CH-2- Risk & Return

Chapter two:
Risk and return
This chapter is all about investment return and risk. It elaborate basic concept of
return and its component, as well as investment risk, component and types.
Moreover, it discusses how risk and return is computed by classifying it as historical
and expected risk and return.

2.1. Return -An Over view and components

Return is a reward and motivating force behind every investment. It is the amount
or rate of gain or profit which accrues to an investment. In finance, rate of return is
also known as return on investment (ROI), rate of profit or also called as return. The
rate of return required by a firm to a great extent depends upon the risk involved,
higher the risk, greater is the return expected by the firm. Return on investment has
two components, regular income in the form of interest or dividend and capital
appreciation (an increase in price).
2.1.1. Components of Required
Rate of Return /Return
In financial theory, the rate of return at which an investment trades is the sum of
five different components. These are:
(1) Real Risk-Free Interest Rate- This is the rate to which all other investments
are compared. It is the rate of return an investor can earn without any risk in a
world with of no inflation.
(2) Inflation Premium- This is the rate that is added to an investment to adjust it
for the market’s expectation of future inflation. For example, the inflation
premium required for a one year corporate bond might be a lot lower than a ten
year corporate bond by the same company because investors think that inflation
will be low over the short-run, but pick up in the future as a result of the trade
and budget deficits of years past.
(3) A Liquidity Premium- Thinly traded investments such as stocks and bonds in a
family controlled company require a liquidity premium. That is, investors are not
going to pay the full value of the asset if there is a very real possibility that
issuer of bonds/shares will not be able to repay in a short period of time because
buyers are scarce. This is expected to compensate investors for the potential
lose the buyers. The size of the liquidity premium is the dependent upon an
investor’s perception of how active a particular market is.
(4) Default Risk Premium: Investors believe that the issuer company will default
(unable to repay) on its obligation or go bankrupt, and as a result of investors
demanding a default risk premium. This is expected to compensate investors for
the potential loss of the repay.
(5) Maturity Premium: is the reward for greater price fluctuation when interest
rates change. It increases as maturity period of security increase.

2.2. Measuring Returns

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Returns on the investments can be seen in two ways. These are: Ex-post
returns and ex-ante returns.
 Ex Post Returns: Return calculations done ‘after-the-fact,’ in order
to analyze what rate of return was earned. Ex-post return is based on
historical data.
 Ex Ante Returns: Return calculations may be done ‘before-the-
fact,’ in which case; assumptions must be made about the future. Ex-
ante return forecasted returns for the future.
2.2.1. Measuring Historical Returns (Ex Post Returns)
Measurement of historical rates of return that have been earned on a
security or a class of securities allows us to identify trends or tendencies that
may be useful in predicting the future. One of the measurements of return is
the holding period return (HPR),
Holding Period Return (HPR): The simplest measure of return is the
holding period return. HPR represents the return an investor received for
holding an investment for a certain period of time. This calculation is
independent of the passage of time and incorporates only a beginning point
and an ending point. It is important to understand the calculation and
limitations of various measures. The formula for determining the HPR is as
follows:
HPR = (Ending value – Beginning value) + Income
Beginning value
Or;
(Sale price−Purchase price)+ Current income
HPR=
Purchase price
Capital gain/loss+ Current income
=
Purchase price
It is important to understand that the HPR is an ex-post return, i.e. a return
that has already taken place. It is sometimes known as the historical return.
Another thing that you should be aware of is that the HPR is a measurement
for return over a single period (i.e. 4 months, 5 years, etc.)
Example 1: Assume Mr. X has purchased 100 common shares at $25 per
share, receives a 10 cents per share dividend, and later sell the shares for
$30. What is holding period return of Mr. X?
HPR = $(30 x 100) – $(25 x 100) + $(0.10 x 100)
$(25 x 100)
= $3,000 – $2,500 + $10 = 20.4%
ETB2500

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 CH-2- Risk & Return

It makes no difference if the holding period return is calculated on the basis

of a single share or 100 shares. The holding period return is exactly the same
because every term is multiplied by 100.
Has this investment done well? The answer depends on how much time
passed between the purchase and the sale. Assume, if these shares were
acquired in 2003 and sold in 2013, the total gain of 20.4% is less than what
could have been earned in the bank saving account which pays 5% annual
interest rate. If, however, the stocks were purchased after 2010, the return is
attractive.
Example 2: At the beginning of the year a stock was selling for birr 40 per
share and at a time Ato Abebe purchased 100 shares. Over the year the
stock paid 5 per share and year-end market price became 45. What is the
return of Ato Abebe from the investment?
Dividend = 5* 100= 500
Capital gain = (45-40) * 100 =500
Total return = 500+500 = 1000
Percentage of return: this is summarizing returns in terms of percentage
than absolute dollars. It answers a question of how much do we get for each
dollar we invest. Following the previous example
Dividend yield = Dt+1/Pt = 5/40= 12.5%
Capital gain = (Pt+1 -Pt)/Pt = (45-40)/40 = 12.5%
Total return = dividend yield + Capital gain = 12.5%+12.5%= 25%
Total percentage of return = (D t+1 + (Pt+1 -Pt))/ Pt
Total percentage of return= 5+(45-40)/40 = 25%
Average rate of return
What happen if you needed to determine the investment returns over
multiple periods? In other words, what if you are interested in the average
returns of an investment over a number of quarters or years? There are two
different types’ of measures for ex post mean average returns:
(i) Arithmetic average
(ii) Geometric mean
i. Arithmetic Average Returns: The best known statistic to most people
is the arithmetic average. It is also called Arithmetic Mean. Therefore,
when someone refers to the mean return they usually are referring to the
arithmetic mean unless otherwise specified. The arithmetic mean return is
an appropriate measure of the central tendency of a distribution
consisting of returns calculated for a particular time" period, such as 5
years. However, when percentage changes in value over time are
involved, as a result of compounding, the arithmetic mean of these
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changes can be misleading. It is a sum of all returns divided by the total

number of observations (periods).
n
∑ ri
Arithmetic Average ( AM) = i =1
n
Where: ri = the individual returns
n = the total number of observations
Example: 1). Assume the following ex-post returns of Mr. X from his
investment for the three years:
Year Returns
1 20%
2 -30%
3 40%
Average Annual Return = (0.2 - 0.3 + 0.4) / 3 = 0.1 = 10%
2) ABC co reported a return of 10%, 12%, 14%, 8% and 6% returns form year
2000 to 2004. What is the average return of ABC co?
ii. Geometric Mean Returns: The geometric mean return measures the
compound rate of growth over time. It is often used in investments and
finance to reflect the steady growth rate of invested funds over some past
period; that is, the uniform rate at which money actually few over time
per period. Therefore, it allows us to measure the realized change in
wealth over multiple periods. Geometric mean measures the compounded
growth rate over a given period. It is thus a good estimate (better that
arithmetic) for the true return over a multi-period horizon.
1
n
Geometric Mean (GM ) =[(1+ r 1 )(1+r 2 )(1+r 3 ). ..(1+r n )] −1
Where:
ri = the individual returns
= the total number of observations
n
Example: 1). Assume that an investment appreciates 20% during the first
year, loses 30% during the second year, and then gains 40% during the third
year.
Solution: GM = [(1+ 0.2)* (1 - 0.3)* (1+ 0.4)(1/3) –1 = [1.176](1/3) -1= 0.055 =
5.5%
2) ABC co reported a return of 10%, 12%, 14%, 8% and 6% returns form year
2000 to 2004. What is the Geometric average return of ABC co?
Geometric Average = [(1+R1) (1+R2) ---- (1+Rn) 1/n
-1

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CH-2- Risk & Return

Following the above example average return will be:

= [(1.10) (1.12) (1.14) (1.08) (1.06)] 1/5 = (1.60785) 1/5
-1= 1.0996-1=
9.96%
Arithmetic Mean vs. Geometric Mean:
When should we use the arithmetic mean and when should we use the
geometric mean to describe the returns from financial assets? The answer
depends on the investor's objective:
 The arithmetic mean is a better measure of average (typical) performance
over single periods. It is also used to estimate of the expected return for
next period.
 The geometric mean is a better measure of the change in wealth over the
past (multiple periods). It is a backward-looking concept, measuring the
realized compound rate of return at which money grew- over a specified
period.
Measuring Expected (Ex-Ante) Returns
While past returns might be interesting, investors are most concerned with
future returns. Sometimes, historical average returns will not be realized in
the future. Developing an independent estimate of ex ante returns usually
involves use of forecasting discrete scenarios with outcomes and
probabilities of occurrence. Ex-ante returns or forecasts made based on
scenario analysis. Scenario analysis is a better measure for short term
forecasts because the current situation has large bearing on what is likely to
happen over a short period. Historical returns are a better long-term
forecast.
Scenario analysis: Forecast multiple rates of return and their probabilities
of occurrence. Forecasted return is the probability weighted sum of the
various rates of return. The general formula for estimating Ex-ante (forecast)
returns is presented as follows:
n
Expected Return ( ER ) =∑ ( r i×Prob i )
i=1

Where: ER = the expected return on an investment

Ri = the estimated return in scenario i
Probi= the probability of state occurring
Example 1: This is type of forecast data that are required to make an ex
ante estimate of expected return. You could forecast the following based on
three state of the economy:
Possible Returns
State of the Probability of on Stock A in that
Economy Occurrence State
Economic
Expansion 25.0% 30% 5
Normal Economy 50.0% 12%
Recession 25.0% -25%
 CH-2- Risk & Return

Solution:
n
Expected Return ( ER ) = ∑ ( r i×Prob i )
i=1
=( r 1× Prob1 )+( r 2× Prob2 )+( r 3 × Prob3 )
=( 30%×0 .25 )+( 12%×0 . 5)+( -25%×0 . 25)
=7 . 25%
(OR): Sum the products of the probabilities and possible returns in each state
of the economy.
Probability Possible Weighted Possible
State of the of Returns on Returns on the
Economy occurrence Stock Stock
(1) (2) (3) (4)=(2)×(3)
Economic
Expansion 25.0% 30% 7.50%
Normal Economy 50.0% 12% 6.00%
Recession 25.0% -25% -6.25%
Expected Return on the Stock
=7.25%
Example 2: Suppose an investor is considering an investment of 200,000 in
the stock of XYZ co or ABC co. hoping to gain dividend and selling it at
appreciated price after one yr. Over the year it is presumed that the
economy will be 20% at boom, 60% at normal and 20% at recession. What is
the expected return from the investment given the following rate of returns
in various economic conditions?
Economic Probabiliti Return of Return of Expected Expected return
conditions es XYZ ABC return of XYZ of ABC
Boom 0.2 10% -4% 2% -0.8%
Normal 0.6 11% 20% 6.6% 12%
Recessions 0.2 26% 40% 5.2% 8%
ER 1 13.8% 19.2%

a. Risk
Riskis the probability of earning lesser return than the expected one or
incurring loss. Risk is often associated with the dispersion in the likely
outcomes. Dispersion refers to variability. It is a chance of unfavorable
event to occur.
Risk is assumed to arise out of variability, which is consistent with our
definition of risk as the chance that the actual outcome of an investment will
differ from the expected outcome. For example; if an investor expects a 10%

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rate of return on a given investment, then any return less than 10% is
considered harmful. If an asset's return has no variability, in effect it has no
risk. An example on this regard is Government treasury securities. This is
basically because virtually there is no chance that the government will fail to
redeem these securities at maturity or that the treasury will default on any
interest payment owed.
When it comes to investments, there are always some levels of uncertainty
associated with future holding period returns. Such uncertainty is commonly
known as the risk of the investment. Then the question will be what causes
the uncertainty (or volatility) of an investment’s returns? The answer
depends on the nature of the investment, the performance of the economy,
and other factors. In other words, when you “dissect” the uncertainty of an
investment’s return, you will realize that it is made up of different
components. The following are some of the components:
(a) Business risk: This is the uncertainty regarding the earnings (or
profitability) of a firm as a result of changes in demand, input prices, and
technological obsolescence.
(b)Default risk: This is the uncertainty regarding an issuing firm’s ability to
pay interest, principal, etc. on its debt instruments.
(c) Inflation risk: This is the uncertainty over future rates of inflation. If the
return from an investment is barely keeping up with the rate of inflation,
an investor’s purchasing power will be eroded as time goes on. In other
words, the investor will receive a lesser amount of purchasing power
than what was originally invested because the cost of buying everything
has gone up. Inflation risk is also known as purchasing power risk.
(d)Market risk: This represents the changes in an investment’s price (or
market value) as a result of an event that affects the entire market. An
example is the impact of a market correction or a market crash on an
investment’s return.
(e) Interest rate risk: This represents the fluctuation in the value of an
investment when market interest rate changes. This has a big impact on
interest-paying investments because as market interest rate rises (falls),
an investor’s money is tied up in a bond that pay less (more) than the
going rate, and hence the value of the investor’s bond decreases
(increases).
(f) Liquidity risk: This is the risk of not being able to sell an investment
immediately with a reasonable price.
(g)Political risk: This is caused by changes in the political environment
that affect an investment’s market value. Political risk can be classified

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as either domestic or foreign political risk. An example of domestic

political risk is a change in the tax laws, and an example of foreign
political risk is a change in a foreign government’s policy regarding
capital outflow.
(h)Call-ability risk: This is the risk that an investment is recalled (or
retired) prior to the original stated date. This type of risk is most
applicable to long-term bonds and preferred stocks. This usually happens
when the issuing firms find the market conditions favorable in
“refinancing” such investments.
(i) Exchange rate risk: This is the uncertainty regarding the changes in
exchange rates that might affect the value of an investment. Exchange
rate uncertainty has an impact on both domestic and foreign
investments.
Broadly speaking, there are two kinds of risks that the investors will deal
with:
(1)Unsystematic Risk
(2)Systematic Risk
(1) Unsystematic risk: It also called diversifiable risk, unique risk, or
firm-specific risk. It is a risk that associated to a particular security. Such
as; risk created from employee strikes or management decision change.
For example, if the asset under consideration is stock in a single company,
 The negative NPV projects will tend to decrease the value of stock.
 Unanticipated lawsuits, industrial accidents, strikes etc will decrease
the FCF’s and thereby decrease the share values.
Unsystematic risk is essentially eliminated by diversification, so a portfolio
with many assets has almost no unsystematic risk.
(2) Systematic risk: is a risk that will affect all in the same manner. It
also called as non-diversifiable risk, unavoidable risk, or market risk. It
affects an overall market. Its examples are such as:
 changes in nation’s economy
 tax reforms
 change is world energy situation
These are the risks that affect securities overall (whether in a portfolio or
single) and, consequently, cannot be diversified away. An investor who holds
a well-diversified portfolio will be exposed to this type of [Link]:
Total Risk = Unsystematic Risk + Systematic Risk
b. Measuring risk
A risk of an investment can be measured in absolute term using standard
deviations and variance or in relative terms using coefficient of variation.

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Variability of returns can be measured by either of range or standard

deviation.
RANGE: Range can be used as a measure of variability (difference between
the maximum and minimum return), however it is a poor measure since it
only uses 2 observations.
The range of total possible
returns on the stock A runs
from -30% to +40%. If the
required return on the stock
is 10%, then those outcomes
less than 10% represent risk

As a rough measure of risk, range tells us that common stock is more risky
than treasury bills.

Standard Deviation (σ): An absolute measure of risk

The most commonly used measure of dispersion over some time period is
the standard deviation, which measures the deviation of each observation
from the arithmetic mean of the observations and is a reliable measure of
variability, because all the information in a sample is used. The standard
deviation is a measure of the total risk of an asset or a portfolio. It can be
represented by “σ”.It captures the total variability in the assets or portfolios
return whatever the source of that variability. A standard deviation is useful
to evaluate investments, which have approximately equaled in expected
returns. In other word, standard deviation is the square root of variance.
Standard deviation can be calculated based on both forecasted returns
and historical returns.

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(i) Ex-post Standard Deviation

The following formula used for calculate historical Standard Deviation is:

√
n
∑ ( r i− AR )2
i =1
Ex post σ =
n−1
where: σ = the standard deviation AR =
Average return
ri = possible return in time i n = number of
observations

Note: To calculate the historical standard deviation, first we should have to

calculate historical average return.
EXAMPLE: Assume the following historical returns for the past four
consecutive on investment of stock A and estimate the standard deviation:
10%, 24%, -12%, 8% and 10%.
Step 1 – Calculate the Historical Average Return
n
∑ ri
10+24-12+ 8+10 40
Average Returm ( AR ) = i=1 = = =8 . 0 %
n 5 5
Step 2 – Calculate the Standard Deviation

√
n ¿
∑ ( r i−r )2
Ex-post σ =
i =1
n−1
=
√ ( 10-8 )2 +( 24−8)2 +(−12−8 )2 +( 8−8 )2 +( 14−8)2
5−1

=
√ 22 +162 −202 + 02 +22
4
=
4 √
4 +256+ 400+0+ 4
=
664
4
=√ 166=12 . 88 %
√
(ii) Estimating Ex-ante Standard Deviation
Ex-ante standard deviation can be calculated in a similar way to ex-ante
returns. Scenario based standard deviation is as below:

√
n
Ex-ante σ = ∑ ( Prob i )×(r i −ERi )2
i=1

Where: Probi= probability of scenario i

ri = possible return at scenario i

ERi = Expected return of the security i

Note: To calculate the Ex-ante standard deviation also, first we should have
to calculate expected return.

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EXAMPLE: Assume the following possible returns on investment of stock A

under three scenarios (State of the Economy) and their respective probability
of their occurrenceand estimate the standard deviation:
Possible
State of Returns
the on Security
Economy Probability A
Recession 25.0% -22.0%
Normal 50.0% 14.0%
Boom 25.0% 35.0%
Solution: First, calculate expected return of stock A:
ERA = 0.25(-22%) + 0.50(14%) + 0.25(35%) = 10.3%
Then; using the formula of ex-ante standard deviation calculate it:

√
n
Ex ante σ = ∑ (Prob i )×(r i −ERi )2
i=1
= √ P1 (r 1− ER A )2 +P 2 (r 2 −ER A )2 +P3 (r 3 −ER A )2
= √. 25(−22−10 . 3)2 +.5(14−10 . 3)2 +.25 (35−10 .3 )2
= √. 25(−32. 3 )2 +. 5(3 .8 )2 +. 25(24 . 8 )2
= √. 25(. 10401)+. 5(.00141 )+.25 (.06126 )
= √. 0420
=.205=20 .5 %
Another way to calculating Ex-ante Standard Deviation is also
illustrated below:
First Step: Calculating expected return of stock A.
ERA = 0.25(-22%) + 0.50(14%) + 0.25(35%) = 10.3%
Second Step: Measure the Weighted and Squared Deviations

Deviation of
Possible Possible
Returns Weighted Return from Weighted and
State of the on Possible Expected Squared Squared
Economy Probabilit Security Returns Return Deviations Deviations
(a) y (b) (c) (d)=(b)*(c) (e)=(c)-(ER) (f)=(e)2 (g)=(f)*(b)
Recession 25.0% -22.0% -5.5% -32.3% 0.10401 0.02600
Normal 50.0% 14.0% 7.0% 3.8% 0.00141 0.00070
Economic
Boom 25.0% 35.0% 8.8% 24.8% 0.06126 0.01531
** Expected Variance(σ2) =0.0420
Return(ER)=10.3% Standard Deviation(σ) = 20.50%
Key Note: In the above table, letters in the brackets are expressed as
follows:
Column (a), (b), & (c) are given.

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CH-2- Risk & Return

(d)= Expected return is determined by multiplying the probabilities with the

possible returns &** is the sum of column (d).
(e)=Calculate the deviation of possible returns from the expected return.
(f)= Square those deviations from the mean.
(g)= Multiply the square deviations by their probability of occurrence.
(σ2)= The sum of the weighted and square deviations is the variance in
percent squared
(σ)=The standard deviation is the square root of the variance (in percent
terms).
 In general, the higher the standard deviation means the higher the
variability/risk.
Example 2: Suppose an investor is considering an investment of 200,000 in
the stock of XYZ co or ABC co. hoping to gain dividend and selling it at
appreciated price after one yr. Over the year it is presumed that the
economy will be 20% at boom, 60% at normal and 20% at recession.
Calculate the standard deviation given the following rate of returns in various
economic conditions?
Economic Probabilities Return of Return Expected Expected
conditions XYZ of ABC return of XYZ return of ABC
Boom 0.2 10% -4% 2% -0.8%
Normal 0.6 11% 20% 6.6% 12%
Recessions 0.2 26% 40% 5.2% 8%
ER 1 13.8% 19.2%
Let us calculate the standard deviation of the above example.
The Probability distribution, can be discrete or continuous, is discrete in our
example. A discrete probability distribution has a limited number of possible
outcomes while a continuous probability distribution indicates the probability
of possible outcomes.
Economic conditions Pi Ri ER (Ri-ER)2 (Ri-ER)2 *
Pi
Boom 0.2 0.1 0.138 0.00144 0.000288
8
Normal 0.6 0.11 0.138 0.00078 0.000470
Recessions 0.2 0.26 0.138 0.01488 4
0.002976
8
Variance 0.003736
Standard deviation of XYZ co
SD = √ variance = √ 0.003736 = 0.061122827
Economic conditions Pi Ri ER (Ri-ER)2 (Ri-ER)2 *
Pi
Boom 0.2 - 0.192 0.053824 0.010765
0.04
Normal 0.6 0.20 0.192 0.000064 0.000038
Recessions 0.2 0.40 0.192 0.043264 0.008653
Variance 0.019456

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CH-2- Risk & Return

Standard deviation of ABC co

√ √
SD = variance = 0.019456 =0.139484766
Coefficient of variation: A relative measure of risk
This is a relative measurement. It measures the standard deviation in
relation to expected return. It measures the risk per unit of expected return.
So as the coefficient of variation increases, so the risk of an asset increases.
Coefficient of variation= SD/ ER
Where: SD: standard deviation; ER: expected return
Which one of the securities is highly risky?
XYZ coefficient of variation = 6.11/13.8=0.44
ABC coefficient of variation =13.95/19.2=0.73
Since the coefficient of variation of ABC is greater than XYZ it is more risky.

Relationship between Risk and Return

The relationship among risk and return is positive which means an increase
of one result an increase to the other. For this reason is then there will be
always a risk return trade off.
 Required rate of return = Risk free rate of return+ Risk
premium
Risk premium is a potential reward that an investor expects to receive
when making a risky investment. This is based on a theory that investors are
risk averse that is they expect an average to be compensated for the risk
that they assume when making investment.
Risk fee rate of return: It is the return available on security with no risk of
default.
 Risk free rate of return= Real rate of return + Expected
inflation premium
Real rate of return: is the return that investors would require from security
having no risk of default in a period of no expected inflation. Real rate of
return is a return necessary to convince investors to postpone current, real
consumption opportunities. It is determined by the interaction of the supply
of funds made available by savers and the demand for funds for investment.
The second component of risk fee rate of return is an inflation premium or
purchasing power loss premium.
Determinants of Risk premium
It is the potential reward that an investor expects to receive when making a
risky investment. And it is a function of several different risk elements. These
factors include:

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o Maturity risk premium

This is the return required on a security. is influenced by the maturity of the
security. Generally the longer the time to maturity, the higher the required
return on the security.
o The default risk premium
The more the default risk, the higher the required rate of return will be. In
this regard the order of lower risk: Treasury bills, Government bonds, High
quality corporate bonds, High quality preferred stocks, Junk bonds, High
quality commons stocks and speculative common stocks are examples.
o Seniority risk premium
It is the difference in securities with respect to their claim on the cash flows
generated by the company and the claim on the company’s assets in the
case of default. The less senior the claims of the security holders, the greater
the required rate of return demanded by the investor in the security.
o Marketability risk premium
It is the ability of the investor to buy and sell a company’s securities quickly
and without a significant loss of value. The marketability risk premium can
be significant for securities that are not regularly traded.
o Business and financial risk
Business risk: is the variability in the firm’s operating earnings over time. It
is influenced by many factors including, the variability in sales, operating
cost over a business cycle, the diversity of a firms; production line, the
market power of the firm, and the choice of production technology.
Financial risk: refers to the additional variability in a company’s earnings
per share that result from the use of fixed cost sources of funds, such as
debt and preferred stock. Business and financial risk are reflected in the
default risk premium applied by investors to firm securities. The higher these
risks are the higher the risk premium and required rate of return on the
firm’s securities.

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