Risk and Return
Risk and return Unit-4
Day – 1
Meaning of Return :
• Motivating force of Investment.
• Income received from investment or reward for investment.
• There are various types of returns.
• Basically we deal with Holding Period Return and Expected
Return in this unit.
Holding Period Return(HPR)
• Return that combines return realized from a change in the price of an
investment(capital gain) and cash receipt (Income) within a certain period.
• Holding period return as its name implies the total return realized in a
holding period that may be 1 day, 2 week, 1 month 1 year etc.
• Return in Rs. = Ending Price(P1)- Beginning Price(P0)+ Cash Receipt(C1)
• Rate of Return (r) =
• If we have to choose the investment alternatives we should go for the
investment with Highest HPR.
• Before comparing we must calculate annualized HPR.
• Annualized HPR = 〖 (1+HPR) 〗 ^1/T . Where T = holding period expressed
in year. T= 0.5 years for Holding Period of 6 months. i.e. 6 divided by 12 .
Example 1: Mr. Ram Purchased 300 shares of SBI at a market price of Rs. 200
per share. After one year SBI pays Rs. 10 in dividend per share and Mr. Ram sold
his share at a price of Rs. 240 per share after receiving dividend income.
Required: Holding Period Return
Solution:
Purchase Price (BP) = Rs. 200
Selling Price(EP) = Rs. 240
Dividend Income (C) = Rs. 10
Rupee return = EP – BP + C = 240 – 200 + 10 = Rs. 50 per share
Rate of Return = = = 0.25 or 25%
Dividend Yield = = = 5%
Capital Gain Yield = = = 20%
Hence, the rate of return made by Mr. Ram in this period is 25%. Out of this 25%, Dividend yield is 5% and capital gain
yield is 20%
Example 2: From the Following Data find Annual Rate of return(HPR)
Year Stock Price Dividend Annual Return/ HPR
1998 400 400 -
1999 412 412 = 8%
2000 440 440 = 11.65%
2001 562 562
2002 562 562
2003 1500 1500
Expected Return , E(Rj) or (
• Expected Return is the mean of Holding period Return.
• It is the return expected by investor in the future from investment.
• The calculation of expected rate of return is based on HPR of some periods.
• It is calculated in three ways:
• A. When historical HPR is given
• B. When probability distribution is given.
• C. When time value of money is to be considered.
Calculating E(Rj) when historical HPR’s are
given. State ofHPR
Economy Moderate
20%
Recession
10%
Boom
3%
State HPR Now,
Moderate 20% Expected rate of Return of Assets I, E(Ri) =
Recession 10%
Boom 3%
=
=
Calculating E(Rj) when Probability distributions
are given State ofHPR
Economy Moderate
20%
Recession
25%
Boom
30%
Probability 0.5 0.4 0.1
State HPR (R) P Px R
Moderate 20% 20% 10%
Recession 25% 25% 4%
Boom 30% 30% 3%
Now,
Expected rate of Return of Assets I, E(Ri) =
Risk:
•• Chances of some unfavourable event that will occur.
• In finance, risk refers to the variability in the return from an
investment.
• Possibility of earning less than expected earning is risk.
• The degree of risk can be measured via:
• Standard Deviation (
• Variance
• Co-efficient of variation (CV)
• Beta co-efficient of Return
Standard Deviation (
(Based on Historical data)
• Calculate the expected mean return of assets i.e E(RA)=
• Subtract expected return from each possible outcome i.e RA-
• Square the deviation and get a summation of those deviation i.e.
• Apply the formula
Standard deviation( =
Standard Deviation (
(Based on probability)
• Calculate the expected mean return of assets i.e E(RA)=
• Subtract expected return from each possible outcome i.e RA-
• Square the deviation and get a summation of those deviation i.e.
• Multiply the square of deviation by their respective probabilities and make
summation
• Apply the formula
Standard deviation( =
Variance (
• Higher
the variance greater the degree of dispersion .
• Smaller variance, the lower the riskness of the stock.
Co-efficient of Variation(CV)
• Risk per unit of return.
• Higher CV denotes higher the risk and vice versa.
• CV =
State Probability Return
Boom 0.3 100%
Calculate:
Average 0.4 15%
a. Expected rate of Return b. Standard Deviation
Recession 0.3 -70%
c. Variance d. Co-efficient of Variation
State x
Boom 0.3 100% 30% 85%
85% 7,225
7,225 2,167.50
2,167.50
0.3 100%
Average 0.4 15% 0
0 0
0 0
0
0.4 15% 6%
Recession 0.3 -70% -85%
-85% 7,225
7,225 2167.5
2167.5
0.3 -70% -21%
a. Expected Return () =
b. Standard Deviation ( ¿ ¿ 65. 84 %
√ 4,335
c. Variance ( ¿ 4335
d. C = 4 .39
¿
Consider the following historical data for A
and B:
Year
Answer: RA RB Calculate:
a. 13 %, 13% a. Expected Return for both stocks
b. 2010 20%
14.095, 2.582 10% b. Standard Deviation and variance for both
c. 2011 18%
1.0842, 0.1968 12% stock.
d. 2012
CV of stock-8%
B is lower14%
than stock
c. Coefficient
A. So, the Stock
of variation
B seemsformore
bothattractive
stock.
from investment due to less risk
d. Which
per unit.
stock may be appropriate for
2013 22% 16% investment why?
Co-variance(
• Statistical
measure that shows the movement of two investment or
assets.
• Positive co-variance indicates that the return of two assets move
in same direction where as negative co-variance indicates that
return of two assets move in opposite direction.
• Zero Co-variance indicates that the return of two assets are
independent.
• or .
Correlation (cor, r,)
• Measure
of degree of relationship with which two variables move together.
• It lies between +1 and -1. +1 indicates that there is perfect positive correlation
and the return on two assets move on same direction with same amount. -1
indicates that there is perfect negative relation and the return on two assets
move on opposite direction with same amount.
• Cor =
Probability Rx Ry
0.2 5% 30%
Calculate:
a. Expected return on risk on Stock X and Y 0.5 15% 20%
b. Co-efficient of correlation and covariance
0.3 25% 10%
Calculation of Expected return and standard deviation of stock X
P Rx Rx . P i Rx- E(RX) (Rx- E(RX)2 (Rx- E(RX)2 . Pi
0.20 5% 1% -11% 121% 24.2%
0.50 15% 7.5% -1% 1% 0.5%
0.30 25% 7.5% 9% 81% 24.3%
= 16% = 49%
a. Expected Return on X E(Rx) = 16%
b. Standard Deviation of Stock X ( =
∑√ (Rx− E(RX)2 . Pi √ 49 % 7%
= =
Probability Rx Ry
0.2 5% 30%
Calculate:
a. Expected return on risk on Stock X and Y 0.5 15% 20%
b. Co-efficient of correlation and covariance
0.3 25% 10%
Calculation of Expected return and standard deviation of stock Y
P Ry Ry . P i Ry- E(Ry) (Ry- E(Ry)2 (Ry- E(Ry)2 . Pi
0.20 30% 6% 11% 121% 24.2%
0.50 20% 10% 1% 1% 0.5%
0.30 10% 3% -9% 81% 24.3%
= 19% = 49%
a. Expected Return on Y E(Ry) = 19%
b. Standard Deviation of Stock Y ( =
∑√ (Ry− E(Ry)2 . Pi √ 49 % 7%
= =
Probability Rx Ry
0.2 5% 30%
Calculate:
a. Expected return on risk on Stock X and Y 0.5 15% 20%
b. Co-efficient of correlation and covariance
0.3 25% 10%
Calculation of coefficient of correlation and covariance
P (Rx- E(RX)) (Ry- E(Ry)) (Rx- E(RX)). (Ry- E(Ry)) . PI
0.20 -11% 11% -24.2%
0.50 -1% 1% -0.5%
0.30 9% -9% -24.35
.Pi= -49%
a. Covariance of return ( COVXY) = .Pi ¿ − 49 %
𝐶𝑂𝑉
− 49 %
b. Co-efficient of correlation (CORxy) =
𝑋𝑌
𝜎 𝑋 . 𝜎𝑌
=
7 𝑋 7
= -1
Year Return on NIC market Return on market
1 7.5% 17%
2 22.8% 14%
Consider the given information :
3 0 5.8%
4 -9.9% -7
5 0.6% 5.6
a. Based on Historical rate of return data, calculate the expected return on
common stock of NIC and on market.
b. Calculate standard deviation of the return of stock on NIC and on market.
c. Calculate the covariance and correlation coefficient of the return on NIC and
market.
Portfolio:
• Simply Defined as the combination of investments in various
securities.
• Portfolio is created to minimize the risk of investment with higher
return.
• Portfolio Theory was proposed by Harry Markowitz in 1952s.
• Markowitz Model is based on following assumptions:
• Investors are risk averse.
• All investors have same expected single period investment horizon.
• Investors base their investment decision on the expected return and
standard deviation of returns.
Portfolio Return , E(Rp) or
• Portfolio
return refers to the return on total investment when an
investor invests in more than one assets or security.
• We can find the Portfolio return by using following formula:
• E(Rp) = or it is the sum of product of weight and return of
individual assets
• E(Rp) = E(RA) x WA + E(RB) x WB or,
• The total weight must be 100% or 1. If the weight is not given in
the question. We need to calculate the weight
• Wi =
Company Investment Expected
Retrun
Calculate the A Rs. 1,20,000 10%
expected portfolio B Rs. 2,00,000 12%
return:
C Rs. 40,000 6%
Company Investmet E(R) Weight(W) E(R) x W Thi
s is
A 1,20,000 10% 0.3333 3.33% Ret Expe
run cte
B 2,00,000 12% 0.5555 6.66%
por o n th d
C 40,000 6% 0.1112 0.66 % tfol e
io
Total Investment = 120000+200000+40000 = 3,60,000
Weight of A (WA) = 0.3333 or 33.33 %
Weight of B (WB) = = 0.5555 or 55.55 %
Weight of C (WC) = 1- 0.3333-0.5555 or 100% - 33.33% - 55.55% = 0.1112 or 11.12%
Company Investment Expected
Retrun
Calculate the A Rs. 1,20,000 10%
expected portfolio B Rs. 2,00,000 12%
return:
C Rs. 40,000 6%
Alternative Solution:
E(RP) = E(RA) x WA + E(RB) x WB + E(RC) x WC
= 10% x + 12% x + 6% x
= 10.67%
You own a portfolio that has invested Rs. 40,000 in Stock A and Rs.
60,000 in Stock B. if the expected returns on these stocks are 10% and
20% respectively. What is the expected return on the portfolio?
Answer is given in your text book. ( Illustration 4.6)
Portfolio Risk
• Aggregate
risk of assets included in the portfolio.
• It is not the weighted average of standard deviation of individual securities included
in portfolio.
• The portfolio risk does not depend only upon the risk of individual risk but also on the
relationship(correlation and covariance) between return of two assets.
• OR
• Or, (If probability is given )
• CV of portfolio =
Methods to calculate Portfolio return
Method I Method II
• Find Expected return of • Find individual portfolio return
individual assets. RP by using formula WA.RA+ WB.RB
• Find standard deviation of each • Multiply the Rp with probability
assets. and get summation. Which is
• Find covariance of two assets. expected portfolio return E(Rp).
• Use the formula of portfolio • Find [Rp-E(Rp)]2.Pi
standard deviation which
• Use the formula and get
includes covariance
portfolio standard deviation.
Rate of Return
Scenario P
Stock A Stock B
Consider the given information and answer the questions:
a. Calculate the expected rate of return for each stock and portfolio if Recession 0.3 5% 30%
equal amount of money is invested in each stock. Normal 0.40 10 20
b. Calculate standard deviation for each stock
Boom 0.30 15 10
Scenario Pi RA RB RA.Pi RB.Pi [RA – E(RA)] [RA – E(RA)]2.PI
Recession 0.3 5% 30%
Normal 0.4 10 20
Boom 0.3 15 10
Expected Return on Stock A, E(RA) =
Expected Return on Stock B, E(RB) =
Expected Return on Portfolio, E(Rp) = WA E(RA) + WB. E(RB)
Since equal amount is invested in both stocks WA= WB= 0.5
Standard Deviation of stock A, () =
Rate of Return
Scenario P
Stock A Stock B
Consider the given information and answer the questions:
a. Calculate the expected rate of return for each stock and portfolio if Recession 0.3 5% 30%
equal amount of money is invested in each stock. Normal 0.40 10 20
b. Calculate standard deviation for each stock
Boom 0.30 15 10
Scenario Pi [RB – E(RB)] [RB – E(RB)]2.PI [RA – E(RA)] [RB – E(RB)]
Recession 0.3
Normal 0.4
Boom 0.3
Standard Deviation of stock B, () =
Standard Deviation of Portfolio, () =
Where COVAB= .
ALTERNATIVE SOLUTION : Scenario P
Rate of Return
Stock A Stock B
Consider the given information and answer the questions:
a. Calculate the expected rate of return for each stock and portfolio if Recession 0.3 5% 30%
equal amount of money is invested in each stock. Normal 0.40 10 20
b. Calculate standard deviation for each stock
Boom 0.30 15 10
Scenario Pi RA RB RP= 0.5xRA+ O.5 x RB RP.Pi
Recession 0.3 5% 30% 0.5 x 5 + 0.5 x 30 = 17.5 17.5 x 0.3 = 5.25
Normal 0.4 10 20 0.5 x 10 + 0.5 x 20 = 15 15 x 0.4 = 6
Boom 0.3 15 10 0.5 x 15 + 0.5 x 10 = 12.5 12.5 x 0.3 = 3.75
Expected Return on portfolio E(Rp) = 15% E(Rp) = 15%
Now, Find [Rp- E(Rp)] it’s square and multiply with Pi to get
Portfolio standard deviation (
NOTE:
• when the correlation between assets is perfectly negative it
is possible to eliminate risk.
• When the correlation between assets is perfectly positive
there is not risk diversifying benefit of the portfolio.
• When the correlation is less than 1, it is possible to reduce
the portfolio risk but it would not be eliminated.
Types of Investor According to Risk
Perception
• Risk indifference/ Risk Neutral:
• Investor who does not consider risk while choosing investment.
• This type of investor tries to balance the rate of return and risk
associated with same investment.
• Risk Averse / Risk Averter:
• Investor who demands more return for the small increment in risk.
• He selects the higher return alternative with identical risk.
• Risk Seeker/ Risk Lover/Risk Taker:
• Investor who believes that greater risk provide higher return .
• He selects the higher risk alternative with identical return.
Beta Coefficient (:
• Investment contains risk. Those risk can be diversifiable(and undiversifiable.
• Diversifiable risk is also called unsystematic risk which is created by internal
factors of an organization such as lack of capital, inefficiency of manger etc.
• Undiversifiable risk is also called systematic risk which is created by external
factors such as inflation, change in interest rates etc.
• Unsystematic risk can be eliminated with efficiency of organization but
systematic risk cannot be elilmated.
• Systematic risk thus should be assessed and its effect should be minimized.
• The statistical tool that measures the systematic risk of an assets in relation to
the market is beta coefficient.
Beta Coefficient (:
••
Beta coefficient ( or
• Portfolio Beta (
• The Beta co-efficient of market is always assumed to be 1. Market
refers to the stock market such as NEPSE.
• If beta co-efficient is greater than 1, such stock is regarded as
aggressive stock meaning to say, the stock is riskier than the market.
• If the beta co-efficient is less than 1 , such stock is regarded as
defensive stock and considered to be less riskier than the market.
Practice Problem Prob Rm Rj
0.3 15% 20%
Where, Rm= required rate of return on a portfolio consisting of all 0.4 9% 5%
stocks, which is the market portfolio
Rj= Required rate of return on stock j. 0.4 18% 12%
a. Calculate the expected rates of returns for the market and stock J
b. Calculate the standard deviation for the market and stock J
c. Calculate the co-efficient of variation for the market and stock J
d. Interpret all the above result.
a. Expected return on stock = 11.6% Expected return on market = 13.5%
b. Standard deviation on stock = 6.216%, S.D. on market = 3.85
c. Calculate the co-efficient of variation for the market and stock J
d. Interpret all the above result.
Analyzing the Risk and Return
Capital Assets Pricing Model(CAPM)
•• A
model that helps to calculate the required rate of return to overcome the risk associated with it.
• This Model helps and investor to estimate the return in accordance to the risk associated with it.
• This model suggests the following relationship between required rate and risk relationship.
• Ri = Rf + (Rm-Rf)
• Where Ri = Required rate of return,
Rm = Expected rate of return
Rf = Risk free Rate
Rm = Expected return on market.
Rm – Rf = Market risk premium
= Beta Co-efficient
• The relationship between an assets return and its systematic risk can be expressed by CAPM,
which is called Security Market Line(SML).
