RISK AND RETURN

MEANING OF RISK
Every investor expects to get some return from the investment in the future. But, as future uncertain,
so is the future expected return. We can distinguish between the expected return and the realized
return from an investment.
 The expected return is the uncertain future return on an investment
 The realized return, on the contrary, is certain that an investor actually obtains from his
investment at the end of the holding period.
The realized return may not correspond to the expected return. There is a possibility of variation of
the actual return from the expected return. This possibility of variation is termed as risk.
RISK DEFINED
1. Risk can be defined as “potential for variability in returns”.
2. Risk can be defined as “the probability that the expected return from the security will not
materialize”.
ELEMENTS OF RISK
Variation in returns is caused by a number of factors. These factors, we call as elements or sources of
risk. Elements of risk may be classified broadly into two categories or groups.
 Systematic risk
 Unsystematic risk
The above two categories of risk form total risk.
Total risk = Systematic risk + Unsystematic risk
Systematic risk: affects the entire market. This risk is caused because of the changes occur in social,
economic and political systems. These factors are beyond the control of a corporation and an
investor. The investor cannot avoid this risk.
Virtually all securities have some systematic risk, whether bonds or stocks, because systematic risk
directly encompasses interest rate, market, and inflation risks. The investor cannot escape this part of
the risk because no matter how well he or she diversifies, the risk of the overall market cannot be
avoided. If the stock market declines sharply, most stocks will be adversely affected; if it rises
strongly, most stocks will appreciate in value. These movements occur regardless of what any single
investor does. Clearly, market risk is critical to all investors.
Unsystematic Risk: is for the market as a whole, while unsystematic risk is specific to an industry
or the company individually. The variability in a security's total returns not related to overall market
variability is called the non- systematic risk. This risk is unique to a particular security and is
associated with such factors as business and financial risk as well as liquidity risk. Although all
securities tend to have some non-systematic risk, it is generally connected with common stocks.
Remember the difference: Systematic risk is attributable to broad macro factors affecting all
securities. Non-systematic risk is attributable to factors unique to security.
Systematic risk is sub-divided into the following groups:
 Market risk
 Interest rate risk
 Purchasing power risk
1. Market Risk: This risk arises from the variability in the market returns resulting from
alternating bull and bear market forces. When security index rises fairly consistently from a
low point to peak, over a period of time, this upward trend is called a bull market. The bull

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 market ends when the market index reaches a peak and starts a downward trend. The period
during which the market declines to the next trough is called a bear market. The variability
in a security's returns resulting from fluctuations in the aggregate market is known as market
risk. The forces that affect the stock market can be either:
Tangible Intangible
Tangible events: are real events such recessions, wars, earthquakes, political uncertainty,
structural changes in the economy, and changes in consumer preferences.
Intangible events: Intangible events are related to market psychology. Such psychology is
affected by real events. However, reactions to tangible events become over-reactions and
push the market either upward or downward. For example, a political event or economic
event may lead to rise or fall in the price of a security, which can be accentuated by the over-
reactions of herd-like behavior of investors.
2. Interest Rate Risk: The variability in a security's return resulting from changes in the level
of interest rates is referred to as interest rate risk. Such changes generally affect securities
inversely; that is, other things being equal, security prices move inversely to interest rates.
The reason for this movement is tied up with the valuation of securities. Interest rate risk
affects bonds more directly than common stocks and is a major risk that all bondholdersface.
As interest rates change, bond prices change in the opposite direction.
For example, A bond having a face value of Birr 100 issued with a coupon rate of 10%. If
the market interest moves up to 12.5%, no investor will buy the bond with 10% interest bond
unless the holder of the bond reduces the price of the bond.
 When interest rate rises, the prices of the older bonds or securities go down.
 When interest rate declines, the prices of the older bonds or securities to up.
Indirect impact on common stocks:
 Most stock traders trade in the stock market with borrowed funds with a small margin. The
increase in the interest rates dampens the spirit of speculative traders and thus they may sell their
securities. The fall in demand leads to fall in the stock prices and index.
 Most corporations use borrowed funds. If interest rates increase, they have to pay more
interest on borrowings out of the profits. This leads to a reduction in the earnings per share, and
thus shares prices may fall.
3. Purchasing Power Risk: It refers to the variation in investor returns caused by inflation.
Inflation results in lowering the purchasing power of money. Because of inflation, an investor
experiences a decline in purchasing power of his investments and return on investments.
Unsystematic Risk: The returns from a security may sometmes vary because of certain factors afectnn
only the company issuinn such security. Examples are raw material scarcity, labour strike, mananement
inefficiency etc. When variability of returns occurs because of such frm – specifc factors, it is known as
unsystematc risk. This risk is unique or peculiar to a company or industry and afects it in additon to the
systematc risk afectnn all securites.
The unsystematc or unique risk afectnn specifc securites arises from two sources:
a) The operatnn environment of the company, and
b) The fnancinn patern adopted by the company
The two types of unsystematic risk are referred to as business risk and financial risk
1. Business risk: Business risk is that portion of unsystematic risk caused by the operating
environment of the business. Variations in the expected operating income reflect business

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 risks. Variations that occur in the operating environment are reflected in the operating
incomes and expected dividends. Business risks arise from the inability of a firm to maintain
its competitive edge and the growth or stability of the earnings.
Business risks can be divided into internal business risk and external business risk.
Internal risk is caused due to improper allocation fixed and variable costs, improper product
mix, non-availability of raw materials, incompetence to face competition, absence of strategic
management etc.
External risks arise from operating conditions imposed on the firm by circumstances beyond
its control. The external environments in which it operates exerts some pressure on the firm.
These could be social and regulatory factors like monetary and fiscal policies of government,
business cycles or the general economic environment in which a firm or an industry operates.
For example, a government policy (like tax relaxations, controls on imports and exports) that
favours an industry will lead to a rise in the stock prices of the particular industry and vice
versa.
2. Financial risk: is associated with the capital structure of the company. This structure
consists of equity funds and borrowed funds. The presence of debt and preference capital
results in a commitment of paying interest or pre-fixed rate of dividend. The residual
(remaining) income alone is available to the equity holders. The interest payment affects the
payments that are due to the equity investors. Debt financing increased the variability of the
returns to the common stockholders and affects their expectations regarding the return. The
use of debt with own funds to increase the return to shareholders is known as financial
leveraging. Debt financing enables companies to have funds at a low cost and offer financial
leverage to the shareholders. As long as the earnings of a company are higher than the cost of
borrowed funds, shareholders earnings go up. At the same time, when the earnings are low, it
may lead to bankruptcy for equity holders. The financial risk is an avoidable risk. Proper
planning and other financial adjustments by the management enables a company avoid the
financial risk.
Return: is the primary motivating force that drives investment. It represents the reward for
undertaking investment. Since the game of investing is about returns (after allowing risk),
measurement of realized (historical) returns is necessary to assess how well the investment
manager has done. In addition, historical returns are often used as investment input in estimating
future (prospective or expected) returns.
The return of an investment consists of two components:
Current return: is the periodic income such as dividend or interest, generated by the investment.
It is measured as periodic income in relation to the beginning price of the investment.
Capital return: is reflected in the price change. It is measured simply the price appreciation
(depreciation) over the beginning price of the asset.
Thus the total return of a security is defined as:
Total return = Current return + Capital return
Measuring historical return:

Total Return= TR= I + (PE - PB) Where I = Income received during the period (current income)
PB PE = Price of the investment at the end of period
PB = Price of the investment at the beginning of the period

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Example: XYZ Company bought NYSE stock at $100 per share last year. The price of NYSM is
$135 per share today. NYSE paid $ 25 dividend per share yesterday.
Calculate total return of the stock.
GIVEN
Current income= $25
Price of investment at the beginning=$100
Price of investment at the end=$135

TR= I + (PE - PB)

PB
= $25 + ($135- $100)
$100
= 0.6 Or 60%
Measuring expected return: singe asset
There are two ways to estimate expected returns
1. Average return on historical data
2. Incorporating probabilities in estimates
1. Average return on historical data
The average rate of return is the sum of the various one period rates of return divided the number of
period.
1 n
Ṝ= n ∑
t =1
Rt

1
Ṝ= n {R1+R2+R3+…+Rn}
Ṝ is the average rate of return
Rt is the realized rate of return in period 1, 2 , 3, …t
n is total number of period
Suppose an investment returns the following annually over a period of five full years: 10%, 15%,
10%, 0%, and 5%. To calculate the average return for the investment over this five-year period.
1
Ṝ= {R1+R2+R3+…+Rn}
n
1
Ṝ= {10%+15%+10%+0%+5%}
5
Ṝ=8%
Measuring risk using historical return
 Risk is the variability of actual return from the average return.
 The greater the variability, the risker the security.
 Variance / standard deviation still measure the volatility of returns.
2
Historical Variance =σ Ri is the realized rate of return in period 1, 2, 3 , …n
σ2 = ∑ (Ri - Ṝ)2 n is the total number of period
n–1

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EXAMPLE: Consider the returns from a stock over a six year period:
a. Calculate average return
b. Calculate historical risk (standard deviation)

Year Return(R) (R- Ṝ) (R- Ṝ)2

1 15 5 25
2 12 2 4
3 20 10 100
4 -10 -20 400
5 14 4 16
6 9 -1 1
∑R=60 ∑(R- Ṝ)2= 546
Ṝ=10

σ2 = ∑ (Ri - Ṝ)2 = 546 = 109.2

n–1 5

σ = 10.45
Exercise: The most recent returns on an investments are 15%, 5%, 19%, 4% , -12% ,10 % and 5%.
Find the average return and standard deviation.

Expected Return: Incorporating probabilities in estimates

 Expected return is weighted average of all possible returns.
 The expected return E(r), is an average of possible return from an investment,
Which are given by

E(r) = ∑PiRi E(r)= Expected return

Ri = Return for the ith possible outcome
Pi=probability related with Ri
n = possible outcome
Example: Find the expected return given the possible future states of the economy, the probability of
each state and projected return for each state.

State of the economy Probability Returns (R) PiRi

Recession 0.2 -10 % -0.02
Stable 0.3 12 % 0.036
Boom 0.4 22 % 0.088
∑PiRi =0.072

E(r) = ∑PiRi
E(r) = P1R1+P2R2+P3R3
E(r) = 0.2(-0.1)+0.3x0.12+ 0.4X0.22
E(r) = 0.072=7.2%

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Measuring the risk
σ2=∑ Pi (Ri –E(r))2
Standard deviation (σ) =√ ∑ Pi (Ri –E(r))2
Example: Assume that stock XYZ co. respond to the state of the economy according to the below
table.
Economy Pr. Return(R)%
condition
Growth 0.25 15
Expansion 0.25 11
Stagnation 0.25 6
Decline 0.25 -4

What is standard deviation?

Solution
Economy Pr. Return(R)% P i Ri (Ri –E(r)) (Ri –E(r))2 Pi (Ri –E(r))2
condition
Growth 0.25 15 3.75 8 64 16
Expansion 0.25 11 2.75 4 16 4
Stagnation 0.25 6 1.5 -1 1 0.25
Decline 0.25 -4 -1 -11 121 30.25
E(r)=7% Var. 50.5

σ =√ ∑ Pi (Ri –E(r))2
σ =√0.25(15-7)2 + 0.25(11-7)2 + 0.25(6-7)2 +0.25 (-4-7)2
σ =7.1
The Coefficient of variation (CV) shows risk per unit of expected return.
σ
CV=
E(r )
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The above example Coefcient of variation =( CV)= = 0.98
7.1