RETURN

1. Reward for investing

2. Consists of periodic cash payments or current income and
capital gains (losses) or increases (decreases) in market
value.
3. Expressed either in the form of a percentage or in Ringgit
value.

Risk and Return 1

Classification of Return

1. Realized return: actual return that has been earned or

obtained
2. Required return: minimum rate of return required by
investors to compensate for taking a comparable level of
risk.
3. Expected return: return that is anticipated or expected.
4. Holding Period return (HPR)

Risk and Return 2

Components of Required Return

1. Risk-free rate of return : reward for deferring consumption.

It is also the required rate of return for risk-free investment.
2. Risk premium: additional return that we anticipate to
receive for assuming risk. It is the difference between the
expected return for the market and the risk free return

Risk and Return 3

Holding Period Return (HPR)
 HPR is the return an investor would receive from holding a
security for a designated period of time.
 HPR = Current income + Capital gain
Beginning Investment
 HPR = (Pt/Pt-1) -1

Risk and Return 4

Measurement of Required Return

By using Capital Asset Pricing Model (CAPM)

 Required rate of return:
= risk-free rate + beta ( risk premium)

Risk and Return 5

Required Rate of Return- Example

1. CSB has a beta of 0.765. If the expected market return is

11.5% and the risk-free rate is 7.5%. Calculate the required
rate of return of CSB using CAPM.
2. The expected return for the general market is 12.8%, and the
risk premium in the market is 4.3%. Telco, LBM and Exxon
has betas of 0.864, 0.693 and 0.575 respectively. Compute
the required rate of return for the three securities.

Risk and Return 6

Expected Return

1. The expected return from an investment, either by an

individual investor or a company, is determined by the
different possible outcomes that could occur from making
the investment.
2. Weighted average of possible cash flow outcomes such that
the weights are the possibilities of the occurrences of the
various states of the economy.
3. ER = X1P(X1) + X2P(X2) + ……+ Xn P(Xn)

Risk and Return 7

Expected return – Example

 UC is planning to invest in Probability Return

a security that has several 0.10 -10%
possible rates of return.
0.20 5%
Given the following
probability distribution 0.30 10%
returns, what is the 0.40 25%
expected rate of return on
the investment?

Risk and Return 8

RISK

1. Chance that some unfavorable event will occur. For

example:
1. For a student, risk is the possibility of failing an exam, or
the chance of not making his or her best grades.
2. For a retired person, risk means perhaps not being able to
live comfortably on a fixed income.
3. For the entrepreneur, risk is the chance that a new venture
will fail
2. The prospect of an unfavorable income
3. Risk is defined as a chance of a monetary loss.

Risk and Return 9

Attitudes toward risk

1. Risk- averse : dislike risk. Require an increase in return to

compensate for the increase in risk.
2. Risk-taker: prefer to take risk. Willing to accept a decrease
in return for an increase in risk
3. Risk-indifferent: obtain the same satisfaction from a risk-
free situation and a risky situation.

Risk and Return 10

Measuring Risk

1. Variance: weighted average of squared deviations of

possible occurrence from the mean value (expected return)
of the distribution, with the weights being the probabilities
of occurrence. Measure the return’s volatility.
2. Standard deviation: measure the risk of returns, in terms of
the spread or dispersion of the distribution in the returns. It
tells us how much a particular return can deviate from the
average return or mean return. Standard deviation is a
square root of the variance.

Risk and Return 11

STANDARD DEVIATION (σ)

1. Absolute measure of risk

2. Square-root of the average squared deviation of
each possible return from the expected return.
3. σ = √∑ⁿ (ki –k)2P(ki)
i=1

where n = number of possible outcomes

ki = value of the ith possible rate of return
k = expected rate of return
p(ki) = chance that the ith outcome or return will
occur.

Risk and Return 12

What does a standard deviation of 12.85% means?

 Given an expected return of 15% and a standard deviation of

12.85%, we may anticipate that the actual returns will fall
between 2.15% and 27.85% (15% ± 12.85%) two-thirds of the
time.
 To determine the investment risk, we can compare the
standard deviation of both investments. For example, another
investment with the same expected return and having standard
deviation of 7%. This means that this investment is less risky.

Risk and Return 13

Standard Deviation - Example

 PP Company is evaluating a Probability Return

security. Calculate the
following investment’s
0.15 5%
expected return and 0.30 7%
standard deviation. 0.40 10%
0.15 15%

Risk and Return 14

COEFFICIENT OF VARIATION
1. Measure of risk per unit of expected return.
2. Ratio of standard deviation to expected return
3. COV = Standard deviation
Expected return
4. Provides a more meaningful basis for comparison when the
expected returns on two alternatives are not the same.
5. Measure of relative risk.
6. The larger the coefficient of variation, the larger the relative
risk of the investment.

Risk and Return 15

Coefficient of Variation- Example

 Assume that Stock A and Stocks Expected Standard

Stock B have the following return deviation
standard deviations and A 26.52% 6.40%
expected returns as follows:
B 24.48% 6.40%
 Compute the Coefficient
of Variation.
 Determine which stocks
are less risky.

Risk and Return 16

Types of risk – (1)Systematic risk
1. Also known as Non diversifiable risk/ market risk/
unavoidable risk
2. Attributable to market factors that affect all firms.
3. Results from forces outside the firm’s control
4. Not unique to the given security
5. Defined as the variability of return on stocks or portfolios
associated with changes in return on the market as a whole.
6. Examples include changes in general interest rates, changes
in tax legislation that affects companies, or increasing public
concern about the effect of business practices on the
environment.

Risk and Return 17

Beta

1. Measure the average relationship between a stock’s returns

and the market returns.
2. This is a measure of the investment's systematic risk.
3. A stock with a beta of 0 has no systematic risk; a stock with
a beta of 1 has a systematic or market risk equal to the
typical stock in the marketplace; and a stock with a beta
exceeding 1 has more market risk than the typical stock.
4. Beta can be positive, negative or zero.

Risk and Return 18

UNSYSTEMATIC RISK

1. Also known as a diversifiable risk, unique risk, specific risk

2. Defined as the variability of returns on stocks that is the
result of factors that are unique to the particular firm.
3. Sources include business risk, financial risk, default risk and
liquidity risk.
4. Can be reduced or eliminated through diversification

Risk and Return 19

Diversification

1. Spreading an investment over a range of investment

instruments in order to minimize the risk of losing all the
investments should one investment go bad. For example
holding a portfolio consisting of stocks, bonds, real estate
and marketable securities.
2. Diversification tend to reduce or eliminate unsystematic risk

Risk and Return 20

PORTFOLIO RETURN

 Expected return of a portfolio is the weighted average of

expected returns of the securities held in a portfolio. The
weights are based on the proportion of total funds invested in
each security
 Êp = w1Ê1 + w2Ê2 + …. + wnÊn
where w= weights

Risk and Return 21

Portfolio return - Example

 Assuming an investor has Stocks Expected return

formed a portfolio, investing A 14%
RM25,000 in each of 4
B 13%
stocks having the following
expected return: C 20%
 Compute the expected D 18%
return of the portfolio

Risk and Return 22

Correlation Coefficient, r

 A measure of the degree of relationship between two

variables.
 Perfectly positive correlated stocks (r = +1.0) would move up
and down together. Therefore, diversification does nothing to
reduce risk.
 Perfectly negative correlated stocks (r = -1.0) is where one
stock moves up while the other stock moves down. Thus, all
risk can be diversified away.

Risk and Return 23