Risk and Return

4.1. Understanding and Measuring Risk

• Probability distributions
• Measures of Central tendency
• Measures of dispersion
4.2. Portfolios
– Portfolio weights
– Portfolio expected returns
– Portfolio risk
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 Risk and Return

4.3. Diversification and portfolio risk

– The principle of diversification
– Diversification and unsystematic risk
– Diversification and systematic risk
– Measuring systematic risk
– Portfolio betas
4.4. Risk and the required rate of return
– CAPM
– The security market line
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 4.1. Understanding and Measuring Risk

 It is important to understand the relation

between risk and return so we can determine
appropriate risk-adjusted discount rates for
our NPV analysis.
 Risk and return are the two most important
attributes of an investment
 At least as important, the relation between
risk and return is useful for investors (who
buy securities), corporations (that sell
securities to finance themselves), and for
financial intermediaries (that invest, borrow,
lend, and price securities on behalf of their
clients).

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 4.1. Understanding and Measuring Risk

 Definition: risk is the potential for

deviation between the actual outcome
and what is expected.
 In finance, risk is usually related to
whether expected cash flows will
materialize, whether security prices
will fluctuate unexpectedly, or whether
returns will be as expected.

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 4.1. Understanding and Measuring Risk

• Typically, investment returns are not

known with certainty.
• Investment risk pertains to the
probability of earning a return less
than that expected.
• The greater the chance of a return
far below the expected return, the
greater the risk.

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 4.1. Understanding and Measuring Risk

 Expected returns are based on the

probabilities of possible outcomes
 In this context, “expected” means
average if the process is repeated
many times
 The “expected” return does not even
have to be a possible return
n
E ( R)  pR
i 1
i i

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 4.1. Understanding and Measuring Risk

• Suppose you have predicted the following

returns for stocks C and T in three possible
states of nature. What are the expected
returns?
– State Probability C T
– Boom 0.3 0.15 0.25
– Normal 0.5 0.10 0.20
– Recession ??? 0.02 0.01
• RC = .3(.15) + .5(.10) + .2(.02) = .099 = 9.99%
• RT = .3(.25) + .5(.20) + .2(.01) = .177 = 17.7%

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 4.1. Understanding and Measuring Risk

• Whenever you make a financing or investment

decision, there is some uncertainty about the
outcome. Uncertainty means not knowing exactly
what will happen in the future.
• Though the terms “risk” and “uncertainty” are
often used to mean the same thing, there is a
distinction between them.
• Uncertainty is not knowing what’s going to
happen.
• Risk is how we characterize how much uncertainty
exists:
• The greater the uncertainty, the greater the risk.
• Risk is the degree of uncertainty.
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 4.1. Understanding and Measuring Risk

• Risk (or uncertainty) refers to the variability of

expected returns associated with a given
investment.
• Risk, along with the concept of return, is a key
consideration in investment and financial
decisions.
• Probabilities are used to evaluate the risk
involved in a security.
Types of Risk
There are two types of risk.
A. Controllable Risks (Unsystematic Risks)
B. Uncontrollable Risks (systematic Risks)
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 4.1. Understanding and Measuring Risk

A) Controllable Risks (Unsystematic Risks)

• CR- Represents the portion of a security’s risk that
can be controlled through diversification.
Eg.
1. Operating risk: The risk of loss resulting from
inadequate or failed internal processes, people and
systems
2. Liquidity risk: This is the risk of not being able to
sell an investment immediately with a reasonable
price.
3. Credit Risk : is the risk that a borrower will not
repay a loan according to the terms of the loan,
either defaulting entirely or making late payments of
interest or principal
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 4.1. Understanding and Measuring Risk

B) Uncontrollable Risks (Systematic Risks)

•SR- represents the portion of a security’s risk that cannot be
controlled through diversification.
I. Market risk is the risk that a stock’s price will change
due to changes in the stock market atmosphere as a
whole since prices of all stocks are correlated to some
degree with broad swings in the stock market.
II. Interest rate risk is the risk resulting from
fluctuations in the value of an asset as interest rates
change.
For example, if interest rates rise (fall), bond prices fall
(rise).
III) Inflation risk: This is the uncertainty over future rates
of inflation. Inflation risk is also known as purchasing power
risk.
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 4.1. Understanding and Measuring Risk

IV) Country risk, also called political risk, is the uncertainty of returns
caused by the possibility of a major change in the political or economic
environment of a country.
V) Exchange rate risk is the uncertainty of returns to an investor
who acquires securities denominated in a currency different from his or
her own.

Measures of Return and Risk

Returns on the investments can be seen in two ways. These are:
Ex-post returns and ex-ante returns.
 Ex Post Returns: Return calculations done ‘after-the-fact,’ in
order to analyze what rate of return was earned.
 Ex-post return is based on historical data.
 Ex Ante Returns: Return calculations may be done ‘before-the-
fact,’ in which case; assumptions must be made about the
future.
 Ex-ante returns forecast returns for the future.
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 4.1. Understanding and Measuring Risk

• The concept of return provides investors with a convenient way to

express the financial performance of an investment.
• To illustrate, suppose you buy 10 shares of a stock for $1,000. The
stock pays no dividends, but at the end of 1 year you sell the stock for
$1,100. What is the return on your $1,000 investment? One way to
express an investment’s return is in dollar terms:
• Dollar return =
• Amount Received−Amount invested=1,100-$1,000= $100
 Although expressing returns in dollars is easy, two problems arise:
a) to make a meaningful judgment about the return, you need to know
the scale (size) of the investment and
b) the timing of the return.
 The solution to these scale and timing problems is to express
investment results as rates of return, or percentage returns.

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 4.1. Understanding and Measuring Risk

 For example, the rate of return on the 1-year stock

investment, when $1,100 is received after 1 year, is 10%:

 Generally historical return can be calculated using the

following formula.

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 4.1. Understanding and Measuring Risk

 Distributions include interest on debt, dividends on

common stock, rent on real property and so on.
• The period during which you own an investment is
called its holding period, and the return for that
period is the holding period return (HPR).

Example: To illustrate, suppose you buy 10 shares of

a stock for $1,000. The stock pays no dividends, but
at the end of 1 year you sell the stock for $1,100.
What is the return on your $1,000 investment?
•

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 4.1. Understanding and Measuring Risk

• Holding period Return (HPR) = 𝐸𝑛𝑑𝑖𝑛𝑔 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

𝐵𝑒𝑔𝑔𝑖𝑛𝑖𝑔 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
Holding period Return (HPR) =1.1
Holding period yield (HPY)= HPR-1
Holding period yield (HPY)=1.1-1=0.1=10%
Computing Mean Historical Returns
•To find the arithmetic mean (AM), the sum (∑) of annual HPYs is divided
by the number of years (n) as follows:
AM =∑HPY/n, where: ∑HPY = the sum of annual holding period yields
To illustrate these alternatives, consider an investment with the following data
and calculate AM.

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 4.1. Understanding and Measuring Risk

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 4.1. Understanding and Measuring Risk

•To measure the risk for a series of historical rates of returns, we use the same
measures as for expected returns (variance and standard deviation) except that
we consider the historical holding period yields (HPYs) as follows:

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 4.1. Understanding and Measuring Risk

•Assume that you are given the following information on annual rates of
return (HPY) for common stocks listed on the New York Stock Exchange
(NYSE):

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 4.1. Understanding and Measuring Risk

•Assume that you are given the following information

on annual rates of return (HPY) for common stocks
listed on the New York Stock Exchange (NYSE):
Solution
•

•= 0.00572
• =0.0756 or 7.56%
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 4.1. Understanding and Measuring Risk

• Calculating Expected Rates of Return (Ex-Ante Return)

Risk is the uncertainty that an investment will earn its
expected rate of return.
• In the examples in the prior section, we examined realized
historical rates of return.
• In contrast, an investor who is evaluating a future investment
alternative expects or anticipates a certain rate of return.
• An investor determines how certain the expected rate of return
on an investment is by analyzing estimates of expected
returns.
• To do this, the investor assigns probability values to all
possible returns.
• 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑅𝑒𝑡𝑢𝑟𝑛 = ∑ 𝑃𝑜𝑠𝑠𝑖𝑏𝑙𝑒 𝑅𝑒𝑡𝑢𝑟𝑛 𝑥 𝑃𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝑜𝑓 𝑅𝑒𝑡𝑢𝑟𝑛

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 4.1. Understanding and Measuring Risk

• Variance and standard deviation still measure

the volatility of returns
• Using unequal probabilities for the entire
range of possibilities
• Weighted average of squared deviations

n
σ   pi ( Ri  E ( R))
2 2

i 1

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 4.1. Understanding and Measuring Risk

• Consider the previous example. What are the variance

and standard deviation for each stock?
• Stock C
– 2 = .3(.15-.099)2 + .5(.1-.099)2 + .2(.02-.099)2
= .002029
–  = .045
• Stock T
– 2 = .3(.25-.177)2 + .5(.2-.177)2 + .2(.01-.177)2
= .007441
–  = .0863

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 4.1. Understanding and Measuring Risk

• Consider the following information:

– State Probability ABC, Inc.
– Boom .25 .15
– Normal .50 .08
– Slowdown .15 .04
– Recession .10 -.03
• What is the expected return?
• What is the variance?
• What is the standard deviation?

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 4.2. Portfolios

• A portfolio is a collection of assets

• An asset’s risk and return is important in how it
affects the risk and return of the portfolio
• The risk-return trade-off for a portfolio is
measured by the portfolio expected return and
standard deviation, just as with individual assets
– Portfolio weights
– Portfolio expected returns
– Portfolio risk
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 Portfolios Cont..

• Diversification is the process of accumulating

different securities to reduce the risk of loss.
• Portfolio risk is the total risk associated with
owning a portfolio; the sum of systematic and
unsystematic risk.
• The combination of systematic and
unsystematic risk is defined as the total risk (or
portfolio risk) that the investor bears.
 Portfolios Cont..

• Unsystematic risk may be significantly

reduced through diversification, which occurs
when the investor purchases the securities of
firms in different industries.
• The expected return on any portfolio is easily
calculated as a weighted average of the
individual securities expected returns.
• The expected return of a portfolio is the
weighted average of the returns of the
individual assets that make up the portfolio.
Portfolios Cont..
 Portfolios Cont..
• The expected return on a portfolio () is simply
the weighted average return of the individual
assets in the portfolio, the weights being the
fraction of the total funds invested in each
asset:
 Portfolios Cont..
• Suppose that Mr. Kalo invested his 7,000 Birr
on two stocks; specifically, ETB 2,000 on
stock ‘A’ and ETB 5,000 on the stock ‘B’.
Again assume that the expected return from
stock ‘A’ is 14% and expected return of stock
‘B’ is 6%. Considering these information,
calculate the expected return of the portfolio.
 Portfolios Cont..

• Given: ERA = 14%, ERB = 6%,

• wA = weight of security A = ETB2,000 / ETB7,000 =
0.286 = 28.6%
• wB = weight of security B = ETB5,000 / ETB7,000 =
0.714 = 71.4% or it is (1 - 28.6%)
• Solution:
• For two assets portfolio: ERP = (WA x ERA) + (WB x ERB)
• ERP = (0.286 x 14%) + (0.714 x 6%)
• = 4.004% + 4.288% = 8.288%
• Note: By changing the weights of assets that incorporated
in the portfolio, different portfolio returns can be achieved.
 Portfolios Cont..

• Portfolio risk is stated in terms of standard

deviation which is simply the square root of
the variance.
• Diversification: Diversification is the key to
the management of portfolio risk, because it
allows investors; significantly to lower
portfolio risk without adversely affecting
return.
 Portfolios Cont..

• The riskiness of a portfolio that is constructed

from different risky assets is a function of
three different factors:
• The riskiness of the individual assets that
make up the portfolio
• The relative weights of the assets in the
portfolio
• The degree of co-movement (correlation
coefficient) of returns of the assets making up
the portfolio
 Portfolios Cont..

• Unlike returns, the risk of a portfolio is not simply

the weighted average of the standard deviations of
the individual assets in the contribution, for a
portfolio’s risk is also dependent on the
correlation coefficients of its assets.
• The correlation coefficient () is a measure of the
degree to which two variables “move” together.
• It has a numerical value that ranges from -1.0 to
1.0.
• In a two-asset (A and B) portfolio, the portfolio
risk is defined as:
 Portfolios Cont..

. It has a numerical value that ranges from -1.0

to 1.0. In a two-asset (A and B) portfolio, the
portfolio risk is defined as:
 Portfolios Cont..

• We need 3 (three) correlation coefficients

between A and B; A and C; and B and C.
• The covariance primarily provides information
about whether the association between two
securities is positive, negative, or zero.

 p   A2 wA2   B2 wB2   C2 wC2  2wA wB  A,B A B  2wB wC  B,C B C  2wA wC  A,C A C

 Portfolios Cont..

• A portfolio consists of assets A and B. The

return, the standard deviation, and Weight of
each of these securities is given below.
 Portfolios Cont..

1. The expected return on the portfolio

2. The portfolio standard deviation
a) When the correlation b/n A & B is +1
b) When the correlation b/n A & B is -1
c) When the correlation b/n A & B is 0
d) When the correlation b/n A & B is 0.5
e) When the correlation b/n A & B is -0.5
 Portfolios Cont..
1. The expected return on the portfolio

2. The portfolio standard deviation

Portfolios Cont..
 Efficiency Frontier
• The efficient frontier describes the relationship
between the expected return of a portfolio and the
risk (volatility) of the portfolio.
• It can be drawn as a curve on a graph of risk against
expected return of a portfolio.
• The efficient frontier shows the best return that can be
expected for a given level of risk or the lowest level
of risk needed to achieve a given expected rate of
return.
 Efficiency Frontier
• While the efficient frontier gives all the best
attainable combinations of risk and return, it
does not tell which of the possible
combinations an investor will select.
• That selection depends on the individual’s
willingness to bear risk.
• The combining of the efficient frontier and the
willingness to bear risk determines the
investor’s optimal portfolio.
 Efficiency Frontier
• The Efficient Set of Investments
• the boundary line BCDE defines the efficient set of
portfolios, which is also called the efficient frontier
 Capital Assets Pricing Model (CAPM)

 The capital asset pricing model is a model that relates

the risk measured by beta to the level of expected rate
of return on a security.
 The model is also called security market line(SML)
given as follows:

Where, r=required rate of return

rf = risk free rate (eg. rate of t-bill)
rm = market rate of return
β = an index of non diversifiable risk
 Pictorial Result of CAPM
• if b = 0, asset is risk free
• if b = 1, asset risk = market risk
• if b > 1, asset is riskier than market index
 b < 1, asset is less risky than market index
 Example
 Assuming that the risk free rate is 8% and the
market rate is 12%, calculate the rate of return
for specific security if the beta coefficient has
the following values and draw the security
market line
1. β=0
2. β = 0.5
3. β =1.0
4. β =1.5
5. β =2.0
 Example
• The Security Market Line
 Example
• Assuming that the risk-free rate is 8 percent,
and the expected return for the market is 12
percent, then if
The Arbitrage Pricing Model (APM)
• The CAPM assumes that required rates of
return depend only on one risk factor, the
stock’s beta. The Arbitrage Pricing Model
disputes this and includes any number of risk
factors.
The Arbitrage Pricing Model (APM)
• END
• Arbitrage is the act of buying a good or
security and simultaneously selling it in
another market at a higher price.
 What is Beta(β)?
β is a measure of the security volatility relative to the
average security in the market. It is given by the following
formula

Where:
– M = r m – rf
– K = ri – rf
– n= number of years
 What is Beta(β)?
Compute the beta coefficient using the following
data for stock x and the market portfolio.
Assume that the risk free rate is 6%.
• Solution