CHAPTER-6

RISK AND RETURN

• Risk and Return Fundamentals

• To maximize share price, the financial manager must
learn to assess two key determinants, risk and return.

• Risk: the chance of financial loss or more formally, the

variability of return associated with a given asset –
uncertainty.

• Return: the total gain or loss experienced on an

investment over a given period of time.
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• Return is commonly measured as a cash distribution
during a period plus the change in value.

• The equation for calculating the rate of return earned

on any asset over a period of time t is:
Kt = Ct + Pt – (Pt -1)
Pt -1
Kt = actual, expected, or required rate of return during period t; Ct =cash flow received from the
asset investment in the time period t-1 to t; P t = price (value) of asset at
time t; Pt -1 = price (value) of asset at time t – 1.

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• Example: ABC Co. wishes to determine the return
on two of its video machines, A and B. A was
purchased one year ago for $20,000 and currently
has a market value of $21,500. During the year, it
generated $800 of after tax cash receipts. B was
purchased 4 years ago; its value in the year just
ended declined from $12,000 to $11,800. During
the year it generated $1,700 after tax cash
receipts. Calculate the annual rate of return for
each video machine.
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• Solution:
• Return (Kt) on A=800 + 21,500 –20,000 =11.5%
20,000
• Return (Kt) on B=1,700+11,800-12,000 =12.5%
12,000
Video B’s return is better than video A’s return.

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 Risk of a single asset
• Risk assessment: sensitivity analysis and probability
distribution can be used to assess the general level of
risk embodied in a given asset.
• i) Sensitivity analysis: is the use of several possible
return estimates to obtain a sense of variability
among outcomes.
• One common method is making pessimistic (worst),
most likely (expected), and optimistic (best) estimates
of the returns associated with a given asset.
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• The asset’s risk is measured by the range of
returns.

• The range is found by subtracting the

pessimistic from the optimistic

• The greater the range, the more variable, or

the more risk the asset is said to have.
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• Example: X Co. wants to choose the better of two
investments, A and B. Each requires an initial
investment of $10,000, and each has a most likely
annual rate of return of 15%. Management has the
following pessimistic and optimistic estimates of return:
Asset A Asset B
initial investment $10,000 $10,000
pessimistic 13% 7%
most likely 15% 15%
optimistic 17% 23%
Range (17 -13) 4% 16% (23-7)
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• Asset A is less risky than B. thus, A is preferable.
• ii) probability distribution: chance of occurring of
a given outcome.
• Gives a more quantitative insight in to an asset’s
risk
• Example: X company’s past estimates indicate
that the probabilities of pessimistic, most likely,
and optimistic outcomes are 25%, 50%, and 25%

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• Standard deviation and coefficient of variation
can be used to measure the variability of
return.
• Standard deviation- measures the dispersion
around the expected value – the most likely
value.
• Expected value is the summation of the
product of return and its probability.

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• Expected values of return for X Co. assets (A and B):
• Asset A
Possible probability return weighted value
outcome (1) (2) (1*2)

Pessimistic 0.25 13% 3.25%

Most likely 0.50 15% 7.5%
Optimistic 0.25 17% 4.25%
Total 1 expected return 15%

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• Asset B:
Possible probability return weighted value
outcome (1) (2) (1*2)
Pessimistic 0.25 7% 1.75%
Most likely 0.50 15% 7.50%
Optimistic 0.25 23% 5.75%
Total 1 expected return 15%
•
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• Standard deviations for X Co. assets’ return:
• Asset A
Return expected (1-2) (1-2)2 pro. (1-2)2pro
(1)
value(2)
13% 15% -2 4 0.25 1
15% 15% 0 0 0.50 0
17% 15% 2 4 0.25 1
• Variance (∂2) = 2%
• standard deviation (∂) = √2 = 1.41%
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• Asset B:
Return expected (1-2) (1-2)2 pro. (1-2)2pro
(1)
value(2)
7% 15% -8 64 0.25 16%
15% 15% 0 0 0.50 0
23% 15% 8 64 0.25 16%
Variance (∂2) = 32%

standard deviation (∂) = √32 = 5.66%

Note: the higher the s. deviation the greater is the risk and thus,
Asset B is riskier than asset A.
 c/variation (CV) is relative measure and thus, it should be
considered in risk assessment. CV = SD/expected value
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• In normal probability distribution:
• 68% of the possible outcomes lies b/n +/- 1 st.
deviation from the mean;

• 95% of the possible outcomes lies b/n +/- 2 st.

deviation from the mean;

• 99% of the possible outcomes lies b/n +/- 3 st.

deviation from the mean;
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• In case of X Co. assets:
• Asset A:
• 68% of the possible outcome is b/n 15% -1.41%
and 15%+1.41% = 13.59% and 16.41%
• 95% of the possible outcome is b/n 15% -2*1.41%
and 15%+2*1.41% =12.18% and 17.82%
• 99% of the possible outcome is b/n 15% -3*1.41%
and 15%+3*1.41% = 10.77% and19.23%
 The same procedure is followed for Asset B.
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B) Risk of a Portfolio:
• A portfolio is a bundle or a combination of individual
assets or securities.
• Portfolio theory:
-Risk averse investors normally hold well
diversified portfolio;
-The return of securities is normally distributed;
-The return of a portfolio is the weighted average
of the return of each individual asset/securities.

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• Example: suppose you have an opportunity of investing your
wealth in asset X and asset Y. The possible outcomes of the
assets in different status of economy are given below:
Status of economy probability return (%)
X Y
A 0.1 -8 14
B 0.2 10 -4
C 0.4 8 6
D 0.2 5 15
E 0.1 -4 20

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• Expected rate of return for individual asset:
X =(.1)(-8)+(.2)(10)+(.4)(8)+(.2)(5)+(.1)(-4) = 5%
Y= (.1)(14)+(.2)(-4)+(.4)(6)+(.2)(15)+(.1)(20) =8%
• Assume you decided to invest 50% of your
wealth in X and 50% in Y. what is your
expected rate of return on a portfolio
consisting X and Y.

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• Solution:
Status of probability combined expected
economy(1) (2) return(3) return(2*3)
A 0.1 .5* -8+.5*14=3 0.3
B 0.2 .5*10 +.5*-4=3 0.6
C 0.4 .5* 8+.5*6 = 7 2.8
D 0.2 .5*5+.5*15 = 10 2.0
E 0.1 .5*-4 +.5*20 =8 0.8
Or 0.5*5%+0.5*8% = 6.5%
The expected return of the portfolio is 6.5%. Standard deviation of
a portfolio can be calculated in the same way as a standard
deviation of single asset
 Portfolio risk is determined by the magnitude and direction of
the correlation of anyTamrat
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of the assets
Hawassa in the portfolio.
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• Correlation: is a statistical measure of the
relationship b/n any two series of numbers.

• If the series move in the same direction, they are

positively correlated. If the series move in
opposite direction, they are negatively correlated.

• Correlation coefficient(CC): a measure of the

degree of correlation b/n two series.
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• If CC = +1, the two series are perfectly +vely
correlated.
• If CC = -1, the two series are perfectly –vely
correlated. If CC = 0, no correlation.
• CC (XY) = covariance XY
(st. deviation X)(st. deviation Y)
As we move from perfect +ve correlation to
uncorrelated assets to perfect –ve correlation,
the ability of reducing risk is improved.
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• Covariance of XY for the above example:
Status of proba. return deviation from product
economy exp. Return of deviats.
X Y X Y &probab.
A 0.1 -8 14 -13 6 -7.8
B 0.2 10 -4 5 -12 -12.0
C 0.4 8 6 3 -2 -2.4
D 0.2 5 15 0 7 0.0
E 0.1 -4 20 -9 12 -10.8
covariance = -33
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• Standard deviation for X:
• Variance (∂2)= 0.1(-8-5)2 +0.2(10-5)2+0.4(8-
5)2+0.2(5-5)2+0.1(-4-5)2 = 33.6%
• St. deviation(∂) = √33.6 = 5.8%
• St. deviation for Y:
Variance (∂2)=0.1(14-8)2 +0.2(-4-8)2+0.4(6-
8)2+0.2(15-8)2+0.1(20-8)2 = 58.2%
• St. deviation(∂) = √58.2 = 7.63%
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• Therefore,
• Coefficient of correlation = -33 = -0.746
5.8% *7.63%
• Thus, security X and Y are negatively
correlated.
• If an investor invests in the combination of
these securities, he/she can reduce risk.

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