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CHAPTER 3
RISK & RETURN

LỢI NHUẬN & RỦI RO

LEARNING OBJECT

§ Understand and determine rate of returns of assets and portfolios

§ Identify asset risks and portfolio risks

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3. RISK AND RETURN

3.1. Return on an asset

3.2. Risk of an asset

3.3. Return and risk of an investment portfolio

3.1. RETURN ON AN ASSET

3.1.1. Return

3.1.2. Rate of Return

3.1.3. Average Return

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3.1.1. Return
Suppose you buy an asset, your gain (or loss) from that investment is called the return on
your investment. This return will usually two components.
• First, you may receive some directly while you own the investment. This is called the
income component of your return

• Second, the value of the asset you purchase will change. In case of, you have a capital
gain (or capital loss) on your investment.

(Ross & [Link], 2018, p. 334)

3.1.1. Return

Investing in equity, a shareholder receives the return of the business, including:

• Dividend is the amount of cash received at the end of the year.

• The return from investing in stocks is called capital gain or capital loss.

The return is a measure of the performance of an investment, it depends on:

§ Size of the investment

§ Investment time

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3.1.2. Rate of Return

The return is expressed in relative terms called rate of return.

The rate of return is the rate of return received on the invested capital. The return on equity
securities is equal to the dividend yield plus the capital gain/loss ratio.

𝐃𝐧"𝟏 𝐏𝐧"𝟏 # 𝐏𝐧 𝐃𝐧"𝟏 % (𝐏𝐧"𝟏 # 𝐏𝐧)

R= 𝐏𝐧
+ 𝐏𝐧
= 𝐏𝐧
In which,
Pn : price of the share (asset) at the time n

Pn + 1 : price of the share (asset) at the time (n+1)

Dn + 1 : dividend is received at the time (n+1)

3.1.2. Rate of Return

Example 3.1

An investor owns 1,000 shares of company ABC. At the beginning of the year, the
stock price was VND 110,000 and at the end of the year, it was VND 128,000. Dividend
paid is VND 2,000 per share. Determine the yield and rate of return on stock ABC.

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3.1.3. Average Returns

Over a period, the average rate of return on an investment is simply the average of
the rates of return recorded during that period.
Berk & [Link], 2012

Two methods of determining the average rate of return:

§ Arithmetic Average Returns (Phương pháp trung bình số học)

§ Geometric (Compound) Average Returns (Phương pháp trung bình tích lũy)

3.1.3. Average Returns

Example 3.2

Suppose you buy a stock A for $100. Unforturely, the first you own it, it falls to $50. The
second year you own it, it rises back to $100, leaving you where you started (no dividends
The price of stock A at the end were paid). What are your average return on this
investment?

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3.1.3. Average Returns

Arithmetic Average Returns

𝟏
𝐑 = 𝐧 𝐑𝟏 + 𝐑𝟐 + 𝐑𝟑 + ⋯ + 𝐑𝐧

where,

§ R : the average rate of return

§ R,, R -, R ., … R / ∶ the annual rate of return for period n

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3.1.3. Average Returns

Geometric Average Return

𝐧
𝐑= 𝟏 + 𝐑 𝟏 )(𝟏 + 𝐑 𝟐 )(𝟏 + 𝐑 𝟑 ) … (𝟏 + 𝐑 𝐧 − 𝟏

The average rate of return implies that all profits generated are reinvested until the end of
the investment period.

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3.1.3. Average Returns

The Geometric (multiplied) average returns show the average rate of return compounding
over a particular period of the investment. This method is used to determine the actual (true)
return of an investment in the past.

The Arithmetic average returns indicate the average rate of return per period over an
investment period. It is an unbiased estimate of the true mean of the distribution. This
method is used to estimate the future rate of return on an investment.

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3.1.3. Average Returns

Example 3.3

Calculate the average rate of return of the following investment using the
both methods.

Year Rate of return

2020 20%
2021 50%
2022 - 15%
2023 30%

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3.2 RISK OF AN ASSET

3.2.1. Concept of risk

3.2.2. Risk Measurement

3.2.3. Relationship between Return and Risk

3.2.4. Risk classification

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3.2.1. Concept of risk

Risk is the possibility of one or more unexpected events (situations).

From the financial perspective, risk occurs when the actual rate of return differs
from the expected return.

The risk of an asset is analyzed in two directions.

• Individual risk (risk of each asset)

• Portfolio risk (a portfolio that includes many assets)

(Brigham, E.F. and Ehrhardt, M.C., 2011)

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3.2.1. Concept of risk

Expected rate of return (Tỷ suất sinh lời kỳ vọng)

Expected rate of return is the rate of return investors expect to receive in the
next period.

The expected return can be determined based on the average return in the past
(Ex-post) or forecast in the future (Ex-ante).

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3.1.3. Average Rate of Return

Expected rate of return

Expected rate of return based on historical data (Ex-ante) is the average rate
of returns.

𝟏
𝐑 = 𝐧 𝐑𝟏 + 𝐑𝟐 + 𝐑𝟑 + ⋯ + 𝐑𝐧

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3.2.1. Concept of risk

Expected rate of return

Expected rate of return based on forecast (Ex-ante) is a weighted average of likely
future returns.

𝐄 𝐑 = ∑𝐧𝐢1𝟏 𝐏𝐢 𝐑 𝐢

In which,
E(R) is the expected return on the asset
Ri is the ith return on the asset
Pi is the probability that the ith return on the asset will occur

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3.2.1. Concept of risk

Example 3.4

1. Calculate the expected rate of return of stock X

Probability Distribution
Present value of value of stock at
stock ($) next year ($) Probability (%) Rate of return (%)

140 25

100 110 50

80 25

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3.2.1. Concept of risk

Example 3.4

Demand of Rate of return

Probability
products [Link] Basic Foods

Strong 0.3 90% 45%

Normal 0.4 15% 15%

Weak 0.3 - 60% -15%

1.0

2. Calculate expected rate of return ? ?

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3.2.1. Concept of risk

- 60

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3.2.1. Concept of risk

Risk is the possibility of one or more unexpected events (situations).

From the financial perspective, risk occurs when the actual rate of return differs
from the expected return.

The risk of an asset is analyzed in two directions.

• Individual risk (risk of each asset)

• Portfolio risk (a portfolio that includes many assets)

(Brigham, E.F. and Ehrhardt, M.C., 2011)

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3.2.2. Risk Measurement

A probability distribution is a statistical function that describes all possible values

and the probability that a random variable can achieve these value within a given
range. The sum of the probabilities is 1 (100%).

The tighter the probability distribution of the expected return, the closer the actual
return is to the expected return. Therefore, the risk of the investment is smaller.

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3.2.2. Risk Measurement

Standard Deviation ,Ϭ or SD, is a measure of the dispersion of a probability

distribution. The smaller the standard deviation shows that the actual return has a
small dispersion compared to the expected return, the lower the risk of the
investment, and vice versa.

Variance, Ϭ2 or Var, is the square of the standard deviation. The variance

measures the dispersion of the return relative to the mean return in the sample.

The standard deviation and variance are today's most popular measures of the
volatility of a random variable.

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3.2.2. Risk Measurement

Measure risk based on past data (ex-post)

∑𝐧𝐢1𝟏 𝐑 𝐢
3=
𝐑
𝐧

∑𝐧𝐢#𝟏(𝐑𝐢 #𝐑)𝟐
Ϭ =𝟐 𝐧

Note: If the number of observations (sample) is small, the denominator in the

formula for Ϭ is (n-1)

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3.2.2. Risk Measurement

Example 3.5

1. Sunny Enterprise had return rates from 2019 to 2023 of 15%, 16%, 17%, 20%
and 25% respectively. Calculate the standard deviation of Sunny’s rate of return.

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3.2.2. Risk Measurement

Measure risk based on forecast data (ex-ante)

Ϭ2 = "[𝐑 𝐢 −𝐄(𝐑)]2 ∗ 𝐏𝐢
𝐢1𝟏

𝐧
𝟐
Ϭ = "[𝐑 𝐢 −𝐄(𝐑)]2 ∗ 𝐏𝐢
𝐢1𝟏

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3.2.2. Risk Measurement

Example 3.5
2. Calculate the standard deviation of [Link]
[Link]

Ri - E(R) [Ri - E(R)]2 *Pi

Pi Ri E(R) [Ri - E(R)]2

0.3 90%
0.4 15%
0.3 - 60%
1.0 Var
SD

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3.2.2. Risk Measurement

Example 3.5
2. Calculate the standard deviation of Basic Foods
Basic Foods

Pi Ri E(R) Ri - E(R) [Ri - E(R)]2 [Ri - E(R)]2 *Pi

0.3 45%
0.4 15%
0.3 - 15%
1.0 Var
SD

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3.2.3. The Relationship between Risk and Return

§ Return and risk are two goals that investors have to choose when making
decisions.
§ For two assets with the same expected return but not the same risk, the risk-
averse investor will choose the asset with the smaller standard deviation and vice
versa.
§ For two assets that do not have the same expected return and the same risk, the
risk-averse investor relies on the coefficient of variation to choose the right asset.

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3.2.3. The Relationship between Risk and Return

Coefficient of Variation (CV)

The coefficient of variation (Hệ số biến thiên) is a measure of the amount of risk per unit
of expected return

Ϭ
𝐂𝐕 =
E (R)

in which,

§ CV Coefficient of Variation

§ Ϭ: Standard Deviation
§ E(R): Expected rate of return

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3.2.3. The Relationship between Risk and Return

Example 3.6
Calculate the coefficient of variation of the Plan 1 and the Plan 2 based on the
following information.

Chỉ tiêu Plan 1 Plan 2

Expected rate of return 14% 20%

Standard deviation 16,25% 18,4%

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3.2.3. The Relationship between Risk and Return

If investors accept to invest in a high-risk business, investors usually expect to

receive high returns if they succeed; and vice versa, they also have to accept
losses if they fail with a higher probability.

If an investor invests in a riskier asset, the investor expects a higher rate of return
known as the risk premium (Phần bù rủi ro).

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3.2.3. The Relationship between Risk and Return

Risk Premium (RP) is the difference between the expected rate of return of a
high-risk asset and a lower-risk asset.

Expected rate of return Risk-free rate + Risk

on risky investment
= of return premium

𝐄 𝐑𝐢 = 𝐑 𝐟 + 𝐑𝐏𝐢

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3.2.3. The Relationship between Risk and Return

Graph showing the relationship between return and risk

Expected Rate of return on

rate of return risky investment

Risk Premium
Risk-free
rate of return

Risk level
0

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3.2.3. The Relationship between Risk and Return

Real rate of return in the US (1926 – 2008)

Small Big Long-term Long-term US

business business corporate government Treasury Inflationary
stocks stocks bonds bonds bills
Average rate of
16,4 11,7 6,2 6,1 3,8 3,1
return (%)

SD (%) 33 20,6 8,4 9,4 3,1 4,2

Extra income
compared to 10,3 5,6 0,1
US. T-Bill (%)
Brigham, E.F. and Ehrhardt, M.C. (2011)

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3.2.4. Classification of Risks

The rate of return of an asset consists of two components: the expected return
and the unexpected return.

The unexpected return comes because unanticipated events.

R = E (R) + U

R = E (R) + m + ɛ

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3.2.4. Classification of Risks

Systematic risks

• Systematic risks (also called market risks) are unanticipated events that affect almost all
assets to some degree because the effect are economy-wide.

• It cannot be mitigated by portfolio diversification.

• Causes: general disadvantages to the whole economy such as inflation, high interest rates,
war, etc.

• Systematic risk is measured in beta (β).

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3.2.4. Classification of Risks

Unsystematic risks

• Unsystematic risks are unanticipated events that affect single assets or small group of
assets. Unsystematic risks are also called unique or asset-specific risks.

• It only happens with an investment, a business or a field of business, and so on.

• It can be minimized by diversifying the portfolio.

• Causes: internal problems of the enterprise, of the business field; or external factors such
as changes in macro policies, natural disasters, etc. impacting one or several enterprises
or business fields.

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3.2.4. Classification of Risks

Diversification

Some, but not all, of the risk associated with a risky investment can be eliminated by
diversification.

The reason that unsystematic risks, which are unique to individual assets, tend to wash out in
a large portfolio; but systematic risks, which affect all of the assets in a portfolio to some
extent, do not.

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3.2.4. Classification of Risk

SD of
Portfolio
Return Unsystematic risk

Systemic risk

Number of securities

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3.2.4. Classification of Risks

The Systematic risks Principle and Beta

Because unsystematic risks can be free eliminated by diversification, the systematic

risk principle states that the reward for bearing risk depend on the level of systematic
risk. The level of systematic risk in a particular asset, relative to the average, is given
by the beta of that asset.

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3.2.4. Classification of Risks

The Systematic risks Principle and Beta

§ Systematic risk can be measured in beta. The β is amount of systematic risk present in
an individual asset relative to an asset with medium risk.

§ Medium risk assets have a beta of 1. β of the market portfolio is equal to 1

• An asset with a beta of 0.5 means that its systematic risk is only half the systematic
risk of a medium-risk asset.

• An asset with a beta of 2 means that its systematic risk is twice the systematic risk of
the medium-risk asset.

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3.2.4. Classification of Risks

Measure beta

Beta is defined as the amount of systematic risk of a particular risky asset relative to a
normally risky asset.

Total market risk is measured by the standard deviation of the market return

The degree of variation between the expected return of asset i and the expected
return of the market is measured by covariance

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3.2.4. Classification of Risks

The systematic risk of an asset is expressed as follows:

Ϭ𝐢𝐦
𝛃𝐢 =
Ϭ𝟐𝐦
in which,
β6 : systematic risk of security i
σ67 : covariance of stock i and market portfolio
σ-7 : variance of market portfolio

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3.3. RETURN AND RISK OF AN INVESTMENT PORTFOLIO

3.3.1. The Concept of an Investment Portfolio

3.3.2. Return on the investment portfolio

3.3.3. Risk of the Investment Portfolio

3.3.4. Capital Asset Pricing Model (CAPM)

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3.3.1. The Concept of an Investment Portfolio

An investment portfolio is a collection of investments with different weights.

For example, the investment portfolio includes 30% long-term government

bonds, 30% long-term corporate bonds and 40% stocks.

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3.3.2. Return on the Investment Portfolio

A portfolio's rate of return is the weighted average rate of return of the stocks
(investments) in the portfolio.
E(Rp) = 𝐖𝟏𝐄 𝐑𝟏 + 𝐖𝟐𝐄 𝐑𝟐 + 𝐖𝟑𝐄 𝐑𝟑 + … … + 𝐖𝐧𝐄 𝐑𝒏

E(Rp) = < 𝐖𝐢𝐄 𝐑𝐢

618

In which, E(RP): Rate of return on the investment portfolio; E(Ri): Rate of return on
Stock i; Wi : Weight of stock i in the portfolio; and n: Number of stocks the portfolio

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3.3.2. Return on the Investment Portfolio

Example 3.7

1. Investment portfolio includes 2 stocks A and B with the following information:

• Stock A accounts for 30%, expected return 10%

• Stock B accounts for 70%, expected return 15%

What is the expected rate of return of the portfolio?

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3.3.2. Return on the Investment Portfolio

Example 3.7
2. Calculate the expected rate of return of the following portfolio.

Stock Investment Weight Expected rate of Weighted Average of

value ($) return (%) Expected rate of return (%)

Southwest Airlines 300.000 20

Starbucks 100.000 15

FedEx 200.000 6

Dell 400.000 12

Total investment

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3.3.3. Risk of the Investment Portfolio

§ Variance and Standard Deviation measure the volatility of return on an individual

security, asset, investment project, etc.

§ Covariance (Hiệp phương sai) and Correlation Coefficients (Hệ số tương quan) measure
the relationship between the returns of one security relative to another.

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3.3.3. Risk of the Investment Portfolio

Covariance
Covariance measures the togetherness of the returns of two assets.
Based on past data ex − post

3𝐁
∑𝐧𝐢1𝟏 𝐑𝐀, 𝐢 − 𝐑𝐀 ∗ 𝐑𝐁, 𝐢 − 𝐑
𝐂𝐨𝐯 𝐑𝐀, 𝐑𝐁 = 𝐂𝐨𝐯𝐀𝐁= Ϭ𝐀𝐁 =
𝐧

Note: If the observation is not large enough, divide by (n-1)

Based on forcast data (ex-ante)
𝐧
𝐂𝐨𝐯 𝐑𝐀, 𝐑𝐁 = 𝐂𝐨𝐯𝐀𝐁= Ϭ𝐀𝐁 = < 𝐑𝐀, 𝐢 − 𝐄 𝐑𝐀 ∗ [𝐑𝐁, 𝐢 − 𝐄 𝐑𝐁 ] ∗ 𝐏𝐢
𝐢1𝟏

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3.3.3. Risk of the Investment Portfolio

Covariance

§ Cov&' > 0 represents the rate of return of two assets moving in the same direction,
§ Cov&' < 0 represents the return of two assets moving in opposite directions.
§ Cov&' = 0 indicates that these two assets are not correlated with each other.

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3.3.3. Risk of the Investment Portfolio

Correlation Coefficient

The correlation coefficient indicates the degree of linear correlation between the returns of
two assets.

δ AB
Correl ( RA , RB ) = ρ AB =
δ AδB

The correlation coefficient has a value from -1 to 1 .

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3.3.3. Risk of the Investment Portfolio

Correlation Coefficient
ρ&' = −1 represents the returns of two assets with perfect negative correlation
ρ&' = +1 represents the returns of 2 assets with perfect positive correlation
ρ&' = 0 indicates returns of two assets that are not correlated
Investors can use correlation coefficients to select assets in a portfolio to reduce risk
(unsystematic risk) for the portfolio.

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Ví dụ

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3.3.3. Risk of the Investment Portfolio

Example 3.8
Use the information in Example 3.5 to calculate the covariance and correlation
coefficient for [Link] and Basic Foods.

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3.3.3. Risk of the Investment Portfolio

Portfolio risk is measured by the variance and standard deviation of the portfolio.
Ϭ𝟐 𝐩 = 𝐖𝐀𝟐 Ϭ𝐀𝟐 + 𝐖𝐁𝟐 Ϭ𝐁𝟐 + 𝟐 𝐖𝐀𝐖𝐁𝐂𝐨𝐯𝐀𝐁

In which,
§ Ϭ-= : Variance of the investment portfolio
§ W> : Weight of stock A in the portfolio
§ Ϭ>-: Variance of of stock A
§ CovAB Covariance of rate of returns of stock A and stock B
§ ρ>?: Correlation coefficient of the returns of stock A and stock B

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3.3.3. Risk of the Investment Portfolio

Example 3.9
A portfolio of 2 stocks X and Y has the following information:
E(RX) is 20%, E(RY) is 30%; SDX is 0.3%; SDY is 0.35%; CovXY is 0.5%.
The weights of X and Y are 40% and 60% respectively.
Determine the expected return, variance, and standard deviation of the portfolio.

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3.3.3. Risk of the Investment Portfolio

Beta of Portfolio

The beta of a portfolio is calculated as the expected return of the portfolio. It is calculated
using the weighted average formula with the weight of the assets in the portfolio

βp = & 𝐖𝐢 βi
𝐢"𝟎
In which, βp: Beta of the investment portfolio; βi : Beta of Stock i; Wi : Weight of stock i in
the portfolio; and n: Number of stocks the portfolio

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3.3.3. Risk of the Investment Portfolio

Example 3.10

Calculate the expected return and beta for the following portfolio:

Security Amount invested ($) Expected return (%) Beta

A 1000 8 0.80
B 2000 12 0.95
C 3000 15 1.10
D 4000 18 1.40

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3.3.4. Capital Asset Pricing Model - CAPM

E(Ri) is the expected return of asset i, E(Rm) the expected return of the market,
Rf the risk-free return, βi the systematic risk of asset i,

𝐄 𝐑𝐢 = 𝐑 𝐟 + 𝐑𝐏𝐢
Risk premium of asset i, RPi = βi x RPm

𝐄 𝐑𝐢 = 𝐑 𝐟 + 𝛃𝐢 [𝐑𝐏𝐦]
Risk premium of the market, RPm = [E(R 7) − R A ]

𝐄 𝐑𝐢 = 𝐑 𝐟 + 𝛃𝐢[𝐄(𝐑 𝐦) − 𝐑 𝐟 ]

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3.3.4. Capital Asset Pricing Model - CAPM

Assumptions of CAPM

§ Investors focus on a certain investment term and the criteria for them to choose a
portfolio are expected return and risk; Investors have similar expectations; All
investors can borrow or lend unlimitedly at the risk-free rate.

§ No investor can influence the price of the market; The assets are all divisible and have
perfect liquidity; There is no limit to short selling any asset; The amount of total assets
is fixed.
• No transaction fees, No costs, No taxes.

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3.3.4. Capital Asset Pricing Model - CAPM

§ The Capital Asset Pricing Model (CAPM) is applied in valuing assets in the
financial markets.
§ CAPM was proposed by William Sharpe (1964), also known as one-factor –
market model
§ Fama & French (1993) introduced a three-factor model: market factor, size factor,
and value factor (book price versus market price).
§ Fama-French (2015) introduces a 5-factor model with 2 new factors, namely
investment propensity and profit.

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