Financial Management Chapter 2: Financial Risk and Returns

Chapter 2
Financial Risk and Returns
Machhindranath Patil

Contents

Introduction 3

1 Concepts of Returns and Risks 3

1.1 Returns - Definition and Types . . . . . . . . . . . . . . . . . . . . . . . 3
1.2 Measurement of Historical Returns of a Single Security . . . . . . . . . . 3
1.2.1 Historical Return Formula . . . . . . . . . . . . . . . . . . . . . . 3
1.2.2 Average Annual Returns . . . . . . . . . . . . . . . . . . . . . . . 4
1.3 Expected Returns of a Single Security . . . . . . . . . . . . . . . . . . . . 4
1.4 Returns of a Two-Security Portfolio . . . . . . . . . . . . . . . . . . . . . 5
1.4.1 Historical Portfolio Returns . . . . . . . . . . . . . . . . . . . . . 5
1.4.2 Expected Portfolio Returns . . . . . . . . . . . . . . . . . . . . . 5

2 Measurement of Risk 6
2.1 Risk Definition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
2.2 Historical Risk of a Single Security . . . . . . . . . . . . . . . . . . . . . 6
2.2.1 Variance and Standard Deviation . . . . . . . . . . . . . . . . . . 6
2.3 Expected Risk of a Single Security . . . . . . . . . . . . . . . . . . . . . 6
2.4 Risk of a Two-Security Portfolio . . . . . . . . . . . . . . . . . . . . . . . 7
2.4.1 Portfolio Variance Formula . . . . . . . . . . . . . . . . . . . . . . 7
2.4.2 Correlation Coefficient . . . . . . . . . . . . . . . . . . . . . . . . 7
2.5 Features of Standard Deviation . . . . . . . . . . . . . . . . . . . . . . . 8
2.6 Rationale for Standard Deviation as Risk Measure . . . . . . . . . . . . . 8
2.7 Risk Aversion and Required Returns . . . . . . . . . . . . . . . . . . . . 8
2.8 Market Risk Measurement (Beta) . . . . . . . . . . . . . . . . . . . . . . 8
2.8.1 Beta Calculation using Regression . . . . . . . . . . . . . . . . . . 9
2.8.2 Determinants of Beta . . . . . . . . . . . . . . . . . . . . . . . . . 9

3 Time Value of Money 9

3.1 Fundamental Concept . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
3.2 Doubling Period Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
3.3 Future Value of a Lump Sum . . . . . . . . . . . . . . . . . . . . . . . . 10
3.3.1 Different Compounding Frequencies . . . . . . . . . . . . . . . . . 10
3.4 Future Value of Ordinary Annuity . . . . . . . . . . . . . . . . . . . . . . 10
3.5 Future Value of Annuity Due . . . . . . . . . . . . . . . . . . . . . . . . 11
3.6 Present Value of a Lump Sum . . . . . . . . . . . . . . . . . . . . . . . . 11
3.7 Present Value of Ordinary Annuity . . . . . . . . . . . . . . . . . . . . . 11

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Financial Management Chapter 2: Financial Risk and Returns

3.8 Present Value of Annuity Due . . . . . . . . . . . . . . . . . . . . . . . . 11

3.9 Continuous Compounding and Discounting . . . . . . . . . . . . . . . . . 12
3.9.1 Continuous Compounding . . . . . . . . . . . . . . . . . . . . . . 12
3.9.2 Continuous Discounting . . . . . . . . . . . . . . . . . . . . . . . 12

4 Summary of Key Formulas 12

5 Key Insights 13

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Financial Management Chapter 2: Financial Risk and Returns

Introduction
Financial assets are expected to generate cash flows, and the riskiness of a financial
asset is measured in terms of the riskiness of its cash flows. The fundamental principle in
finance is that returns and risks are highly correlated - increased potential returns usually
imply increased risk. In a well-ordered market, there exists a linear relationship between
market risk and expected return.
Key Concepts:

• Risk is present in virtually every financial decision

• The objective in risk management is not to eliminate risk but to properly assess it

• Asset riskiness can be measured on a stand-alone basis or in a portfolio context

• Portfolio risk is divided into diversifiable risk and market risk

2.1 Concepts of Returns and Risks

2.1.1 Returns - Definition and Types
Definition: Return is the gain or loss on an investment over a specified period, expressed
as a percentage of the initial investment.
Types of Returns:

1. Historical Returns: Actual returns that have occurred in the past

2. Expected Returns: Anticipated returns based on probability distributions

2.1.2 Measurement of Historical Returns of a Single Security

1.2.1 Historical Return Formula
The return on a single security over a period is calculated as:

C + (PE − PB )
R= × 100% (1)
PB
Where:

• R = Return on the investment (%)

• PB = Price at the beginning of the period

• PE = Price at the end of the period

• C = Cash payments received during the period (dividends/interest)

Note: PB > 0, C ≥ 0, and PE can be zero, positive, or negative. Therefore, return

R can be zero, positive, or negative.

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Financial Management Chapter 2: Financial Risk and Returns

Example 1: Equity Investment Return

An investor bought 100 equity shares at |600 per share. After one year, the price
was |684 per share and received dividend of |300.
Solution:

PB = |600 × 100 = |60, 000 (2)

PE = |684 × 100 = |68, 400 (3)
C = |300 (4)
300 + (68, 400 − 60, 000) 8, 700
R= × 100 = × 100 = 14.5% (5)
60, 000 60, 000
Components:

• Current yield = 300

60,000
× 100 = 0.5%

• Capital gain yield = 8,400

60,000
× 100 = 14%

1.2.2 Average Annual Returns

There are two commonly used methods for calculating average annual returns:
1. Arithmetic Mean Pn
Ri
R̄ = i=1 (6)
n
2. Geometric Mean (CAGR - Compound Annual Growth Rate)
" n #1/n
Y
GM = (1 + Ri ) −1 (7)
i=1

Where Ri is the annual return for the ith year and n is the period of investment in
years.

Example 2: Average Returns Calculation

Investment of |60,000 for 5 years with annual returns: {10.5%, 6.5%, -3.4%, 7.5%,
11.6%}
Arithmetic Mean:
10.5 + 6.5 − 3.4 + 7.5 + 11.6 32.7
R̄ = = = 6.54%
5 5
Geometric Mean (CAGR):

CAGR = (1.105 × 1.065 × 0.966 × 1.075 × 1.116)1/5 − 1 = 0.064 = 6.4%

Average yield using arithmetic mean = 6.54% or |3,924 per year

CAGR yield = 6.4% or |3,840 per year

2.1.3 Expected Returns of a Single Security

Expected return is calculated using probability-weighted returns:

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Financial Management Chapter 2: Financial Risk and Returns

n
X
E(R) = pi Ri (8)
i=1

Where:

• E(R) = Expected return

• pi = Probability of outcome i

• Ri = Return in outcome i

Example 3: Expected Return Calculation

Economic State Probability Return

Boom 0.3 25%
Normal 0.5 15%
Recession 0.2 -5%

E(R) = (0.3 × 25%) + (0.5 × 15%) + (0.2 × −5%) = 7.5% + 7.5% − 1% = 14%

2.1.4 Returns of a Two-Security Portfolio

1.4.1 Historical Portfolio Returns
The return on a two-security portfolio is:

Rp = w1 R1 + w2 R2 (9)
Where:

• Rp = Portfolio return

• w1 , w2 = Weights of securities 1 and 2 (where w1 + w2 = 1)

• R1 , R2 = Returns of securities 1 and 2

1.4.2 Expected Portfolio Returns

E(Rp ) = w1 E(R1 ) + w2 E(R2 ) (10)

Example 4: Portfolio Return Calculation

Stock A and B have expected returns of 13% and 16% respectively. Portfolio
consists of 45% Stock A and 55% Stock B.

E(Rp ) = (0.45 × 13%) + (0.55 × 16%) = 5.85% + 8.8% = 14.65%

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Financial Management Chapter 2: Financial Risk and Returns

2.2 Measurement of Risk

2.2.1 Risk Definition
Risk is the variability of returns around the expected return, measured by variance and
standard deviation. Risk reflects the dispersion of possible outcomes from the expected
outcome.

2.2.2 Historical Risk of a Single Security

2.2.1 Variance and Standard Deviation
For historical data, sample variance is calculated as:
Pn 2
2 i=1 (Ri − R̄)
σ = (11)
n−1
Standard deviation: √
σ = σ2 (12)

Example 5: Historical Risk Calculation

Annual returns: {10.5%, 6.5%, -3.4%, 7.5%, 11.6%}
Average return = 6.54%

(10.5 − 6.54)2 + (6.5 − 6.54)2 + (−3.4 − 6.54)2 + (7.5 − 6.54)2 + (11.6 − 6.54)2
σ2 =
4
(13)
15.68 + 0.0016 + 98.8 + 0.92 + 25.60 141.012
= = = 35.253 (14)
4 4
√
Standard deviation = 35.253 = 5.94%

2.2.3 Expected Risk of a Single Security

For expected returns with known probabilities:
n
X
2
σ = pi (Ri − E(R))2 (15)
i=1

Example 6: Expected Risk Calculation

Using data from Example 3 with E(R) = 14%:

Return Probability Deviation Squared Dev Weighted

25% 0.3 11% 121 36.3
15% 0.5 1% 1 0.5
-5% 0.2 -19% 361 72.2

σ 2 = 36.3 + 0.5 + 72.2 = 109

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Financial Management Chapter 2: Financial Risk and Returns

√
σ= 109 = 10.44%

2.2.4 Risk of a Two-Security Portfolio

2.4.1 Portfolio Variance Formula
σp2 = w12 σ12 + w22 σ22 + 2w1 w2 σ1 σ2 ρ12 (16)
Where:

• σp2 = Portfolio variance

• w1 , w2 = Weights of securities

• σ12 , σ22 = Individual variances

• ρ12 = Correlation coefficient between securities 1 and 2

2.4.2 Correlation Coefficient

Cov(R1 , R2 )
ρ12 = (17)
σ1 × σ2
The correlation coefficient ranges from -1 to +1:

• ρ = +1: Perfect positive correlation

• ρ = 0: Zero correlation (independent)

• ρ = −1: Perfect negative correlation

Example 7: Portfolio Risk Calculation

Security A: Weight = 60%, Standard Deviation = 20%
Security B: Weight = 40%, Standard Deviation = 30%
Correlation coefficient = 0.5

σp2 = (0.6)2 (20)2 + (0.4)2 (30)2 + 2(0.6)(0.4)(20)(30)(0.5) (18)

= (0.36)(400) + (0.16)(900) + 2(0.24)(600)(0.5) (19)
= 144 + 144 + 144 = 432 (20)
√
σp = 432 = 20.78%
Different Correlation Cases:

• Perfect Positive (ρ = +1): σp = 24%

• Zero Correlation (ρ = 0): σp = 16.97%

• Perfect Negative (ρ = −1): σp = 0% (Risk elimination possible)

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Financial Management Chapter 2: Financial Risk and Returns

2.2.5 Features of Standard Deviation

Key Characteristics:

1. Because (Ri − E(R)) is squared, the farther the possible value of Ri , the higher its
impact on standard deviation

2. As squared difference (Ri − E(R))2 is multiplied by probability pi , the lower the

probability, the smaller the effect on standard deviation

3. Standard deviation and expected value are measured in the same units, hence can
be directly compared

2.2.6 Rationale for Standard Deviation as Risk Measure

Standard deviation is commonly used in finance because:

• If a variable is normally distributed, mean and standard deviation contain all in-
formation about the probability distribution

• Normal distribution is most commonly used in finance with bell-shaped character-

istics

• If utility of money follows a quadratic function, expected utility depends on mean

and standard deviation

• Standard deviation is analytically tractable

2.2.7 Risk Aversion and Required Returns

Risk Preference Categories:

• Risk-averse: Certainty equivalent ¡ Expected value

• Risk-neutral: Certainty equivalent = Expected value

• Risk-loving: Certainty equivalent ¿ Expected value

2.2.8 Market Risk Measurement (Beta)

Beta (β) measures the sensitivity of a security to market movements:

Cov(Rj , RM ) ρjM σj
βj = 2
= (21)
σM σM
Where:

• β = 1: Same sensitivity as market (market portfolio)

• β > 1: More sensitive to market fluctuations (aggressive stock)

• β < 1: Less sensitive to market fluctuations (defensive stock)

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Financial Management Chapter 2: Financial Risk and Returns

2.8.1 Beta Calculation using Regression

Beta can be calculated using simple linear regression:

Rjt = αj + βj RM t + ej (22)
Where βj is the slope of the regression line.

Example 8: Beta Calculation

Security and Market returns over 5 years:

Year Security Return (%) Market Return (%)

1 10 12
2 7 4
3 -3 -5
4 6 8
5 11 10

Solution: R̄j = 10+7−3+6+11

5
= 6.2%
12+4−5+8+10
R̄M = 5
= 5.8%
Covariance calculation: Cov(Rj , RM ) = [3.8×6.2+0.8×(−1.8)+(−9.2)×(−10.8)+(−0.2)×2.2+4.8×4.2]
4
=
35.3 2 2 2 +2.22 +4.22 ]
Market variance: σM2
= [6.2 +(−1.8) +(−10.8)
4
= 45.2
35.3
Beta: βj = 45.2 = 0.78
Alpha: αj = 6.2 − 0.78 × 5.8 = 1.68%

2.8.2 Determinants of Beta

Beta is determined mainly by:

1. Cyclicality of Revenues: More cyclical businesses have higher beta

2. Operating Leverage: Higher fixed costs lead to higher beta

3. Financial Leverage: Higher debt levels result in higher beta

2.3 Time Value of Money

2.3.1 Fundamental Concept
Money has time value because it can earn returns when invested. A rupee today is worth
more than a rupee tomorrow due to its earning potential.

2.3.2 Doubling Period Rules

Rule of 72 (Approximate):
72
Doubling Period ≈
Interest Rate

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Financial Management Chapter 2: Financial Risk and Returns

Rule of 69 (More Accurate):

69
Doubling Period ≈ 0.35 +
Interest Rate

Example 9: Doubling Period

At 8% interest rate:

• Rule of 72: 72
8
= 9 years

• Rule of 69: 0.35 + 69

8
= 8.975 years

2.3.3 Future Value of a Lump Sum

F V = P V (1 + r)n (23)
Where:
• F V = Future Value

• P V = Present Value

• r = Interest rate per period

• n = Number of periods

3.3.1 Different Compounding Frequencies

For compounding m times per year:
 r mn
FV = PV 1 + (24)
m

Example 10: Compounding Frequencies

Principal = |5,000, Rate = 12%, Time = 3 years

• Annual: F V = 5, 000(1.12)3 = |7, 024.64

• Semi-annual: F V = 5, 000(1.06)6 = |7, 089.15

• Quarterly: F V = 5, 000(1.03)12 = |7, 127.45

• Monthly: F V = 5, 000(1.01)36 = |7, 153.54

2.3.4 Future Value of Ordinary Annuity

An ordinary annuity has payments at the end of each period:

(1 + r)n − 1
F VOA = P M T × (25)
r

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Financial Management Chapter 2: Financial Risk and Returns

Example 11: Ordinary Annuity FV

Annual payment = |2,000, Interest rate = 10%, Number of years = 6

(1.10)6 − 1 1.7716 − 1
F V = 2, 000 × = 2, 000 × = |15, 432
0.10 0.10

2.3.5 Future Value of Annuity Due

An annuity due has payments at the beginning of each period:

(1 + r)n − 1
F VAD = P M T × × (1 + r) (26)
r

Example 12: Annuity Due FV

Using same data as Example 11:

F VAD = 15, 432 × 1.10 = |16, 975.20

2.3.6 Present Value of a Lump Sum

FV
PV = (27)
(1 + r)n

Example 13: Lump Sum PV

Future Value = |25,000, Interest rate = 12%, Time = 4 years
25, 000 25, 000
PV = 4
= = |15, 887
(1.12) 1.5735

2.3.7 Present Value of Ordinary Annuity

1 − (1 + r)−n
P VOA = P M T × (28)
r

Example 14: Ordinary Annuity PV

Annual payment = |3,000, Interest rate = 8%, Number of years = 5

1 − (1.08)−5 1 − 0.6806
P V = 3, 000 × = 3, 000 × = |11, 978
0.08 0.08

2.3.8 Present Value of Annuity Due

1 − (1 + r)−n
P VAD = P M T × × (1 + r) (29)
r

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Financial Management Chapter 2: Financial Risk and Returns

Example 15: Annuity Due PV

Using same data as Example 14:

P VAD = 11, 978 × 1.08 = |12, 936.24

2.3.9 Continuous Compounding and Discounting

3.9.1 Continuous Compounding
F V = P V × ert (30)
Where e = 2.71828 (Euler’s number)

3.9.2 Continuous Discounting

P V = F V × e−rt (31)

Example 16: Continuous Compounding and Discounting

Compounding:
PV = |8,000, r = 15%, t = 4 years
F V = 8, 000 × e0.15×4 = 8, 000 × e0.6 = |14, 577
Discounting:
FV = |20,000, r = 12%, t = 3 years
P V = 20, 000 × e−0.12×3 = 20, 000 × e−0.36 = |13, 954

2.4 Summary of Key Formulas

Concept Formula
Single Security Return R = C+(PPEB−PB ) × 100%
P
Expected Return E(R) = pi Ri
Portfolio Return Rp = Pw1 R1 + w2 R2
Variance (Expected) σ = P pi (Ri − E(R))2
2
2
i −R̄)
Variance (Historical) σ 2 = (Rn−1
Portfolio Variance σp2 = w12 σ12 + w22 σ22 + 2w1 w2 σ1 σ2 ρ12
Cov(Rj ,RM )
Beta β= 2
σM
Future Value (Lump Sum) F V = P V (1 + r)n
FV
Present Value (Lump Sum) P V = (1+r) n
n
FV Ordinary Annuity F V = P M T × (1+r)r −1
−n
PV Ordinary Annuity P V = P M T × 1−(1+r)
r
FV Annuity Due F VAD = F VOA × (1 + r)
PV Annuity Due P VAD = P VOA × (1 + r)
Continuous Compounding F V = P V × ert
Continuous Discounting P V = F V × e−rt

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Financial Management Chapter 2: Financial Risk and Returns

2.5 Key Insights

1. Risk-Return Trade-off: Higher potential returns generally involve higher risk

2. Diversification Benefits: Portfolio risk can be reduced through proper diversifi-

cation, but only diversifiable risk can be eliminated

3. Beta as Systematic Risk: Beta measures market risk that cannot be diversified
away

4. Correlation Impact: The correlation between securities significantly affects port-

folio risk

5. Time Value Importance: Money’s earning potential makes present values more
valuable than future equivalents

6. Compounding Effect: Frequency of compounding affects returns significantly

7. Mean Differences: Arithmetic mean typically overestimates compound returns

compared to geometric mean

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