Chapter 6:
Analysis of
Risk &
Return
I m ro z M a h m u d
A s s i s t a n t P ro f e s s o r ( UA P )
LEARNING OBJECTIVES
LO-1: Components of return
LO-2: How to calculate return from historical / past data
LO-3: How to calculate risk using historical / past data
LO-4: Nominal vs. Real Return
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INTRODUCTION
If you buy an asset of any sort, your gain (or loss) from that investment is
called the return
Return is closely associated with……….?
The required return/reward depends on the risk of the investment.
The greater the risk, the greater is the required return/potential reward
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RETURNS
Return has two components:
o Income component
o Capital gain (or loss) component
Example 1: Video Concept Company (VCC) has several thousand shares of stock
outstanding. You purchased 100 shares in the company at the beginning of the year for
$37 per share. Suppose that, over the year, the stock paid a dividend of $1.85 per share.
Also, the value of the stock has risen to $40.33 per share by the end of the year.
What’s your income (dividend) gain?
What’s your capital gain? Total gain?
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PERCENTAGE RETURNS
It is usually more convenient to summarize information about returns in percentage
terms, rather than dollar terms.
Express everything on per-share basis
Income gain:
𝐷𝑡+1
▪ 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑌𝑖𝑒𝑙𝑑 =
𝑃𝑡
▪ 𝑃𝑡 = 𝐵𝑒𝑔𝑖𝑛𝑖𝑛𝑔 𝑠𝑡𝑜𝑐𝑘 𝑝𝑟𝑖𝑐𝑒
▪ 𝐷𝑡+1 = 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑝𝑎𝑖𝑑 𝑑𝑢𝑟𝑖𝑛𝑔 𝑡ℎ𝑒 𝑦𝑒𝑎𝑟
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PERCENTAGE RETURNS
Capital gain (or loss):
Pt+1 −Pt
• Capital Gains Yield =
Pt
• 𝑃𝑡 = 𝐵𝑒𝑔𝑖𝑛𝑖𝑛𝑔 𝑠𝑡𝑜𝑐𝑘 𝑝𝑟𝑖𝑐𝑒
• 𝑃𝑡+1 = 𝐸𝑛𝑑𝑖𝑛𝑔 𝑠𝑡𝑜𝑐𝑘 𝑝𝑟𝑖𝑐𝑒
• Total Return= Dividend Yield + Capital Gains Yield
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EXAMPLE 2: CALCULATING RETURNS
Suppose you bought some stock at the beginning of the year for Tk.
3801.40 per share. At the end of the year, the price is Tk. 4,442.60 per
share. During the year, you got a Tk. 140 dividend per share. What is the
dividend yield? The capital gains yield? The percentage return?
If your total investment was Tk. 100,000, how much do you have at the
end of the year?
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AVERAGE RETURNS
The history of capital market returns is too complicated to be of much use in its
undigested form
Therefore, we take average returns
σ 𝑅𝑖
Formula: ത
𝑅=
𝑛
• 𝑅𝑖 = 𝑎𝑐𝑡𝑢𝑎𝑙 𝑟𝑒𝑡𝑢𝑟𝑛
• 𝑛 = 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑜𝑏𝑠𝑒𝑟𝑣𝑎𝑡𝑖𝑜𝑛𝑠
• 𝑅ത = 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑟𝑒𝑡𝑢𝑟𝑛
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CALCULATING RISK
Measured using the variability of stock’s return
How much actual returns deviate from the average?
Variance, 𝜎 2
Standard Deviation, 𝜎
The bigger the variance/standard deviation, the more the actual return differs from
average returns.
There is more risk.
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CALCULATING RISK
Variance:
2
σ 𝑅𝑖 − ത
𝑅
𝑉𝑎𝑟 𝑅 𝑜𝑟 𝜎 2 =
𝑛−1
Standard Deviation:
2
ത
σ(𝑅𝑖 − 𝑅)
𝑆𝐷 𝑅 𝑜𝑟 𝜎 =
𝑛−1
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EXAMPLE 3: CALCULATING RISK AND RETURN
Suppose the Supertech Company and the Hyperdrive Company have experienced the
following returns in the last four years:
Year Supertech Hyperdrive
Return Return
2017 (20%) 5%
2018 50% 9%
2019 30% (12%)
2020 10% 20%
What are the average returns? The variances? The standard deviations?
Which investment was more volatile/risky?
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RISK: SYSTEMATIC AND UNSYSTEMATIC
True risk of an investment is the unanticipated part of the return.
Systematic Risk: a risk that influences a large number of assets.
Also called market risk
Can’t be avoided through diversification
Unsystematic Risk is unique to a specific company or industry.
Also called diversifiable risk / asset specific risk
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NOMINAL VS. REAL RATES
Real Rates: Interest rates or rates of return that have been adjusted for inflation.
Shows percentage change in your purchasing power
Nominal Rates: Interest rates or rates of return that have not been adjusted for
inflation.
Shows percentage change in the amount of money you have
Investors are ultimately concerned with what they can buy with their money.
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THE FISHER EFFECT
Shows the relationship between nominal returns, real returns and inflation.
1+𝑅
𝑟= −1
1+𝑖
Example 4: For Example 3, suppose the average inflation rate over this period was 4
percent. Then, what was the real return?
Example 5:You own an asset that had a total return last year of 10.7 percent. If the
inflation rate last year was 3.7 percent, what was your real return?
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End of Chapter