Risk and Return

Zoom Session 4
Reference:

Chapter 8 of Brigham, E.F. and Houston, J.F., 2015.

13th Edition. Fundamentals of financial management.
Cengage
 Example-1
Example-1 Solution demonstrated in Excel sheet

Probability of this Martin Products U.S Water

State of the economy demand Expected Return Expected Return
  P R R
Strong 0.3 80% 15%
Normal 0.4 10% 10%
Weak 0.3 -60% 5%
Example
 Return and Risk calculations
Example-1 Solution demonstrated in Excel sheet

For risk, the measure is standard deviation, the symbol for which is σ , pronounced
“sigma.” The smaller the standard deviation, the tighter the probability distribution,
and, accordingly, the less risky the stock
A statistical measure of the variability of a set of observations
1. Calculate the expected rate of return:

2. Subtract the expected rate of return from each possible outcome

 Return and Risk calculations
Example-1 Solution demonstrated in Excel sheet
3. Square each deviation, then multiply the result by the probability
of occurrence for its related outcome and then sum to obtain the
variance

4. Find the square root of the variance to obtain the standard

deviation
Using historical data to measure return & risk
 Example- 2
Example-2 Solution demonstrated in Excel sheet

Year Rate of Return

2005 30%
2006 -10%
2007 -19%
2008 40%

What is the average return and risk?

 Measuring stand alone risk

The coefficient of variation shows the risk per unit of return

the coefficient of variation for Martin is 54.22/10 = 5.42 and

that for Water is 3.87/10 = 0.39. Thus, Martin is about 14
times riskier than U.S. Water based on this criterion.
 Practice Question 8-6
Solution in Excel Sheet
Stocks X and Y have the following probability distributions of expected future returns:
Calculate the expected rate of return for Stock Y (rX = 12%).
Probability X Y
0.1 -10% -35%
0.2 2% 0%
0.4 12% 20%
0.2 20% 25%
0.1 38% 45%
Calculate the standard deviation of expected returns for stock X, SD of stock y=20.35%
Now calculate the coefficient of variation for Stock Y.
THANK YOU!!