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Financial Institution And Investment Management

Lecture 11
Risk and Return
Course leader : Tadele Tesfay (Asst. Prof)

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Return
• If you buy an asset of any sort, your gain (or
loss) from that investment is called the re-turn
on your investment. This return will usually
have two components. First, you may receive
some cash directly while you own the
investment.
• This is called the income component of your
return. Second, the value of the asset you
purchase will often change. In this case, you
have a capital gain or capital loss on your
investment 4
Return
• At the beginning of the year, the stock was selling for
$37 per share. If you had bought 100 shares, you
would have had a total outlay of $3,700. Suppose,
over the year, the stock paid a dividend of $1.85per
share. Also, the value of the stock has risen to $40.33
per share by the end of the year. How much your
return?

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Total dollar return= Dividend income Capital gain (or loss)
Dividend= $1.85 * 100= $185
Capital gain= ($40.33- 37) * 100= $333
Total dollar return= $185 + 333= $518

 Percentage return = Dividends paid at +Change in market

end of period value over period
Beginning market value
% of return= 1.85+3.33/37=14%
DY=1.85/37= .05=5%
CG/L=3.33/37=.09=9%
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Risk
• Variability of stock returns so we
can begin examining the subject of
risk.
• The variance and its square root,
the standard deviation, are the
most commonly used measures of
volatility.
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Expected Returns and Variances
• We start with a straightforward case.
Consider a single period of time, say, a
year
• When we invest in a stoke we know that
the return from it can take various
possible values. For example, it may be
5%, or 35%. Further, the likelihood of this
possible rate of returns can vary. Hence
you should think in terms of probability
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distribution
Computing of Expected return

E(R)

Where: E(R) = expected return from the return

Ri =return from the stock under state i

Pi = probability that the state i occurs

n = number of possible states of

the world
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 Expected Rate of return
State of prob. of
Ri Pi*Ri
economy occurrence
Boom 0.3 16% 0.048
Normal 0.5 11% 0.055
Recession 0.2 6% 0.012
E(R)
0.115 =11.5%
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Measures of risk
• One way to measure risk is to calculate the
variance and standard deviation of the
distribution of returns.
• The variance essentially measures the
average square difference between the actual
return and average expected return then
multiply each possible squared deviation by
it’s probability finally add these up.
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Cont…
• The standard deviation, as always, is the
square root of the variance.
• The bigger these numbers is the more the
actual return tend to differ from the
average expected return.
• Also, the larger the variance or standard
deviation is, the more spread out the
returns will be.
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 Cont…

• Given an asset's expected return, its

variance can be calculated using the
following equation:
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Var(R) = s2 = S pi(Ri – E[R])2
i=1

• Where:
– N = the number of states
– pi = the probability of state i
– Ri = the return on the stock in state i 14

– E[R] = the expected return on the stock

 Expected risk
State prob.
of the Of
Ri
econo occurre
my nce Pi*Ri Ri-E(r) (Ri-E(r))2 (Ri-E(r))2*.pi
Boom 0.3 16% 0.048 4.500% 0.202500% 0.0006075
Norma
0.5 11%
l 0.055 -0.500% 0.002500% 0.0000125
Recessi
0.2 6%
on 0.012 -5.500% 0.302500% 0.000605
Variance 0.122500%
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satandard deviation 0.35=35%

Systematic and Unsystematic Risk
• Systematic risk is one that influences a
large number of assets, each to a greater or
lesser extent. Because systematic risks
have market wide effects, they are
sometimes called market risks.
• Unsystematic risk is one that affects a
single asset or a small group of assets.
Because these risks are unique to
individual companies or assets, they are
sometimes called unique or asset-specific 16
risks.
Systematic Risks
(a)Market risk
The market risk is caused due to market cycles
i.e. demand and supply pressures, sudden
movements in the market
Factors that lead to market risks are recessions,
wars, and structural changes in the economy,
tax law changes, even changes in consumer
preferences 17
Purchasing power risk

• The purchasing power risk is also called as inflation

risk. It refers to change in the real value of return as a
result of inflation. Inflation or rise in prices leads to
rise in cost of production, lower margins, lesser
profits, etc. These risks are inherent in all the
investments and are beyond the control of an investor.
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Interest rate risk

 The interest rate risk refers to uncertain returns caused by the

uncertain market rates of interest. The return on an investment
depends upon the interest rates promised on it and changes in
market rates of interest from time to time adversely affects the
investor's return. Interest rate risk affects bonds more directly than
common stocks and is a major risk faced by all bondholders. As
interest rates change, bond prices change in the opposite direction.
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Foreign exchange risk
Country or sovereign risk
Technology risk

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Unsystematic Risk

A)Business risk:-This risk refers to uncertain

return to the investor caused due to uncertain
business environment in
B) Financial risk:- It refers to risk caused
due to inability of the organization to meet its
financial obligations which it operates.
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C)Default risk:- It is also called as insolvency risk or
credit risk. This is the risk that a company or individual
will be unable to pay - the contractual interest or
principal on its debt obligations

D)Liquidity risk:- Liquidity here means both ability of

converting asset into cash and doing it without
compromising on price levels

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