FNCE 220: BUSINESS FINANCE

TOPIC: RISK & RETURN RELATIONSHIPS

0722909421

KAIBOS MOSES
 Devotional Meditation

Proverbs 1:7
The fear of the LORD is the beginning of
knowledge, but fools despise wisdom and
instruction.
 Introduction

Return - income received on an investment plus any change in

market price, usually expressed as a percent of the beginning
market price of the investment.

The return from holding an investment over some period – say, a

year – is simply any cash payments received due to ownership,
plus the change in market price, divided by the beginning price.
Example 1:

You might buy $100 security that would pay you $7 in cash and be worth
$106 one year later. The return would be ($7+ $6) / $100 = 13%. Thus the
return comes to you from two sources: income plus any price appreciation (or
loss in price).
 Example 2: Return on a single Asset

You bought 2,000 shares of KK Company at the beginning of the year at a market
price of sh. 250. The par value of each share is sh.10.

Q. What is the total investment cost?

Investment cost = 2,000 x sh. 250 = sh.500, 000

During the year, KK Company paid a dividend at 25%.

.Q. What is dividend per share?
= sh.10 x 25% = sh. 2.50
Q. What is the total dividends?
Total dividends = dividend per share x number of shares
= 2,000 x sh.2.50 = sh.5,000
At the end of the year share’s price turns out to be sh. 280.
Q. What is the capital gain?
 
Capital gain = (selling price – buying price) x number of shares
= sh.(280 – 250) x 2,000 = sh.60, 000

Q. What is the total returns?

Total returns = total dividends + capital gain
= sh. 5,000 + 60,000 = sh.65, 000
Q. What is the percentage returns?
= total returns/ initial investment
= sh.65,000/sh.500,000 X 100 = 13%
Risk – the variability of returns from those that are expected.
The greater the variability the riskier the security is said to be.

NB: Treasury- bill a risk free security while the common stock a risky
security.
 RISK OF RATES OF RETURN:

Variance and standard deviation

 
Risk rate of return is the variability in rates of returns.

Q. How could one measure the variability of rates of return of a share (or an asset)?

The variability of rates of returns may be defined as the extent of the deviations (or
dispersion) of individual rates of returns from the average rate of return.
 
There are two measures of this dispersion: variance or standard deviation.
 
Standard deviation is the square root of variance.
Formula for calculating variance and standard deviation
 
Variance(∂2) = (R1 – E(R))2 Pi + (R2 – E(R))2P2 + --- + (Rn –
E(R))2Pn

n
Variance(∂2) = ∑(Rn – E(R))2Pn
t=1

Standard deviation (∂) = √variance

Expected rate of return

E(R) = ∑ RiPi
t=1
E(R) = R1x P1 + R2 x P2 +R3 x P3 + …+ Rn x Pn
 Example 1.
From the table determine
(a) the expected rate of return
(b) Risk of rate of return
(c) Advice management on what to do

Table: Returns and probabilities

Economic conditions Rate of return (%) Probability

Growth 18.5 0.25

Expansion 10.5 0.25
Stagnation 1.00 0.25
Decline -6.00 0.25
1.00
E(R) = (18.5 x0.25) + (10.5x0.25) + (1x0.25) + (-6x 0.25) = 6%

Risk
var = (18.5 -6)2 x 0.25 + (10.5 -6)2 x 0.25 + ( 1- 6)2 x0.25 + (-6 – 6)2 x 0.25
= 86.375

stand dev = 9.29%

Expected rate of return = 6%
Var = 86.375
Std dev = 9.29%

Should you invest in the share of KK Company? The returns are expected to
fluctuate widely. The expected rate of return is low (6%) and the standard
deviation is high (9.29%). You are likely to search for an investment with higher
expected return and lower standard deviation.
 Example 2.
The shares of hypothetical company ltd has the following
anticipated returns with associated probabilities

Returns -20 -10 10 15 20 25 30

(%)
Probability 0.05 0.10 0.20 0.25 0.20 0.15 0.05
Required:
(a) Required rate of return = 13%
(b) Risk of rate of return ( var = 156, stand dev = 12.5%)
(c) Advice whether we should invest in the shares of the
company
- Accept to invest in the shares of the company
Risk preference
The information about the expected return and standard deviation helps an investor
to make decision about investments. This depends on the investor’s risk preference.
Generally investors would prefer investments with higher rates of returns and lower
standard deviations.
RISK PREFERENCE:
Risk –averse – this investor will choose from investments with the
equal rates of return, the investment with lowest standard deviation.
Similarly, if investments have equal risk (standard deviation) the
investor would prefer the one with higher return.

Neutral risk – this investor does not consider risk, and he would
always prefer investments with higher returns.

Risk seeking – this investor likes investments with higher risk

irrespective of the rates of returns.
 PORTFOLIO RETURNS

Portfolio – a bundle of or a combination of individual assets or securities.

Portfolio theory – provides a normative approach to investors to make decisions to

invest their wealth in assets or securities under risk. It is based on the assumption
that investors are risk averse. This implies that investors hold well - diversified
portfolios instead of investing their entire wealth in a single or a few assets. i.e.
investors concern is the expected rate of return and risk of the portfolio rather than
individual risk.

The second assumption of the portfolio theory is that the returns of assets are
normally distributed. This means that the mean (the expected value) and variance
(or standard deviation) analysis is the foundation of the portfolio decisions.
Diversification

The idea of diversification is to spread your risk across a number of assets or investments.
Combining securities that are not perfectly correlated can help to lessen the risk of a portfolio.
Investing in world financial markets can achieve greater diversification than investing in securities
from a single security.

Systematic and unsystematic risk

Total portfolio risk comprises of two components: systematic risk and unsystematic risk
Total risk = Systematic Risk + Unsystematic Risk

Systematic risk or non-diversifiable risk is due to risk factors that affect the overall market such as
change in a country’s economy or rise in world energy prices. They cannot be diversified away. This
implies that even an investor who holds a well diversified portfolio will be exposed to systematic risk.
Unsystematic risk is unique to a particular company or industry.

This implies it is independent of economic, political or other factors that affect all securities in
a systematic manner. For example, a strike may affect only one company or a new
competitor may emerge producing a very similar product. Through diversification, this type of
risk can be reduced or even largely eliminated assuming the diversification is efficient.
 
 PORTFOLIO RETURN: TWO – ASSET CASE
The return of a portfolio- is equal to the weighted average of the returns of
individual assets (or securities) in the portfolio with weights being equal to the
proportion of investments value in each asset.

Table: Possible outcome of two assets, X and Y.

NB: equal amounts is invested in assets x and y
W = 50%, 1-w = 50%
E(Rx) = 5%
E(Ry) = 8%
E(Rp) = 0.5 x 5 + (1 -0,5) x 8 = 6.5% ok

invest 25% in x, 75% in Y, what is the portfolio returns?

E(Rp) = 0.25 x 5 + 0.75 x 8 = 7.25% ok ok
Invest 70% in X, 30% in asset Y, what is portfolio returns
E(Rp) = 0.7 x 5 + 0.3 x 8 = 5.9%
Invest 0% in X, 100% in Y, what is portfolio returns?
E(Rp) = 0 x 5 + 1 x8= 8%xxxxxxxxxxxxxxxxxxxx
Invest 100% in x, 0% in Y, what is portfolio returns
E(Rp) = 1 x5 + 0 x 8 = 5%
Q. Determine the portfolio returns

Expected rate of return on a portfolio:

= weight of security X x expected return on security X + weight of security Y
x expected return on security Y

NB; Equal amounts are Invested in asset X and Y.

E (Rp) = w x E (Rx) + (1-w) x E (Ry )
 
NB: w is the proportion of investment in asset X and (1- w) is the remaining
Investment in asset Y.

Q. What is the advantage of investing your entire wealth in both assets X and Y
when you could expect highest return of 8% by investing your entire wealth in Y?
Investing your entire wealth in Y is more risky. The probability of negative returns is
eliminated when you combine X and Y.
 PORTFOLIO RISK: TWO –ASSET CASE
The risk of individual assets is measured by their variance or standard deviation. We use
variance or standard deviation to measure the risk of the portfolio of assets as well.
 
Q. Why is a portfolio less risky than individual assets?

Example: Suppose you have two investment opportunities A and B as follows:

The expected rate of return, variance and standard deviation of A is:

E(RA) = 0,5 x 40 + 0.5x 0 = 20%

∂A2 = (40-20)2 0.5+ (0-20)2 0.5 = 400
∂A = 20%

Simply, the expected rate of return, variance and standard deviation of B are:

E(RB) = 0.5 x0 + 0.5x 40 = 20%

∂B2 = ( 0- 20)2 0.5 + (40 -20)2 0.5= 400
∂ B = = 20%.

Both investments A and B have the same expected rate of return (20%) and same
variance (400) and standard deviation (20%).Thus; they are equally profitable and
equally risky.
 
Q. How does combining A and B help an investor?

If a portfolio consisting of equal amount of A and B were constructed the portfolio return would be:

E(Rp) = (0.5 x 20) + 0.5 x 20 = 20%

This return is the same as the expected return from individual securities, but without any risk.

Why? If the economic conditions are good, then A would yield 40% return and B 0% and constructed
return will be:

E (Rp) = (0.5 x 40) + (0.5 x 0) = 20%

When economic conditions are bad, then A’s return will be zero(0%) and B’s 40% and the portfolio
return would still remain the same:

E (Rp) = (0.5 x 0) + (0.5 x 40) = 20%

END = END = END