ESTIMATING RISK AND RETURN

ON ASSETS
BASIC RISK AND RETURN CONCEPT
Risk is the variability of an asset’s future return. Risk refers
also to the chance that some unfavorable event will occur.
Risk is present whenever future outcomes are not completely
certain or unpredictable. From an investor’s viewpoint, the
uncertainty of, or variability in, an asset’s future return
creates risk.
To illustrate the riskiness of financial assets
An investor buys P 1,000,000 of short-term government bonds
with an expected return of 10%. In this case, the rate of return
on the investment, 10% can be estimated quite precisely and
the investment is defined as being risk-free. However, if the P
1,000,000 were invested in the stock of a company just being
organized to prospect for oil in the Mid-Pacific, then the
investments’ return could not be estimated precisely and the
stock would be describe as relatively risky.
RISK AND RETURN
RELATIONSHIP
RISK AND RETURN RELATIONSHIP
Investment risk, then is related to the probability of
actually earning less than the expected return- the
greater the chance of low negative returns, the riskier the
investment. Very low risk investment also provide very low
return.
Investors take on higher risk investments in
expectation of earning higher returns.
RISK AND RETURN RELATIONSHIP
Business also take on risky capital investment. Both
investor and business sentiments create positive
relationship between risk and expected return.
Taking risk also means that the investor does not get a
guarantee that the investment will be recouped. In the
short run, higher risk investments often significantly
underperform lower risk investments
RISK AND RETURN RELATIONSHIP
Companies and investors should expect higher risk
investments to earn higher returns over the long term (many
years). In addition, not all forms of risk are rewarded.
An investor can use historical information to characterize
past returns and risks, to be able to diversify investment to
eliminate some risk and expect the highest return possible for
desired risk level.
PROBABILITY &
PROBABILITY DISTRIBUTION
Probability is the percentage chance that an event will
occur.
If all possible events or outcomes are listed, and the
probability is assigned to each event, the listingis called
Probability Distribution
E.g. A senatorial candidates states, " There is a 40%
chance that I will lose the election and 60% chance that I
shall win. "
• An Objective Probability Distribution is generally
based on past outcomes of similar events.
• A Subjective Probability Distribution is based on
opinions or "educated guesses" aboit the likelihood that
an event will have a particular future outcome.
• A Discrete Probability Distribution is an arrangement of
the probabilities associated with the valuesof a variable
that can assume a limited or infinite number of values
(outcomes).

• A Continuous Probability Distribution is an

arrangement of probabilities associated with the values of
a variable that can assume an infinite number of possible
values (outcomes).
The flatter or the less peaked the probability distribution
of expected future returns, the higher the risk of the
project.
The Range of the probability distribution is the difference
between the highest and lowest possible outcome. A flat
probability distribution has a wider range than peaked
distribution.
To illustrate, assume that two investment prospects are
available to Mr. Martin who has P100,000 investible
funds. He is considering the following.:

• Investment in X'OR Products Inc., a manufacturer and

distributor of computer terminals and equipment for a
rapidly growing data transmission industry : or

• Investment in Zamboanga Electric Company which

supplies an essential service.
Expected Portfolio Return
• Is the weighted average of the expected returns from the
individual assets in the portfolio
Illustrative Case 22-1. Calculation of Expected Return

• Nokus properties is evaluating two opportunities, each

having the same initial investment. The project’s risk and
return characteristics are shown below:

Project Project
E F
Expected Return 0.10 0.20

Proportion Invested in each project 0.50 0.50

Using the formula above, the expected return of portfolio
combining Project E and Project F is:

E(Rp)= (0.5)(0.10)+(0.5)(0.20)= 0.15 or 15%

STANDARD DEVIATION
• Standard deviation, σ (pronounced “sigma”), is a

statistical measure of the variability of probability

distribution around its expected value.
• The standard deviation can be used as a measure of

the amount of absolute risk associated with an

outcome.
• Absolute risk does not consider the relationship of

the variability of outcomes to its expected value.

• Standard deviation also measures the tightness of

a probability distribution.

• A tight probability distribution is one in which the set

of possible returns is close to the expected value of

the returns. If a probability distribution is tight, then
the range or difference between the highest and
lowest value in the distribution will be relatively
small. Thus, the smaller the standard deviation, the
tighter the probability distribution, the smaller the
range of returns, and the lower the risk.
 Symmetrical distribution is one in which each half
of the distribution is a mirror image of the other half.

 Skewed distribution is a distribution which is not

symmetric.
The standard deviation is calculated as follows:

1. Compute the expected value (ȓ).

2. Subtract the expected value from each possible

return to obtain the deviations (ri - ȓ).

3. Square each deviation (ri - ȓ) 2.

4. Multiply each squared deviation by its probability of

occurrence, and then add. The result is called the

variance (σ2), which is the standard deviation

squared.

5. Take the square root of the variance to get the

Illustrative Case
Computation of Standard Deviation for X’OR
Products, Inc.
(1) The expected rate of return as
previously computed is 15% (ǩ).
(2)
ki - ǩ
100% - 15% = 85%
15% - 15% = 0
-70% - 15% = -85%
(3)
(ki – ǩ)2
7,225%
0
7,225%
Variance
(4)
(ki – ǩ)2 Pi
(7,225%) (0.3) = 2,167.5%
(0) (0.4) = 0.0
(7,225%) (0.3) = 2,167.5%
4,335.0%
(5) Standard Deviation (σ)
= √4,355%
= 65.84%
 X’OR PRODUCTS, ZAMBOANGA
INC. ELECTRIC
COMPANY

65.84% 3.87%

• The larger standard deviation indicates a greater

variation in returns, thus a greater chance that
expected return will not be realized.
•Therefore, X’OR Products would be considered a
riskier investment than Zamboanga Electric
according to this measure of risk.
ILLUSTRATIVE CASE
22-3
ILLUSTRATIVE CASE 22-3
Suppose the following projections are available for three
alternative investments in equity shares (stock).
ILLUSTRATIVE CASE 22-3
Required:
1. What would be the expected return on a portfolio with
equal amounts invested in each of the three stocks
(Portfolio 1)?
2. What would be the expected return if half of the
portfolio were in (1) with the remainder equally divided
between B and C (Portfolio 2)?
SOLUTION
1. Expected Return on Portfolio 1
(A = 1/3; B = 1/3; C = 1/3)

a. Portfolio Expected Return (Boom)

= (1/3)(10%)+(1/3)(15%)+(1/3)(20%)
= 3.33% + 5% + 6.67%
= 15%
b. Portfolio Expected Return (Recession)
= (1/3)(8%)+(1/3)(4%)+(1/3)(0%)
= 2.67% + 1.33%
= 4%
SOLUTION
Expected return on the Portfolio
= (.40)(15%) + (.60)(4%)
= 6% +2.4%
= 8.4%
SOLUTION
1. Expected Return on Portfolio 2
(A = 50%; B = 25%; C = 25%)

a. Portfolio Expected Return (Boom)

= (.50)(10%)+(.25)(15%)+(.25)(20%)
= 13.25%
b. Portfolio Expected Return (Recession)
= (.50)(8%)+(.25)(4%)+(.25)(0%)
= 5%
SOLUTION
Expected return on the Portfolio
= (.40)(13.75%) + (.60)(5%)
= 5.5% + 3%
= 8.5%
ILLUSTRATIVE CASE
22-4
ILLUSTRATIVE CASE 22-4
Using the data in Illustrative Case 22-3, the portfolio
standard deviations for Portfolio 1 and Portfolio 2 are
computed as follows:

Standard deviation – Portfolio 1

σ= (.40) (15%-8.4%)2 + (.60) (4%-8.4%)2

= (.40) (.004356) + (.60) (.001936)

= .002905

= 5.4%
ILLUSTRATIVE CASE 22-4
Standard deviation – Portfolio 2

σ= (.40) (13.75%-8.5%)2 + (.60) (5%-8.5%)2

= (.40) (.002756) + (.60) (.001225)

= .0018375

= 4.3%
Coefficient of variation (cv)
• It is the standardized measure of the risk
per unit of return; calculated as:
Standard Deviation____
Expected Return
Example:

X’OR Products, Inc. = 65.84% =

4.39 15%

Zamboanga Electric Company = 3.87% =

.26 15%

*The coefficient of variation provides a more meaningful basis

for comparison when the expected returns on two or more
alternatives are not the same. Based on the above
computations, X’OR Products is almost 17% riskier than
Zamboanga Electric.
•Portfolio Risk is the variability of returns of the
portfolio as a whole.

•Diversification is investing in more than

one type of asset in order to reduce risk.
• The amount of risk reduction achieved through depends on the
correlation of the individual assets’ returns with one another. This
could be measured by computing for the correlation coefficient (ρ
or rho).
• It ranges from +1.0 to -1.0

ρ = +1.0 (perfectly positively correlated)

ρ = -1.0 (perfectly negatively correlated)
ρ = 0, the two variables are uncorrelated/ independent of each
other.

• Risk reduction is achieved through diversification whenever the

returns of the assets combined in a portfolio are not perfectly
positively correlated. In other words, greater benefits are achieved
with less positive or more negative correlation among asset
returns.
The following formula could be used to solve for the
standard deviation of portfolio returns for a two-asset
portfolio:

Where: = proportion invested in asset 1

= proportion invested in asset 2
= standard deviation of asset 1
= standard deviation of asset 1
= correlation coefficient between asset 1
and 2
RISK
PREFERENCES
 Required rate of return - The actual amount of
compensation demanded, is influenced by the individual
decision maker’s attitudes toward risk. Thus, decision
makers have different required rates of return for the
same investment because their risk preferences differ.
Classification of Decision Makers
1. Risk-averse investors are those that require higher rates
of return on higher-risk securities. They are unwilling to
pay an amount as much as the expected value of an
uncertain investment. Risk averse investors are willing to
accept greater risk provided that the return is sufficiently
high. Most investors in stocks and bonds are risk averse.
Classification of Decision Makers
2. Risk-neutral decision makers are willing to pay the
expected value.

3. Risk-takers investors are willing to pay more than the

expected value.
Illustrative Case: Risk-Averse, Risk-Neutral
and Risk-Taker Decision Makers
The following data are available for Projects A and
B
 A risk averse investor would select Project A
because it involves the same expected return as
Project B but has less risk. A risk neutral would be
indifferent between the two investments. A risk
taker would prefer Project B. Although the
expected value of each project is equal, Project B
has a greater potential return and more risk. That
is, with a strong economy the maximum return for
Project B is P1,800 compared with only P1,200 for
Project A. The risk averse would be unwilling to
pay Project B’s expected value of P1,000. A risk
neutral investor would be willing to pay exactly
P1,000 and a risk taker would be willing to pay
more than the expected value.
RISK AND RETURN OF A PORTFOLIO
Until this point, risk-return analysis has focused on both
a single asset and a portfolio or collection of two or more
assets. Portfolio theory
involves a selection of efficient portfolios. An efficient
portfolio provides the highest return for a given level of risk
or the least risk for a given level of return. While portfolio
theory originated in the context of financial assets such as
investment in equity shares, the general concepts also
apply to physical assets such as the capital budgeting
projects.