Risk and Return[1]

Abel M. Agoba; PhD.

 Chapter Objectives
• Discuss the concepts of average and expected rates of return.

• Define and measure risk for individual assets.

• Show the steps in the calculation of standard deviation and variance of returns.

• Compute historical average return of securities and market premium.

• Determine Expected Returns and Variances.

• Calculating Coefficient of Variation.

• Portfolio Risk and Return.

• Systematic and Unsystematic.

• Risk Diversification.

• Capital Asset Pricing Model (CAPM).

 Introduction
An investment is the current commitment of cedis for a period of time in
order to derive future payments that will compensate the investor for:
– the time the funds are committed,
– the expected rate of inflation, and
– the uncertainty of the future payments.

 The goal of investing is to generate income and increasing value over time.

 This includes the purchase of bonds, stocks, or real estate property, among
other examples.

 Additionally, purchasing a property that can be used to produce goods can

be considered an investment.
 Holding Period Return /Yield
• The period during which you own an investment, or the period between the
purchase and sale of a security, is called its holding period

• Holding period return or yield (HPR). is the total return received from holding

an asset or portfolio of assets over a period of time. , and the return for that
period is the

• It is generally expressed as a percentage.

• Holding period return is calculated on the basis of total returns from the asset or
portfolio (income plus changes in value).

• It is particularly useful for comparing returns between investments held for

different periods of time.
 Return on a Stand Alone Asset
• Total return = Dividend + Capital gain
Rate of return  Dividend yield  Capital gain yield
DIV1 P1  P0 DIV1   P1  P0 
R1   
P0 P0 P0
 Holding Period Return/Yield
• 1. If you commit GHȼ200 to an investment at the beginning of
the year and you get back GHȼ220 at the end of the year,
what is your return for the period?

• In this example, the HPR is 0.1 or 10%, calculated as follows:

 Holding Period Return/Yield
• 2. Which investment performed better: Mutual Fund X, which was held for three
years and appreciated from Ghc100 to Ghc150, providing Ghc5 in distributions, or
Mutual Fund B, which went from Ghc200 to Ghc320 and generated Ghc10
in distributions over four years?
Holding Period Return/Yield
 Holding Period Return/Yield
• 4.  Your stock portfolio had the following returns in the four quarters of a given
year: +8%, -5%, +6%, +4%. How did it compare against the benchmark index, which
had total returns of 12% over the year?
 Average Rate of Return
• The average rate of return is the sum of the
various one-period rates of return divided by
the number of period.

• Formula for the average rate nof return is as

1 1
follows: R =
n
[ R1  R 2    R n ] 
n
 Rt
t =1

• The rate of return can be calculated for a single

asset or a portfolio of assets.
 Return on a Stand Alone Asset
• Find the average rete of return for HLL share
given the following Year-to-Year Total Returns
on HLL Share.
160.00 149.70
140.00
Tota l R e turn (% )

120.00
100.00 92.33

80.00 70.54

60.00 49.52 52.64

36.13
40.00 22.71
16.52 12.95
20.00 7.29
0.00
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

Year
 Risk
• Risk is the uncertainty that an investment will earn its expected rate of
return.

• It also refers to the chance that some unfavourable event will occur.

• The greater the chance of a return far below the expected

return, the greater the risk.

• An asset’s risk can be analyzed in two ways:

1. on a stand-alone basis, where the asset is considered in isolation, and

2. on a portfolio basis, where the asset is held as one of a number of assets

in a portfolio.
 Risk for a Stand Alone Asset
• Thus, an asset’s stand-alone risk is the risk an
investor would face if he or she held only this one
asset.

• Two possible measures of risk (uncertainty) have

received support in theoretical work on portfolio
theory:
– the variance and
– the standard deviation of the estimated distribution of
expected returns
 Risk of Rates of Return: Variance and Standard Deviation

• Formulae for calculating variance and

standard deviation:
Standard deviation = Variance

 R 
n 2
1
2  t R
n 1 t 1
 Risk of Rates of Return: Variance and Standard Deviation

• ABC Ltd, a company traded on the GSE made

the following returns over a ten-year period.
Year Returns
2000 0.1
2001 0.32
2002 0.12
2003 0.25
2004 0.23
2005 0.09
2006 0.11
2007 0.42
2008 -0.12
2009 0.15
 Calculate the average return and the risk of ABC
 Risk of Rates of Return: Variance and
Standard Deviation
• Average return = 0.167
Year Returns (R-Rbar)(R-Rbar)^2
2000 0.1 -0.067 0.0045
2001 0.32 0.153 0.0234
2002 0.12 -0.047 0.0022
2003 0.25 0.083 0.0069 0.0219
2004 0.23 0.063 0.0040
2005 0.09 -0.077 0.0059
2006 0.11 -0.057 0.0032 0.148
2007 0.42 0.253 0.0640
2008 -0.12 -0.287 0.0824
2009 0.15 -0.017 0.0003
Risk of Rates of Return: Variance and
Standard Deviation

• Standard deviation measures the stand-alone

risk of an investment.

• The larger the standard deviation, the higher

the probability that returns will be far below
the expected return and therefore the higher
the risk
 Expected Return Vrs Risk
• If the current price of a share is €5 and the following estimates are made about what
will happen over the next 12 months:

• Then we estimate that the return will be 38% if the economy grows strongly, 22% if it
exhibits steady growth and only 6% if there is no economic growth.

• This information is of interest, but of limited use for decision-making purposes unless
we have some idea about how likely each possible set of economic conditions is, and
hence each possible investment outcome is. We need to apply some probabilities to
each outcome in order to produce a probability distribution of possible returns.
 Expected Return Vrs Risk
• The expected return from an investment is
defined as

(Prob. of returns) X (Possible return)

 Expected Return Vrs Risk
• Below are forecasts of the various economic
conditions in Ghana with the likely returns for
Zee Ltd.

Calculate the expected return for Zee Ltd

 Expected Return Vrs Risk

Economic Conditions Prob Returns (P*R)

Strong Economy 0.15 0.2 0.03
Waek Economy 0.15 -0.2 -0.03
Normal Economy 0.7 0.1 0.07
Expected return= 0.07
 Expected Return Vrs Risk
• We can then calculate the variance and
standard deviation of the returns as follows;
 Expected Return Vrs Risk
• We can calculate the variance and standard
deviation for Zee Ltd as;
Economic Conditions Prob Returns (P*R) R- E(R) [R-E(R )]^2P[R-E(R )]^2
Strong Economy 0.15 0.2 0.03 0.13 0.0169 0.002535
Waek Economy 0.15 -0.2 -0.03 -0.27 0.0729 0.010935
Normal Economy 0.7 0.1 0.07 0.03 0.0009 0.00063
Variance =0.0141
𝑺𝒕𝒂𝒏𝒅𝒂𝒓𝒅 𝑫𝒆𝒗 = ξ 𝟎. 𝟎𝟏𝟒𝟏 = 0.1187
 Relative Measure of Risk
• In some cases, an unadjusted variance or standard deviation can be misleading.

• If conditions for two or more investment alternatives are not similar—that is if

there are major differences in the expected rates of return—it is necessary to use a
measure of relative variability to indicate risk per unit of expected return.

• A widely used relative measure of risk is the coefficient of variation (CV).

• In finance, the coefficient of variation allows investors to determine how much

volatility, or risk, is assumed in comparison to the amount of return expected from
investments.

• Ideally, if the coefficient of variation formula should result in a lower ratio of

the standard deviation to mean return, then the better the risk-return trade-off.
 Relative Measure of Risk

The CV for the preceding example would be;

 Relative Measure of Risk
Consider the following two investments;
Stock A Stock B
Expected Return 0.07 0.12
Standard Deviation 0.05 0.07
Expected Return : Incorporating Probabilities
in Estimates
• The expected rate of return [E (R)] is the sum of the product of
each outcome (return) and its associated probability:
RETURNS UNDER VARI OUS ECONOMIC CONDI TIONS
Economic Conditions Share Price Dividend Dividend Yield Capital Gain Return
(1) (2) (3) (4) (5) (6) = (4) + (5)
High growth 305.50 4.00 0.015 0.169 0.185
Expansion 285.50 3.25 0.012 0.093 0.105
Stagnation 261.25 2.50 0.010 0.000 0.010
Decline 243.50 2.00 0.008 – 0.068 – 0.060

RETURNS AND PROBABIL ITIES

Economic Conditions Rate of Return (% ) Probability Expected Rate of Return (%)
(1) (2) (3) (4) = (2)  (3)
Growth 18.5 0.25 4.63
Expansion 10.5 0.25 2.62
Stagnation 1.0 0.25 0.25
Decline – 6.0 0.25 – 1.50
1.00 6.00
 Expected Risk and Preference
• A risk-averse investor will choose among investments with
the equal rates of return, the investment with lowest
standard deviation. Similarly, if investments have equal risk
(standard deviations), the investor would prefer the one
with higher return.

• A risk-neutral investor does not consider risk, and would

always prefer investments with higher returns.

• A risk-seeking investor likes investments with higher risk

irrespective of the rates of return. In reality, most (if not all)
investors are risk-averse.
 Review Question 1
• Cronox Industries and Zealous Incorporated share
prices and dividends are shown below for the
period 1995 – 2000.
  Cronox Industries Zealous Incorporated

Year Stock price Dividend (GH¢) Stock price Dividend(GH¢)

2010 7.62 0.85 55.75 2.00

2011 12 0.90 60.00 2.25

2012 10.75 0.95 57.25 2.50

2013 17 1.00 48.75 2.75

2014 15.75 1.06 52.30 2.90

2015 17.25 1.15 48.75 3.00

 Review Question 1
• Use the data given to calculate annual returns for Cronox, and Zealous.
• Compute average return (Arithmetic Average) over the five year period (2006-
2010)
• Calculate the risk (standard deviation of returns) for both Cronox and Zealous.
• Calculate the coefficient of variation for both companies
• Compare the two companies in terms of risk and returns.
• Calculate the correlation coefficient between the two stock
• Calculate the portfolio risk and return assuming the assets are equally weighted.
• Assuming Kweku invested GH¢20,000 in the stocks of Cronox Industries and GH
¢30,000 in that of Zealous Incorporated with a correlation coefficient between
the two firms of 0.8, what is the portfolio risk and return?