RISK AND RETURN

• What is Risk?
• How is it measured?
• What is return?
• How is it measured?
 Rationale of studying risk &
return
• If we know how to measure and price financial
risk correctly, we can properly value risky
assets.
• This in turn leads to better allocation of
resources in the economy:
(i) Investors can better allocate their savings to
various types of risky securities;
(ii) Managers can better allocate the funds
provided by shareholders and creditors.
• Again the purpose of this lecture is to
explain to you how an individual will
choose among different investment
opportunities (financial products).

• Consider an individual who wants to buy

one financial product
 RETURN
• The return of a share gives an indication as
to what has been his gain.
• The rate of return on a share consists of its
dividend yield and the capital gain
percentage.
• The return on an investment measures
the increase/decrease in wealth that an
individual has obtained through doing
an investment.
 RETURN
• The return from holding a share over a
single period is simply the sum of dividend
received and capital gain or loss during
that period expressed as a percentage of
the price of the share at the start of the
period.

Return = Dividend Yield + Capital

Gain
 Computation of Return on
Individual Security
• Dividend Received = Dt
• Capital Gain or Loss = (Pt – Pt-1)
• Price at the start of the period = Pt-1

R = Dt + (Pt – Pt-1)
Pt-1
 Computation of Return
• Suppose you buy one share of Mauritius
Cements on 31st March 2007 for Rs 225.
You expect to receive a dividend of Rs
2.50 and sell the share for Rs 272 after
one year.

• Calculate the expected return on that

share.
 Computation of Return
• R = (2.5/225) + (272 – 225)/225 = 22%

• What would be your return if the market

price of Mauritius Cement’s share is Rs
200 after a year?
 Computation of Return
• R = (2.5/225) + (200– 225)/225 = -10%

• Negative rate of return because of capital

loss.
 Computation of Return
• A share is bought at Rs40; in one year’s
time, its price increases to Rs42 and it
pays a dividend of Rs2. calculate the
return of the investment
 Determinants of Return
1.Time the funds are committed
• Without interests/dividends, an individual
obtains a higher satisfaction by using an
amount of money for consumption today;
instead of investing that amount of money
today and consuming the same amount
tomorrow. Individuals are ready to defer
consumption, i.e. invest, only if they are
obtaining a certain level of return.
 Determinants of Return
2. Expected rate of inflation
• If the investor anticipates that over the
period of investment inflation rate will
increase (i.e. prices will increase); then he
will ask for a higher interest rate.
 Determinants of Return
3. Uncertainty of future payments
• An additional return is asked by the
investor, if he perceives that there is an
uncertainty over the payments from an
investment. This uncertainty is called the
investment risk and a risk premium is
required by the investor to compensate for
the risk.
TYPES OF RETURN
 Historical rates of return
(return on investments done)
• To assess the performance of an
investment that has been done, the
historical rate of return of the investment
can be calculated. Historical rates of return
are obtained by calculating the annual
holding period return (HPR) and the
annual holding period yield (HPY).
 Historical rates of return
(return on investments done)
• Annual HPR = [Ending value of
investment/ Beginning value of
investment] 1/n
• Where: n = number of years the
investment is held
 
• Annual HPY = HPR – 1
 Historical rates of return
(return on investments done)
• Calculate the annual holding period return
and the annual holding period yield of an
investment that cost Rs500 and is worth
Rs750 after being held for two years.
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 periods.
• The average rate of return can be
calculated as the sum of the yearly rate of
return divided by the number of years.
AVERAGE RATE OF RETURN
ARR = 1/n [R1 +R2+ R3 ………Rn]
 Subjective Probability
• What is the chance or likelihood for each
outcome to occur?

• Since probability of occurrence is not

given, we make use of SUBJECTIVE
Probability; i.e, based on judgment of the
investor; for e.g, each outcome is equally
likely to occur.
 Subjective Probability
Economic Rate of Probability Expected
Conditions Return (%) rate of
return
Growth 18.5 0.25 4.63

Expansion 10.5 0.25 2.62

Stagnation 1 0.25 0.25

Decline -6.0 0.25 -1.50

 EXPECTED RATE OF
RETURN
• Expected return – it is an estimate of the
return that an investment can provide.
The actual return obtained after the
investment period may differ from the
expected return.
• The rate of return will mainly depend
upon the economic conditions that are
going to prevail. If strong economic
conditions prevail (e.g. high profits
earned by company in which invest. done),
then return will also be high. If economic
conditions are poor, then return will be
low.
 EXPECTED RATE OF
RETURN
• In order to obtain an expected return, the
individual will:
• estimate all the possible returns that
may be obtained from the investment;
• then assigns probability values to all
possible returns
 Expected Return

Expected Return = Rate of

Return * probability
 Expected Return
• Expected rate of return from investment =
∑ (possible return)*(probability of return)
s=1

• Expected rate of return = E (R) = P1R1 +

P2R2 + P3R3 + …. + PnRn
• Where s represents the different economic
situations; future economic situations
range from 1
 Risk
• All investments are associated with risks.

• Risk in finance is measured by standard

deviation (σ – called sigma) which
measures the average dispersion from the
actual mean.
Steps in calculating standard
deviation of rates of return
Step 1: Calculate the average rate of return
using the following equation:
- n
• R = 1/n ∑ Rt
t=1
 Steps in calculating standard
deviation of rates of return
• Step 2: Calculate the deviation of
individual rate of return from the average
rate of return and square it:
-
(R – R)2
 Steps in calculating standard
deviation of rates of return
• Step 3: Calculate the sum of the squares
of the deviations as determined in the
second step and divide it by the number of
periods to obtain the variance.
n -
Var = σ2 = 1/n ∑ ((R t– R)2
t=1
 Steps in calculating standard
deviation of rates of return
• Step 4: Calculate the square root of the
variance to determine the standard
deviation.
Standard deviation = √ Variance
= √ σ2
Question 1:
Jenson & Nicholson, a paint company has the
following dividend per share (DIV) and the
market price per share (AMP) for the period
1997 – 2002:
Year Div (Rs) AMP
1997 1.53 31.25
1998 1.53 20.75
1999 1.53 30.88
2000 2.00 67.00
2001 2.00 100.00
2002 3.00 154.00
(a) Calculate the annual rates of return for
the last five years.
(b) Calculate the average rate of return.
(c) How risky is the share?
 Question 2
You are given the share Economic Share Dividend
price and dividend Conditions Price
payment over four
possible states of High 305.50 4.00
economic conditions: Growth
(a) Calculate annual
and average rate of Expansion 285.50 3.25
return.
(b) Calculate standard Stagnation 261.25 2.50
deviation.
Note that the current
share price is 261.25 Decline 243.50 2.00
 Standard Deviation

• σ2 = [R1 – E(R)]2 *P1 + [R2 –

E(R)]2*P2 + [R3 – E(R)]3 *P3
+………….[Rn –E(R)]2 *Pn
 Question 3
• The shares of a Return (%) Probability
hypothetical company
has the following -20 0.05
anticipated return with -10 0.10
the associated
probabilities: 10 0.20
• (a) Calculate 15 0.25
expected return; 20 0.20
• (b) Calculate risk as
25 0.15
measured by
standard deviation 30 0.05
 Implications of expected return
and standard deviation
• Info about expected return and standard
deviation helps an investor to make
decision about investments:
(1) A risk averse investor will prefer
investment with high rate of return and
lower std deviation.