SCHOOL OF SOCIAL SCIENCES
Edinburgh Business School
Financial Markets Theory
C38FM
Prof. Mustafa Caglayan
Finance Group
Heriot-Watt University, Edinburgh
Investments and Portfolio Management
Shares, Risk and Return
Return on a Share
The return on a share in any given period has two components:
1) Capital gains over the holding period (𝑷𝒕 − 𝑷𝒕−𝟏 )
2) dividend payments over the holding period, 𝑫𝒕 .
𝐺𝑎𝑖𝑛 𝑖𝑛 𝑊𝑒𝑎𝑙𝑡ℎ
• Return = 𝑅 =
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑊𝑒𝑎𝑙𝑡ℎ
𝑃𝑡 −𝑃𝑡−1 +𝐷𝑡
• Return on a share 𝑅 𝑡 =
𝑃𝑡−1
(Numerator captures your gain in wealth and the denominator captures your initial wealth)
End of period wealth
Wealth relative =
Beginning of period wealth
• WR (t) = 1 + R (t) > 0
Return on a Share in Company Z
• Calculate Return and Wealth Relative for share Z in 2009
• Return(2009) = (360 - 400 + 15)/400 = -0.0625
• WR (2009) = 1 - .0625 = 0.9375 = 93.75%
Return on a Share in Company Z
Calculate the return and wealth relative of share Z in 2010
402−360+12
• R (2010) = = 0.15 = 15%
360
• Wealth relative for share Z in 2010
• WR (2010) = 1 + .15 = 1.15 = 115%
Returns over more than one year
Reinvest...
Suppose that we originally spent £96 purchasing 24 shares
at 400p. We then receive 15p dividend on these shares,
yielding 360p , which can then be spent on another share.
1) The current total value of the investment is
25x402p = £100.50
2) The current earned dividend on 25 shares, 25x12p = £3
3) So from an initial investment of £96 we get a return (in
pence) of
10050−9600+300
• R (2009 − 11) = = 0.078 = 7.8%
9600
Wealth Relative over more than one year
Holding period wealth relative: WR1 x WR2 x…x WRn
The wealth relative over the two periods is easier; it is
simply the product of the WRs for the two periods
WR (2009) = 0.9375
WR (2010) = 1.15
WR (2009 − 11) = 1.078 = 107.8%
Understanding check
Verify this...
Annualised Return
We have two very different one-period
returns; −6.25% and 15%. What constant
one-period return, compounded over the
two-year holding period, would give us the
same return?
(1 + 𝐴𝑅)2 = 1.078
1 + AR = 1.038
AR = 0.038 or 3.8%
Information
Past and future
• The past is known to us - looking backward we can
calculate the actual past return, which is important
• We do not know the future - looking forward both the
expected return and the variation in the expected return
becomes important
Risk
We know the probability distribution of outcomes
Uncertainty
We do not have enough information, or there is considerable
disagreement, about the possible distribution of outcomes.
Describing Information
Discrete probability distributions
A discrete probability distribution has a finite number of outcomes,
where the probability of each outcome is known. The sum of these
probabilities equals one; there is a 100% probability of one of the
outcomes occurring.
Example
Suppose that the returns to holding share X are dependent on the
aggregate economic conditions, where there are three possible
outcomes; recession, low growth or high growth. The returns on each
of these are:
Describing Information (ctnd)
Describing Information (ctnd)
Describing Information (ctnd)
Continuous probability distributions
• A continuous probability distribution has an infinite
number of outcomes, where the probability of a
specific outcome is indistinguishable from zero.
• We can only express the probability over a range
of values, which is equal to the area under the curve
between the two cut-off points.
• Similarly to the sum of probabilities for a discrete
distribution equalling one, for a continuous
distribution the total area under the function is one.
Describing Information (ctnd)
Describing a distribution
We need:
• A measure of central tendency - the mean,
also known as the expected value
• A measure of dispersion - the standard
deviation, or the variance.
Describing a Discrete distribution
For share X, which has random outcomes
(returns), 𝑅𝑖 , occurring with probability 𝑝𝑖 we
can compute
Mean = 𝑅ത = E(R) = σ 𝑝𝑖 𝑅𝑖
ത 2
Variance = 𝜎 2 = σ 𝑝𝑖 (𝑅𝑖 − 𝑅)
Standard deviation (risk) = s
The Expected Return of share X
ത return, or expected return E(R), of
The mean (average, 𝑅)
share X is .0475
The Variance of the Return of share X
• The variance of return (𝜎 2 ) is 0.02987.
• The standard deviation (risk) is (s) 0.173