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CORPORATE FINANCE
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ABHIJEET CHANDRA
Vinod Gupta School of Management, IIT KHARAGPUR
Lecture 04: Return and Risk
CONCEPTS COVERED
⮚ Return and Stylized Facts
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⮚ Risk: More than a four-letter word
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⮚ Return-Risk Relationship
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REITs Gold Cash Local Bonds Small Cap Stocks Large Cap Stocks
40.00%
Historical Returns on
Asset Classes: 2010-2020
30.00%
Gold
20.00%
10.00%
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Bond
0.00%
Large-cap Stocks
2020 Cash
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2010 2011 2012 2013 2014 2015 2016 2017 2018 2019
Small-cap Stocks
-10.00%
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REITs
-20.00%
-30.00%
-40.00%
KEY POINTS
⮚ Relationship between the type of investments have had the
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highest average returns and their volatility from year to year
⮚ Investor’s Dream: Highest return with lowest risk!
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Historical Return and Risk of Stocks
Computing Historical Returns
Realized return: Total return that occurs over a particular time period. It includes both interim income,
if any, and capital gains.
Suppose you buy a stock on date t for price Pt. If the stock pays a dividend, Divt+1, on date t+1, and you
sell the stock for price Pt+1 at time t+1, then your cashflows for the stock on a timeline is as follows:
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t t+1
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– Pt + Divt+1
+ Pt+1
The realized return from this investment in the stock from time t to t+1 is:
• Total (realized) return = Dividend Yield + Capital Gain Yield
𝐷𝑖𝑣𝑡+1 + 𝑃𝑡+1 − 𝑃𝑡 𝐷𝑖𝑣𝑡+1 𝑃𝑡+1 − 𝑃𝑡
𝑅𝑡+1 = = +
𝑃𝑡 𝑃𝑡 𝑃𝑡
Historical Return and Risk of Stocks (cont.)
Computing Historical Returns
Suppose that Sinfosys Ltd. Paid a one-time special dividend of Rs. 30.80 on March 15, 20x1. Now
suppose I bought Sinfosys Ltd.’s stock for Rs. 280.80 on March 1, 20x1, and sold it immediately after
the dividend was paid for a price of Rs. 273.90. What was my realized return from holding the stock?
Mar 1, 20x1 Mar 15, 20x1
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– Rs. 280.80 + Rs. 30.80
+ Rs. 273.90
The realized return from this investment in the stock for the holding period is:
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𝐷𝑖𝑣𝑡+1 + 𝑃𝑡+1 − 𝑃𝑡 𝐷𝑖𝑣𝑡+1 𝑃𝑡+1 − 𝑃𝑡
𝑅𝑡+1 = = +
𝑃𝑡 𝑃𝑡 𝑃𝑡
𝐷𝑖𝑣𝑡+1 +𝑃𝑡+1 −𝑃𝑡 𝑅𝑠.30.80 𝑅𝑠.273.90−𝑅𝑠.280.80
𝑅𝑡+1 = = + = 0.0851, or, 8.51%
𝑃𝑡 𝑅𝑠.280.80 𝑅𝑠.280.80
Historical Return and Risk of Stocks (cont.)
Compounding Realized Returns
If an investment pays multiple interim incomes (e.g., quarterly dividends) and you hold the stock
beyond the date of the first dividend, then we assume that:
All dividends are immediately reinvested and used to purchase additional shares of the same security.
In this case, we compute the annual realized return by compounding the returns from each dividend
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interval. Q1 Q2 Q3 Q4
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R1 R2 R3 R4
The annual realized return (Rannual) from this investment in the stock for the year is:
1 + 𝑅𝑎𝑛𝑛𝑢𝑎𝑙 = 1 + 𝑅1 1 + 𝑅2 1 + 𝑅3 1 + 𝑅4
Historical Return and Risk of Stocks (cont.)
Compounding Realized Returns
Suppose you purchased Sinfosys Ltd.’s stock on December 1, 20x9, and held it for one year, selling it
on November 30, 20x0. If the company paid the following dividends, what was your annual return?
Date Dec. 1, 20x9 Dec. 31, 20x9 Mar. 31, 20x0 Jun. 30, 20x0 Sep. 30, 20x0 Nov. 30, 20x0
Price (Rs.) 280.80 273.90 259.30 254.90 271.30 257.00
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Dividend - Rs.30.80 Rs.0.80 Rs.0.80 Rs.0.80 -
First, we compute the realized return between each dividend interval (using previous formula):
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Then, we determine one-year return by compounding them.
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Historical Return and Risk of Stocks (cont.)
Compounding Realized Returns
Suppose you purchased Sinfosys Ltd.’s stock on December 1, 20x9, and held it for one year, selling it
on November 30, 20x0. If the company paid the following dividends, what was your annual return?
Date Dec. 1, 20x9 Dec. 31, 20x9 Mar. 31, 20x0 Jun. 30, 20x0 Sep. 30, 20x0 Nov. 30, 20x0
Price (Rs.) 280.80 273.90 259.30 254.90 271.30 257.00
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Dividend - Rs.30.80 Rs.0.80 Rs.0.80 Rs.0.80 -
First, we compute the realized return between each dividend interval (using previous formula):
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Date Dec. 1, 20x9 Dec. 31, 20x9 Mar. 31, 20x0 Jun. 30, 20x0 Sep. 30, 20x0 Nov. 30, 20x0
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Price (Rs.) 280.80 273.90 259.30 254.90 271.30 257.00
Dividend - Rs.30.80 Rs.0.80 Rs.0.80 Rs.0.80 -
Return - 8.51% –5.04% –1.39% 6.75% –5.27%
Then, we determine one-year return by compounding them:
1 + 𝑅𝑎𝑛𝑛𝑢𝑎𝑙 = 1 + 𝑅1 1 + 𝑅2 1 + 𝑅3 1 + 𝑅4 = 1.0275; 𝑅𝑎𝑛𝑛𝑢𝑎𝑙 = 0.0275 𝑜𝑟 𝟐. 𝟕𝟓%
Historical Return and Risk of Stocks (cont.)
Average Annual Returns
The average annual annual return of an investment during a sample historical period is simply the
average of of the realized returns for each period (i.e., year).
In this case, if Rt is the realized return of a security in each year t, then the average annual return for
years 1 through T is:
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𝑅 = 𝑅1 + 𝑅2 + ⋯ + 𝑅𝑇
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𝑇
Assumption: the distribution of possible return is the same over time. The average return,
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thus calculated, provides an estimate of the return we should expect in a given year.
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Example: suppose the average returns for Nifty Index for the last 5 years are as follows:
20x6 20x7 20x8 20x9 20x0
4.9% 15.8% 5.5% –37.0% 26.5%
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Then, the average return: 𝑅ത = 4.9% + 15.8% + 5.5% − 37.0% + 26.5% = 3.1%
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Historical Return and Risk of Stocks (cont.) Year Annual The average annual
Average Annual Returns: Nifty 50 Index 2000
2001
-14.65%
-16.18%
return of Nifty 50
Index: 15.53% (for the
100.00% 2002 3.25%
period 2000-2020)
2003 71.90%
80.00% 2004 10.68%
2005 36.34% What about the
60.00% 2006 39.83%
variability?
Annual Percentage Returns
2007 54.77%
2008 -51.79%
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40.00%
2009 75.76%
2010 17.95%
20.00%
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2011 -24.62%
2012 27.70%
0.00%
2013 6.76%
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2014 31.39%
-20.00%
2015 -4.06%
2016 3.01%
-40.00%
2017 28.65%
2018 3.15%
-60.00% 2019 12.02%
Year: 2000 - 2020
2020 14.17%
Data Source: NSE India
Return-Risk Relationship (cont.)
Risk: Variability of Returns
To determine the variability of returns, we compute the standard deviation of the distribution of
realized returns.
The standard deviation is the square root of the variance of the distribution of realized returns.
As we know, variance measures the variability in returns by taking the differences of the returns
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from the average return and squaring those differences.
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𝑉𝑎𝑟(𝑅) = 𝑅1 − 𝑅ത 2 + 𝑅2 − 𝑅ത 2 + ⋯ + 𝑅𝑇 − 𝑅ത 2
𝑇−1
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The standard deviation, which we may call the volatility, is the square root of the variance:
𝑆𝐷 𝑅 = 𝑉𝑎𝑟(𝑅)
Risk, in general, is denoted as the standard deviation of returns.
Return-Risk Relationship (cont.) Year Annual The average annual
Looking back at the average annual returns: Nifty 50 Index 2000
2001
-14.65%
-16.18%
return of Nifty 50
Index: 15.53% (for the
100.00% 2002 3.25%
period 2000-2020)
2003 71.90%
80.00% 2004 10.68%
2005 36.34% What about the
60.00% 2006 39.83%
variability?
Annual Percentage Returns
2007 54.77%
2008 -51.79%
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40.00%
2009 75.76%
2010 17.95%
20.00%
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2011 -24.62%
2012 27.70%
0.00%
2013 6.76%
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2014 31.39%
-20.00%
2015 -4.06%
2016 3.01%
-40.00%
2017 28.65%
2018 3.15%
-60.00% 2019 12.02%
Year: 2000 - 2020
2020 14.17%
Data Source: NSE India
Return-Risk Relationship (cont.)
Year Annual Return Deviation Squared Deviation Using the data on Nifty 50 Index from 2000-2020, we calculate
2000 -14.65% -30.18% 0.0911
2001 -16.18% -31.71% 0.1005 variance as following:
2002 3.25% -12.28% 0.0151 1
2003 71.90% 56.37% 0.3178 𝑉𝑎𝑟(𝑅) = 𝑅1 − 𝑅ത 2 + 𝑅2 − 𝑅ത 2 + ⋯ + 𝑅𝑇 − 𝑅ത 2
2004 10.68% -4.85% 0.0023 𝑇−1
2005 36.34% 20.81% 0.0433
2006 39.83% 24.30% 0.0591
2007 54.77% 39.24% 0.1540
The standard deviation, the square root of the variance, is:
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2008 -51.79% -67.32% 0.4531
2009 75.76% 60.23% 0.3628 𝑆𝐷 𝑅 = 𝑉𝑎𝑟(𝑅)
2010 17.95% 2.42% 0.0006
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2011 -24.62% -40.15% 0.1612
2012 27.70% 12.17% 0.0148
Mean Return 15.53%
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2013 6.76% -8.77% 0.0077
2014 31.39% 15.86% 0.0252
2015 -4.06% -19.59% 0.0384 Variance 0.0948
2016 3.01% -12.52% 0.0157
2017 28.65% 13.12% 0.0172
2018 3.15% -12.38% 0.0153 Std. Dev. 0.30794
2019 12.02% -3.51% 0.0012
2020 14.17% -1.36% 0.0002 Refer to the Excel example
Total 326.03% 1.8966
CONCLUSION
• Return (on an investment or a security) is the prime factor that drives one’s
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intention to invest in that security in the first place.
• Returns can be defined as a function of historical price changes.
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• In general, we refer to the average periodical return as the expected return,
assuming that the distribution of return would remain the same in future.
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• Risk associated with a single asset is defined as the standard deviation of returns
over the period.
REFERENCES
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⮚ Historical returns on asset classes. Source: [Link]
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