CASTILLO, MARGAUX JULIENNE R.

NCST: CAP MARKET : MWF 6-7PM

MIDTERM

OVERVIEW OF RISK AND RETURN

Investor go through the following process in making an investment decision:
1. Set objectives
2. Identify available resources.
3. Evaluate various investment alternatives- stocks, bonds, mutual funds, pension funds, t- notes
and t – bonds, t – bills, CPs security derivatives, MMMFs, CDs, precious metals, futures, option
4. Choose or identify the investment alternatives that will provide the best return and at the same
time.

Concept of risk
Risks refer to chances that outcome of an event is unfavorable or undesirable.
Return, on the other hand, refer to yields or earning on an investment. Generally, the higher the risk,
the higher the required return on an investment.
Risk is a chance or possibility of danger, loss, injury and the like. It is uncertainty of the expected
outcome. It is the consequence or the stake of doing things.

Investment risk force investor to evaluate the return and risk characteristics of each investment
alternative before making a decision.
Risk are further classified as systematic and unsystematic risk (Fabozzi and Modigliani 2009)
1. Systematic risk – also called undiversifiable risk or market risk. Systematic risk result from the
general market and economic condition that cannot be diversifies away
2. Unsystematic risk – sometimes called diversified risk, residual risk or company specific risk. This
is risk that is unique to a company such as a strike, the outcome of unfavorable litigation, or a
natural catastrophe.

Measurement of risk
It is axiomatic that “if it can’t be measured, it can’t be managed”. This is perhaps the reason why expert
try to measure risk. Following are the different standards for risk.

BS 25999 – risk is an average effect by summing the combined effect of each possible consequence
weighted by the associated likelihood of each consequence.
ISO 27005 – risk estimation is the process to assign values to the probability and consequences of risk.
NFPA 1600 - risk assessment categorizes threats, hazards, or perils by both their relative’s frequency and
severity.
BS 25999-2 specifies requirements for establishing, implementing, operating, monitoring, reviewing,
exercising, maintaining and improving a documented business continuity management system (BCMS)
within the context of managing an organization’s overall business risks.
ISO 22301 – superseded the original British Standard, BS 25999-2, and builds on the success and
fundamental of this standard.
BS ISO 22301 specifies the requirements for setting up and managing an effective BCMS for any
organization, regardless of types or size.
British Standard Institution (BSI) recommended that every business has a system in place to avoid
excessive downtime and reduced productivity in the event of an interruption.
The ISO27K standards are deliberately risk aligned, meaning. Organizations are encouraged to assess the
security risks to their information.
ISO 27005 – is broader in scope than merely addressing the risk management requirements identified
in ISO/IEC 27001. However , the standard does not specify, recommend, or even name any specific risk
management method. It does however imply a continual process consisting of a structured sequences of
activities, some of which are iterative (ISO 21001 security.com)
 Establish the risk management context( e.g scope, compliance , obligations approaches/
methods to be used, and relevant policies and criteria such as the organization’s risk tolerance
or appetite)
 Quantitatively or qualitatively assess (i.e., identify , analyze and evaluate ) relevant risks, taking
into account the information asset, threat, existing controls, and vulnerabilities to determine the
likelihood of incidents or incident scenarios.
 Treat (i.e., modify [ use information security control], retain [accept], avoid and or share [ with
third parties] the risk appropriately using those levels of risk to prioritize them.
 Keep stakeholders informed throughout the process.
 Monitor and review risks, risk treatment, obligation and criteria on an ongoing basis, identifying
and responding appropriately to significant changes.

The National Fire Protection Association (NFPA) 1600 “Standard on Disaster/ Emergency Management
and Business Continuity Programs” is designed to be description of the basic criteria for comprehensive
program that addresses disaster recovery, emergency management and business continuity. NFPA is an
international body with over 60,000 members from all over the world. Less than a quarter of these
members are affiliated with fire department. The majority of the members are representative of the
private and public sector and come from a wide variety of fields. NFPA standard are developed through
a consensus standards development process approved by the American National Standards Institutes.
NFPA 1600 is considered by many to be an excellent benchmark for continuity and emergency planners
in both the public and private sectors. The standard addresses methodologies for defining and
identifying risks and vulnerabilities and provides planning guideline which address (Davislogic.com)
 Stabilizing the restoration of the physical infrastructure
 Protecting the health and safety of personnel
 Crisis communication procedures
 Management structures for both short term recovery and ongoing long-term continuity of
operations.

Spurred by the financial crisis in late 2008, risk management experienced increased importance as a
function within the financial service industry. According, familiarity with the basic methodologies for
measuring, assessing and controlling risk is vital for those wishing to get ahead in finance.
Some of these methods are (Kolakowski 2016)
1. Loss of principal and or interest payment.
The crudest yet most conservative measurement of risk is the total sum of money invested or loaned.
The worst possible outcome is that the entire investment become worthless or that borrower defaults.
2. Probability
A refinement is the introduction of probabilities to the analysis.
The mathematical theory of probability deals with patterns that occur in random events.
Probability is a set of all possible outcomes like an 80% probability of success and a 20 % probability in
failure.
3. Volatility and variability
Volatility is a basic measure for risk associated with a financial market’s instrument . It represent as
asset’s price fluctuation and is accounted as the difference between maximum and minimum prices
within trading session, trading day, month, and the like.
The wider range of fluctuation(higher volatility) means higher trading risk involved.

It also refers to the extent to which these data point differ from each other. There are four common
used measure of variability:
1. Range – the highest data minus the lowest data
2. Mean – also known as the arithmetic average, which is the result when you add up all the
numbers, then divide by how many numbers there are.
3. Variance – measure of how close the scores in the data set are to the middle of the distribution ,
it is mainly used to calculate the standards deviation.
4. Standard deviation – measure of how spread out number are. It is the square root of the
variance.
---------------------------------------------------------------------------------------------------------------------------
4. Assessment of counterparty risk
Counterparty risk, which includes default risk, is the risk that other party to a transaction, such as
another firm in the financial services industry, will prove unable to fulfill its obligation on time. Example
of these obligation include delivering securities or cash to settle trades, and repaying short terms loans
as scheduled.
5. The role of actuaries
Actuaries are most associated with analyzing mortality tables on behalf of life insurance companies and
any other venture which involves measurement of risks. It plays a critical part in setting of premium on
policies and payout schedule on annuities. Actuarial science , as it often called, is an application of
advanced statistical techniques to huge data sets which themselves have high degrees of measurement
accuracy.

Concept of Return
Returns are the revenues , earnings, yields, proceeds, income, or profit from some undertaking made
like financial investment, capital investment, and business operation. They are measured based on the
net income from business operation .
Net cash flows refer to the difference between the cash flow received from an investment and the cash
flow expended on an investment.

Net income from an investment refer to the difference between revenues from an investment and the
expenses spent on an investment. They are normally translated in the form of percentages, which are
called rates of return. Rate of return is used to compare the outcomes of different investment. It is used
to measure historical performance determining future investment and estimating cost of capital for
capital investment decision. It shows the return made on a investment.
For example : for an investment in bond of P1,000 with a maturity period of 10 years, paying P40 in
interest every 6 month, the income on the bond would be equal to P80 a year., which is equivalent to
8% of the face value of the bond(P80/ P1,000). If, at any time during the life of the bond, the bond sells
at 110 (P1,000/ 110%) = P1,100), investor will not only earn the P80/ year interest on the bond but also
the increase in price from P1,000 to P1,100 or gain P100 gain, should he decide to sell the bond prior to
maturity.

In the foregoing example , the computation of the interest rate would be:
r= I/P
Where r = interest rate
I = interest received
P= Principal or cost of investment
r = P80/ P1,000 = 8%

The increase in value or capital gain, which is the growth(g) in the investment would be:
g= (CP-P)/ P
Where CP = current price
P= principal or cost of investment

g = P1,100 – P1,000 = P100

P1,000 P1,000
Therefore , the rate of return (RoR) = r+g
=8% +10%
= 18%

RISK AND RETURN

Risk and return are interrelated because the returns from the investment should equate the risk
involved. As stated earlier, the risk- averse investor, before making investment in a risky asset, require a
higher return than the risk- free asset. Return computed from historical data can be used in measuring
future returns, however, the uncertainty of the occurrence or the risk involved should also be taken into
account.
Risk is the possibility that actual returns will deviate or differ from what is expected. The actual return
can go up or down depending on the market.

If the returns go up, the risk in investing is worth it; if the returns go down, then the risk is not worth
taking. Taking risks involves knowledge of expected return, terminal value, present value and rate of
returns. Expected returns are the future cash flows associated with the investment. Terminal value is
the maturity value of an investment. Present value are the discounted value of the future returns. Rate
of return is the ratio of the net cash flow and the principal or initial investment.

Return is the profit or earning and rate of return is the percentage of profit or earnings on a particular
investment , which is why it is often termed ROI or return on investment.
If you invest P1,000 and you earned P100 your rate of return is 10% (P100/p1,000). The interest rates on
your investment, including deposits, are the return that you earn on your investment or deposits. The
yield you get on your investment in government securities is your return on your investment in those
government securities. The dividend that you earn as a stockholder is the return you earn on your stock ,
in addition to any capital gain or increase in value of said stock.
To increase the rate of return of company, the company has taken certain risk. “Keep you alpha high
and your beta low” is an old adage related to investment and therefore, to risk and return. Alpha means
return and beta mean risk.

METHODS OF CALCULATING RATES OF RETURN

1. Holding period return – rate of return measured for a given period which can be in month or in
a year. The period cover 1 month to several month or 1 year to several years. However, if it
covers several years, the result from this method no longer present realistic rate of return.

This is used when the holder of the security does not hold on to the security until maturity. The holding
period is the time the investor holds the investment from the time of acquisition to time of sale
generally prior to maturity . The formula is

R= EV+I – IV
IV
Where R = return for the period
EV=ending value of the investment after an interval
I = income received from investment(dividend for stock; interest for bonds)
IV= initial value of the investment at the beginning of the interval

Example : the market value of the stock of Bright Corporation at the beginning of year 1 is P120 per
share ; at the beginning of year 2 is P130. It declares dividend of P20 per share. What is the holding
period return from the said investment ?
R= EV+I – IV
IV
= P130 +P20 – P120 = P30 /P120 = 25%
P120
Assume no dividend was declared. The holding period return

R = ( P130 +0 – P120) / P120

R = P10 / P120 = 8.33%

2. Average rate of return- measure the return across months a year.

a. Arithmetic average – an unweighted average of the return which formula is :

AR =(∑▒〖𝑅𝑜𝑅) 〗 𝑛⁄𝑛
Where AR= average rate of return
n = Number of intervals
RoR = holding period return for ach month or each year.

For the month of January , return is computed as ( February value – January value ) / January value :

P122- P120 = P2 / P120 = .01667 = 1.667%

Then , for the month February, return is computed as (march value – February value) / February value:

P120 – P122 = (P2) / P122 = (.01639) =(1.639%)

Take note that the return for February is negative because the value of return for march is less than the
value for February.
For the succeeding months, the same procedure will be followed . To compute for the average rate of
return , the sum of the calculated returns for each month is divided by the number of intervals which is
12. In our example, the computed average of return is .68% for the 12- month period.

B. Geometric average – measure the compounded growth rate of the initial investment which formula is

{ ( 1 + 𝑅_𝑂 𝑅_1)(1+ 𝑅_0 𝑅_2)…(1+𝑅_0 𝑅_𝑛) }1⁄𝑛 - 1

Example / taking the 5 months information from above (January to may , the average rate of return
would be :

AR = [ 1.67% + (1.64%) +1.67% + 0.82% + 1.63%] / 5

= 4.15 % / 5 = .83%

Using geometric average method : note that the RoRs are converted into decimal for easier
computation.
ga = {(1+ .0167) [ 1+ (-.0164)] ( 1+ .0167) (1+ .0082) (1+.0163) } 1⁄(5 )- 1
Ga = { 1.0167)(.9836)(1.0167)(1.0082)(1.0163)
(1.04177)}1⁄5 -1

= 1.008218 -1
=.008218% or .8218
= .82%
Take note that the arithmetic average (.83%) is just slightly higher than the geometric average (.82%)
C. Internal rate of return (IRR) / yield to maturity – in computing for the IRR of the investment, the
present value of the expected cash flow is taken into account. We have to use the present value table
( present value of P1.00 per year for each of n year) if the future returns are all the same; if they are not
the same, we have to use the discount table ( present value of P1.00 to be received after n years)
Internal rate of return (IRR) is a metric used in capital budgeting measuring the profitability of potential
investment. Internal rate of return is a discount rate that makes the net present value(NPV) of all cash
flow from particular investment equal to zero.

Net present value is the difference between the present value of future cash flows inflows and the
present value of the investment or the principal. If the NPV is positive, the investment is accepted, if the
negative , the investment is rejected.
However , this method will require trial and error and interpolation. Yield to maturity is the IRR for
bonds. Since it will require trial error, the computation can start with finding the estimated yield to
maturity (Mejorada 1999). The approximate yield to maturity (YM) would be :

Example : A 10 years, 8% bond of P10,000 each was purchased at 9,800. what is the yield to maturity of
the bond ?
Interest = P 10,000 X 8% = P800

= 800 + [ (10,000 – 9,800) / 10]

(10,000 + 9,800) /2
= 800+ (200) /10
19,800/2
=800 +20 /9,900 = .0828 = 8.28%
The yield to maturity (YM) or the IRR is between 8% and 9%. To compute for the exact YTM ,compute
the present value using the said rates which should equal to the initial value of the investment which is
P 9,800.00.
Assume a 15 year P 1,000 bond paying interest of P110 (11%) . The current price of the bond is
P932.21. We find the YM.
Since the bond is trading at a discount, we assume that the YM is higher than the 11% nominal rate. So
let us try 12%:
Present value of interest payments = P 110 X ordinary annuity PV factor at 12% for 15 years.
= P110 X 6.811 = P 749.21

Present value of principal = P1,000 x PV factor at 12% for 15 years

= P1,000 X .183 = P 183.00
Total present value or price of the bond = P932.21

Another example of determining the YM by trial and error or through the use of a formula would be as
follows:

Trial and error

What we need to do is to try different rates until we find the rate that will make the price of the bond
equal to present value of the interest payment plus present value of the principal upon maturity. If the
bond is trading below par ( at a discount), we can assume the YM ( discount rate) to be above the
nominal rate on the bond and vice versa.

ii. Approximate YM
approx. YM = P 110 +(P1,000 – P932.21) / 15
P1,000 + 932.21 / 2

= P110 + 4.52 / 966.10 = 11 .85 %

you will see that the 12% we got from the trial and error process is very near the 11.85 %.
EXPECTED RETURN,VARIANCE AND STANDARD DEVIATION OF A PORTFOLIO
There are two types of return
1. expected returns – which is what you expect to get on your investment.
2. unexpected returns – which are gains or losses caused by unforeseen events.
Expected return is the sum of the products of the weight of each asset and their forecasted returns. It is
calculated as the weighted average of the likely profits of the assets in portfolio, weighted by the likely
profits of each asset class.

Expected return is calculated by using the following formula:

E(R) = 𝑤_1 𝑅_1+𝑤_2 𝑅_𝑞 +…+ 𝑤_𝑛 𝑅_𝑛

Example 1 : For a simple portfolio of two mutual funds, one investing in stock and the other in bonds, if
we expect the stock fund to return 12 % and the bond fund to return 8% and our allocation is 50 % to
each asset class.
E(R) = (0.12)*(0.5) +(0.08)*(0.5)
= 0.06 +.04
=.10 or 10%
Example 2 : Assume an investment manager has created a portfolio with stock A and stock B. Stock A has
a expected return of 15% and weight of 40 % in the portfolio. Stock B has an expected return of 20%
and a weight of 60%. What is the expected return of the portfolio?

E( R) = (0.40) (0.15) + (0.60) (0.20)

= .06 + .12
= .18 or 18 %

Variance
Variance (ծ^(2 )) is measure of how spread out numbers are, that is , how far each value in the data set
is from the mean(µ). It is the average of the squared difference from the mean. Variance measure the
variability from an average, that is volatility, which is a measure of the risk. Therefore , this statistic can
help determine the risk an investor might take when purchasing a specific security. To find the
variance, we follow the three steps:
1. Subtract the mean from each value in the data set
2. Square each difference and add all the squares together
3. Divide the sum of the square by the number of values in the data set.

To incorporate expected return with the concept of variance , we first compute for the expected
returns. Given the probability and the forecast sales for given scenario, for example, we get the
expected returns by multiplying each probability by each forecasted sales. Adding all the expected
returns together gives the mean which we will need in computing the variance.
Variance then weighs each squared deviation by its probability, giving us to following calculation :

(0.15) *(9) + (0.25)*(1) + ( 0.25)* (0) + (0.35) *(4)

= 1.35 +.25 + 0 +1.4

=3
Therefore, variance is equal to P 3 million. The mean is P14 million.
Portfolio Variance
A portfolio is a collection of financial asset or investment such as stocks, bond and cash. Portfolio
variance is a measure of the risk of a portfolio, a combination of the return variance and co – variance of
each security, and its proportion in that portfolio. Therefore, the variance of the portfolio’s return is a
function of the variance of the component asset as well as the covariance between each of them.
Covariance provides diversification reducing the overall volatility for a portfolio. Covariance is a
statistical measure of how two assets move in relation to each other.

A positive covariance indicates that two assets move together in tandem. A negative covariance
indicate two assets move in opposite direction.
Modern portfolio theory(MPT) or mean- variance analysis is a mathematical framework for assembling
a portfolio of assets such that the expected return is maximized for a given level of risk, defined as
variance. This theory posits that portfolio variance can be reduced by diversification, choosing asset
classes with a low or negative covariance thereby reducing risk.

Portfolio variance is calculated by multiplying the squared weight of each security by its corresponding
variance and adding two times the weighted average weight multiplied by the covariance of all
individual security pairs expressed in the following formula for a simple two asset portfolio:

Portfolio Variance = 𝑤_1^2 ծ_1^2 + 𝑤_2^2 ծ_2^2 + 2p𝑤_1 𝑤_2 ծ_1 ծ_2

This mean that we multiply the weight of each asset by their respective to get the total for the assets
and then add twice the product of the weights and the covariance of the assets.

Portfolio Variance = 𝑤_𝐴^2 * ծ^(2 )(𝑅_𝐴)+ 𝑤_𝐵^2 *ծ^(2 )(𝑅_𝐵)+ 2*(𝑊_𝐴)* (𝑊_𝐵) * Cov(𝑅_(𝐴,) 𝑅_𝐵)
Where 𝑊_𝐴 and 𝑊_𝐵 - portfolio weights
ծ^(2 )(𝑅_𝐴) and ծ^(2 )(𝑅_𝐵) – variances
Cov(𝑅_(𝐴,) 𝑅_𝐵) - covariance

Data on both variance and covariance may be displayed in a covariance matrix. Assume the following
covariance matrix for two case.
Portfolio variance = 𝑤_𝐴^2 * ծ^(2 )(𝑅_𝐴)+ 𝑤_𝐵^2 *ծ^(2 )(𝑅_𝐵)+ 2*(𝑊_𝐴)* (𝑊_𝐵) * Cov(𝑅_(𝐴,) 𝑅_𝐵)
= 〖(0.5)〗^2 * 300 + 〖(0.5)〗^2 *200 + 2 *(0.5) *(0.5) * (90)
=.25 (300) + .25 (200) + 2(.25) * (90)
= 75 + 50 + 45
= 170

Standard Deviation
Standard deviation (ծx) can be defined in two ways:
Standard deviation is calculated as the square root of variance. It derives from the variance, measure of
the dispersion of as set of data from its mean. The more spread apart the data, the higher the deviation.
In finance, standard deviation is also known as historical volatility and used by investors as a gauge for
the amount of expected volatility. It is applied to the annual rate of return of an investment to measure
the investment’s volatility.

Example 1: Standard deviation(ծ) is found by taking the square root of variance.

√(170 )=13.04 %

When used a two – asset portfolio to illustrate this principle, but most portfolios contain far more than
two assets. The formula for variance become more complicated for multi – asset portfolios. All terms in
a covariance matrix need to be added to the calculation.

Variance = (0.10)〖(0.10 −0.14)〗^2 + (0.80) 〖(0.14 −0.14)〗^2 + (0.10)+ 〖(0.18 −0.14)〗^2

= 0.0003

Standard deviation is 0.0173 or 1.73%

The adage “don’t put all your eggs in one basket” holds true when it comes to investment.

Structure of Rates of Return

The difference in interest rates arising from difference in length of time to maturity or term of the
security is called the term structure of interest rates. It is the relationship between interest rates and the
length of time to maturity on debt securities , other things being equal.
The difference in interest rates arising from the credit or default risk is termed default risk or credit risk
structure of interest rates. It is relationship between the return or yield on debt securities and the risk
that the issuer may default on its obligation to pay the interest or the principal.

Default risk premium is the difference between the interest on the debt security of a specific issuer and
the interest on a government treasury security with the same maturity.

The yield curve is a graphical of the term structure of interest rates at a particular point in time.
Constructing the yield curve involves measuring the length of time to maturity or the term of the
instrument on the horizontal axis or x-axis and the yield to maturity or interest rate on the vertical or y –
axis.

Upward – sloping yield curve ( ascending) – means that the longer the maturity of the security, the
higher the interest rate, which is the general trend.

Flat yield curve – means the interest rate are the same across the maturity spectrum, that is among
different maturities that may happen occasionally.

Downward – sloping means that short term rates are higher than long term rates which can happen
under certain market condition. This mean that yields decline as maturity increases.