Risk and Rates of Return

Risk and Rates of Return
Investment Returns
The percentage change in value of the investment over a given period of time.
The rate of return on an investment can be calculated as follows:
Example:
1. If $1,000 is invested and $1,100 is returned after one year
R= $ 1100 $1000 =10%

$1000
2. The stock price for Stock A was $10 per share 1 year ago. The stock is currently trading at $9.50 per share
and shareholders just received a $1 dividend. What return was earned over the past year?
Investment Risk
The chance that an investment's actual return will be different than expected.
The greater the chance of lower than expected or negative returns, the riskier the investment.
Stand Alone Risk
The risk an investor would face if he or she held only one asset.
Probability Distribution
o A listing of all possible outcomes, and the probability of each occurrence.
Expected Rate of Return

o The rate of return expected to be realized from an investment, the weighted average of the
probability distribution if possible.
MBA Financial Management
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Example:
Measuring Stand Alone Risk
Standard Deviation
o A statistical measure of the variability of a set of observations.
Variance
o The square of the standard deviation.
Coefficient of Variation (CV)

o Standardized measure of the risk per unit of return.
CV
Std dev
^
Mean
k
Example:
Martins Product
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US Water
Martins product has the larger deviation, which indicates a greater variation of returns and thus a greater
chance that the expected return will not be realized.
The coefficient of variation is 65.84/15 = 4.39 and US Water is 3.87/15 = .26. Thus, Martin is almost 17
times riskier than US water.
Investor Attitude towards risk
Risk aversion assumes investors dislike risk and require higher rates of return to encourage them to
hold riskier securities.
For example, if two investments have the same expected return, the one with lower risk will be preferred.
A riskier investment has to have a higher expected return in order to provide an incentive for a risk-averse
investor to select it.
Risk premium the difference between the return on a risky asset and less risky asset, which serves as
compensation for investors to hold riskier securities
Portfolio Risk
Chance that combination of assets or units within individual group of investments fail to meet financial objectives.
Portfolio risk can be eliminated by successful diversification.
The idea is to create a portfolio that includes multiple investments in order to reduce risk.
What do you need to have a well diversified portfolio?
Your portfolio should be spread among many different investment vehicles such as cash, stocks, bonds,
mutual funds, and perhaps even some real estate.
Your securities should vary in risk.
Your securities should vary by industry, minimizing unsystematic risk to small groups of companies.
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Expected return on a portfolio is calculated as the weighted average of the likely profits of the assets in the
portfolio, weighted by the likely profits of each asset class.
Written another way, the same formula is as follows: E(R) = w1R1 + w2Rq + ...+ wnRn
Example: Portfolio Risk

1.
For a simple portfolio of two mutual funds, one investing in stocks and the other in bonds, if we expect
the stock fund to return 10% and the bond fund to return 6% and our allocation is 50% to each asset class,
we have the following:
Expected return (portfolio) = (0.1)*(0.5) + (0.06)*(0.5) = 0.08, or 8%
2.
Assume an investment manager has created a portfolio with Stock A and Stock B. Stock A has an expected
return of 20% and a weight of 30% in the portfolio. Stock B has an expected return of 15% and a weight of
70%. What is the expected return of the portfolio?
E(R) = (0.30)(0.20) + (0.70)(0.15)
= 6% + 10.5% = 16.5%
The expected return of the portfolio is 16.5%.
Portfolio Variance
The variance of a portfolio's return is a function of the variance of the component assets as well as the
covariance between each of them.
Covariance is a measure of the degree to which returns on two risky assets move in tandem.
A positive covariance means that asset returns move together.
A negative covariance means returns move inversely.
Correlation Coefficient measures the degree of correlation, ranging from -1 for a perfectly negative correlation to
+1 for a perfectly positive correlation
Computing Variance and Standard Deviation for an Individual

To measure the risk of an investment, both the variance and standard deviation for that investment can be
calculated.
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Example: Variance and Standard Deviation of an Investment

Given the following data for Newco's stock, calculate the stock's variance and standard deviation. The expected
return based on the data is 14%.
Figure: Expected return for Newco in various states
Answer:
2 = (0.10)(0.10 - 0.14)2 + (0.80)(0.14 - 0.14)2 + (0.10)(0.18 - 0.14)2
= 0.0003
The variance for Newco's stock is 0.0003.
Given that the standard deviation of Newco's stock is simply the square root of the variance, the standard
deviation is 0.0179 or 1.79%.
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Covariance
The covariance is the measure of how two assets relate (move) together. If the covariance of the two assets is
positive, the assets move in the same direction.
For example, if two assets have a covariance of 0.50, then the assets move in the same direction. If however the
two assets have a negative covariance, the assets move in opposite directions. If the covariance of the two assets is
zero, they have no relationship.
Example: Calculate the covariance between two assets

Assume the mean return on Asset A is 10% and the mean return on Asset B is 15%. Given the following returns
over the past 5 periods, calculate the covariance for Asset A as it relates to Asset B.
The covariance would equal 18 (90/5).
Correlation
The correlation coefficient is the relative measure of the relationship between two assets. It is between +1 and -1,
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with a +1 indicating that the two assets move completely together and a -1 indicating that the two assets move in
opposite directions from each other.
Example: Calculate the correlation of Asset A with Asset B.

Given our covariance of 18 in the example above, what is the correlation coefficient for Asset A relative to Asset B
if Asset A has a standard deviation of 4 and Asset B has a standard deviation of 8.
Answer:
Correlation coefficient = 18/(8)(4) = 0.563
Standard Deviation Formula
Capital Asset Pricing Model (CAPM)
A model that describes the relationship between risk and expected return and that is used in the pricing
of risky securities.
It is used to calculate the required rate of return for any risky asset. Your required rate of return is the
increase in value you should expect to see based on the inherent risk level of the asset.
Systematic risk, which is also called market risk or undiversifiable risk, is the portion of an asset's risk that
cannot be eliminated via diversification.
Interest rates, recession and wars all represent sources of systematic risk because they affect the
entire market and cannot be avoided through diversification.
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Unsystematic risk, which is also called firm-specific or diversifiable risk, is the portion of an asset's total
risk that can be eliminated by including the security as part of a diversifiable portfolio.
It is the type of uncertainty that comes with the company or industry you invest in.
For example, news that is specific to a small number of stocks, such as a sudden strike by the
employees of a company you have shares in, is considered to be unsystematic risk
ExampleCalculating the Required Return Using the CAPM

1.
For example, let's say that the current risk free-rate is 5%, and the S&P 500 is expected to return to 12%
next year. You are interested in determining the return that Joe's Oyster Bar Inc (JOB) will have next year.
You have determined that its beta value is 1.9. The overall stock market has a beta of 1.0, so JOB's beta of
1.9 tells us that it carries more risk than the overall market; this extra risk means that we should expect a
higher potential return than the 12% of the S&P 500. We can calculate this as the following:
Required (or expected) Return = RF Rate + (Market Return - RF Rate)*Beta

Required (or expected) Return =5% + (12% - 5%)*1.9Required (or expected) Return =18.3%
what CAPM tells us is that Joe's Oyster Bar has a required rate of return of 18.3%. So, if you invest in JOB, you
should be getting at least 18.3% return on your investment. If you don't think that JOB will produce those kinds
of returns for you, then you should consider investing in a different company
2.
If the risk-free rate of a Treasury bill is 4%, and the return of the stock market has averaged about 12%,
what is the required return of a stock that has a beta of 1.4?
Required Return
= 4% + [1.4 (12% - 4%)]

= 4% + 1.4 8%
= 4% + 11.2%
= 15.2%
Beta: A Measure of Specific Systematic Risk
The beta of an asset, measures the market risk of that particular asset as compared to the rest of the
market.
Beta (Ba) -- Most investors use a beta calculated by a third party, whether it's an analyst, broker or Yahoo!
Finance.
Market return (rm) Your input of market rate of return, rm, can be based on past returns or projected future
returns.
Risk-free return (rrf): U.S. Treasury bills and bonds are most often used as the proxy for the risk-free rate.
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Security Market Line (SML)
When the relative risk premium, represented by beta, is plotted in a graph against the required return, it
yields a straight line known as the security market line (SML). This line begins at the risk-free rate and
rises with beta.
References:
http://www.investopedia.com/exam-guide/cfa-level-1/portfolio-management/portfolio-calculations.asp
http://www.investopedia.com/university/concepts/concepts8.asp
http://thismatter.com/money/investments/capital-asset-pricing-model.htm
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Risk and Rates of Return

R= $ 1100 $1000 =10%

Expected Rate of Return

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