Financial Management-I Chapter-4

CHAPTER FOUR
BASICS OF RISK AND RETURN
4.1. Definition of Risk and Return

Return is the total gain or loss experienced on behalf of the owner of an investment over a
given period of time. It is calculated by dividing the asset’s change in value plus any cash
distributions during the period by its beginning of period investment value.
P  P C
K= t t 1
Pt-1
t

K = actual, expected, or required rate of return during period t.

Pt = price (value) of asset at time t.
Pt 1 = price (value) of asset at t-1
Ct = cash (flow) received from the asset investment in time period t-1 to t.
N.B. the return, k, reflects the combined effect of changes in value, Pt  Pt 1 or capital
gain, and cash flow, Ct or yield, realized over the period t. The beginning value, Pt 1 , and
the ending value, Pt , are not necessarily realized values.
Example: Alpha Co. wishes to determine the actual rate of return on two of its video
machines, X and Y. X was purchased exactly 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. Y
was purchased four years ago, and its value at the beginning and end of the year just ended
declined from $12,000 to $11,800. During the year it generated $1700 of after-tax cash
receipts. What is the annual rate of return on asset X and asset Y?
K X = 21, 500  20,000 800  11.5%
20,000
K = 11,800 12,000 1,700  12.5%
Y
12,000
RISK is the probability or likelihood that actual results (rates of returns) deviate from
expected returns. It is the variability of returns associated with a given investment. The
word risk is usually used interchangeably with uncertainty. Behavioral Assumptions

Some assumptions are needed to describe the way in which financial managers evaluate
risky projects. There are three attitudes toward risk.
1. Risk indifferent – the attitude toward risk in which no change is required for an
increase in risk.
2. Risk averse - the attitude in which an increased return would be required for an
increase in risk. Because managers with this attitude shy away from risk, they
require higher returns to compensate them for taking greater risk.
3. Risk seeking is the attitude toward risk in which a decreased return would be
accepted for an increase in risk. Because they enjoy risk, managers of this attitude
are willing to give up some returns to take more risk.
In general, managers are assumed to be risk averse. i.e. they accept additional risk only if
coupled with an appropriate increase in expected return. Managerial risk aversion provides
two criteria that can be used to rank risky projects:
1. If two projects have the same expected return, the manager will prefer the one with
the lesser amount of risk.
2. If two projects have the same degree of risk, manager will prefer the one with the
higher expected return.
4.2. Measuring Risk and Return
Risk (uncertainty) has to do with the future. So to measure risk we use data from a
probability distribution. Probability distribution lists the set of possible returns that can
occur at a specific time and their associated probabilities of occurrence. Because the
possible returns are mutually exclusive, the probabilities sum to 1.0 or 100%. Probability
distributions are prepared based on past data, industry trends and ratios, and forecasts of

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the general economy of the country. From a probability distribution the following
measures are obtained.
1. expected rate of return
2. standard deviation or variance
3. coefficient of variation
N.B. under conditions of risk a separate probability distribution is used for each year.
1. Expected rate of return ( k )
The first step in measuring the desirability of a project is to compute the expected rate
of return of each probability distribution. Expected rate of return is the return expected
to be realized from an investment. It is the sum of the products of each possible
outcome times its associated probability—it is a weighted average of the various
possible outcomes, with the weights being their probabilities of occurrence. It is the
mean value of the probability distribution of possible returns.
n
k = ∑(ki )( pi ) , where, k ki = possible return in year i
i 1

pi = probability of occurrence of ki
n = number of possible returns
Example 1. Mr. Max is considering the possible rates of return (dividend yield plus capital
gain or loss) that he might earn next year on a $10,000 investment in the stock of either
Alpha Co. or Beta Co. The rate-of-return probability distributions for the two companies
are shown below.
State of the Probability of the Rate of return if the state occurs
economy state Alpha Co. Beta Co.
Boom 0.3 100% 20%
Normal 0.4 15% 15%
Recession 0.3 (70%) 10%

Required: Compute the expected rate of return on each Company’s stock.

3
k (Alpha) = ∑(ki )( pi ) = 0.3 x 100% +0.4 x 15% + 0.3 x -70% = 15%
i 1

k (Beta) = 0.3 x 20% + 0.4 x 15% + 0.3 x 10% = 15%

N.B. one assumption in probability distribution is that they are known in certainty and
the returns in successive years are independent. That is, returns in one year don’t
change as a result of the actual return in the preceding year.
2. Standard Deviation (σ)
Standard deviation is the most common statistical indicator of an asset’s risk (stand alone
risk). The standard deviation is a probability-weighted average deviation from the expected value, and
it gives you an idea of how far above or below the expected value the actual value is likely to be.
It measures the average dispersion of the probability distribution around its expected value.
It measures the variability of a set of observations, i.e. how “tightly” the probability
distribution is centered around the expected return.
n 
2
Standard deviation =  =  (k - k ) P .
i =1
i i

Example 2: assuming the data in example 1 above compute the standard deviation of each
Co. stock.
2 2 2
σ (Alpha) = (100 15) (0.3)  (15 15) (0.4)  (70 15) (0.3) = 65.84%
⇒ The probability-weighted-average deviation from the expected value for Alpha Co.
stock is 65.84%.
2 2 2
σ (Beta) = (20 15) (0.3)  (15 15) (0.4)  (10 15) (0.3) = 3.87%
⇒ Alpha has a larger standard deviation which indicates a greater variation of returns and
thus a greater chance that the expected return will not be realized. Therefore, Alpha is a
riskier investment than Beta.

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N.B. the square of σ is called variance and it indicates the same thing as σ.
3. Coefficient of variation (CV)
Another useful measure of risk is the coefficient of variation (CV), which is the standard
deviation divided by the expected return. It shows the risk per unit of return, and it
provides a more meaningful basis for comparison when the expected returns on two
alternatives are not the same:
Coefficient of variation is a measure of relative dispersion that is useful in comparing the
risk of assets with differing expected returns. It shows the risk per unit of return and it
provides a more meaningful basis for comparison when the expected returns on two
alternatives are not the same. In the above example CV is not necessary.

CV =
K
Example 3: given the following information about two assets which one is of lesser risk?
Asset X Asset Y
Expected return 12% 20%
Standard deviation 9% 10%
CV (X) = 9% = 0.75
10%
CV (Y) = 10%= 0.50
20
Asset Y would be preferred as it gives a lower amount of risk per unit of a return. If the firm
were to compare the assets solely on the basis of standard deviation, it would prefer asset X.
However, comparing the CV of the assets shows that management would be making a serious
error in choosing X over Y.
Exercise 1.Given the following probability distributions of cash flows for two projects A and B,

Project Cash flow probability

$600 0.25
A 800 0.50
1000 0.25
$400 0.10
600 0.20
B 800 0.40
1 000 0.20
1200 0.10
Required: compute: a) expected cash flow
b) Variance
c) Standard deviation
d) Which of the two projects should be selected?

Summary -Risk and Return measurement

1. Expected Rate of Return
 Weighted average of all possible outcomes
 The rate of return expected to be realized from an investment
 The mean value of the probability distribution of possible results
2. Variance
 Standard Deviation
 Measures total risk
 Coefficient of Variation
 Measures risk per unit of return
 Can be used to rank stocks based upon their risk/return characteristics
 The CV is most useful when analyzing investments that have different expected
rates of return and different levels of risk

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4.3. Portfolio Risk and return

Portfolio is a collection or a group of investment assets. If you hold only one asset, you suffer
a loss if the return turns out to be very low. If you hold two assets, the chance of suffering a
loss is reduced and returns on both assets must be low for you to suffer a loss.
By diversifying, or investing in multiple assets that do not move proportionately in the same
direction at the same time, you reduce your risk. It is the total portfolio risk and return that is
important. The risk and return of individual assets should not be analyzed in isolation; rather,
they should be analyzed in terms of how they affect the risk and return of the portfolio in
which they are included. The goal of the financial manager should be to create an efficient
portfolio, one that maximizes return for a given level of risk or minimizes risk for a given
level of return.
A. Expected return on a portfolio (k p)
Expected return on a portfolio is the average of the returns of the assets weighted by the
proportion of the portfolio devoted to each asset.
n
k p = ∑(wi )(Ki ) , where: wi = the proportion of the portfolio devoted to the i th asset
i1
th
K i = expected rates or return on the i asset
n = number of assets composing the portfolio
Example 4: consider a portfolio of three stocks A, B, and C, with expected returns of
16%, 12%, and 20%, respectively. The portfolio consists of 50% stock A, 25% stock B,
and 25% stock C. What is the expected return on this portfolio?
k p = 0.5(16%) + 0.25(12%) + 0.25(20%) = 16%
B. Portfolio risk ( p)
Unlike the expected return, the portfolio risk, as measured by its standard deviation, is not
a weighted average of the standard deviations of the assets making up the portfolio. A
portfolio’s standard deviation depends not only on the risk of the individual securities, or
assets, but also on the correlations between their returns.
Correlation (co-movement) refers to the association of movement between two numbers.
It measures the degree of linear relationship to which two variables, such as returns on two
assets, move together. Correlation takes on numerical values that range from +1 to -1.
While the positive or negative sign indicates the direction of the co-movement and the
absolute value of the correlation indicates the relative strength of the association. The
closer the correlation coefficient is to +1 or -1, the stronger the association.

 If the variables move together, they are positively correlated ( a positive correlation
 coefficient)
 If the variables move in opposite direction they are negatively correlated( a
 negative correlation)
 A correlation of 0.0 indicates that no relationship between the variables, that is
 they are unrelated.
 Correlation coefficient of +1.0 indicates that the variables move up and down
together, the relative magnitude of the movements is exactly the same (perfect
 positive correlation)
 If correlation is between 0.0 and +1.0, the returns usually move up and down
together, but not all the time. The closer the correlation is to 0.0, the lesser the two
 sets of returns move together.
 Correlation of -1.0 implies that they move exactly opposite to each other. (perfect
negative correlation)


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……… …..
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….. …. …………………. …….
….. …… …………………….. ……………..
…………. ……………………. ………………..
……………. …………..
………….
……………… ………….
………….
…

A) Positive correlation b) negative correlation c) zero correlation

∑ pi (k x  k x )(k y  k y )
CorrXY = i 1
YX
Example 5: Consider a portfolio of two investment ventures under three different
economic climates.
State of the Probability of the Rate of return
economy state
X Y
Bad 0.2 0% -10%
Average 0.6 10% 10%
good 0.2 20% 40%

Required: calculate Corrxy.

k x = 0.2(0%) + 0.6(10%) + 0.2(20%) = 10%

k y = 0.2(-10%) + 0.6(10%) + 0.2(405) = 12%

  x = (0 10) 2 (0.2)  (10 10) 2 (0.6)  (20 10) 2 (0.2) = 6.3246%

 y= (10 12) 2 (0.2)  (10 12) 2 (0.6)  (40 12) 2 (0.2) = 16%

corrxy  0.2(0 10)(10 12)  0.6(10 10)(10 12)  (20 10)(40 12) = +0.988
(6.3246)(16)

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4.4. Risk –Systematic and Unsystematic

The total risk of a portfolio, measured by its standard deviation, declines as more assets are
added to the portfolio. Adding more assets to the portfolio can eliminate some of the risk, but
not all of it. The total risk can thus be divided in to two parts: diversifiable risk and non-
diversifiable risk
1. Diversifiable risk (unsystematic risk or Company-specific risk)
Also known as "specific risk," "diversifiable risk" or "residual risk," this type of
uncertainty comes with the company or industry you invest in and can be reduced through
diversification.
It is the portion of an asset’s risk that is attributable to firm-specific, random causes, such
as strikes, lawsuits, product development, new patents, regulatory actions, and loss of a
key account. Because these events occur somewhat independently, they can be largely
diversified away so that negative events affecting one firm can be offset by positive events
for other firms. For example, news that is specific to a small number of stocks, such as a
sudden strike by the employees of a company you have shares in, is considered to be
unsystematic risk.
2. Non-diversifiable risk (systematic or market risk)
Also known as "market risk" or "un-diversifiable risk", systematic risk is the uncertainty
inherent to the entire market or entire market segment. International incidents, impact of
monetary and fiscal policies, Interest rates, recession, inflation and political events all
represent sources of systematic risk because they affect the entire market and cannot be
avoided through diversification. This risk cannot be eliminated through diversification
Systematic risk can be mitigated only by being hedged.

NB:-Diversification decreases the variability from unique risk but not from market risk.
Summary - Portfolio Risk and return, systematic and Unsystematic risk
Portfolio Risk
 Portfolio – a collection or grouping of investment securities or assets
 Efficient Portfolio
 Maximize return for a given level of risk
 Minimize risk for a given level of return
 Portfolio Return
 the expected return on a portfolio, kp, is the weighted average of the expected returns on
the individual stocks in the portfolio
 the portfolio weights must sum to 1.0
 the realized rate of return is the return that is actually earned on a stock or portfolio of
stocks
 Portfolio Risk
 the riskiness of a portfolio of securities, (p, in general is not a weighted average of the
standard deviations of the individual securities in the portfolio
 the correlation coefficient, r, is a measure of the degree of co-movement between two
variables; in this case, the variable is the rate of return on two stocks over some past
period
 the riskiness of a portfolio will be reduced as the number of stocks in the portfolio
increases; the lower the correlation between stocks that are added to the portfolio the
greater the benefits of continued diversification
 Firm-Specific, Diversifiable, or Unsystematic Risk
 That part of a security’s risk associated with random outcomes generated by events or
behaviors specific to the firm; firm-specific risk can be eliminated by proper
diversification
 Market, No diversifiable, or Systematic Risk
 That part of a security’s risk that cannot be eliminated by diversification because it is
associated with economic or market factors that will affect most firms

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