risk and return

Topics: Capital asset pricing model, Financial markets, Modern portfolio theory Pages: 21 (2076 words) Published: October 11, 2013
RISK & RETURN
TOPIC 4

Learning Objectives
1. Understand the meaning of risk and return
2. Identify risk and return relationship
3. Discuss the measurement of expected return
and standard deviation
4. Understand portfolio and diversification
5. Distinguish the different types of investment
risks
6. Measurement of return based on CAPM
WRMAS

2

RETURN DEFINED
• Return represents the total gain or loss on an investment. •

Basic concept:
Each investor desires a return for every single dollar of their investment.
Example 1:
Rita invests in 10 unit shares valued at RM1000. At the end of year, she sells all the shares @ RM1100. How much return
received by Rita for her investment?

RM100 (Holding return dollar gain)
r = RM1,100 + 0 – RM1,000
RM1,000
= 10% (so holding period rate of return is 10%)
WRMAS

3

Return Defined
Exercise 1
Calculate the holding period rate of return of each
quarter below.
1st Quarter

2nd Quarter

3rd Quarter

4th Quarter

Dividend

0.50

1.20

0

1.95

Purchase price

100

98

101

102

Selling Price

98

101

102

108

HP Rate of
Return

?

?

?

?

WRMAS

4

EXPECTED RETURN
• Expected Return ( r )- the return that an investor expects to earn on an asset, given its price, growth potential, etc.
• Required Return ( r )- the return that an investor requires on an asset given its risk and market interest rates.
 Expected rate of return from investment is determined by the different possible outcomes such probabilities of the
occurrence of the various states of the economy.
 In the unstable situation, it is hard for the investors to be assured on the expected rate of return.

WRMAS

5

Expected Rate of Return
• Expected rate of return - The weighted average of all possible returns where the returns are weighted by the probability that each will occur.

OR, WE CAN PUT THIS WAY

r = Pb1*r1 + Pb2*r2 + ...+ Pbn*rn
where;
Pb = probability of occurrence of the outcome
r = return for the outcome
n = number of outcomes considered
WRMAS

6

Expected Rate of Return
Example 2
State of the
economy

Probability

Return

Recession

20%

10%

Normal

30%

12%

Boom

50%

14%

r = (0.2)(10%) + (0.3)(12%) + (0.5)(14%)
= 12.6%
WRMAS

7

Expected Rate of Return
Exercise 2
State of
Economy
Recession
Normal
Boom

Probability
Return
(Pb)
Company A
Company B
0.20
4%
-10%
0.50
10%
14%
0.30
14%
30%

a. What is the expected return for each company?
b. Explain which company’s return is more risky?

WRMAS

8

RISK DEFINED
• Risk is potential variability in future cash flow.
• The possibility that an actual return will differ from our expected return.
• The wider the range of possible future events that can occur, the greater the risk.
• Concept: If the investment involved is a high risk investment, the investor will target for the greater expected rate of return. (High risk, high return)
Probability- Chances that an
investment will generate
expected rate of return for
investor.

Return

WRMAS

Risk

9

STANDARD DEVIATION
HOW DO WE MEASURE RISK?
• Standard deviation (SD) is one way to measure risk. It
measures the volatility or riskiness of portfolio returns
(dispersion of possible outcomes).


SD (-sigma) = square root of the weighted average squared deviation of each possible return from the expected return.



The greater the standard deviation, the greater the
uncertainty, and the greater the risk.
Standard Deviation Formula:

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10

Standard Deviation

Example 3 (From Exercise 2)

Which stock would you prefer?
How would you decide?

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11

Standard Deviation

Summary
Expected Return
Standard Deviation

Company
A
B
10%
14%
3.46% 13.86%

We can conclude that, company A has lower risk compared to

investment B BUT Company B has higher return.
Final choice is determined...
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