Risk and Return

Dr. Md. Rostam Ali

Assistant Professor
Department of Business Administration
Mawlana Bhashani Science and Technology University
Santosh, Tangail-1902, Bangladesh
 Risk

The variability of returns associated with a given

asset.
 Return
The total gain or loss experienced on an investment
over a given period of time.

Calculating the rate of return

 EXAMPLE

Mr. ‘X’ wishes to determine the return on two investment, C

and D. C was purchased 1 year ago for $20,000 and currently
has a market value of $21,500. During the year, it generated
$800 of after-tax cash receipts. D was purchased 4 years ago;
its value in the year just completed declined from $12,000 to
$11,800. During the year, it generated $1,700 of after-tax
cash receipts.
 Risk Assessment

 Sensitivity analysis and

 probability distributions
 Risk Assessment

Sensitivity analysis
An approach for assessing risk that uses several
possible-return estimates to obtain a sense of the
variability among outcomes

Range
 A measure of an asset’s risk, which is found by
subtracting the pessimistic (worst) outcome
from the optimistic (best) outcome.
Risk Assessment
 Probability distribution
A model that relates probabilities to the associated
outcomes

Probability
The chance that a given outcome will occur.
The risk and return of an asset can be measured
quantitatively by using statistics.
 Risk Measurement
 Standard deviation: it measures the dispersion around the
expected value.
 Coefficient of variation: A measure of relative dispersion
that is useful in comparing the risks of assets with differing
expected returns.
 Risk Measurement
 Standard deviation: it measures the dispersion around the
expected value.

 In general, the higher the standard deviation, the greater the

risk.
Coefficient of variation
A measure of relative dispersion that is useful in comparing
the risks of assets with differing expected returns.

The higher the coefficient of variation, the greater the risk.

Coefficient of variation
 Risk and Return of a Portfolio
Portfolio Return and Standard Deviation

Assume that we wish to determine the expected value and standard

deviation of returns for portfolio XY, created by combining equal
portions (50%) of assets X and Y. The forecasted returns of assets X
and Y for each of the next 5 years (2004–2008) are given in columns 1
and 2, respectively, in part A of Table 5.7. In column 3, the weights of
50% for both assets X and Y along with their respective returns from
columns 1 and 2 are substituted into Equation 5.5. Column 4 shows
the results of the calculation—an expected portfolio return of 12% for
each year, 2004 to 2008.
Risk and Return of a Portfolio
 Risk and Return of a Portfolio
Correlation
A statistical measure of the relationship between any two
series of numbers representing data of any kind.
Positively correlated: Describes two series that move in the
same direction.
Negatively correlated: Describes two series that move in
opposite directions.
Uncorrelated: Describes two series that have no relation
 Risk and Return of a Portfolio
correlation coefficient
A measure of the degree of correlation between two series.
Perfectly positively correlated: Describes two positively
correlated series that have a correlation coefficient +1
Perfectly negatively correlated: Describes two negatively
correlated series that have a correlation coefficient of -1.
Uncorrelated: Describes two series that lack any interaction
and therefore have a correlation coefficient close to zero (0).
Risk and Return of a Portfolio
correlation coefficient
 Risk and Return of a Portfolio
Diversification
Combining negatively correlated assets to diversify risk
 Risk and Return of a Portfolio
The creation of a portfolio that combines two assets with
perfectly positively correlated returns results in overall
portfolio risk that at minimum equals that of the least risky
asset and at maximum equals that of the most risky asset.
However, a portfolio combining two assets with less than
perfectly positive correlation can reduce total risk to a level
below that of either of the components, which in certain
situations may be zero.
Risk and Return of a Portfolio
 Risk and Return of a Portfolio
EXAMPLE
A firm has calculated the expected return and the risk
for each of two assets—R and S.

To evaluate possible combinations, the firm considered three

possible correlations—perfect positive, uncorrelated, and
perfect negative.
Risk and Return of a Portfolio