Chapter Two
Risk and Return
Introduction
• Risk and return are the most important concepts in finance
and they are the foundations of modern finance theory.
• The first is A dollar today is worth more than a dollar
tomorrow, and is often called the time value of money.
• The second is a safe dollar is worth more than a risky dollar.
• Anyone who studies finance learns the universal application
of these statements and rational decision making. The
tradeoff between risk and return is the principles theme in
the investment decision.
• Most people are risk averse, which does not mean, however,
Measuring historical rate 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.
First, you may receive some cash directly while you
own the investment.
This is called the income component of your return.
Second, the value of the asset you purchase will
often change.
In this case, you have a capital gain or capital loss on
your investment.
Example: Suppose, at the beginning of the year, the
stock for a company was selling for $37 per share. If
you had bought 100 shares, you would have a total
out lay of $3700.
Suppose, over the year, the stock paid a dividend of
$1.85per share.
By the end of the year, then, you would have
received income of;
Dividend= $1.85 x 100= $185
Also, suppose the value of the stock has risen to
$40.33per share by the end of the year. Your 100
shares are now worth $4,033, so you have a capital
GM 1 r11 r2 . .1 rn 1
1/ n
Computing Mean Historical Returns
Now, we want to consider mean rates of return for a
single investment and for a portfolio of investments.
Over a number of years, a single investment will
likely give high rates of return during some years
and low rates of return, or possibly negative rates of
return, during others.
Your analysis should consider each of these returns,
but you also want a summary figure that indicates
this investment’s typical experience, or the rate of
n
GM 1 r1 1 r2 . . 1 rn 1
return you might expect to receive if you owned this
investment over an extended period of time.
You can derive such a summary figure by computing
the mean annual rate of return (it’s HPY) for this
investment over some period of time.
Alternatively, you might want to evaluate a portfolio
of investments that might include similar
investments (for example, all stocks or all bonds) or
a combination of investments (for example, stocks,
bonds, and real estate).
In this instance, you would calculate the mean rate
of return for this portfolio of investments for an
individual year or for a number of years.
MEASURING EXPECTED RETURN
x xi P( xi )
The expected return of the investment is the
probability weighted average of all the possible
returns.
If the possible returns are denoted by and the
related probabilities are , expected return may be
represented as and can be calculated as:
2
Measuring the Risk of Expected Rates of Return
n possible Expected
2
Variance( ) probability x
i 1 return Re turn
n
2
Variance( ) (Pi ) Ri E(Ri )
2
i 1
n
S tan dard deviation( ) (Pi ) Ri E(Ri ) 2
i1
S tan dard Deviation of Re turns
A Relative Measure of Risk:
In some cases, an unadjusted variance or standard coefficient of var iation CV
Expected Rate of Re turn
deviation can be misleading.
If conditions for two or more investment
alternatives are not similar—that is, if there are
major differences in the expected rates of return—it
i
is necessary to use a measure of relative variability
to indicate risk per unit of expected return.
A widely used relative measure of risk is the
coefficient of variation (CV), calculated as follows:
E ( R)
Risk Measures for Historical Returns
To measure the risk for a series of historical rates of
returns, we use the same measures as for expected
returns (variance and standard deviation) except
that we consider the historical holding period yields
(HPYs) as follows:
Where:
σ2 = the variance of the series,
HPYi = the holding period yield during period,
E(HPY) = the expected value of the holding period
yield that is equal to the arithmetic mean (AM) of
the series
n=the number of observations
The standard deviation is the square root of the
variance.
Both measures indicate how much the individual
HPYs over time deviated from the expected value of
the series.
TYPES OF RISK:
Thus far, our discussion has concerned the total risk
of an asset, which is one important consideration in
investment analysis.
However, modern investment analysis categorizes
the traditional sources of risk identified previously
as causing variability in returns into two general
types:
those that are pervasive in nature, such as market
Capital Asset Pricing Model (CAPM)
The Capital Asset Pricing Model (CAPM) and the Security
Market Line
