CHAPTER 4

RISK AND RETURN

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 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.

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 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): total return
earned on an investment for a period of
time

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 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
RP=Rm-Rf
Rp=Risk premium
Rm=Market expected return
Rf=Risk free return

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 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+1/Pt) -1
Pt+1 =Stock price at end of period t + 1
Pt =Stock price at the beginning of period t

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Holding Period Return (HPR)

EXAMPLE!!!

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 Holding Period Return (HPR)
• Eiman purchased one lot of Golden Bhd shares
for RM20 per shares in January 2015 and sold
the shares in December 2015 for RM8 per
share. In 2015, he received dividends of
RM0.80 per share. Calculate Eiman’s HPR

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 Holding Period Return (HPR)
• From the following price data, calculate Alia’s
holding period return
Year Stock Price
1 RM30
2 RM35
3 RM31

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Holding Period Return (HPR)

DIY!!!

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 Holding Period Return (HPR)
• Suppose that you invest in Amazon.com Inc.
common shares on June 14, 2015 the close price of
$273.99 per share, and hold it until July 7, 2017 when
the price of the same shares closed at $333.55 per
share. Calculate the holding period return

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 Holding Period Return (HPR)
• Suppose you invest in Intel corporation common
shares on February 4, 2015, when share price closed
at $33.60 per share. On May 5, 2015, the stock price
closed at $32.64, and shareholders were entitled a
dividend payment of $0.24 per share.

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Measurement of Required Return
• By using Capital Asset Pricing Model
(CAPM)
• CAPM equates the expected rate of return
on a stock to the risk free rate plus a risk
premium for the stock’s systematic risk
• Required rate of return:
= Risk-free rate + Beta (risk premium)*

Note:* RP=Rm-Rf
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Required Rate of Return

EXAMPLE!!!

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Measurement of Required Return
• It is given that the risk-free rate is 7% and the
expected market return is 14%, compute the
required rate of return for stock of Celcom
with a beta coefficient of 1.50.

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Required Rate of Return

DIY!!!

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Measurement of Required Return
• Stock B has a beta of 2. It is assumed that the
expected market return is 17% and the risk-
free rate is 9%. How much is the required rate
of return?

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 Expected Return
1. Expected earnings that the investment
would generate, in terms of cash flows.
2. Weighted average of all possible returns,
weighted by the probability of the
occurrence of that return.
3. ER = ∑ (Pi x Ri)
Pi=probability of occurence of X return
Ri=return associated with ith return
n= number of possible outcomes

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 Expected Return
Azman is considering buying MAS stocks. If there
is a 20% chance of getting 12% return,a 30%
change of getting 15% return, a 40%chance of
getting 10% return and a 10% chance of getting
5% return, calculate Azman’s expected return.

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Expected Return

DIY!!!

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 Expected Return
Aina hold a portfolio comprising RM32,000 of
stock A and RM48,000 of stock B. She expects to
earn a return of 12% from stock A and 20%
from stock B. Calculate the expected return on
this portfolio.

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 Risk
1. Chance that some unfavorable
event will occur.
2. The prospect of an unfavorable
income
3. Risk is defined as a chance of a
monetary loss.
4. It is the potential variability in
future cash flows.

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 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.

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 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: purchasing power risk; interest
rate risk.
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 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.

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 Variance

EXAMPLE!!!

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 Measuring Risk
Assume that Stock A had return of 15%, 17%, 8%,-14% and
4% over the recent 5 years. Calculate the variance
^
1. Average return (R)= 15%+17%+8%+(-14%)+4%
5
= 6%
2. The deviations of the each year’s individual return from the
average return

^
R-R Differences
15-6 9
17-6 11
8-6 2
-14-6 -20
4-6 -2

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 Measuring Risk
3. Variance is the total square of each deviation divide by the
number of returns minus 1
^
R-R Difference Square
Difference
15-6 9 81
17-6 11 121
8-6 2 4
-14-6 -20 400
4-6 -2 4
Total 610
σ2 610
5-1
=152.5%

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 Measuring Risk
1. Since variance is measured in “squared”
percentage, it is difficult for us to interpret.
2. Standard deviation need to be calculated.

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 Standard Deviation (σ)
1. It measures the risk of returns in term of the
spread or dispersion of the distribution in the
returns.
2. Absolute measure of risk.
3. It refers to the distance spanned by one
deviation above the expected value or one
deviation below the expected value.
4. If the computed standard deviation of a
given security is large, then the risk is large.
5. Standard deviation is the square root of the
variance.

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Standard Deviation

EXAMPLE!!!

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 Measuring Risk

Difference Square Standard

Difference Deviation
15-6 9 81
17-6 11 121
8-6 2 4
-14-6 -20 400
4-6 -2 4
Total 610
σ2 610 σ= √152.5
5-1
=12.349
=152.5%

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What Does A Standard Deviation of
12.349% Means?
• Given an expected return of 6% and a standard
deviation of 12.349%, we may anticipate that
68% of the actual returns will fall between a -ve
6.349% and 18.349%, 95% of the actual returns
will fall between a -ve 18.7% and 30.7% and
99% of the actual returns will fall between a -ve
of 31.05% and 43.05%
• 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.
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Standard Deviation

EXAMPLE!!!

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 Measuring Risk
Assume we are examining an investment with the possible
outcomes and probability outcomes shown below:

State of economy Probability Outcome(Return)

Outcome
Optimistic 0.2 0.20
Normal 0.7 0.30
Pessimistic 0.1 0.40

Required:
a.Calculate the expected return of the above investment.
b.Determine the variance and standard deviation of the above
investment.

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 Measuring Risk
a. Expected Return=0.2(0.20)+0.7(0.30)+0.1(0.40)
= 0.04+0.21+0.04
=0.29
=29%

b. Subtract the Multiply by Determine

expected value Square probability and sum the square
from each return up (σ 2) root

0.20-0.29=-0.09 0.0081 0.2(0.0081)=0.00162

0.30-0.29=0.01 0.0001 0.7(0.0001)=0.00007
0.40-0.29=0.11 0.0121 0.1(0.0121)=0.00121 √0.0029
0.0029 =0.05385
σ =5.385%

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 SELECTION OF INVESTMENT
ALTERNATIVES

^
Situation 1 Expected Return ( R ) Standard Deviation (σ )
A 30% 6%
B 30% 12.35%
^
Situation 2 Expected Return ( R ) Standard Deviation (σ )
M 25% 12%
N 35% 12%
^
Situation 3 Expected Return ( R ) Standard Deviation (σ )
X 25% 3.25%
Y 38% 9.2%
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 Coefficient of Variation
1. Measure of risk per unit of expected return.
2. Ratio of standard deviation to expected return
3. COV = Standard deviation σ
^
Expected return R

4. Provides a more meaningful basis for

comparison when the expected returns and
the standard deviation of alternatives
investment are not the same.
5. Measure of relative risk.
6. The larger the coefficient of variation, the
larger the relative risk of the investment.
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Coefficient of Variation

EXAMPLE!!!

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 SELECTION OF INVESTMENT
ALTERNATIVES

Investment Return (RM)

State of Probability A B C
Economy
Recession 0.25 1,500 1,875 1,685
Normal 0.45 2,810 2.250 3,000
Boom 0.30 3,375 3,000 3,750

Required:
Evaluate the investment alternatives in relation to risk and return,
and decide which one is to be chosen

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 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: purchasing power risk; interest
rate risk.
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 Beta Coefficient
1. Measure the average relationship between
a stock’s returns and the market returns.
2. Measures a security’s return over time
compared to that of the overall market
3. Beta can be positive, negative or zero.
• Example: If a company’s beta is 3.5 and
the stock market goes up 15%, then the
company’s common stock would go up
52.5%, vice versa. If the beta is -2.5 and
the market goes up by 10%, the company’s
stock return would drop by 25% and when
the market goes down by 10%, the
company’s stock’s return would rise by
25%.

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 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

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 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

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