CHAPTER TWO: RISK AND RETURN

2.1 Meaning of Risk

 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

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.

(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).

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 (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) Callability risk: This is the risk that an investment is recalled (or retired) prior to the
original stated date. This type of risk is most applicable to long-term bonds and preferred
stocks. This usually happens when the issuing firms find the market conditions favorable
in “refinancing” such investments.

(i) 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.

Measurement of risk

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 form 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, which have approximately equaled in
expected returns.

√∑
n
( Ri−ER )2∗Pi
i=1

SD =

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Let us calculate the standard deviation for the following example.

The Probability distribution, can be discrete or continuous, is discrete in our example. A discrete
probabiblity distribution has a limited number of possible outcomes while a continuous
probability distribution indicates the probability of possible outcomes.

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

Boom 0.2 0.1 0.138 0.00144 0.0002888
Normal 0.6 0.11 0.138 0.00078 0.0004704
Recessions 0.2 0.26 0.138 0.01488 0.0029768
Variance 0.003736

Standard deviation of XYZ co

SD = √ variance = √ 0. 003736 = 0.061122827

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

conditions
Boom 0.2 -0.04 0.192 0.053824 0.010765
Normal 0.6 0.20 0.192 0.000064 0.000038
Recessions 0.2 0.40 0.192 0.043264 0.008653
Variance 0.019456

Standard deviation of ABC co

SD = √ variance =ahvdhd √ 0 . 019456 =0.139484766

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.

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

INVESTMENT & PORTIFOLIO ANALYSIS ACFN

Since the coefficient of variation of ABC is greater than XYZ it is more risky.

Relation ship between risk and return

The relationship among risk and return is positive which means an increase of one result an
increase to the other. For this reason is then there will be always a risk return trade off.

Required rate of return = Risk free rate of return+ Risk premium

Risk premium is a potential reward that an investor expects to receive when making a risky
investment. This is based on a theory that investors are risk averse that is they expect an average
to be compensated for the risk that they assume when making investment.

Risk fee rate of return

It is the return available on security with no risk of default.

Risk free rate of return= Real rate of return + Expected inflation premium

Real rate of return is the return that investors would require from security having no risk of
default in a period of no expected inflation. Real rate of return is a return necessary to convince
investors to postpone current, real consumption opportunities. It is determined by the interaction
of the supply of funds made available by savers and the demand for funds for investment. The
second component of risk fee rate of return is an inflation premium or purchasing power loss
premium.

Determinants of Risk premium

It the potential reward that an investor expects to receive when making a risky investment. And it
is a function of several different risk elements. These factors include:

Maturity risk premium

This is the return required on a security is influenced by the maturity of the security. Generally
the longer the time to maturity, the higher the required return on the security.

The default risk premium

The more the default risk, the higher the required rate of return will be. In this regard the order of
lower risk Treasury bills, Government bonds, High quality corporate bonds, High quality
preferred stocks, Junk bonds, High quality commons stocks and speculative common stocks are
examples.

Seniority risk premium

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It is the difference in securities with respect to their claim on the cash flows generated by the
company and the claim on the company’s assets in the case of default. The less senior the claims
of the security holders, the greater the required rate of return demanded by the investor in the
security.

Marketability risk premium

It is the ability of the investor to buy and sell a company’s securities quickly and without a
significant loss of value .The marketability risk premium can be significant for securities that are
not regularly traded.

Business and financial risk

Business risk is the variability in the firm’s operating earning over time. It is influenced by many
factors including, the variability in sales, operating cost over a business cycle, the diversity of a
firms; production line, the market power of the firm, and the choice of production technology.

Financial risk refers to the additional variability in a company’s earning per share that result
from the use of fixed cost sources of funds, such as debt and preferred stock. Business and
financial risk are reflected in the default risk premium applied by investors to firm securities. The
higher these risks are the higher the risk premium and required rate of return on the firm’s
securities.

2.2 Meaning of Return

It is a gain or loss from an investment made. And it does have two components an income
component and a capital gain or loss component. The income component is cash you receive
while owning the asset while the capital gain or loss component is when the value of asset owned
is appreciating in price or depreciating. For example a stock does provide a dividend to its
shareholders and at time of sales capital gain.

Measuring Return

Historical rate of return

One of the measurements of return is the holding period return (HPR), which represents the
return an investor received for holding an investment for a certain period of time. The formula
for determining the HPR is as follows:

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 (Sale price−Purchase price)+ Current income
HPR=
Purchase price
Capital gain/loss+ Current income
=
Purchase price
It is important to understand that the HPR is an ex-post return, i.e. a return that has already taken
place. It is sometimes known as the historical return. Another thing that you should be aware of
is that the HPR is a measurement for return over a single period (i.e. 4 months, 5 years, etc.)

Example: At the beginning of the year a stock was selling for birr 40 per share and at a time Ato
Abebe purchased 100 shares. Over the year the stock paid 5 per share as dividend and year-end
market price became 45. What is the return of Ato Abebe from the investment?

Dividend = 5* 100= 500

Capital gain = (45-40) * 100 =500

Total return = 500+500 = 1000

Percentage of return: this is summarizing returns in terms of percentage than absolute dollars. It
answers a question of how much do we get for each dollar we invest. Following the previous
example

Dividend yield = Dt+1/Pt = 5/40= 12.5%

Capital gain = (Pt+1 -Pt)/Pt = (45-40)/40 = 12.5%

Total return = dividend yield + Capital gain = 12.5%+12.5%= 25%

Total percentage of return = (D t+1 + (Pt+1 -Pt))/ Pt

Expected Rate of Return

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. The determination of probability distributions can be driven either form objective basis
or subjective basis. 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,

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 n
∑ RiPi
ER= 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 yr. 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?
Solution
Economic Probabilities Return of Return of Expected Expected
conditions XYZ ABC return of return of
XYZ 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 1 13.8% 19.2%

INVESTMENT & PORTIFOLIO ANALYSIS ACFN