Risk and Rates of Return

Financial Management 1 Second Semester AY 2012-2013

ACM

Investment
Can be delimited into 1. stand-alone as if invested only in one type of asset 2. portfolio invested in various kinds/types of asset grouped in a set

Return
Can be understood as earnings or profit The rate of return on an investment can be calculated as follows:
Return =

________________________
Amount invested

(Amount received Amount invested)

Return can be understood from the context of investment

How do returns behave?

Certain assets have fixed return (i.e. does not change over the life of the asset) Certain assets have non-fixed returns (i.e. changes in response to various factors such as market, internal governance, stability of supply, etc.)

So how do we show return in a single numerical figure?

For fixed income assets/investments the expected return is the promised return itself
take for instance the case of Treasury securities

For non-fixed income assets/investments the overall expected return is the average of expected returns throughout the term of the investment
take the case of a share of stock from a start-up company

 The proponents of the start-up company promised the following:

Year 1st Year
2nd Year 3rd Year 4th Year

Expected Return 12%

12% 14% 18%

Therefore the expected return over 4 years is (12+12+14+18) / 4 = 14% or the average of the expected returns of the life

 Sometimes, the expected return may be determined in relation to certain factors. Taking the previous example, the proponents showed that the returns may be expected in this fashion:
Demand Equivalent / Specific Return 37% 16% -8% Probability of Occurring 17% 56% 27% Expected return 6.29% 8.96% -2.16 13.09

High Normal Low

Expected Return
Therefore, we can infer that the expected return on an investment is based on the average or the sum of the weighted-average of the various specific possible returns.

How is return related to risk?

Not all returns are fixed. There are various instances when the return is high, normal or low (negative or loss). Certain factors drive the return to become high, normal or low. Naturally, an investor would want a high or normal return. However, what are the chances that an investment would have a low return or incur a negative profit?

Look at various return factors

The following shows a table of some of the possible factors that have impact on an investments return:
Factors affecting profit, income or return Supply and demand (market dynamics) Local political environment

Regional political environment Operations (production)

Governance issues Brand recognition

Now lets add specific situations

Factors affecting profit, income or return Supply and demand (market dynamics) Local political environment Regional political environment Operations (production) Specific situation Bleak or low demand Unstable political situation Regional deadlock on trade issues Work stoppage or labor strike

Governance issues
Brand recognition

BoD sanctioning top officers

Image model involved in scandalous affairs

 The foregoing factors are summarily paired with negative specific situations. Such factors then take their toll on the expected return (i.e. the return becomes low or incurs losses). Risk, then, can be inferred in laymans term as what are the chances that a specific situation create a negative factor?

Merging the concepts of risk and return

Therefore, RISK is a chance that a return factor creates a NEGATIVE impact on the expected investment RETURN.

Investment Risks
Concepts of: Investment + Risk = Investment Risks Stand alone risk associated with an asset when such asset is held individually Portfolio risk associated with an asset when such asset is held together with other assets in a particular set, group or portfolio

Risk
Risk manifests in various ways as provided in the previous example. An essential element of risk is PROBABILITY or the chance of an event to occur. Mathematically, risk can be associated with variance or the variability of a particular distribution set.

Risk
For example:
A Interest rate on bonds issued by a steel manufacturing company 18% B Expected profits of a pharmaceutical company developing dengue vaccines (investment in common stock) -9% 9%

54%

Now find the average return of the pharmaceutical company (assuming equal chances of earning each of the expected profits)

Risk
With the knowledge that risk can be stated in terms of probability, several finance theories have utilized STANDARD DEVIATION as its (risk) numerical manifestation. Descriptive statistics postulates that given two sets of data with similar means but different standard deviation, the set with a higher standard deviation has a higher degree of variability of data.

Risk
Given the example above, various circumstances, investment A has zero standard deviation. On the other hand, investment B has some degree of standard deviation.

How do we compute standard deviation in a stand alone investment?

Standard deviation
Variance 2
n

)2 Pi (k i k
i1

 In our previous example, we assume that the expected profits of the pharmaceutical company occur in equal chances:
Conditions Expected profits
-9% 9% 54% 18% 702

Deviation

Deviation Squared
729 81 1,296

Deviation Squared x Probability

243 27 432

Weak Normal Strong Average Sum (Variance)

-27% 9% 36%

 We will now get the square-root of the sum of the variances:

702 26.5

Risk Aversion
Thinking rationally as an investor, which investment option would you choose? OF COURSE, THE PRIMARY OPTION WOULD BE TO INVEST ON THE BONDS EARNING ASSURED PROFIT RATHER THAN THE STOCKS WITH CHANCES OF LOSING.

Risk Aversion
Given two investment options with similar expected returns, a rational investor would choose the investment option which is less riskier (more assurance).