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Chapter 2

“The Investment Setting”

 Lecture 1
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Learning Objectives
Return and Risk Measures
Calculation of Historical & Expected Return
Calculation of Risk of Historical Return
Relationship between Risk and Return
 Return & Risk
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 Risk and Return are two sides of a coin.

 A rational investor focuses on both aspects before
making an investment.
 Every investor wants to achieve a higher level of
return against a lower level of risk.
 Therefore, he must carefully study the both
patterns.
 Return & Risk
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 Return & Risk
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 Return & Risk
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Return

Historical/
Expected
Realized
Return
Return
1. Holding Period Return
(HPR)
2. Holding Period Yield
(HPY)
3. Annual HPR
4. Annual HPY
 Measures of Historical Rates of Return
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1.

2.
3.

4.
 Historical Rates of Return
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Example 1

Your investment of $250 in Stock A is worth

$350 in two years while the investment of $100
in Stock B is worth $112 in six months. What
are the annual HPRs and the HPYs on these
two stocks?
 Your Investments Rise in Value
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Example 1
 Stock A
– Annual HPR=HPR1/n = ($350/$250)1/2 =1.1832
– Annual HPY=Annual HPR-1=1.1832-1=18.32%

 Stock B
– Annual HPR=HPR1/n = ($112/$100)1/0.5 =1.2544
– Annual HPY=Annual HPR-1=1.2544-1=25.44%
 Historical Rates of Return
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Example 2

Your investment of $350 in Stock A is worth

$250 in two years while the investment of $112
in Stock B is worth $100 in six months. What
are the annual HPRs and the HPYs on these
two stocks?
 Your Investments Decline in Value
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Example 2

 Stock A
– Annual HPR=HPR1/n = ($250/$350)1/2 =.84515
– Annual HPY=Annual HPR-1=.84514 - 1= -15.48%

 Stock B
– Annual HPR=HPR1/n = ($100/$112)1/0.5 =.79719
– Annual HPY=Annual HPR-1=.79719-1= -20.28%
 Expected Return
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 The return expected from an investment is

called expected return.
 Return may vary due to uncertainty.
 The sum of the probabilities of all the possible
outcomes is equal to 1
 Calculating Expected Returns
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n
E(R i )   ( Probabilit y of Return)  (Possible Return)
i 1

n
  ( P )( R )
i 1
i i

Where:
Pi = the probability of return on asset i
Ri = the return on asset i
 Risk of Expected Returns
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• Variance
• Standard Deviation
• Coefficient of Variation
 Risk of Expected Return
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 The Variance Measure

Variance
n
Possible Expected 2
  (Pr obability ) x (  )
i 1 Re turn Re turn
n
  Pi [ Ri  E ( Ri )]2
i 1
 Risk of Expected Return
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 Standard Deviation (σ)

 square root of the variance
 measures the total risk

n
  Pi [ Ri E ( Ri )]
i 1
 2
 Risk of Expected Return
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 Coefficient of Variation (CV)

 measures risk per unit of expected return
 relative measure of risk

Standard Deviation of Return

CV 
Expected Rate of Return

E (R )