Learning Objectives

After you read this chapter, you should be able to

answer the following questions:
 What do we mean by risk, and what are some of the
alternative measures of risk used in investments?
 What do we mean by risk and risk aversion?
 How do you compute the expected rate of return for an individual risky asset
 How do you compute the standard deviation of rates of return for an individual
risky asset?

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 Con’t…
Risk analysis can be confusing, but it will help if you
remember the following:
1. All financial assets are expected to produce cash
flows, and the risk of an asset is judged in terms of
the risk of its cash flows.

2. The risk of an asset can be considered in two ways:

(1) on a stand-alone basis, or (2) in a portfolio
context,

3. In a portfolio context, an asset’s risk can be divided

into two components: (a) diversifiable Risk, and (b)
market risk,
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 Con’t…
4. An asset with a high degree of relevant (market) risk must provide a
relatively high expected rate of return to attract investors.
Investors in general are averse to risk, so they will not buy risky assets
unless those assets have high expected returns.

5. In this chapter, we focus on financial assets such as stocks and bonds,

but the concepts discussed here also apply to physical assets such as
computers, trucks, or even whole plants.

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 What is Uncertainty ?
Whenever you make a financing or investment decision,
there is some uncertainty about the outcome.
Uncertainty means not knowing exactly what will
happen in the future.
There is uncertainty in most everything we do as financial
managers, because no one knows precisely what changes will
occur in such things as
tax laws,
consumer demand,
the economy, or
interest rates etc.

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Con’t….
Though the terms “risk” and “uncertainty” are often used
to mean the same thing, there is a distinction between them.
Uncertainty is not knowing what’s going to happen. Risk is
how we characterize how much uncertainty exists: The greater
the uncertainty, the greater the risk.
Risk is the degree of uncertainty.

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Con't...

Risk Analysis
Risk --- What is this?
Consider the two cases.
 1)Mr Ramesh has put his money in National Bank of Ethiopia
(NBE) bond where he is going to get 12% p.a.. He is really happy
with the rate of return. Will he have sleepless nights, if the economy
goes into recession?. Of course no.
 2) Mr. Ramesh is very bullish with the stock market and invests
money into equity diversified fund with the expectation that he
will get 12% return. Will he have sleepless nights if economy goes
into deep recession, and now he feels that he may get negative
returns of say 5-7%? Of course yes.

In the second situation, he has a fear, which is the result of huge

difference in his expected return and the actual return, which he
may get. T his difference itself is the risk that he bears. D oes he face
this kind of difference in the first situation? N o. So there is no risk.
What is risk ?
Literally risk is defined as “exposing to danger or
hazard”.
 W hich is perceived as negative terms.

 In finance,
• Risk refers to the likelihood that we will receive a return on an
investment that is different from the return we expected to make.

• Risk is the probability or likelihood that actual results (rates of

return) deviates from expected returns.

9
21 -
Con’t…
Thus, risk includes not only the bad outcomes
(returns that are lower than expected), but also
good outcomes (returns that are higher than
expected).

In fact, we can refer to the former as downside

risk and the latter as upside risk.
 What is Risk ?
Chinese Symbol for Risk: The first symbol is the symbol
for “danger” while the second is the symbol for
“opportunity”, making risk a mix of danger and
opportunity.

H ence, risk is both bad outcomes and good outcomes.

 Risk and Risk Premium
Risk is the possibility that we won’t achieve our expectations or the chance that
actual investment returns will differ from those expected.

Positive relationship – high risk; high return

- low risk; low return

The relationship between risk and return is called risk-

return tradeoff.

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 Risk-Return Tradeoffs for Various
Investment Vehicles

Futures
Option

Expected Mutual fund

Return Common stock

Preferred stock Convertible

securities
Certificate of
A risk-return tradeoff exists
deposit such that for a higher risk one
Bond
expects a higher return, and
Risk-free
rate , RF Treasury bills vice versa. Low risk and low
return is government t-bill.

Risk
Sources of Risk
 Sources of Risk Con’t…
Business Risk:
Uncertainty of income flows caused by the
nature of a firm’s business

Sales volatility and operating leverage

determine the level of business risk.

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 Source of risk Con’t…
Financial Risk
Uncertainty caused by the use of debt financing. (Level of
Financial Leverage)

Borrowing requires fixed payments which must be paid

ahead of payments to stockholders.

The use of debt increases uncertainty of stockholder

income and causes an increase in the stock’s risk
premium.

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 Source of Risk Con’t…
Liquidity Risk
Uncertainty is introduced by the secondary
market for an investment.
How long will it take to convert an investment
into cash?
How certain is the price that will be
received?

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 Source of Risk Con’t…
Exchange Rate Risk:
Uncertainty of return is introduced by acquiring securities denominated in a
currency different from that of the investor.

Changes in exchange rates affect the investors return when converting an

investment back into the “home” currency.

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 Source of Risk Con’t…
Country Risk:
Political risk is the uncertainty of returns caused by the possibility of a major
change in the political or economic environment in a country.

Individuals who invest in countries that have unstable political-economic systems

must include a country risk-premium when determining their required rate of
return

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 Source of Risk Con’t…
 Interest rate risk is the chance that changes in interest rates will adversely affect
a security’s value.

 Purchasing Power Risk refers to the chance that changing price levels (inflation
or deflation) will adversely affect investment returns.

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D iversifiable and N ondiversifiable Risk
Although there are many reasons why actual returns
may differ from expected returns, we can group the
reasons into two categories:
A. M arket wide/Systematic Risk/N on-D iversifiable and
B. F irm-specific/ U nsystematic Risk/U niq ue
risk.
A. SYSTEMATIC RISK
 Systematic risk - The risk inherent to the entire market or entire
market segments is known as systematic risk.
 The portion of the variability of return of a security that is caused by
external factors, is called systematic risk.
 Risk due to
Economic and political instability,
Economic recession,
Inflation affect the price of all
Change in Government policy shares.
Change in interest rate policy
Corporate tax rate
Foreign exchange control
Natural calamities etc.

Thus the variation of return in shares, which is caused by these

factors, is called systematic risk.
 This
Systematic risk cannot be reduced through diversification.
risk can be mitigated through hedging or by
using the correct asset allocation strategy.

What is 'Asset Allocation:

Asset allocation is an investment strategy that aims to
balance risk and reward by apportioning a portfolio's
assets according to an individual's goals, risk
tolerance and investment horizon.
The three main asset classes - equities, fixed-income, and
cash and equivalents - have different levels of risk and
return, so each will behave differently over time.
B. NON - SYSTEMATIC RISK (UNSYSTEMATIC)
The return from a security sometimes varies because of
certain factors affecting only the company issuing such
security.
Risk due to
Shortage of raw material,
Labor strike, affect the share price of
R & D expert leave the company one company.
Management inefficiency etc.

When variability of returns occurs because of

such firm-specific factors, it is known as
unsystematic risk
 Total risk
Risk of an individual security is the variance (standard
deviation) of its return.
It consists of two parts:
Total risk of a security= systematic risk + unsystematic risk

Total Risk variance variance

attribute to attributable to
macroecono firm specific
mic factors factors
Con’t…
How is Unsystematic Risk
Reduced?
 Con’t…
Activity-1
W hy D iversification Reduces or Eliminates F irm-Specific Risk: G ive an
Intuitive Explanation!
Q uantification of Returns and Risk

 Measuring of Return:
If you buy an asset of any sort, your gain (loss) from that
investment is called the return on your investment. This return
will usually have two components:
Current return – It is the periodic cash inflow in the form of interest or
dividend.
Capital return --- It represents change in the price of asset.
T hus Total Return = Current Return + Capital Return

T hus; return is nothing but the reward for undertaking investment.

Assessment of historical returns is must to know the performance of the
fund manager. This also helps as an important input to estimate future
returns.
The current return can be zero or positive, whereas capital
return can be zero, positive or negative.
Con’t…
1. Calculation of H istorical Returns (Ex post):
S ingle period return:
Example: Suppose, at the beginning of the year, the stock for a
company was selling for $3 7 per share. If you had bought
100 shares, you would have a total out-lay of $3 7 00.
Suppose, over the year, the stock paid a dividend of $1.8 5per
share. B y the end of the year, then, you would have received
income of:
D ividend Income interms of dollar = $ 1.8 5 x 10 0 = $ 18 5
Con’t…
Also, suppose that the value of the stock has risen to $4 0.3 3 per
share by the end of the year. Y our 100 shares are now worth
$4 ,03 3 , so you have a capital gain of:
Capital gain = ($ 40 .33 - $ 37 ) x 10 0 = $ 333

Therefore, the total return of on your investment is the sum of

the dividend and the capital gain.
Total dollar return = dividend income + capital gain (loss)
= $18 5 + $3 3 3 = $ 518

N otice that, if you sold the stock at the end of the year, the total
amount of cash you would have would eq ual your initial
investment plus total return. Then, total cash if the stock is
sold is :
Con’t….
Total cash = initial investment + total return
$ 3 7 00 + $ 518 = $ 4 ,218
As a check, notice that this is the same as the proceeds
from the sale of the stock plus the dividends:
Proceeds from stock sale + dividends = $ 40 .33 x 10 0 + 18 5= $ 4,218
Although expressing returns in dollars is easy, two
problems arise:
 (1) to make a meaningful judgment about the return, you
need to know the scale (size) of the investment;
 A $100 return on a $100 investment is a great return
(assuming the investment is held for 1 year), but a
$100 return on a $10,000 investment would be a poor
return.
 T he q uestion is, how much do we get for each dollar
we invest?
Con’t…
 (2) Y ou also need to know the timing of the return;
a $100 return on a $100 investment is a great
return if it occurs after 1 year, but the same dollar
return after 20 years is not very good.

The solution to these scale and timing problems is to

express investment results as rates of return, or
percentage returns.
 Con’t…
Basic T erms:
D ividend yield: The annual stock dividend as a percentage of the initial
stock price.

Capital gains yield: The change in stock price as a percentage of the initial
stock price.

Total percent return: The return on an investment measured as a

percentage that accounts for all cash flows and capital gains or losses.
 Con’t….
It is usually more convenient to summarize information
about returns in percentage terms, rather than in dollar
terms, because that way your return does not depend on
how much you actually invest.

To answer this q uestion, let Pt be the price of the stock at

the beginning of the year and let D t+ 1be the dividend
paid on the stock during the year.

In the example above, the price at the beginning of the year

was $3 7 per share and the dividend paid during the year
on each share was $1.8 5. Therefore, dividend yield is:
Con’t…
D ividend yield= D t/ P t-1
= $1.8 5/3 7 = .05= 5%, this implies that for each dollar we
invest, we get five cents in dividends.
The second component of the return from investment is the capital gains
yield. This is calculated as the change in the price during the year (the
capital gain) divided by the beginning price:
Capital gains yield = (P t – P t-1)/ P t-1
= (4 0.3 3 -3 7 )/3 7 = .09 = 9 %. This means that per dollar we
invest, we get nine cents in capital gain. P utting it together, per dollar
invested, we get 5 cents in dividends and nine cents in capital gains: so
we get a total of 14 cents. O ur percentage return is 14 %.
Simply, the total percentage return of an investment can be calculated as:

T he rate of return = ((Pt +D t- Pt-1) / Pt-1) × 10 0 = ((40 .33+1.8 5--37 ) / 37 ) × 10 0 = 14%

Total P ercentage return =

D ividend paid at end of period + C hange in market value over period
B eginning market value
= $1.8 5 + (4 0.3 3 – 3 7 )/ 3 7 = 5.18 /3 7 = .14 = 14 %
In general;
Cont’t…
Con’t…
Q uantification of Returns and Risk
2. Quantification of Historical Risk
o As it has already been mentioned, risk is nothing but
possibility that actual outcome of investment will
differ from expected outcome of investment.

o To measure this deviation, statistical tools like

V ariance and standard deviations are used.

o V ariance is the sq uare of standard deviation.

o So let’s see the basic behind usage of standard
deviation to measure the risk and also the way to
calculate it.
Con’t…
The variance essentially measures the average
sq uared difference between the actual returns and
the average return.

The bigger this number is, the more the actual returns
tend to differ from the average return.

Also, the larger the variance or standard deviation is,

the more spread out the returns will be.
Con’t…
The way we will calculate the variance and standard
deviation will depend on the specific situation.
In this section, we are looking at historical returns;

If we were examining estimated future returns, then

the procedure would be different from the risk of
historical returns. W e describe this procedure in the
next topic.

S o the variance can now be calculated by dividing the

sum of the sq uared deviations, by the number of
returns less 1 .
Con’t…
Example
Measuring the Expected Return and Risk of a S ingle Asset
1) Calculation of Expected Return (EX ANTE)
W hen we talk about expectations, we talk about
probability.
The future or expected return of a security is uncertain;
however it is possible to describe the future returns
statistically as a probability distribution.
T he mean of this distribution is the expected return.

The expected return of the investment is the probability

weighted average of all the possible returns.

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Con’t….
If the possible returns are denoted by Xi
and the related probabilities are P(Xi),
expected return may be represented as
and can be calculated as:
E(Ri) = Σ X i P (X i).
It is the sum of the products of
possible returns with their respective
probabilities. Consider the example
below.
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Con’t…
Expected value of return for asset, E(Ri) : Expected rate of return is the
return expected to be realized from an investment.
E(Ri) = p1r1 + p2r2……+ pnrn
where,
p1,p2…. pn = is the probability of the ith out come.
r1, r2..... rn = is the ith possible out come (return).
n = number of outcomes considered
or
E(Ri)=  (Rj x Prj)
Where Rj = return for the jth outcome
Prj = probability of occurrence of the jth outcome

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47
21 -
Con’t…
Example: Mr. X 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 Company or Beta
Company. The rates of return probability
distributions Probability
State of the
for the of two
the
companies are shown here
Rate of return if the state economy
under:
economy state economy occurs

Alpha Co Beta Co.

Boom 0.35 20% 24%

Normal 0.40 15% 12%

Recession 0.25 5% 8%
Req uired: compute the expected rate of return on each company’s stock
Sun Feb 5 11:00:49
and recommend
2023 where M r “X” has to invest the $ 10 ,0 0 0 investable fund.
48
Solution
E(Ri) =  (Rj x P rj)
E(Ralpha) = (0 .3 5 *2 0 ) + (0 .4 *1 5 ) + (0 .2 5 *5 )
E(Ralpha) = 7 + 6 + 1 .2 5 = 1 4 .2 5 %

E(RB eta) = (0 .3 5 * 2 4 ) + (0 .4 * 1 2 ) +
(0 .2 5 * 8 )
E(RB eta) = 8 .4 + 4 .8 + 2 = 1 5 .2 %

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 Calculation of Expected Risk

What is investment risk?

 Typically, investment returns are not known with certainty.
 Investment risk relates to the probability of earning a return less than that
expected.

 The greater the chance of a return far below the expected return, the greater the
risk.

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 Probability Distribution

Stock X

Stock Y

Rate of
-20 0 15 50 return (%)
 Which stock is riskier? Why ?
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 Answer: Con’t…
The tighter (or more peaked) the probability distribution, the
more likely it is that the actual outcome will be close to the
expected value, and hence the less likely it is that the actual
return will end up far below the expected return.
Thus, the tighter the probability distribution, the lower the risk
assigned to a stock.
Since Stock X has a relatively tight probability
distribution, its actual return is likely to be closer to
its 15% expected return than that of Stock Y.
According to this definition, Stock X is less risky than Stock Y because there
is a smaller chance that its actual return will end up far below its
expected return.

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 Measuring the Expected Risk of a S ingle Asset
Standard deviation is the most common statistical indicator of an asset’s risk (stand
alone risk).
S.D measures the variability of a set of observations.
The larger the standard deviation, the higher the probability that actual returns will
be far below the expected return.
Coefficient of variation is an alternative measure of stand-alone risk.

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 Con’t…
• Standard deviation is indicator of risk asset (an absolute measure of risk)
of that asset’s expected return, σ (Ri), which measures the dispersion
around its expected value.

The standard deviation considers the distance

(deviation) of each possible outcome from the
expected value and the probability associated with
that distance.
 This can be calculated using eq uation below:
σ (Ri) = √ [R j - E(Ri) ]2 x Pr j

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 Con’t…
Steps to calculate the σ or sigma:
1. Calculate the expected rate of return:
Expected rate of return, E(Ri) =  (Rj x Prj)

2. Subtract the expected rate of return (E(Ri ) ) from each possible outcome (ri) to
obtain a set of deviations about E(Ri ), Deviationi = ri − E(Ri)

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 Con’t…
3. Square each deviation:
Deviationi = (ri − E(Ri))2
4. Multiply the squared deviations by the probability of occurrence for its related
outcome.
Pi(ri − E(Ri) )2
5. Sum these products to obtain the variance of the
probability distribution:
6.

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How to Determine the Expected Return and
Standard Deviation

Stock BW
RiPi (Ri)(Pi)
The
-.15 .10 -.015 expected
-.03 .20 -.006 return, R,
.09 .40 .036 for Stock
.21 .20 .042 BW is .09
or 9%
.33 .10 .033
Sum 1.00 .090
57
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How to Determine the Expected Return and
Standard Deviation

Stock BW
RiPi (Ri)(Pi) (Ri - R )2(Pi)
-.15 .10 -.015 .00576
-.03 .20 -.006 .00288
.09 .40 .036 .00000
.21 .20 .042 .00288
.33 .10 .033 .00576
Sum 1.00 .090 .01728
58
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 MEASURING EXPECTED (EX ANTE)
RETURN AND RISK

EXPECTED RATE OF RETURN

n
E (R) =pi Ri
i=1

STANDARD DEVIATION OF RETURN

 pi (Ri - E(R) ) ]
2

Bharat Foods Stock

i. State of the
Economy pi Ri piRiRi-E(R) (Ri-E(R))2 pi(Ri-E(R))2
1. Boom 0.30 16 4.8 4.5 20.25 6.075
2. Normal 0.50 11 5.5 -0.5 0.25 0.125
3. Recession 0.20 6 1.2 -5.5 30.25 6.050
E(R ) = piRi = 11.5 pi(Ri –E(R))2 =12.25
σ = [pi(Ri-E(R))2]1/2 = (12.25)1/2 = 3.5%
 Scenario-based Estimate of Risk
Example Using the Ex ante Standard Deviation – Raw Data
GIVEN INFORMATION INCLUDES:
- Possible returns on the investment for different discrete states
- Associated probabilities for those possible returns

Possible
State of the Returns on
Economy Probability Security A

Recession 25.0% -22.0%

Normal 50.0% 14.0%
Economic Boom
Sun Feb 5 11:00:50
25.0% 35.0%
2023
 Scenario-based Estimate of Risk
First Step – Calculate the Expected Return

Determined by
multiplying the
probability times the
possible return.
Possible Weighted
State of the Returns on Possible
Economy Probability Security A Returns

Recession 25.0% -22.0% -5.5%

Normal 50.0% 14.0% 7.0%
Economic Boom 25.0% 35.0% 8.8%
Expected Return = 10.3%

Expected return equals the sum of

the weighted possible returns.
Sun Feb 5 11:00:50
2023
 Scenario-based Estimate of Risk
Second Step – Measure the Weighted and Squared Deviations

Now multiply the square

First calculate the deviation of
deviations by their probability of
possible returns from the
occurrence.
expected.
Possible Weighted Deviation of Weighted and
State of the Returns on Possible Possible Return Squared Squared
Economy Probability Security A Returns from Expected Deviations Deviations

Recession 25.0% -22.0% -5.5% -32.3% 0.10401 0.02600

Normal 50.0% 14.0% 7.0% 3.8% 0.00141 0.00070

Economic Boom 25.0% 35.0% 8.8% 24.8% 0.06126 0.01531

Expected
Return = 10.3% Variance = 0.0420

Standard
Deviation = 20.50%

Second, square those deviations

The sum Theof the
fromweighted
standard and is
thedeviation
mean. square
the square
Sun Feb deviations
5 11:00:50
root ofisthe
thevariance
variance(ininpercent
percentterms).
2023 62
squared terms. 8-
 D etermining Standard D eviation
(Risk M easure)

n
= ( Ri - R )2( Pi )
i=1
Standard Deviation, s, is a statistical measure of
the variability of a distribution around its mean.
It is the square root of variance.
Note, this is for a discrete distribution.

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 Comments on Standard Deviation as a Measure of Risk
Standard deviation (σi) measures total, or stand-alone, risk.

The larger σi is, the lower the probability that actual returns
will be closer to expected returns.

Larger σi is associated with a wider probability distribution

of returns.
The larger standard deviation (σi) indicates a greater
variation of returns and thus a greater chance that the
expected return will not be realized.

The larger the Standard deviation (σi), the higher the risk,
because Standard deviation (σi), is a measure of total
risk.
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 Coefficient of Variation: A Relative Measure of Risk
If conditions for two or more investment alternatives are not
similar—that is, if there are major differences in the expected rates
of return or standard deviation—it is necessary to use a measure of
relative variability to indicate risk per unit of expected return.
The coefficient of variation is a useful measure of risk when we are comparing the
investment alternatives which have
(i) same standard deviations but different expected values, or
(ii) different standard deviations but same expected values, or
(iii) different standard deviations and different expected values.

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A widely used relative measure of risk is the coefficient of
variation (CV), calculated as follows:
Formula for CV is:
Coefficient of Variation = Standard Deviation
Average or Expected Return
CV= σ (Ri)
E(Ri)

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 Coefficient of Variation con’t…
CAse-1: CAse-3:
E(Rx)=10% E(Rx)=7%
S.Dx=8% Dx=5%
E(Ry)= 12% E(Ry)= 12%
S.Dy=8% S.Dy=7%
CAse-2:
E(Rx)=12%
Dx=8%
E(Ry)= 12%
S.Dy=10%
THANK U
AND