Risk and Return

DR.SAYLEE GHARGE
 RETURN ON A SINGLE ASSET
India Cements is a large company with several thousand shareholders.
Suppose you bought 100 shares at the rate 225. The par value of each share is 10 rs.
Investment: `225 × 100 = `22,500
.
Rupee returns: India Cements paid a dividend at 25 per cent. As the dividend rate applies to the par value of
the share, your dividend per share would be: `10 × 25% = `2.50
Dividend = (Dividend rate × Par value)× Number of shares = `2.50 × 100 = `250
suppose the price of the share at the end of the year turns out to be `267.50.
Capital gain/loss = (Selling price – Buying price) × Number of shares = (`267.50 – `225) × 100 = `4,250
Your total return is: Total return = Dividend + Capital gain
Total return = `250 + `4,250 = `4,500
If you sold your shares at the end of the year, your cash inflows would be the dividend income plus the
proceeds from the sale of shares:
Cash flow at the end of the year = Dividends + Value of sold shares = `250 + (`267.50 × 100) = `27,000
Percentage returns: You earned a total return of `4,500 on an investment of `22,500.
Return in percentage = 4,500 / 22,500 = 0.20 or 20%.
Returns from each share have two components: the dividend income and the capital gain. Hence, the rate of
return on a share would consist of the dividend yield and the capital gain yield.
The rate of return of a share held for one year is as follows: Rate of return = Dividend yield + Capital gain yield

R1 is the rate of return in year 1, DIV1 is dividend per share received in year 1, P0 is the price of the share in the
beginning of the year and P1 is the price of the share at the end of the year.
Dividend yield is the percentage of dividend income, and it is given by dividing the dividend per share at the
end the year by the share price in the beginning of the year; that is, DIV1/P0.
Capital gain is the difference of the share price at the end and the share price in the beginning divided by the
share price in the beginning; that is, (P1 – P0)/P0.
If the ending price were less than the beginning price, there would be a negative capital gain or capital loss.
Unrealized capital gain or loss: If an investor holds a share and does not sell it at
the end of a period, the difference between the beginning and ending share
prices is the unrealized capital gain (or loss).
The investor must consider the unrealized capital gain (or loss) as part of her total
return.
The fact of the matter is that if the investor so wanted, she could have sold the
share and realized the capital gain (or loss).
 Annual Rates of Return
Example of Hindustan Unilever Limited
Average Rate of Return
 Rates of Return and Holding Periods

Suppose you invest `1 today in a company’s share for five years. The rates of return are 18 per
cent, 9 per cent, 0 per cent, –10 per cent and 14 per cent. You hold the share for five years;
hence, you can calculate the worth of your investment assuming that each year dividends
from the previous year are reinvested in shares.
The worth of your investment after five years is: = (1 + 0.18) × (1 + 0.09) × (1 + 0.0) × (1 – 0.10)
× (1 + 0.14) = 1.18 × 1.09 × 1.00 × 0.90 × 1.14 = `1.32
Thus your total return is: 1.32 –1 = 0.32 or 32 per cent.

Compound annual rate of return

This compound rate of return is the geometric mean return. After five years: (1.057)5 = `1.32.
 RISK OF RATES OF RETURN: VARIANCE AND STANDARD DEVIATION
The variability of rates of return may be defined as the extent of the deviations (or dispersions) of individual
rates of return from the average rate of return. There are two measures of this dispersion: variance and
standard deviation. Standard deviation is the square root of variance.
How to Calculate Variance and Standard Deviation

1. Calculate the average rate of return using Equation

2. Calculate the deviation of individual rates of return from the average rate of return and square it,

3.Calculate the sum of the squares of the deviations as determined in the preceding step and divide it by
the number of periods (or observations) less one to obtain variance, i.e., 2

4. Calculate the square root of the variance to determine the standard deviation
The annual rates of return of HUL’s share show a high degree of variability; they deviate on an
average, by about 21.61 % from the average rate of return of 11.44%.
 HISTORICAL CAPITAL MARKET RETURNS
1. Ordinary shares We use Sensex share price data for calculating market
return.
2. Long-term government of India bonds This is a portfolio of government
of India bonds with maturity over 15 years.
3. Call money market This is a portfolio of interbank
Transactions(short term).
4. 91-Day treasury bills Treasury bills are money market instruments issued
by the Government of India as a promissory note with guaranteed
repayment at a later date. Funds collected through such tools are typically
used to meet short term requirements of the government, hence, to
reduce the overall fiscal deficit of a country.
This is a portfolio of treasury bills of three-month maturity. The interest
rate structure in India was controlled by the Government until the
beginning of nineties.
The return on 91-day treasury bills remained fixed (arbitrarily) at 4.60 per
cent until 1993.
 HISTORICAL CAPITAL MARKET RETURNS

Required rate of return (RRR) will be calculated as: RRR = Risk-free rate + Risk premium
 HISTORICAL CAPITAL MARKET RETURNS

 The historical capital-market returns can be summarized by two numbers:

 The arithmetic average return
 The standard deviation: It explains variability and it is a measure of total risk.
 Table 4.3 shows :
 The average return from stock market (Sensex) is not only highest (17.7%) but its variability is
also highest (34.6%).
 The return from long-term government bonds is 9.5 per cent and its standard deviation is
lowest at 1.9 per cent.
 The 91-day T-bills yield a return of 7.3 per cent with a standard deviation of 2.2 per cent.
 T-bills return is almost equal to inflation rate.
 EXPECTED RETURN AND RISK
 Instead of using historical data for calculating return and risk, we may use forecasted data.
Suppose you are considering buying one share of India Cements, which has a market price of
`261.25 today. The company pays a dividend of `2.50 per share. You want to hold the share for
one year. What is your expected rate of return?
 This will depend on the dividend per share you would actually receive and the market price
at which you could sell the share. You do not know both the outcomes.
 The outcomes may depend on the economic conditions, the performance of the company and
other factors. You will have to think of the outcomes of dividend and the share price under
possible economic scenarios to arrive at a judgment about the expected return. Assume four
(equally likely) possible states of economic conditions and performance: high growth,
expansion, stagnation and decline.
EXPECTED RETURN AND RISK

Rate of return
 EXPECTED RETURN AND RISK

The expected rate of return [E(R)] is the sum of the product of each outcome (return) and its
associated probability:
Variance can be calculated by following equation:
PROBLEM: Calculate expected rate of return ,variance and standard deviation
 Risk Preference
 The information about the expected return and standard deviation helps an investor to
make decision about investments. This depends on the investor’s risk preference.
Generally investors would prefer investments with higher rates of return and lower
standard deviations.
 A risk-averse investor will choose from investments with the equal rates of return, the
investment with lowest standard deviation. Similarly, if investments have equal risk
(standard deviations), the investor would prefer the one with higher return.
 A risk-neutral investor does not consider risk, and he would always prefer investments
with higher returns.
 A risk-seeking investor likes investments with higher risk irrespective of the rates of
return.
Risk Preference
 Normal Distribution and Standard Deviation
 The normal distribution is a smooth, symmetric,
continuous, bell-shaped curve as shown in Figure.
 The distribution is neither skewed nor peaked. The
spread of the normal distribution is characterized by
the standard deviation.
 What is the probability of obtaining a return exceeding
or lower than the expected (mean) return?
 In case of normally distributed returns, it depends only
on the standard deviation.
 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 % of the area lies within ± 0.67 standard deviations of the expected value;
about 68 % of the area lies within ± 1.0 standard deviations of the expected value; 95 % of the area lies
within ± 1.96 standard deviation of the expected value and 99 % of the area lies within ± 3.0 standard
deviations of the expected value.
 Normal Distribution and Standard Deviation
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. However, any normal
distribution can be standardized and hence the table of normal probabilities will serve for
any normal distribution. The formula to standardize is:

R : Outcome (return) in which we are interested,

E(R) : Mean or the expected return and
S : Number of standard deviations from the expected return.

Problem: An asset has an expected return of 29.32 per cent and the standard deviation
of the possible returns is 13.52 per cent. Determine the probability that the return of
the asset will be zero or less.
 Normal Distribution and Standard Deviation
Problem: An asset has an expected return of 29.32
per cent and the standard deviation of the possible
returns is 13.52 per cent. Determine the probability
that the return of the asset will be zero or less.

This figure (–2.17) implies that a return of 0 is positioned 2.17 standard deviations to
the left of the expected value of the probability distribution of possible returns. 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.
The following are the returns during five years on a market portfolio of shares and ‘AAA’
corporate bonds: You are require to calculate
(i) the realized risk premium of shares over the ‘AAA’ bonds in each year; and
(ii) the average risk premium of shares over ‘AAA’ bonds during the period.
Can the realized premium be negative? Why?
The calculations for the premium in each year and the average premium are shown
below. The average premium is 4.7 per cent.
The realized premium can be negative as the share prices in practice show wide
swings. However, over a long period of time the premium would be positive, as
shares are more risky than bonds.
 Value and Return
 The recognition of the time value of money and risk is extremely vital in financial
decision-making. If the timing and risk of cash flows is not considered, the firm may
make decisions that may allow it to miss its objective of maximizing the owners’
welfare(Wealth) .
 Most individuals value the opportunity to receive money now higher than waiting for
one or more periods to receive the same amount. Time preference for money or Time
Value of Money (TVM) is an individual’s preference for possession of a given amount of
money now, rather than the same amount at some future time.
 Three reasons may be attributed to the individual’s time preference for money:
1. risk , 2. preference for consumption, 3. investment opportunities
 Required Rate of Return

 The time preference for money is generally expressed by an interest rate. This rate
will be positive even in the absence of any risk. It may therefore be called the risk-
free rate.
 Thus the required rate of return (RRR) will be calculated as:
RRR = Risk-free rate + Risk premium
Two most common methods of adjusting cash flows for time value of money:
 Compounding—the process of calculating future values of cash flows
 Discounting—the process of calculating present values of cash flows.
 PORTFOLIO RETURN: TWO-ASSET CASE

 A portfolio is a bundle or a combination of individual assets or securities.

 Portfolio theory provides a normative approach to investors to make decisions to
invest their wealth in assets or securities under risk.
 It is based on the assumption that investors are risk-averse (A risk-averse investor will
choose from investments with the equal rates of return, the investment with lowest
standard deviation)
 This implies that investors hold well-diversified portfolios instead of investing their
entire wealth in a single or a few assets
 PORTFOLIO RETURN: TWO-ASSET CASE
The return of a portfolio is equal to the weighted average of the returns of individual assets (or securities) in
the portfolio with weights being equal to the proportion of investment value in each asset. Suppose you have
an opportunity of investing your wealth in either asset X or asset Y. The possible outcomes of two assets in
different states of economy are given in Table 5.1.
PORTFOLIO RETURN: TWO-ASSET CASE
 Measuring Portfolio Risk for Two Assets

The risk of a portfolio could be measured in terms of its variance or standard deviation.
The portfolio return is the weighted average of returns on individual assets. The portfolio
variance or standard deviation depends on the co-movement of returns on two assets.
Covariance When we consider two assets, we are concerned with the co-movement of
the assets. Covariance of returns on two assets measures their co-movement. Three
steps are involved in the calculation of covariance between two assets:
 Determine the expected returns on assets.
 Determine the deviation of possible returns from the expected return for each asset.
 Determine the sum of the product of each deviation of returns of two assets and
respective probability.
PORTFOLIO RISK: TWO-ASSET CASE
Correlation is a measure of the linear relationship
between two variables.
 Positive covariance X’s and Y’s returns could be above their average returns at the
same time. Alternatively, X’s and Y’s returns could be below their average returns
at the same time. In either situation, this implies positive relation between two
returns. The covariance would be positive.
 Negative covariance X’s returns could be above its average return while Y’s return
could be below its average return and vice versa. This denotes a negative
relationship between returns of X and Y. The covariance would be negative.
 Zero covariance Returns on X and Y could show no pattern; that is, there is no
relationship. In this situation, covariance would be zero. In reality, covariance may
be non-zero due to randomness and the negative and positive terms may not
cancel out each other.
 FUTURE VALUE

Compound interest is the interest that is received on the original amount (principal) as
well as on any interest earned but not withdrawn during earlier periods.
Compounding is the process of finding the future values of cash flows by applying the
concept of compound interest.
Simple interest is the interest that is calculated only on the original amount (principal)
 Future Value of a Single Cash Flow
Suppose your father gave you `100 on your eighteenth birthday. You deposited this amount in a
bank at 10 per cent rate of interest for one year.
Future value = Principal + Interest = 100 + (0.10 × 100) = 100 × (1.10) = `110
What would be the future value if you deposited `100 for two years?
Future value = [100 + 0.10 × 100) + 0.10[100 + (0.10 × 100)] = 100 × 1.10 × 1.10 = `121

i represent the interest rate per period, n the number of periods before pay-off, and FV
the future value, or compound value. The term (1+ i)^n is the compound value factor
(CVF) of a lump sum of `1.
PROBLEM: Suppose that `1,000 are placed in the savings account of a bank at 5 per cent
interest rate. How much shall it grow at the end of three years?
 Future Value of an Annuity
Annuity is a fixed amount (payment or receipt) each year for a specified number of years.
E.g. If you rent a flat and promise to make a series of payments over an agreed period, you
have created an annuity.
The compound value of `1 deposited in the first year will be: 1 ×
1.06^3 = `1.191,
1 deposited in the second year will be: `1 × 1.06^2 = `1.124
1 deposited at the end of third year will be: `1 × 1.06^1 = `1.06
1 deposited at the end of fourth year will remain `1.
The aggregate compound value of `1 deposited at the end of
each year for four years would be: 1.191 + 1.124 + 1.060 + 1.00 =
`4.375. This is the compound value of an annuity of `1 for four
years at 6 per cent rate of interest.
 Future Value of an Annuity

PROBLEM: Suppose a firm deposits `5,000 at the end of each year for four years at
6 per cent rate of interest. How much would this annuity accumulate at
the end of the fourth year?
 Sinking Fund
 Sinking fund is a fund, which is created out of fixed payments each period to accumulate to
a future sum after a specified period. For example, companies generally create sinking
funds to retire bonds (debentures) or loan on maturity.
 The factor used to calculate the annuity for a given future sum is called the sinking fund
factor (SFF). SFF ranges between zero and 1.0. It is equal to the reciprocal of the compound
value factor for an annuity.
 PRESENT VALUE
 With the compounding technique, the amount of present cash can be converted into
an amount of cash of equivalent value in future.
 However, it is a common practice to translate future cash flows into their present
values. Present value of a future cash flow (inflow or outflow) is the amount of current
cash that is of equivalent value to the decision maker.
 Discounting is the process of determining present values of a series of future cash
flows. The compound interest rate used for discounting cash flows is also called the
discount rate.
How much would the investor give up now to get an amount of `1 at the end of one
year? Assuming a 10 per cent interest rate.
 Present Value of a Single Cash Flow
Amount sacrificed in the beginning of year will grow to 110 per cent or 1.10 after a year. Thus
the amount to be sacrificed today would be: 1/1.10 = `0.909.
Stated differently, `0.909 deposited now at 10 per cent rate of interest will grow to `1 after
one year. If `1 is received after two years, then the amount needed to be sacrificed today
would be: 1/1.21 = `0.826.
Let i represent the interest rate per period, n the number of periods, F the Future value (or
cash flow) and P the present value (cash flow).
Future value after one year, F1 (viz., present value (principal) plus interest), will be
F1 = P(1 + i)
 Present Value of a Single Cash Flow (Lump Sum)
The following general formula can be employed to calculate the present value of a lump
sum to be received after some future periods:

The term in parentheses is the discount factor or present value factor (PVF), and it is
always less than 1.0 for positive i, indicating that a future amount has a smaller
present value.

PROBLEM: Find out the present value of `50,000 to be received after 15 years. The
interest rate is 9 per cent.
 Present Value of an Annuity
An investor may have an investment opportunity of receiving an annuity—a
constant periodic amount—for a certain specified number of years.
example, an investor, who has a required interest rate as 10 per cent per year, may
have an opportunity to receive an annuity of `1 for four years

Figure : Graphic representation of present value of an annuity of `1 at 10%

 Present Value of an Annuity

Suppose that a person receives an annuity of `5,000 for four years. If the rate of
interest is 10 per cent, the present value of `5,000 annuity is:
 Capital Recovery and Loan Amortization
Capital recovery is the annuity of an investment made today, for a specified period of
time, at a given rate of interest. The reciprocal of the present value annuity factor is
called the capital recovery factor (CRF).
 Capital Recovery and Loan Amortization
Capital recovery factor helps in the preparation of a loan amortization schedule or loan
repayment schedule.
PROBLEM: Suppose you have borrowed a 3-year loan of `10,000 at 9 % from your
employer to buy a motorcycle. If your employer requires three equal end-of-year
repayments. What will be your annual installment.

A
 Present Value of Perpetuity

 Perpetuity is an annuity that occurs indefinitely. E.g. irredeemable preference shares

(i.e., preference shares without a maturity), the company is expected to pay
preference dividend perpetually.
 By definition, in a perpetuity, time period, n, is so large (mathematically n approaches
infinity) that the expression (1 + i)^n in tends to become zero, and the formula for a
perpetuity simply becomes

PROBLEM: Investor expects a perpetual sum of `500 annually from his investment.
What is the present value of this perpetuity if interest rate is 10 per cent?
 Present Value of an Uneven Cash Flow
Consider that an investor has an opportunity of receiving `1,000, `1,500, `800, `1,100 and
`400 respectively at the end of one through five years. Find out the present value of this
stream of uneven cash flows, if the investor’s required interest rate is 8 per cent. The
present value is calculated as follows:
 Present Value of Growing Annuity
In financial decision-making there are number of situations where cash flows may grow at a
constant rate.
Assume that to finance your post-graduate studies in an evening college, you undertake a
part-time job for 5 years. Your employer fixes an annual salary of `1,000 at the end with the
provision that you will get annual increment at the rate of 10 per cent. It means that you
shall get the following amounts from year 1 through year 5.
 Present Value of Growing Annuity
If your required rate of return is 12 per cent, you can use the following formula to calculate
the present value of your salary
 MULTI-PERIOD COMPOUNDING
 The interest rate is usually specified on an annual basis, in a loan agreement or security
(such as bonds), and is known as the nominal interest rate.
 If compounding is done more than once a year, the actual annualized rate of interest
would be higher than the nominal interest rate and it is called the effective interest rate.
 Suppose you invest `100 now in a bank, interest rate being 10 per cent a year, and that
the bank will compound interest semi-annually (i.e., twice a year).

Interest = `100 × 10% × ½ = `5 Interest = `105 × 10% × ½ = `5.25

so the Effective interest rate (EIR) is:

 MULTI-PERIOD COMPOUNDING

r = interest rate m multiplied by the number of years n

 Continuous Compounding
The continuous compounding function takes the form of the following formula:

r = interest rate m multiplied by the number of years n

Above equation can be transformed into a formula for calculating present value under
continuous compounding.
Suppose you deposit Rs.5,000 in a bank for 6 years. If the interest rate is 12 percent and the
frequency of compounding is 4 times a year. your deposit after 6 years will be:
 Continuous Discounting
Cash flows have to be discounted more frequently than once a year - semi-annually,
quarterly, monthly, or daily. As in the case of intra-year compounding, the shorter
discounting period implies that (i) the number of periods in the analysis increases and (ii)
the discount rate applicable per period decreases. The general formula for calculating the
present value in the case of shorter discounting period is:

where PV is the present value, FV, is the cash flow after n years, m is the number of
times per year discounting is done, and r is the annual discount rate.
 Continuous Discounting

To illustrate, consider a cash flow of Rs.10,000 to be received at the end of four years.
The present value of this cash flow when the discount rate is 12 percent (r = 12 percent)
and discounting is done quarterly (m = 4) is determined as follows:
 Annuity Due
Cash flows occur at the beginning of each period. Such an annuity is called an annuity due.
For example, when you enter into a lease for an apartment, the lease payments are due at
the beginning of the month. Lease is a contract to pay lease rentals (payments) for the use of
an asset. Hire purchase contract involves regular payments (instalments) for acquiring
(owning) an asset.
The time lines for ordinary annuity and annuity due are shown below:
 Annuity Due

Since the cash flows of an annuity due occur one period earlier in comparison to the
cash flows on an ordinary annuity, the following relationship holds:
Annuity due value = Ordinary annuity value x (1 + i)
This applies for both present and future values. So, two steps are involved in
calculating the value of an annuity due.
1. Calculate the present or future value as though it were an ordinary annuity.
2. Multiply your answer by (1 + i).
 Future Value of an Annuity Due
Suppose you deposit `1 in a savings account at the beginning of each year for 4 years to
earn 6 per cent interest? How much will be the compound value at the end of 4 years?

Future value of an annuity due = Future value of an annuity × (1 + i)

= A × CVFAn,i × (1 + i)

× (1 + i)

Present Value of an Annuity Due

Present value of an annuity due = Present value of an annuity × (1 + i)
= A × PVFAn,i × (1 + i)

× (1 + i)
 Doubling Period
How long would it take to double the amount at a given rate of interest?
we find that when the interest rate is 12 percent it takes about 6 years to double the
amount, when the interest is 6 percent it takes about 12 years to double the amount, so
on and so forth.
Is there a rule of thumb which dispenses with the use of the future value interest factor
table?
Yes, there is one and it is called the rule of 72. According to this rule of thumb, the
doubling period is obtained by dividing 72 by the interest rate. For example, if the
interest rate is 8 percent, the doubling period is about 9 years (72/8). Likewise, if the
interest rate is 4 percent the doubling period is about 18 years (72/4). Though somewhat
crude, it is a handy and useful rule of thumb.
 Doubling Period
If you are inclined to do a slightly more involved calculation, a more accurate rule of
thumb is the rule of 69. According to this rule of thumb, the doubling period is equal to:

As an illustration of this rule of thumb, the doubling period is calculated for two
interest rates, 10 percent and 15 percent.
 Finding the Growth Rate

Suppose your company currently has 5,000 employees and this number is expected to
grow by 5 percent per year. How many employees will your company have in 10
years? The number of employees 10 years hence will be:
5,000 x (1.05)10 = 5000 x 1.629 = 8,145
Consider another example. Phoenix Limited had revenues of Rs.100 million in 2000
which increased to Rs.1000 million in 2010. What was the compound growth rate in
revenues? The compound growth rate may be calculated as follows:
100 (1 + g)10 = 1,000
(1+g)10 = 1000 /100=10
(1 + g) = 10 1/10
g=101/10- l
= 1.26 - 1 = 0.26 or 26 percent
 PROBLEM
1. Suppose you have decided to deposit Rs.30,000 per year in your Public Provident Fund
Account for 30 years. What will be the accumulated amount in your Public Provident Fund
Account at the end of 30 years if the interest rate is 8 percent?
2. You want to buy a house after 5 years when it is expected to cost Rs.2 million. How much
should you save annually if your savings earn a compound return of 12 percent?
3. A finance company advertises that it will pay a lump sum of Rs.8,000 at the end of 6 years to
investors who deposit annually Rs. 1,000 for 6 years. What interest rate is implicit in this offer?
4.You want to take up a trip to the moon which costs Rs.1,000,000 - the cost is expected to
remain unchanged in nominal terms. You can save annually Rs.50,000 to fulfill your desire. How
long will you have to wait if your savings earn an interest of 12 percent?
1. Suppose you have decided to deposit Rs.30,000 per year in your Public Provident Fund
Account for 30 years. What will be the accumulated amount in your Public Provident Fund
Account at the end of 30 years if the interest rate is 8 percent?
2. You want to buy a house after 5 years when it is expected to cost Rs.2 million. How
much should you save annually if your savings earn a compound return of 12 percent?

3. A finance company advertises that it will pay a lump sum of Rs.8,000 at the end of 6
years to investors who deposit annually Rs. 1,000 for 6 years. What interest rate is
implicit in this offer?
4.You want to take up a trip to the moon which costs Rs.1,000,000 - the cost is expected to
remain unchanged in nominal terms. You can save annually Rs.50,000 to fulfill your
desire. How long will you have to wait if your savings earn an interest of 12 percent?