Chapter 7: Risk and Return
Chapter Outline
Return – Definition
Risk – Definition
Actual Return
Actual Risk
Expected Return
Expected Risk
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Defining Return
Income received on an investment plus any
change in market price, usually expressed as a
percent of the beginning market price of the
investment.
Dt + (Pt – Pt - 1 )
R=
Pt - 1
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Return Example
The stock price for Stock A was $10 per share 1
year ago. The stock is currently trading at $9.50 per
share and shareholders just received a $1 dividend.
What return was earned over the past year?
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Return Example
The stock price for Stock A was $10 per share 1
year ago. The stock is currently trading at $9.50 per
share and shareholders just received a $1 dividend.
What return was earned over the past year?
$1.00 + ($9.50 – $10.00 )
R= = 5%
$10.00
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Defining Risk
The variability of returns from those that are
expected. It is calculated by using standard
deviation method.
What rate of return do you expect on your
investment (savings) this year?
What rate will you actually earn?
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Actual Return and Actual Risk (Example)
Periods Returns (X) (X-Mean) (X-Mean)ˆ2
1 0.10 -0.0040 0.000016
2 0.12 0.0160 0.000256
3 0.08 -0.0240 0.000576
4 0.09 -0.0140 0.000196
5 0.13 0.0260 0.000676
∑ 0.52 0.0000 0.0017
Mean 0.10
Actual Retrun
Mean (%) 10.40%
S.D 0.0207
Actual Risk
S.D (%) 2.07%
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Determining Expected Return
(Discrete Dist.)
n
R = S ( Ri )( Pi )
I=1
R is the expected return for the asset,
Ri is the return for the ith possibility,
Pi is the probability of that return occurring,
n is the total number of possibilities.
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How to Determine the Expected
Return and Standard Deviation
Stock BW
(Ri)(Pi) Ri Pi
The
-0.15 0.10 –0.015 expected
-0.03 0.20 –0.006 return, R,
0.09 0.40 0.036 for Stock
0.21 0.20 0.042 BW is .09
or 9%
0.33 0.10 0.033
Sum 1.00 0.090
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Determining Standard Deviation
(Risk Measure)
n
s= S ( Ri – R )2( Pi )
i=1
Standard Deviation, s, is a statistical measure of
the variability of a distribution around its mean.
It is the square root of variance.
Note, this is for a discrete distribution.
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How to Determine the Expected
Return and Standard Deviation
Stock BW
Ri Pi (Ri)(Pi) (Ri - R )2(Pi)
–0.15 0.10 –0.015 0.00576
–0.03 0.20 –0.006 0.00288
0.09 0.40 0.036 0.00000
0.21 0.20 0.042 0.00288
0.33 0.10 0.033 0.00576
Sum 1.00 0.090 0.01728
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Determining Standard Deviation
(Risk Measure)
n
s= S
i=1
( Ri – R ) 2( P )
i
s= .01728
s = 0.1315 or 13.15%
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Expected Return and Expected Risk (Example)
Alternatives Returns (Ri) Probabilities (Pi) Ri*Pi (R-Mean) (R-Mean)^2 (R-Mean)^2*Pi
1 0.10 0.2000 0.0200 -0.0105 0.00011025 0.00002205
2 0.12 0.2500 0.0300 0.0095 0.0000902 0.0000226
3 0.08 0.1000 0.0080 -0.0305 0.00093025 0.0000930
4 0.09 0.1500 0.0135 -0.0205 0.00042025 0.0000630
5 0.13 0.3000 0.0390 0.0195 0.00038025 0.0001141
∑ 0.52 1.0000 0.1105 -0.0325 0.0003148
Exoected Return 0.1105
Expected Return (%) 11.05%
Expected Risk 0.0177
Expected Risk (%) 1.77%
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