 90,000 initially on the stock portfolio and Rs 60,000 on the bong ee 4 He plan to hold this portfolio of investment over one-year of period, Dy, % year stock pays Rs 8,000 in dividend and bond pays Rs 3,000 in interest, a hy of year he sells stock at Rs 95,000 and bond at Rs 63,000. me a. Whats the holding period return on stock? b. What is the holding period return on bond? c. What is the holding period return on the total portfolio? You purchased 1,000 shares of Nepal Bank Ltd. at Rs 200 per share ad 50) sh, Nabil Bank Ltd. at Rs 700 per share in January 2015, Nepal Bank didnot de dividend while Nabil Bank declared and paid dividend of R520 per share inp and Rs 0 per share in 2016. You sold the stock of Nepal Bank at R510 per and the shares of Nabil Bank Lid. at Rs800 per share after a two-year hy period. i & Calculate the two-year holding-period return on your total invesine, assuming that the dividend received in 2015 was not reinvested. », Calculate the two-year holding-period return, assuming that the divdey received in 2015 was reinvested at 10 percent. What is the annualized HDR this two-year HPR? AA T-month Rs 100,000 face value commercial paper i selling at Rs 98,500 fycu by the commercial paper; hold it over one month period and thus relaize the fae value, what is your rate of return over one month's holding period? What i te annual percentage rate on this investment? What is the effective annual rate? You have two alternative short-term investments: Investment A and Investment 8 They have following features; Investment A Purchase price Rs 15,000 Rs 20,000 Cash income Rs 1,000 Rs 2,000 Ending price Rs 15,500 Rs 21,000 Maturity 3 months 6 months Assume that if you purchase any of these two investments, you tend to hold then until the stated maturity. a, Whatare the respective holding period returns for these two investments? b. What are their annual percentage rates? c. What are their effective annual rates? d. Which investment is better? Why? Suppose that the nominal rate of return currently prevailing is 10 percent, and IH rate of inflation is 7 percent. What is the approximate real rate of return? What se exact real rate of return? If the rate of inflation were 85 percent, what would b= been the real rate of return? 1Problem 514. "itt Genetic Hieahion ed k "SK AND RETURN _ Consider the following historical Chartered Bank Nepal Limited Price and income data on the stock of Standard per share Dividend per share ‘2006/07 2007/08 2008/09 2009/10 2010/11 Calculate the annual holding peri i i 18 Period return on the stock each year. Wrat 7 A arithmetic average rate of return over the period 206 07-201 0/11? What is the are ean e/a oe ee fear es return on your original investment if you Pu 2008/09? As stock at the beginning of 2006/07 and sold it at the end of 7 ssume that you do not reinvest the dividend? e, Rework part ‘e’ on the assumption that you reinvest dividend at 5 percent annual rate? chased pose stock A and Stock B have the following historical returns: through 2015. b. Calculate the geometric mean return for each stock du through 2015. xen Returns, Ra Returns, Re t =15.00% -8.00% ae 185 20 ae 3867 MB M433 545 a 335 283 ‘a. Calculate the arithmetic mean return for each stock durin ig the period 2011 ring the period 2011 c. Assuming equal risk, which stock do you prefer? Why? ‘You invest Rs 7,000 in stock and receive Rs 65, Rs 70, Rs 70 and Rs 65 in dividends over the following four years. At the end of the four years, you sell the stock for 7,900, What was the cash-flow weighted average return or internal rate of return con this investment? If required rate of return is 5 percent, do you think this investment is better? tory of ABC Stock are as follows: Beginning, of year Year-end dividend Rs 100 RSS 10 6 110 5 100 4 ares of ABC Stock at the beginning of 2013, buys another 014, sells one share at the beginning of 2015, and the beginning of 2016. An investor buys three shi two shares at the beginning of 2 sells all four remaining shares at U ‘a. Whatare the arithmetic and geot metric average rates of return for the investor? ate of return) for the investor? 'b. Whats the cash-flow weighted return (or internal r216 INVESTMENT ANALYSIS. ition and reports the following «pith Rs 15 million th ind begins will Problem 5.15. Suppose a fut — mnie results: flows (Rein ne millions) ighlted average returns, iq and cash-flow wig! | Compute arithmetic, geomet 7 distribution of an investment return Problem 5.16. Consider the following probability a babi (pce! Slate of economy Sirong growth oa Moderate growth Weak growth | Recession 8, Calculate the expected rate of return. b. Calculate the variance. ©. Calculate the standard deviation. 4, Calculate the coefficient of variation, ‘e. What does the coefficient of variation mean‘ | ' Problem 5.17. Following are the probability distribution of rates of return associated with s..,, Expectedreumand and Stock Y. “ Probability Return on Stock X Return on Stocky 030 -20% 5% 030 30% 25% 0.40 40% 30% a. What are the expected returns and standard deviation of each stock? b. Which stock investment would you prefer? Why? Problem5.18, Following are the probability distribution of rates of return associated with Sixty Bipxtedietmand and Stock Y. “= Probability 02 03 03 02 a. What are the expected returns of Stock X and Stock Y.? b. What are the standard deviations of Stock X and Stock Y,? c. Which stock do you prefer? Why? yProblem5.19, Consider the following ex-post HPRs for Himalayan Bank's stock (HBL) and But / wrcageretumand of Kathmandu’ stock (BOK): fk a. Which stock has higher average return? HBL Stock BOK Stock 1 10% 4% 2 15 -10 8 30 b. Which stock has higher variance and standard deviation? ©. Which stock is more risky? Explain,rote 522 eel nd RISK aN yu scnapters 217 istorical returns 1H low for the ere A and Investment B are summarized in the to 2015, umm follows: 5. Use the data to answer the questions that Investment A Rate of return Tn the basis of a review of a of the — ky? Why? return data, which investment appears to be more Calculate the average return on two investments ents, Calculate the standard deviation for each investment’s retu On the basis of ed return. a ae calculations in part '¢, which investment is more risky? Compare this conclusion to your observation in part‘. st e - Stock Xand stock Y have the following probability distributions of expected future [oa 02 TT eee a i 20 4. Calculate expected return and standard deviation of returns on’ Stock X. b, Calculate expected return and standard deviation of returns on Stock Y. c._ Calculate the coefficient of variation of returns on Stock X and Stock Y. 4. Is it possible that most investors might regard Stock Y as being less risky than Stock X? Explain. ast 5 years Nilima has slowly built a diversified portfolio of common stock. Currently her portfolio includes 20 different common stock issues and has a total market value of Rs 825,000. Nilima is, at present, considering the addition of 50 shares of one of two common stock issues - A and B. To assess the return and risk of tach of these issues, she has gathered dividend income and share price dala for both over each of the last 5 years (2011 through 2015). Nilima’s investigation of the Sutlook for these issues suggest that each will, on average tend to behave in the future just as it has in the past. She therefore believes that the expected return can be estimated by finding the average holding period return over the past 5 years for teach of the stocks. The historical dividend income and stock price data collected by ing table. Nilima are given in the accompany os Over the ps Stock A ‘Stock B Dividend Share price Dividend ‘Share price vider egianing [Ending _|_ income: Beginning | Ending Rs 16 Rs 3 Bsa) ‘RS20 Rs22 | RS23 7 % 5 21 B B 20 B a 22 B 24 21 m a 23 a 3 22 27 30 24 23 5 Fod rotuen for each stock in each of the preceding 5 a. Determine the holding pet years. Find the expected rel Nilima. arn for each stock, using the approach specified by218 investMENT ANALYSIS; slated in part‘a’ to find boy f the HPRs for cach stocy. wh, return calc! d Pee f variations ©! id ex} b, Use the HPRs an deviation and coefficient > turn and risk period 2011-2015. uss the retu = te and disc : = is erable? Explain. ‘ 6. Use your findings t eater stocks A and B. Which ag hat recommendations Would yoy p . sti ort " Ignoring her existing portolio wvthrgard to stocks Aa Wi Case Analysis major Assume that you recently graduated ro 2 : nn ; me planner with Online Investment Inc., a ae ant needs funds at the end 0 a YERH YOU t Because your restricted you in ‘ itr ’ bares ne ie ‘ ca holding period. Further, your bee hs YOU in the tag instructed to plan fora T-year ho eee . , vesinentaermaves wi icons nd see PS Estimated rate of return : facturing _ Technology | Manu State of Economy | Probability a a = Recessi (22.0%) - a oO (20) ( 0) ia — 04 80 200 io i Aare aoe 02 80 350 40 at Beam 4 80 500 a Note that the estimated returns of manufacturing sectors do not aloays move i the same direction oh gverll economy, For example, when the economy is below average, consumers purchase fewer than thy wa if the economy was stronger. However, ifthe economy is in a flat out recession, a large numer of cr, choose to wait and instead purchase neto items for they currently own. Under these circumstances, we yi expect manufacturing sector's stock price tobe higher if here isa recession than ifthe economy tas he average, Online Investment Inc.'s economic forecastin, staff has developed probability estimates forthe xe of economy and its security analysts have di leveloped a sophisticated computer program which ns ‘0 estimate the rate of return on each alternative under each state of the economy. The fim a imainiains an “index of market return” with a market-weighted fraction of all Publicly traded sods you can invest in that fund, and the aven; 8° stock market results. Given these situation, you required to answer the following questions, & Why is the T-ills return independent of the state of the economy? Do T-bills promise: SomPletely risk-free return? Why are Technology Stock’s retinas expected to move with econay whereas Manufacturing Stocks are expected to nove counter to the economy? b. Calculate the expected rate of return on each alternative, © You should recognize that basi tisk is measured by 4. Suppose you sudden! Widely differing expected returns. Cal, the standard deviation? Cates the CVs.