RISK

Dr H N Shivaprasad
MEASURING EXPECTED (EX ANTE) RETURNS

• While past returns might be interesting, investor’s

are most concerned with future returns.
• Sometimes, historical average returns will
not be realized in the future.
• Developing an independent estimate of ex
ante returns usually involves use of
forecasting discrete scenarios with
outcomes and probabilities of occurrence.
 ESTIMATING EXPECTED RETURNS
• The general formula:

Expected Return (ER)   (ri 

Where: Prob i )
i1
ER = the expected return on an investment
Ri = the estimated return in scenario i
Probi = the probability of state i occurring
ESTIMATING EXPECTED RETURNS
•Example:
• This is type of forecast data that are required to make an
estimate of expected return.
State of the Economy Probability of Possible Returns
Occurrence on Stock A in that
State

Economic Expansion 25.0% 30%

Normal Economy 50.0% 12%

Recession 25.0% -25%

ESTIMATING EXPECTED RETURNS
(1) (2) (3) (4) = (2)×(3)
State of the Probability of Possible Returns Possible Returns
Economy occurrence on Stock A in that on Stock A in that
state state

Economic 25.0% 30% 7.50%

Expansion

Normal 50.0% 12% 6.00%

Economy

Recession 25.0% -25% -6.25%

Expected Return on the Stock = 7.25%

MEASURING RISK
 Risk
•Probability of incurring harm
• For investors, risk is the probability of earning an
inadequate return.
• If investors require a 10% rate of return on a given
investment, then any return less than 10% is
considered harmful.
 RISK
ILLUSTRATED

The range of total possible returns

on the stock A runs from -30% to
Probability
more than +40%. If the required is
return on the stock is 10%, then ,
R
e
those outcomes less than 10%
Outcomes that produce harm tu
represent risk to the investor. rn
a
n
d
P
A o
rt f
o
loi
T
h
e
o
ry

-30% -20% -10% 0% 10% 20% 30% 40%

Possible Returns on the Stock
 Range
• The difference between the maximum and minimum
values is called the range
• Canadian common stocks have had a range of annual
returns of 74.36 % over the 1938-2005 period
• Treasury bills had a range of 21.07% over the same
period.
• As a rough measure of risk, range tells us that common
stock is more risky than treasury bills.
 REFINING THE
MEASUREMENT OF RISK
STANDARD DEVIATION (Σ) (or σ)
• Range measures risk based on only two observations
(minimum and maximum value)
• Standard deviation uses all observations.

• Standard deviation can be calculated on forecast or possible

returns returns as well as historical or ex post returns.

(The following two slides show the two different formula used for
Standard Deviation )
MEASURING RISK
EX POST STANDARD DEVIATION

n _

 i
(r  r) 2

Ex post   i1

n 1

Where :
 = the standard deviation
_
r = the average return
ri = the return in year i
n =the number of observations
 MEASURING RISK
EXAMPLE USING THE EX POST STANDARD DEVIATION
Problem
Estimate the standard deviation of the historical returns on investment A that
were: 10%, 24%, -12%, 8% and 10%.
Step 1 – Calculate the Historical Average Return

n
r i
Arithmetic Average (AM)  i1
 10  24 -12  8 10 40 
n 5 8.0%
5
Step 2 – Calculate the Standard Deviation

n _

 (r  2

(10 - 8)2  (24  8)2  (12  8)2  (8  8)2  (14 

i
Ex post   r)
 8)2
i1
n 1 5
22 162  202  02  22 1  0  4
4  256  400
  664 166 
4 4 4  12.88%

 MEASURING RISK
EX ANTE STANDARD DEVIATION

A Scenario-Based Estimate of Risk

n
Ex ante   (Probi )  (ri  2

 i1
ERi )
 SCENARIO-BASED ESTIMATE OF RISK
EXAMPLE USING THE EX ANTE STANDARD
DEVIATION – RAW DATA

Possible
State of the Returns on
Economy Probability Security A

Recession 25.0% -22.0%

Normal 50.0% 14.0%
Economic Boom 25.0% 35.0%
SCENARIO-BASED ESTIMATE OF RISK
FIRST STEP – CALCULATE THE EXPECTED RETURN
Determined by multiplying
the probability times the
possible return.

Possible Weighted
State of the Returns on Possible
Economy Probability Security A Returns

Recession 25.0% -22.0% -5.5%

Normal 50.0% 14.0% 7.0%
Economic Boom 25.0% 35.0% 8.8%
Expected Return = 10.3%

Expected return equals the sum of

the weighted possible returns.
SCENARIO-BASED ESTIMATE OF RISK
SECOND STEP – MEASURE THE WEIGHTED AND SQUARED DEVIATIONS

Now multiply the square deviations by

First calculate the deviation of
their probability of occurrence.
possible returns from the expected.

Deviation of Weighted
Possible Possible and
State of the Weighted Return from Squared Squared
Returns on Possible
Economy Probability Security A Returns Expected Deviations Deviations

Recession 25.0% -22.0% -5.5% -32.3% 0.10401 0.02600

Normal 50.0% 14.0% 7.0% 3.8% 0.00141 0.00070
Economic Boom 25.0% 35.0% 8.8% 24.8% 0.06126 0.01531
Expected Return = 10.3% Variance = 0.0420
Standard Deviation = 20.50%

Second, square those deviations

The su ofm the weighted
from theand
The standard
square deviations
mean.
deviation is theterms.
square root
is t he variance in percent squared
of the variance (in percent terms).
SCENARIO-BASED ESTIMATE OF RISK
EXAMPLE USING THE EX ANTE STANDARD DEVIATION FORMULA

Possible Weighted
State of the Returns on Possible
Economy Probability Security A Returns

Recession 25.0% -22.0% -5.5%

Normal 50.0% 14.0% 7.0%
Economic Boom 25.0% 35.0% 8.8%
Expected Return = 10.3%
n
Ex ante    (Prob ) (r  ER )
i1
i i i
2

 P1 (r1  ER1 ) 2  P2 (r2  ER 2) 2  P 1(r 3 ER 3) 2

 .25(22 10.3)2 .5(14 10.3)2 .25(35 10.3)2
 .25(32.3)2 .5(3.8)2 .25(24.8)2
 .25(.10401) .5(.00141) .25(.06126)
 .0420
 .205 
20.5%