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QUARTER 4- M2

MEASUREMENT OF INVESTMENT RISK

LEARNING OBJECTIVES

Familiarize the ways to measure

investment risks

Identify the types of investment

risks

Apply in simple case problems ways

to measure investment risk
GUIDE QUESTIONS
 BASIC CLASSIFICATION OF RISK

SYSTEMATIC RISK UNSYSTEMATIC RISK

Noa Schumacher
CEO Of Liceria & Co.
 WHAT IS SYSTEMATIC RISK?

non-controllable risk or undiversifiable

risk
. results from forces outside of the firm’s
control
TYPES OF SYSTEMATIC RISK

01 Currency Risk

02 Equity Risk -

03 Inflation Risk-

04 Country Risk

05 Interest Rate Risk

06 Purchasing power risk

Event Risk
 WHAT IS UNSYSTEMATIC RISK?

controllable risk or diversifiable risk.

represents the portion of a security’s risk that
can be controlled through diversification.
TYPES OF UNSYSTEMATIC RISK

01 Principal Risk

02 Compliance risk

03 Liquidity Risk

04 Call Risk

05 Business Risk
ILLUSTRATION
WHAT ARE MEASUREMENT OF INVESTMENT RISK?

The Standard Deviation Required Rate of Return

Noa Schumacher
CEO Of Liceria & Co.
 STANDARD DEVIATION

In Statistics
 , refers to how much variation is in the data
 outlines how much the data points differ from the
mean (average

IN FINANCE
 helps determine the risk associated with stocks
 A high standard deviation of stocks often indicates a riskier investment, while a low
standard deviation often indicates a safer investment.

Financiers use the standard deviation of stocks to determine the

returns' potential variation, or standard deviation. Using the
potential range in returns and the level of risk, investors can
compare different stocks and make well-informed decisions about
 STANDARD DEVIATION
statistical measure of the variability of a
probability distribution around its expected
value
smaller standard deviation tells that
the data points tend to be very close to
the mean and therefore have a lower
risk

high standard deviation shows that the data points are far
from the mean and therefore has a higher risk.
FORMULA

INTERPRETATION
STEPS IN COMPUTATION OF STANDARD
DEVIATION
RISK MEASURE ON PROBABILITY
SAMPLE PROBLEM

Assume that Montag Corporation is considering the possible rate of return that
it might earn next year on a P500,000 investment on the stock of BCD and EFG.
The future returns depend on the state of the economy with the corresponding
probability distribution.
BCD COMPANY
STATE OF ECONOMY RETURN (

RECESSION -8.0% O.15

NORMAL 15% 0.70
PROSPERITY 35% 0.15
SAMPLE PROBLEM

EFG COMPANY
STATE OF ECONOMY RETURN (

RECESSION -5.0% O.12

NORMAL 10% 0.60
PROSPERITY 30% 0.12
SOLUTION

STEP 1: AVERAGE RETURN FOR BCD

STATE RETURN PROBABILITY AVERAGE RETURN

RECESSION -8.0% 0.15 = -0.0120

NORMAL 15% 0.70 = 0.1050

PROSPERITY 35% 0.15 0.0525

TOTAL=0.1455
SOLUTION
STEP 2:Subtract the expected average return from each individual expected
return

STEP 3:Square the difference:

STEP 4: Get the summation of the squared difference multiplied to the probability

STEP 5: Get the square root of the summation from number (4).

= 0.1179 0r 11.79%
SOLUTION

STEP 1: AVERAGE RETURN FOR EFG

STATE RETURN PROBABILITY AVERAGE RETURN

RECESSION -5.0% 0.12 -0.0060

NORMAL 10% 0.60 0.0600

PROSPERITY 30% 0.12 0.0360

TOTAL=0.0900
SOLUTION
STEP 2:Subtract the expected average return from each individual expected
return

STEP 3:Square the difference:

STEP 4: Get the summation of the squared difference multiplied to the
probability

STEP 5: Get the square root of the summation from number (4).
 LETS TRY

1. Compute for expected return

2. Compute for standard deviation
RISK MEASURE- SINGLE Asset
Measures the variance & standard deviation of returns
 EXAMPLE
YEAR STOCK X

2015 16.25%

2016 19.50%

2017 13.80%

2018 25.50%

2019 9.20%

1. Compute the expected risk on these returns

2. Compute the standard deviation
 SOLUTION
STEP 1- Get the mean of Stock X

16.25% +19.50% +13.80 +25.50% +9.20%/5

=16.85%
 SOLUTION
STEP 2- Get the difference of each return and mean
YEARS DIFFERENCE PERCENTAGE

1 16-25%-16.85% -0.6%

2 19.50%-16.85% 2.65%

3 13.80%-16.85% -3.05%

4 25.50%-16.85% 8.65%

5 9.20%-16.85% -7.65%
 SOLUTION
STEP 3- Get the squared difference
YEARS DIFFERENCE PERCENTAGE

1 16-25%-16.85% (-0.6%)2
2 19.50%-16.85% (2.65%)2
3 13.80%-16.85% (-3.05%)2
4 25.50%-16.85% (8.65%)2
5 9.20%-16.85% (-7.65%)2
 SOLUTION
STEP 4- ADD the squared difference

YEARS PERCENTAGE

1 (-0.6%)2 .000036

2 (2.65%)2 .00070225

3 (-3.05%)2 .00093025

4 (8.65%)2 .00748225

5 (-7.65%)2 .00585225

SUM= 0.015003
 SOLUTION
STEP 5- Divide the number of periods

SUM= 0.015003
SD= = 0.015003/5 YRS
0.0030006

SD=.054777733

Coefficient of Variation= SD/ Rm

==.054777733/16.85%
=.32504
MEASUREMENT OF SYSTEMATIC
RISK
 REQUIRED RATE OF RETURN

determining the appropriate required rate of return of an individual asset or

a portfolio for different levels of risks.

Capital Asset Pricing Model (CAPM), also called security market line (SML), it is a model developed to help
determine a share’s required rate of Return for a given level of risk.

Noa Schumacher
CEO Of Liceria & Co.
HOW TO COMPUTE REQUIRED RATE OF RETURN
 EXPLANATION

Risk-free rate represents the interest an investor would expect from an absolutely
risk-free investment over a specified period of time.

Beta is a measure of the sensitivity of a security’s return relative to the returns of broad-based
market portfolio securities. It measures the movement between a stock and the market portfolio.

An asset that has a beta equivalent to 1 has the same market. A beta whose value is less than 1 has
a lesser risk than the market and a value greater than 1 has a greater risk than the market.
HOW TO COMPUTE REQUIRED RATE OF RETURN
 EXAMPLE

Mr. Perez considers investing in SMC stocks. The risk-free rate is 9%,
the expected rate of return on the market is 12% and SMC stock has a
beta of 0.75. What is the required rate of return of SMC stock?
 SOLUTION

= 0.09 + 0.75(0.12 −.09)

= 0.1125 or 11.25%
 LETS TRY

D Company has a beta coefficient of 1.6. The current rate of

return on treasury securities is 9 %. Analysts estimate the return on the market po
to be 13 %.
 PROBLEM

Risk free rate=2.5%

Expected market return=8.0%
Equity risk premium=5.5%
 PROBLEM

COMPANY RETURNS PROBABILITY

IBM -22% 10%
MARKET -2% 20%
USR 20% 40%
T-BILL 35% 20%
SHELL 50% 10%
Thank
You
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