Financial Management I (ACFN 3041) : Risk and Return

Financial Management I
(ACFN 3041)
Chapter IV
Risk and Return
12/26/2022 Compiled By Habtamu B. (PhD) 1

Important Points to note!
◼ Financial assets are expected to generate cash flows
and hence the riskiness of a financial asset is measured
in terms of the riskiness of its cash flows.
◼ Theriskiness of an asset may be measured on a stand

alone basis or in a portfolio context.
◼ An
asset may be very risky if held by itself but may be
much less risky when it is part of a large portfolio.
Lessons from the capital market history
◼There are two central lessons that emerge

from study of stock market.
❑ There is a reward for bearing risk
❑ The greater the potential reward, the greater is the risk

The Basics of Risk
◼ Literally
risk is defined as “exposing to danger or hazard”
❑ Which is perceived as negative terms
In finance,
Risk refers to the likelihood that we will receive a
return on an investment that is different from the
return we expected to make.
Hence, it is both bad outcomes and good outcomes.

Risk - types
◼ Firm specific risks
❑ Business Risk
❑ Financial risk
◼ Shareholders Specific risks

❑ Interest rate risk
❑ Liquidity risk
❑ Market risk
◼ Firm and shareholder risks

❑ Event risk
❑ Exchange rate risk
❑ Purchasing power risk
❑ Tax risk

Risk preferences
◼ There are three basic risk preference behaviors:
❑ Risk averse,
❑ Risk indifferent, and
❑ Risk seeking

Returns
▪ The return is the total gain or loss experienced on
investment over a given period of time.
▪ Return is commonly measured as a cash distributions
during the period plus the change in value, expressed as
a percentage of the beginning of period investment
value.
▪ Returns may be
1. Realized return (Actual return)
2. Percentage of return
1. Realized return /Actual return
◼ Is a return earned during the holding period for an investment. It
may include dividends, interest payments, and other cash
distributions.
◼ It is a historical return
❖ E.g. Actual return/Cash or birr return= Dividend or Interest
income + Capital gain
Return
◼ 2. Percentage of return
◼ Is a percentage of return computed based on an actual
return earned from holding an investment over some
period.
◼ It is computed as:
R = expected (actual) return

Dt = cash dividend at time t
Pt = stock’s price at time t
Pt-1 = stock’s price at time
period t-1
Return
◼ Example:
◼ Assume that you might buy a security for Br.
4000 which would pay Br. 80 in cash to you as
dividend and be worth Br. 4200 one year later.
What is the rate (probability) of return?
Current
Yield Capital
Gain

Stand Alone Risk and
Return
What is a standalone risk?
◼ In finance, a standalone risk is the risk that an investor or
could be an organization faces when he holds only one
single asset as an investment.
◼ The asset in question can be in the form of a stock or
any other similar asset of commercial value.
◼ Standalone risk arises when we go against the policy of
diversification of portfolios.
◼ We just concentrate our resources on a single asset. We
calculate this risk by assuming that all of the losses and
gains will come from that one particular asset to an
investor.

How do we measure a standalone risk?
◼ The following statistical techniques can be used to
assess the standalone risk of an asset
◼ Risk measures:
❑ Individual standard deviation,
❑ Individual variance,
❑ Individual coefficient of variance etc.
◼ Diversification:
❑ Stand-alone risk measures the undiversified risk of an individual
asset.
◼ Risk consideration:
❑ An asset stand-alone risk considers the total of an asset.

Standalone Risk Assessment
◼ To assess the general level risk embodied in a given
asset, sensitivity analysis and probability
distributions can be used.
◼ Sensitivity Analysis:
❑ Uses several possible-return estimates to obtain a
sense of the variability among outcomes.

❑ One common method involves making pessimistic
(worst), most likely (expected), and optimistic (best)
estimates of the returns associated with a given asset.
❑ In this case the asset’s risk can be measured by the
range of returns.
❑ The range is found by subtracting the pessimistic
outcome from the optimistic outcome.

◼ Probability Distributions:
◼ Provide a more quantitative insight into an asset ‘s risk.
◼ The probability of a given outcome is its chance of
occurring.
◼ A probability distribution is a model that relates probabilities
the associated outcomes.
◼ In defining the probability distribution for the rate of return,
remember the following:
❑ The possible outcomes:
◼ mutually exclusive and collectively exhaustive
❑ The probability assigned:
◼ may vary between 0 and 1
❑ The sum of the probabilities assigned to various possible
outcomes is 1
◼ If we knew all the possible outcomes and associated
probabilities, we could develop a continuous probability
distributions.

Example
State of Probability of Security Returns if the
Economy state of the state occurs
Economy X Y
Recession 0.5 -5% 15%
Boom 0.5 70% 25%
For Stock X and Stock Y, individually compute:

a. The expected rate of return
b. Risk premium, if the risk free rate is 5%
c. Variance
d. Standard deviation
e. Coefficient of variation

Example
◼ Expected rate of return (E(R))
n
❑ E(R) =  Pi * Ri
i =0
❑ For Stock X => E(R) = 0.325 or 32.5%

❑ For Stock Y => E (R) = 0.20 or 20%
◼ Risk Premium = Expected return – Risk free rate

❑ For Stock X=> 32.5% - 5% = 27.5 % or 0.275
❑ For Stock Y=> 20% - 5% = 15% or 0.15

Example
◼


2
  Pi * (Ri - E(R))
2 2

Example
◼ Variance (Stock X)
State of Probability R – E(R) 2
Economy (R− E(R))

2
(R− E(R))
Recession 0.5 -0.375 0.140625 0.0703125
Boom 0.5 0.375 0.140625 0.0703125
0.140625
Stand. Dev. = Variance

Stand. Dev (Stock X) = 0.140625
Stand. Dev. (Stock X )= 0.375 or 37.5%

Example
◼ Variance (Stock Y)
State of Probability R – E(R) 2
Economy (R− E(R))

2
(R− E(R))
Recession 0.5 -0.05 0. 0025 0.00125
Boom 0.5 0.05 0.0025 0.00125
0.0025
Stand. Dev. = Variance

Stand. Dev (Stock Y) = 0.0025
Stand. Dev. (Stock Y)= 0.05 or 5%

Example
◼ Co-efficient of Variation (CV)
◼ Is a statistical measure of the dispersion of data points in a data series
around the mean.
◼ Investors use it to determine whether the expected return of the
investment is worth the degree of volatility, or the downside risk, that it
may experience over time.
◼ It is a useful statistic for comparing the degree of variation from one
data series to another, even if the means are drastically different from
one another.
◼ The co-efficient of variation represents the ratio of the standard
deviation to the mean.
◼ Formula:
S tan dard Deviation
❑ CV =
Expected Mean
❑ CV of Stock X = 1.3593 and CV of Stock Y = 0.25

Example 1 - Summary
◼ Stock X Stock Y
◼ Expected Return 0.325 (32.5%) 0.2 (20%)
◼ Variance 0.140625 0.0025
◼ Stad. Dev. 0.375 0.05
◼ CV 1.154 0.25

Exercise
Asset A Asset B
Initial investment $10,000 $10,000
Income or return
Pessimistic [P] 13% 7%
Most Likely [M] 15% 15%
Optimistic [O] 17% 23%
Assuming the probability of the state of the economy for P is

20%, M is 30% and O is 50%, for each asset compute
a. Expected return
b. Stand. Deviation
c. Coefficient of variation

Risk and Return in a
Portfolio Context
What is a Portfolio?
◼ Portfolio is a collection of investment vehicles
assembled to achieve expected returns with
minimal risks to meet one or more investment
goals
◼ Two types of portfolios:
❑ Growth-Oriented Portfolio:
◼ primary objective is long-term price appreciation
❑ Income-Oriented Portfolio:
◼ primary objective is current dividend and
interest income
Measuring Portfolio Risk and return
◼ In real world situations, the risk of any investment would not
be viewed independently of other assets.
◼ New investments must be considered in light of their impact
on the risk and return of the portfolio of assets.
◼ Goal of a financial manager, among others, in this regard is
to create an efficient portfolio, one that maximizes risk for a
given level of return.
◼ Hence, it is good to measure the return of a portfolio and
the standard deviation of assets.
◼ Return of a portfolio is a weighted average of returns on
individual assets from which it is formed.
◼ Formula: = ( * ) = ( * ) + ... + ( + )
k p w k
1 1 w k2 2 w k n n

Measuring Portfolio Risk and return
◼ Formula:
E(R) = (w * E(R) ) = (w * E(R )) + ... + (w + E(R) )

p 1 1 2 2 n n
E(R) =  wi * E ( R )
p i
i =1
Where:
E(Rp) = Expected return of the portfolio
Wi = proportion of portfolio invested in security i
E(Ri) = Expected return of security i

Example: Expected Return of Portfolio
State of Probability of Returns (in %)
Economy state
Stock A Stock B Stock C
Boom 0.40 10 15 20
Bust 0.60 8 4 0
◼ Assume the investor allocate his fund to the three assets

according to the following conditions:
◼ Condition a: Equal amount allocated to all

◼ Condition b: 50% to stock A and the remaining equally to
Stock B and Stock C
Diversification
Principles of Diversification
◼ Diversification is essential to the creation of an efficient
investment [as it can reduce the variability of returns around the
expected return].
◼ A single asset or portfolio of assets is considered to be

efficient if no other asset or portfolio of assets offers higher
expected return with the same (or lower) risk, or lower risk
with the same (or higher) expected return.
◼ Will diversification eliminate all our risk?

❑ No.
❑ Only it eliminates company-specific risk.
❑ It reduces risk to an un-diversifiable (up to market risks)
level.
Principles of Diversification
◼ Diversification can substantially reduce the
variability of returns without an equivalent
reduction in expected returns
◼ This reduction in risk arises because worse-
than-expected returns from one asset are offset
by better-than-expected returns from another
◼ However, there is a minimum level of risk that
cannot be diversified away - that is the
systematic portion

Types of Diversification
◼ Simple diversification— randomly selected stocks, equally
weighted investments.
◼ Diversification across industries— investing in stock

across different industries such transportation, utilities,
energy, consumer electronics, airlines, computer
hardware, computer software, etc.
◼ International diversification: investing in stock across

different companies and industries of different countries
which offers more diverse investment alternatives than
single country investments.
Diversification and Portfolio Risk
Diversification reduces risk if returns are not perfectly positively
correlated.
◼ Diversification
❑ holding a group of assets
❑ lower risk with out lowering E(R)
Unsystematic Risk
Total Risk
Risk
Systematic Risk
No of Securities in Portfolio
Diversifiable Risk
◼ The risk that can be eliminated by combining
assets into a portfolio
◼ Often considered the same as unsystematic,
unique, or asset-specific risk
◼ If we hold only one asset, or assets in the same
industry, then we are exposing ourselves to risk
that we could diversify away

Total Risk
◼ Total risk = systematic risk + unsystematic risk
◼ The standard deviation of returns is a measure
of total risk
◼ For well-diversified portfolios, unsystematic risk
is very small
◼ Consequently, the total risk for a diversified
portfolio is essentially equivalent to the
systematic risk

Systemic risk principles
◼ There is a reward for bearing risk
◼ There is not a reward for bearing risk
unnecessarily
◼ The expected return on a risky asset depends
only on that asset’s systematic risk since
unsystematic risk can be diversified away

Measuring Systematic Risk
◼ How do we measure systematic risk?
◼ We use the beta coefficient to measure systematic
risk
◼ What does beta (𝜷) tell us?
❑ A beta of 1 implies the asset has the same
systematic risk as the overall market
❑ A beta < 1 implies the asset has less systematic
risk than the overall market
❑ A beta > 1 implies the asset has more systematic
risk than the overall market

Total Versus Systemic Risk
◼ Consider the following information:
Standard Deviation Beta
❑ Security A 15% 1.35
❑ Security B 25% 0.95
◼ Which security has more total risk?

◼ Which security has more systemic risk?
◼ Which security should have the higher expected
return?

Portfolio Betas
◼ Consider the previous example with the following
four securities
❑Security Weight Beta
W 0.133 4.03
X 0.20 0.84
Y 0.267 1.05
Z 0.40 0.59
What is the portfolio beta?
Formula: 𝑷𝒐𝒓𝒕𝒇𝒐𝒍𝒊𝒐 𝑩𝒆𝒕𝒂 = 𝜮 𝜷𝒊 ∗ 𝑾𝒊
𝑷𝒐𝒓𝒕𝒇𝒐𝒍𝒊𝒐 𝑩𝒆𝒕𝒂 = 1.22

Beta and the Risk Premium
◼ Remember that the risk premium = expected
return – risk-free rate
◼ The higher the beta, the greater the risk
premium should be
◼ Can we define the relationship between the risk
premium and beta so that we can estimate the
expected return?
◼ YES!

Portfolio Expected Returns and Beta

Market Equilibrium
◼ In equilibrium, all assets and portfolios must
have the same reward-to-risk ratio, and each
must equal the reward-to-risk ratio for the
market.
◼ This means:
𝐸(𝑅𝐴 ) − 𝑅𝑓 𝐸(𝑅𝑀 − 𝑅𝑓 )
◼ =
𝛽𝐴 𝛽𝑀

Security Market Line (SML)
◼ The SML is the representation of market equilibrium
𝐸(𝑅𝑀 − 𝑅𝑓 )
◼ The slope of the SML is the reward-to-risk ratio:
𝛽𝑀
◼ But since the beta for the market is ALWAYS equal to one,
the slope can be rewritten
◼ Slope = E(𝑅𝑀 − 𝑅𝑓 ) = Market Premium
E(𝑅𝑀 − 𝑅𝑓 )
E (RM)
Rf
 M = 1.0 Risk, i
Habtamu B. Abera [PhD] 50

Measuring Unsystematic Risk
◼ You can calculate unsystematic risks using the
following formula:
❑ Unsystematic risk = (Systematic variance +
Unsystematic variance) - Systematic risk
❑ Unsystematic risk = Total variance - Systematic risk
◼ It’s worth noting that unsystematic risk is the same
as unsystematic variance.
◼ For example, if the total variance is 15% and the
systematic risk is 7.5%, your unsystematic risk
would be:
❑ Unsystematic risk = 15% - 7.5% = 7.5%

Risk and Required
rate of return
Capital Assets Pricing Model (CAPM)
CAPM
◼ CAPM defines the relationship between risk and return
◼E(Ri) = Rf + ßi * (Rm - Rf)

Where:
E(Rj) = Expected Return on security i
RF = Risk Free return
E(RM) = Expected Return on the market portfolio
ßi = Is the beta coefficient for security i
◼ Ifwe know an asset’s systemic risk , we can use the

CAPM to determine its expected return
◼ This true whether we are talking about financial assets
of physical assets
Factors affecting expected return
◼ Pure time value of money – measured by the
risk free rate
◼ Reward for bearing systematic risk-measured
by the market risk premium
◼ Amount of systematic risk – measured by
beta

Example: CAPM
◼ Consider the betas for each of the assets given
below. If the risk free rate is 3.15% and the
market risk is 13.5%, what is the expected return
for each security?
❑ Security Beta
L 2.03
M 0.75
N 3.05
O 0.65

Solution
◼ E(Ri) = Rf + ßi * (Rm - Rf)
◼ E(RL) = 3.15% + 2.03 * (13.5%-3.15%) = 24.16%

◼ E(RM) = 3.15% + 0.75 * (13.5%-3.15%) = 10.91%
◼ E(RN) = 3.15% + 3.05 * (13.5%-3.15%) = 34.72%
◼ E(RO) = 3.15% + 0.65 * (13.5%-3.15%) = 9.88%

End of Chapter Four

Financial Management I (ACFN 3041) : Risk and Return

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Financial Management I

12/26/2022 Compiled By Habtamu B. (PhD) 1

◼ Theriskiness of an asset may be measured on a stand

◼There are two central lessons that emerge

❑ There is a reward for bearing risk

❑ The greater the potential reward, the greater is the risk

Hence, it is both bad outcomes and good outcomes.

◼ Shareholders Specific risks

◼ Firm and shareholder risks

❑ Exchange rate risk

❑ Purchasing power risk

12/26/2022 Compiled By Habtamu B. (PhD) 5

12/26/2022 Compiled By Habtamu B. (PhD) 6

R = expected (actual) return

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sense of the variability among outcomes.

outcome from the optimistic outcome.

◼ mutually exclusive and collectively exhaustive

❑ The probability assigned:

◼ may vary between 0 and 1

❑ The sum of the probabilities assigned to various possible

12/26/2022 Compiled By Habtamu B. (PhD) 16

For Stock X and Stock Y, individually compute:

12/26/2022 Compiled By Habtamu B. (PhD) 17

❑ For Stock X => E(R) = 0.325 or 32.5%

◼ Risk Premium = Expected return – Risk free rate

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Economy (R− E(R))

Stand. Dev. = Variance

Stand. Dev. (Stock X )= 0.375 or 37.5%

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Economy (R− E(R))

Stand. Dev. = Variance

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Assuming the probability of the state of the economy for P is

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E(R) = (w * E(R) ) = (w * E(R )) + ... + (w + E(R) )

12/26/2022 Compiled By Habtamu B. (PhD) 28

◼ Assume the investor allocate his fund to the three assets

◼ Condition a: Equal amount allocated to all

◼ A single asset or portfolio of assets is considered to be

◼ Will diversification eliminate all our risk?

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◼ Diversification across industries— investing in stock

◼ International diversification: investing in stock across

❑ lower risk with out lowering E(R)

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◼ Which security has more total risk?

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Habtamu B. Abera [PhD] 50