Risk and Return

 Return and risk are two dimensions of an

investment
 All investments are made in anticipation of a return
 The realization of the anticipated return is however
uncertain
 Relativity is another dimension where return
and risk are related in some ways
 Risk and returns are directly related
 The higher the risk the higher the potential returns
 You CAN NOT minimize risk AND maximize returns
 It is EITHER ….. OR
November 1, 2023 Lecture3_Risk and Return 1
 Risk and Return: RETURNS
 Return is what is earned on an investment
 The sum of [net] income and capital gains
generated by a investment expressed in relative
terms
 There are different views about returns
 Required return is the what is necessary to
induce an individual to make an investment
 It is what an investor requires on an investment
given its risk
 It is the inducement to bear risk associated with an
investment
November 1, 2023 Lecture3_Risk and Return 2
 Risk and Return: RETURNS
 Required return depends on:
 What an investor may earn on an alternative
investment (that is free of risk)
 A premium for bearing (the additional) risk(s)
 Expected return is what an investor expects
to earn from a specific investment given its
price, growth potential, etc:
 It is the incentive for accepting risk
 Expected return must be compared with the
required return
November 1, 2023 Lecture3_Risk and Return 3
 Risk and Return: RETURNS
 Expected return depends on:
 Individuals expected outcomes
 The probability of the outcomes’ occurrences
 Expected return and actual/realized return are
not synonymous
 Even with rational expectations there is a room for
random error

November 1, 2023 Lecture3_Risk and Return 4

 Risk and Return: Example
 We will use the following data to illustrate the
computation of risk and return:

State of the Probability Annual Return (RAsset/S)

Economy (S) (PS) Asset A (RA/S) Asset B(RB/S)

Recession 0.20 -7% 17%

Normal 0.30 12% 7%
Boom 0.50 28% -3%

November 1, 2023 Lecture3_Risk and Return 5

 Computing Expected Returns: Example

State of Probability Annual Return PS *RS

the (PS)
Economy Asset A Asset B PS *RS,A PS *RS,B
(S) (RA/S) (RB/S)

Recession 0.20 -7% 17% -0.014 0.034

Normal 0.30 12% 7% 0.036 0.021
Boom 0.50 28% -3% 0.14 -0.015
Summation: Expected Return [E(R)] 0.162 0.04
November 1, 2023 Lecture3_Risk and Return 6
 Returns: Some Additional Issues
 The term Holding Period Return (HPR) is often
used for securities
 HPR of a security is the return from holding a
security over a period of time
 For example, the HPR for a stock is the "gain
divided by the pain“ – expressed as:

November 1, 2023 Lecture3_Risk and Return 7

 Returns: Some Additional Issues
 For a security held over multiple periods, there
are several ways of calculating average rates
of return:
 Arithmetic Average – by dividing the return
over the multiple periods by the number of
periods
 Geometric Average
 Monetary Weighted Average Return

November 1, 2023 Lecture3_Risk and Return 8

 Returns: Some Additional Issues
 Returns are expressed as percent per period
 The standard period is a year. That is, returns
are normally expressed on “per annum” basis
 However, sometimes returns are quoted for periods
other than a year
 There are several ways of annualizing returns
are quoted for periods other than a year
 The Annual Percentage Rate (APR)

APR = Per Period Rate X Number of Periods per Year.

November 1, 2023 Lecture3_Risk and Return 9

 Returns: Some Additional Issues
 The Equivalent Annual Return (EAR)

 Where N is the number of Periods per Year

 Of the two, EAR is more economically
meaningful, but APRs are widely quoted
because of their simplicity

November 1, 2023 Lecture3_Risk and Return 10

 Returns: Concept Checks
 CONCEPT CHECK 1: Compute the holding period
return for a stock that was bought for Tshs 800 (per
share) and sold for Tshs 780 (per share) with the
investor receiving a dividend of Tshs 15 (per share) in-
between.
 CONCEPT CHECK 2: Suppose you bought a stock for
Tshs 800 and sold it four years latter for Tshs 1,100
while pocketing a total of Tshs 420 cash dividend over
the four year period. Compute:
 The HPR over the period
 The annual return over the period

November 1, 2023 Lecture3_Risk and Return 11

 Risk and Return: RISK
 Risk is the UNCERAINTY that the realized
return will not equal the expected return
 The discrepancy can be “positive” or “negative”
 Risk is, however, often viewed negatively
 It is the possibility of loss; the uncertainty that the
anticipated returns will not be achieved
 For some assets the return is known for certain
 There is no risk involved
 One example of such an asset is a T-Bill where the
return is ‘guaranteed’ by the government
November 1, 2023 Lecture3_Risk and Return 12
 Risk and Return: RISK
 There are two sources of risk
 The individual asset/investment e.g. the firm’s
business and how it is financed (firm specific risks)
 The market or the economy (market risk)
 Firm specific risks are grouped into business
and financial risk
 Market risk is associated the uncertainty
inherent in the [whole] market or economy
 It is “global” in nature

November 1, 2023 Lecture3_Risk and Return 13

 Risk and Return: RISK
 Business Risk is the risk associated with the
nature of the firm’s business (operations)
 One aspect of this is the extent to which firm’s
expenses are fixed
 Financial Risk is associated with the type of
financing used to acquire firm’s assets
 One aspect of this is the extent to which a firm is
financed with fixed obligation sources

November 1, 2023 Lecture3_Risk and Return 14

 Risk and Return: RISK
 Firm specific risks can be eliminated by holding
different assets (diversification)
 That is, firm specific risk is diversifiable (it is also
known as UNSYSTEMATIC risk)
 Diversification involves holding a reasonable
number of investments such that:
 Each does not represent a significant proportion of
the whole investment
 The returns of the individual investments are not
perfectly in sync
November 1, 2023 Lecture3_Risk and Return 15
 Risk and Return: RISK
 Market risk is associated with the uncertainty
inherent in the [whole] market or economy.
 Market risk is SYSTEMATIC (its effect cuts across
all investments)
 It is therefore NONDIVERSIFIABLE (That is, it is not
reduced by diversification)
 NOTE: Though the term “market risk” is often
used in general, it more specifically relates to
the risk associated with movement in security
prices (especially stock prices)
November 1, 2023 Lecture3_Risk and Return 16
 Risk and Return: RISK
 Non-diversifiable or systematic risks include:
 Interest rate risk
 Reinvestment risk – the risk associated with
reinvesting funds generated from an investment
 Purchasing power risk
 Exchange rate risk

November 1, 2023 Lecture3_Risk and Return 17

 Risk and Return: RISK
 One measure of risk is the variability of returns
 The standard deviation (SD) is used for this
purpose
 SD is a measure of dispersion around an average
value
 SD emphasizes the extent to which the return
differ from the average or expected return
 Standard deviation mainly measures the
asset’s (or firm’s) specific risk

November 1, 2023 Lecture3_Risk and Return 18

 Computing Variability of Returns: Example
 The earlier example is used here to compute δ2
State of Probability Deviation Product of deviations
the (PS) times probabilities
Economy A B {RS,A –E(RA)}2 {RS,B –E(RB)}2
(S) RS,A –E(RA) RS,B –E(RB) *PS *PS

Recession 0.20 -0.232 0.13 0.010765 0.00338

Normal 0.30 -0.042 0.03 0.000529 0.00027
Boom 0.50 0.118 -0.07 0.006962 0.00245

Summation: Variances (δ2) of A and B 0.018256 0.0061

November 1, 2023 Lecture3_Risk and Return 19
 Risk and Return: Alternative
 Instead of using scenario analysis to compute
expected return and variance, we can use
historical data
 This is appropriate if:
 we expect the (near) future to be similar to the
(near) past.
 we are reasonably confident that the correlations
between the securities are changing slowly.

November 1, 2023 Lecture3_Risk and Return 20

 Risk and Return: RISK
 Variance and standard deviation of expected
return are not the only measures of risk.
 Other measures include range of returns, returns
below expectations, and semi-variance (a measure
that only considers deviations below the mean).
 The use of semi-variance to measure risk implicitly
assume that investors want to minimize the damage
from returns less than some target (or average)
rate.

November 1, 2023 Lecture3_Risk and Return 21

 Risk and Return: RISK
 Another measure of risk is the beta coefficient
 A beta coefficient is an index of systematic risk
 It measures the volatility of the investments return
relative to the economy (market) return
 More will be discussed on this in a latter topic

November 1, 2023 Lecture3_Risk and Return 22