RISK AND RETURN: AN OVERVIEW OF CAPITAL MARKET

THEORY – Chapter 4

Lecture 5
(Based on IM Pandey’s book on Financial Management)

MSESPM
Prof. Amrit Nakarmi
02 Jan 2020

04/13/2020 1
LEARNING OBJECTIVES
Discuss the concepts of average and expected rates of
return.
Define and measure risk for individual assets.
Show the steps in the calculation of standard deviation
and variance of returns.
Explain the concept of normal distribution and the
importance of standard deviation.
Compute historical average return of securities and market
premium.
Determine the relationship between risk and return.
Highlight the difference between relevant and irrelevant
risks.

2
Return on a Single Asset

Total return = Dividend + Capital gain

Rate of return  Dividend yield  Capital gain yield

DIV1 P1  P0 DIV1   P1  P0 
R1   
P0 P0 P0

3
Return on a Single Asset
Year-to-Year Total Returns on HUL Share

50
40.94
40 36.99

30
21.84
Total Return (%)

20 15.65
10.81 12.83
10 2.93
0
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
-10 -6.73

-20 -16.43

-30 -27.45

-40
Year

4
Average Rate of Return
The average rate of return is the sum of the various
one-period rates of return divided by the number of
period.
Formula for the average rate of return is as follows:

n
1 1
R = [ R1  R 2    R n ] 
n n
R t
t =1

5
Risk of Rates of Return: Variance and
Standard Deviation

Formulae for calculating variance and standard

deviation:

Standard deviation = Variance

1 n
 
2
Variance   
2

n  1 t 1
Rt  R

6
Investment Worth of Different Portfolios,
1980-81 to 2007–08

7
HISTORICAL CAPITAL MARKET RETURNS

Year-by-
Year
Returns
in India:
1981-
2008

8
Averages and Standard Deviations, 1980–81 to
2007–08

*Relative to 91-Days T-bills.

9
 Historical Risk Premium
The 28-year average return on the stock market is higher by
about 15 per cent in comparison with the average return on
91-day T-bills.

The 28-year average return on the stock market is higher by

about 12 per cent in comparison with the average return on
the long-term government bonds.

This excess return is a compensation for the higher risk of

the return on the stock market; it is commonly referred to as
risk premium.

10
 Expected Return : Incorporating Probabilities in
Estimates
 The expected rate of return [E (R)] is the sum of the product of each outcome
(return) and its associated probability:
Rates of Returns Under Various Economic Conditions

Returns and Probabilities

11
Cont…
The following formula can be used to calculate the
variance of returns:

 2   R1  E  R 2   P1   R2  E  R 2   P2  ...   Rn  E  R 2   Pn
n
   Ri  E  R 2  Pi
i 1

12
Example

13
Expected Risk and Preference
A risk-averse investor will choose among investments
with the equal rates of return, the investment with lowest
standard deviation and among investments with equal risk
she would prefer the one with higher return.

A risk-neutral investor does not consider risk, and would

always prefer investments with higher returns.

A risk-seeking investor likes investments with higher risk

irrespective of the rates of return. In reality, most (if not
all) investors are risk-averse.

14
Risk preferences

15
Normal Distribution and Standard Deviation

In explaining the risk-return relationship, we assume

that returns are normally distributed.
The spread of the normal distribution is
characterized by the standard deviation.
Normal distribution is a population-based, theoretical
distribution.

16
Normal distribution

17
Properties of a Normal Distribution
The area under the curve sums to 1.
The curve reaches its maximum at the expected value
(mean) of the distribution and one-half of the area lies on
either side of the mean.
Approximately 50 per cent of the area lies within ± 0.67
standard deviations of the expected value; about 68 per
cent of the area lies within ± 1.0 standard deviations of the
expected value; 95 per cent of the area lies within ± 1.96
standard deviation of the expected value and 99 per cent
of the area lies within ± 3.0 standard deviations of the
expected value.

18
Probability of Expected Returns
The normal probability table, can be used to determine
the area under the normal curve for various standard
deviations.
The distribution tabulated is a normal distribution with
mean zero and standard deviation of 1. Such a distribution
is known as a standard normal distribution.
Any normal distribution can be standardised and hence
the table of normal probabilities will serve for any normal
distribution. The formula to standardise is:
S = R - E ( R)
s

19
Example
 An asset has an expected return of 29.32 per cent and the
standard deviation of the possible returns is 13.52 per cent.
 To find the probability that the return of the asset will be zero or
less, we can divide the difference between zero and the expected
value of the return by standard deviation of possible net present
value as follows:

 S = 0 - 29.32 = – 2.17
13.52

 The probability of being less than 2.17 standard deviations from

the expected value, according to the normal probability
distribution table is 0.015. This means that there is 0.015 or 1.5%
probability that the return of the asset will be zero or less.

20
Assignment
Page
1,3,4,6,8,10, 11, 13 & 15.

21