Basics of Risk and Return

Dr. Vinod Kumar

 Agenda

1. Calculate the return on an investment

2. Understand historical returns and risk premium
3. Difference between arithmetic and geometric average returns
4. Calculate the standard deviation of an investment’s returns
5. Importance of the normal distribution
 Risk-Return Tradeoff

18%
Small-Company Stocks
16%
Annual Return Average

14%

12% Large-Company Stocks

10%

8%

6%
T-Bonds
4%
T-Bills
2%
0% 5% 10% 15% 20% 25% 30% 35%

Annual Return Standard Deviation

 Historical Returns
• Ibbotson and Sinquefield conducted an
study (1926-2015) on rates of returns on
following five types of investments:
• Large-company common stocks
• Small-company common stocks
• Long-term corporate bonds
• Long-term U.S. government bonds
• U.S. Treasury bills
 Basics of Risk and Return
• People like return, but not risk
• We can invest in risky asset only if there is extra expected return.

• But how much extra return?

• How to measure risk and how to relate expected return with risk
measure?

• So first let us understand return and risk

 Basics of Risk and Return
• Type of assets
• Equity
• Bond (Risk free bonds, Risky bonds)
• Other: Derivatives, Currencies, Commodities, Cryptocurrency
• Buying asset (Investment): Negative cash flow
• Sale of asset (share, bond etc.): Capital Gain/loss
• Return: positive cash flow
• The extra over the cost of investment (can be negative also)
• Share: dividend, Gain on sale (capital gain/loss)
• Bond: interest, Gain on sale (capital gain/loss) or payment of face value
 Return on investment

• Dollar Returns
the sum of the dividend income Dividends
and the capital gain or loss on the
investment Ending
market value

Time 0 1

Percentage Returns
Initial the sum of the dividend income and
investment the change in value of the asset,
divided by the initial investment.
 Returns
• Expected return
• Actual return (realised return)

• Dollar return
• Percentage return
• Dividend yield
• Capital gain (or loss)
• Total return

• Holding period return

• Standardisation of return
• Percentage annualised return
 Returns

Dollar Return = Dividend income + Capital gain (or loss)

 Returns: Example
• Suppose you bought 100 shares of XYZ Co. one year ago today at $45.
during the year, you received 27 cents per share in dividends. At the end of
the year, the stock sells for $48. what is return in your investment?

• Investment = $45 × 100 = $4,500.

• At the end of the year, stock value = 48 × 100 = $4,800
• Cash dividends =100 ×0.27 = $27
• Capital Gain = $4,800 – $4,500 = $ 300
• Dollar gain = $27 + ($4,800 – $4,500) = $327
• Percentage return for the year is = 327/4500 = 7.3%
 Returns: Example

$27
Dollar Return = $327
$300

Time 0 Time 1

Percentage Return:

–$4,500 $327
7.3% =
$4,500
Holding Period Returns

• The holding period return is the return that an investor

would get when holding an investment over a period
of T years, when the return during year i is given as Ri:

HPR = (1 + R1) × (1 + R2) × …× (1 + Rn) – 1

 Holding Period Return: Example

• Suppose your investment provides the following returns

over a four-year period:

Your holding period return 

 (1 R1 )  (1 R2 )  (1 R3 )  (1 R4 ) 1
 (1.10)  (.95)  (1.20)  (1.15) 1
 .4421  44.21%


 Risk, Return and Risk Premium
• Risk free asset: where return can de estimated precisely
• Risky Asset:
• Expected return is not estimated precisely but only in statistical sense.
• Actual return may be drastically different from the estimated/expected return.
• Risk in bonds: Credit risk, Interest rate risk
• Risk in Stock: Volatility in price & return
• Risk in derivatives: different risk profile due to non-linearity in return
• Stand alone risk (coefficient of variance)
• Risk in portfolio context (correlation and incremental risk)
 Risk, Return and Risk Premium
• Risk free return, Risky return, and Risk premium
• The risk premium is the added return (over and above the risk-free rate) resulting from bearing risk.
• Risk aversion and risk premium

• A classification of Risk (in CAPM Context)

• Avoidable risk
• Unavoidable risk
• Market risk and Systematic risk
• Unsystematic risk

• Risk measurement: Probability distribution of return

• Expected rate of return
 Risk Premium

• Stock market data shows long-run excess of stock return over the risk-
free return.
• The average excess return from large company common stocks for the period
1926 through 2017 was:
8.7% (= 12.1% – 3.4%)
• The average excess return from small company common stocks for the period
1926 through 2017 was:
13.1% (= 16.5% – 3.4%)
• The average excess return from long-term corporate bonds for the period 1926
through 2017 was:
3.0% (= 6.4% – 3.4%)
 Risk Premiums and expected return
• Suppose that current rate for one-year Treasury bills is 2%.
• What is the expected return on the market of small-company stocks?

• Assuming that the average excess return on small-company common stocks for
the period 1926 through 2017 will continue, then expected risk premium is
13.1%.
• Given a risk-free rate of 2%, we have an expected return on the market of
small-company stocks of 15.1% = 13.1% + 2%
• Here assumption is that historical risk premium will continue to be expected risk
premium.
• Expected return is changing with change in risk free interest rate, but not risk
premium.
 Equity Risk Premium: Historical & International Perspectives

• Over 1926 to 2017, the U.S. equity risk premium has been quite large:
• Earlier years (beginning in 1802) provide a smaller estimate at 5.4%
• Comparable data for 1900 to 2010 put the international equity risk premium at
an average of 6.9%, versus 7.2% in the U.S.

• Going forward, an estimate of 7% seems reasonable, although somewhat

higher or lower numbers could also be considered rational
 Measurement of Risk

• The context matters

1. Standalone risk
2. Portfolio context
 Stand alone return
• Probability distribution
• Expected rate of return
• Expected variance
• Normal distribution and the confidence interval
• Past data and return and variance
• Coefficient of variance
 Risk in Portfolio context
• Portfolio return
• Portfolio risk
• Portfolio variance
• Correlation coefficient: Positive or negative correlation
• Perfectly correlated: Positive or negative
• Diversification and risk reduction
• Degree of Correlation of return
• Diversifiable risk
• Non-diversifiable risk (market risk, systematic risk)
• Relevant risk (definition from CAPM)
• Beta
• Individual stock beta
• Portfolio beta
 Average stock return
• Simple average
• Geometric average
• Forward rate for nth year

• Normal distribution of return

• Variance and standard deviation and volatility
• Confidence interval and Implication
 Return Statistics

• The history of capital market returns can be

summarized by describing the:
• average return

• the standard deviation of those returns

𝑆𝐷=√ 𝑉𝐴𝑅=√ ¿ ¿ ¿
• the frequency distribution of the returns
 Example – Return and Variance

Year Actual Average Deviation from the Squared

Return Return Mean Deviation
1 .15 .105 .045 .002025

2 .09 .105 –.015 .000225

3 .06 .105 –.045 .002025

4 .12 .105 .015 .000225

Totals .00 .0045

Variance = .0045 / (4 – 1) = .0015 Standard Deviation = .03873

 Geometric Return

• Recall our earlier example:

Geometric average return 

(1 Rg ) 4  (1 R1 )  (1 R2 )  (1 R3 )  (1 R4 )
Rg  4 (1.10)  (.95)  (1.20)  (1.15) 1
 .095844  9.58%
So, our investor made an average of 9.58% per year, realizing a
holding period return of 44.21%.
 1.4421  (1.095844) 4
 Arithmetic average return

R1  R2  R3  R4
Arithmetic average return 
4
10%  5%  20% 15%
  10%
4

• Note that the geometric average is not the same as the


arithmetic average:
 More on Average Returns
• Arithmetic average—return earned in an average period over a particular period
• Geometric average—average compound return per year over a particular period
• The geometric average will be less than the arithmetic average unless all the
returns are equal.
• Which is better?
• The arithmetic average is overly optimistic for long horizons.
• The geometric average is overly pessimistic for short horizons.
 Normal Distribution of return

• A normal distribution looks like a bell-shaped curve.

Standard deviation for large stock returns
Probability from 1926 through 2017 was 19.8%.

The probability that a yearly return will fall

within 1 standard deviation of the mean of
12.1 percent will be approximately 2/3.

– 3s – 2s – 1s 0 + 1s + 2s + 3s
– 47.3% – 27.5% – 7.7% 12.1% 31.9% 51.7% 71.5% Return on
large company common
68.26% stocks
95.44%

99.74%