TOPIC 3:

RETURN & RISK

Content

1. Return

2. Risk

3. Risk premium
 How to choose investment assets?

TRADE-OFF BETWEEN RETURN AND RISK

1. MEASURES OF RETURNS| Holding period yield

Return over a holding period

• Holding Period yield (HPY)

Ending Value of Investment

HPY = -1
• Annual HPY Beginning Value of Investment
Annual HPY= (1+HPY) 1/n – 1
where n=number of years of the investment

* HPY (x years) => AHPY : following compound interest rate

HPY (x months, quarters,…) => APHY: following simple interest rate
Within a year => Can use simple interest rate
1. MEASURES OF RETURNS | Holding period yield

Example 1: Assume that you invest $200 at the beginning of

the year and get back $220 at the end of the year. What
is the HPY for your investment?
1. MEASURES OF RETURNS | Holding period yield
Example 2:

Selling Price in 12/2008 = $110

Buying Price in 1/2006 = $100
Dividends = $4, $4.5 , $6

HPY=?
AHPY?
1. MEASURES OF RETURNS | Holding period yield
Example 3: Your investment of $250 in Share A is worth $350 in
two years while the investment of $100 in Share B is worth
$120 in six months. What are the annual HPYs on these two
shares?
1. MEASURES OF RETURNS | Historical returns

Suppose you have a set of annual rates of return (AHPYs) for

an investment. How do you measure the mean annual return?

• Arithmetic Mean Return (AM)

AM=  AHPY / n
where  AHPY=the sum of all the annual HPYs
n=number of years * Note: For simplicity, we denote
• Geometric Mean Return (GM) AHPY as R, r (return)
GM= [ (1+AHPY)] 1/n -1
where  the product of ending value/Begining value
n=number of years
1. MEASURES OF RETURNS | Historical returns
Comparison of AM and GM
• When rates of return are the same for all years, the AM and the GM will
be equal.
• When rates of return are not the same for all years, the AM will always
be higher than the GM.
• While the AM is best used as an ‘expected value’ for an individual year,
the GM is the best measure of an asset’s long-term performance.
1. MEASURES OF RETURNS | Historical returns

Example 4

Suppose you invested $100 three years ago and it is worth

$110.40 today. Provide the computation of the AM over a three-
year period for an investment.
 1. MEASURES OF RETURNS | Expected returns

An investor would be more interested in the expected return on a future risky

investment.

Risk refers to the uncertainty of the future outcomes of an investment

• There are many possible returns/outcomes from investment due to the

uncertainty

• Probability is the likelihood of an outcome

• The sum of the probabilities of all the possible outcomes is equal to 1.0.
1. MEASURES OF RETURNS | Expected return

where P i = Probability for possible return i

R i = Possible return i
 1. MEASURES OF RETURNS | Expected returns

Example 5

Considering the following cases. What is the expected return for

a project with initial investment of USD100.
State of Probability Year –end price Cash dividend AHPY
economy (R)
Boom 0.3 129.5 4.5
Normal growth 0.5 110 4
Recession 0.2 80.5 3.5
1. MEASURES OF RETURNS | Expected return

Perfect certainty allows only one possible return

1. MEASURES OF RETURNS | Expected return

Less certain on the return depending on different possible economic conditions

1. MEASURES OF RETURNS | Expected return

Highly uncertain about the actual rate of return

 1. MEASURES OF RETURNS | Expected return

•True means and variances are unobservable because we don’t actually

know possible scenarios like the one in the examples
•So we must estimate them (the means and variances, not the scenarios)
•One way: analysing time series of past rates of return
1. MEASURES OF RETURNS | Expected return

Arithmetic Average
𝑛
1
𝐸 𝑅 = 𝑟ҧ = ෍ 𝑟𝑖
𝑛
𝑖=1
 1. MEASURES OF RETURNS | Expected return
Example 6

Stock A and B have the historical closing prices as follow:

Date P(A) Div(A) P(B) Div(B)
Q4-2015 50 5 60
Q3-2015 55 62 Calculate the expected return of
Q2-2105 52 59 two stocks.
Q1-2015 54 57 9 (2 stocks have the same
Q4-2014 56 6 57 proportion in portfolio)
Q3-2014 49 60
1. MEASURES OF RETURNS | Portfolio returns

Portfolio HPY: The mean historical rate of return for a portfolio of investments
is measured as the weighted average of the HPYs for the individual
investments in the portfolio, or the overall change in the value of the
original portfolio.

The weights used in the computation are the relative beginning market values
for each investment, which is often referred to as dollar-weighted or value-
weighted mean rate of return.
1. MEASURES OF RETURNS | Portfolio returns

𝑛 𝑛

𝐸(𝑅𝑝 ) = ෍ 𝑤𝑖 𝐸 𝑅𝑖 = ෍ 𝑤𝑖 𝑟ഥ𝑖
𝑖 𝑖

Where E(Rp): Expected return of a portfolio

wi: Percentage of asset i in the portfolio
E(Ri): Expected return of asset i
n: numbers of assets in the portfolio
1. MEASURES OF RETURNS | Portfolio returns
Example 7 Bear Normal Bull
market market Market
Probability 0.2 0.5 0.3
Stock X -20% 18% 50%
Stock Y -15% 20% 10%

Investors normally don’t buy only 1 stock. They have a

portfolio with many stocks. Assume that of $10,000
portfolio, $9,000 in stock X and $1,000 in stock Y. What is
the expected return of this portfolio?
 2. MEASURES OF RISK | Risk

▪ Risk refers to the uncertainty of an investment; therefore the measure of risk

should reflect the degree of the uncertainty.

▪ The risk of expected return reflect the degree of uncertainty that the actual
return will be different from the expected return.

▪ The common measures of risk are based on the variance of rates of return
distribution of an investment.
2. MEASURES OF RISK | Risk

The variance measure

2. MEASURES OF RISK | Risk

• Given a series of historical returns measured by r, the risk of returns

is measured as:
σ 𝑛 2
𝑖=1 (𝑟𝑖 − 𝑟)
ҧ
𝜎2 =
𝑛

where, σ 2 = the variance of the series

ri = the holding period yield during period i
𝑟=
ҧ the expected value of the HPY equal to the arithmetic mean of the
series (AM)
n = the number of observations (months, years, …)
2. MEASURES OF RISK | Risk
• Standard deviation (σ): It is the square root of the
variance and measures the total risk

s= 𝜎2

• Coefficient of variation (CV): It measures the risk

per unit of expected return and is a relative
measure of risk
= Standard Deviation of Return
CV
Expected Rate of Return
=s
E (R )
2. MEASURES OF RISK | Risk
r

27
 2. MEASURES OF RISK | Risk

Cov ( rD , rE ) = ෍ 𝑝(𝑠) [𝑅𝐷(𝑠) − 𝐸(𝑅𝐷 )][(𝑅𝐸(𝑠) − 𝐸(𝑅𝐸 )]

𝑠
or

σ(𝑟𝐷,𝑖 −𝑟𝐷 )((𝑟𝐸,𝑖 −𝑟ഥ𝐸 )

Cov ( rD , rE ) =
𝑛

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 2. MEASURES OF RISK | Risk

Cov ( rD , rE ) = DEsDsE

DE : Correlation coefficient of returns

▪ Range of values for 
−1 ≤ 𝜌 ≤ 1
If  = 1.0, the securities are perfectly positively correlated
If  = - 1.0, the securities are perfectly negatively correlated
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2. MEASURES OF RISK | Risk

𝑛 𝑛
𝜎𝑝2 σ σ
= 𝑖=1 𝑗=1 𝑤𝑖 𝑤𝑗 𝐶𝑜𝑣(𝑟𝑖 , 𝑟𝑗 )

For a portfolio with 2 assets D and E

s p2 = wD2 s D2 + wE2s E2 + 2wD wE Cov ( rD , rE )

Cov ( rD , rE ) = DEsDsE
DE : Correlation coefficient of returns
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2. MEASURES OF RISK | Risk

Now you come back

Example 6 and 7
to calculate risk of
portfolios

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Some note: REQUIRED RATE OF RETURNS

This is the minimum rate of return that you should accept from an
investment to compensate you for deferring consumption.

Three components of required return:

• The time value of money during the time period

• The expected rate of inflation during the period

• The risk involved

Some note: REQUIRED RATE OF RETURNS

Complications of estimating required return:

• A wide range of rates is available for alternative investments at any time.

• The rates of return on specific assets change dramatically over time.

• The difference between the rates available on different assets change over
time.C
 The difference between the rates available on different assets
rates of return
Wide on
range
specific
of(spread)
available
assetschanges
change
assetsover
overtime.
time
 3. RISK PREMIUM| Risk free rate

The real risk free rate (RRFR)

• Basic interest assuming no inflation and no uncertainty about future cash flows.
• Influenced by time preference for consumption of income and investment opportunities
in the economy
→ Government fixed income securities are used as a default-free investment because the
government has unlimited ability to derive income from taxes or to create money from
which to pay interest.
Nominal risk-free rate (NRFR)
• Conditions in the capital market
• Expected rate of inflation

NRFR=(1+RRFR) x (1+ Rate of Inflation) - 1

RRFR=[(1+NRFR) / (1+ Rate of Inflation)] - 1
3. RISK PREMIUM

Most investors require higher rates of return on investments if they perceive that
there is any uncertainty about the expected rate of return.
3. RISK PREMIUM
Business
risk

Exchange Financial
rate risk risk
Risk
premium

Liquidity Country
risk risk
3. RISK PREMIUM

Business risk Financial risk

Uncertainty of income flows caused by Uncertainty caused by the use of debt
the nature of a firm’s business financing
Sales volatility and operating leverage Borrowing requires fixed payments which
determine the level of business risk must be paid ahead of payments to
shareholders
The use of debt increases uncertainty of
shareholder income and causes an
increase in the share’s risk premium
3. RISK PREMIUM

Liquidity risk Exchange rate risk

How long will it take to convert an Uncertainty of return is introduced
investment into cash? by acquiring securities
How certain is the price that will be denominated in a currency
received? different from that of the investor.
Changes in exchange rates affect
the investors return when
converting an investment back into
the ‘home’ currency.
3. RISK PREMIUM
Example:
Assume that you buy 100 shares in Mitsubishi Electric at 1050 yen
when the exchange rate is 105 yen to the dollar.
A year later you sell the 100 shares at 1200 yen when the exchange
rate is 115 yen to the dollar. What is your HPY?
3. RISK PREMIUM

Country risk

• Political risk is the uncertainty of returns caused by the possibility of a major

change in the political or economic environment in a country.

• Individuals who invest in countries that have unstable political–economic

systems must include a country risk-premium when determining their
required rate of return.
3. RISK PREMIUM

Fundamental risk comprises business risk, financial risk, liquidity risk, exchange rate risk,
and country risk.

Risk Premium= f ( Business risk, Financial risk, Liquidity risk, Exchange rate risk,
Country risk)

Systematic risk refers to the portion of an individual asset’s total variance attributable
to the variability of the total market portfolio.

Risk Premium= f (Systematic market risk)