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Return and Risk Chapter 2

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This chapter covers the concept of risk and return and
the different ways of measuring risk. The two types of
risk associated with investment will also be discussed
in this chapter

Learning objectives

After learning this chapter, you should be able to:

1. Explain the concept and relationship between risk and return
2. Distinguish between systematic and unsystematic risk
3. Measure the risk

Return and Risk

GOAL
Chapter 2 Return and Risk

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2.0 INTRODUCTION
Risk is commonly defined as a chance of bad consequences happens. For our purpose, it is
anything that may deviate the actual return from the expected return. For example, if you
forecast that your company will get RM1,000,000 of profits next year and due to the
presence risk, you may find that the actual income will be less than expected.

Return, on the other hand is the payoff from an investment or effort or for foregoing current
consumption. In essence, it is the compensation for taking the risks. The basic rule states
that higher uncertainty reflects higher risks, and consequently higher return is required by
investors to compensate for absorbing the associated risks.

2.1 RISK AND RETURN

Different investments have different return and risk characteristics. Some investments will
give you immediate returns with little risk, while others may give higher returns with high risk.
Identifying investments on the basis of their return and risk characteristics is not easy. The
following discussion will cover the topic of measuring return and risk.

2.2 RETURN

Return, as defined by Keown, is the benefits that an investor will receive from an investment
over some period. Return is normally expressed in a percent form. If, for example, you
bought an investment for RM200 that pays RM10 in cash dividend and is worth RM208 one
year later, your return would therefore be:

(RM10 + RM8) = 9%
RM200

For investment in common stock, the return is known as Holding Period Return (HPR) and
involves three cash flow elements:

1. The initial price of the stock bought (P
0
)
2. Periodic distribution received while the stock is held (D
1
)
3. The amount received when the stock is sold (P
1
)
Mathematically HPR can be expressed as follows:

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D
1
+ (P
1
- P
0
)
HPR = P
0

Suppose P
0
= RM100, P
1
= RM150 and D
1
= RM5, then,

HPR = RM5 + (RM150 RM100)
(RM100)

= 0.55 or 55%

Return can be classified as current return and future return. Current returns are those
benefits that you expect to get on a regular basis. Dividends paid by the company to the
investors or interest payment made to the bondholder annually are an example of current
returns.

When an investment appreciates in value over time, this is referred to as future return.
Referring to the earlier example, when your investment increased in value from RM200 to
RM208 the additional RM8 is said to be your future return.

2.2.1 Measuring Expected Return (R) Using Probability Distribution

Conventionally, we can measure expected return as follows:
n
R = R
i
P (R
i
)
i = 1

Where n = the number of possible states of the economy

R
i
= the return/cash flow in its states of the economy

P(R
i
) = the probability of the return occurring

R = the expected return

Hence, the expected return is simply the weighted average of the possible
returns, with the weights being the probabilities of occurrence (Van Horne,
1995).

Table 1 1 demonstrates how the expected return (R) is computed.

Probability of
Event Occuring P
i

Possible
Return, R
i

Expected Return
(R) (R
i
) (P
i
)
0.2 10.0 (0.2) (10) = 2.0
0.5 8.0 (0.5) (8) = 4.0
0.3 6.0 (0.3) (6) = 1.8

= R = 7.8
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Table 1 1 : Calculating an expected return (R)

As seen in the table, the expected return for the investment is 7.8 percent.

2.3 SYSTEMATIC RISKS
The systematic risk is non-diversifiable risks that cannot be eliminated no matter how many
securities are held in investment portfolio. These risks occur outside the company or
externally and beyond the financial manager's direct control. When looking at risk inherent in
stock investment, stocks normally do not have the same degree of non-diversifiable risk as it
depends on the variability of the security's returns in relation to the market returns. The
degree of systematic risk is measured by beta coefficients.

2.3.1 Market Risk
It is the result of the investors' expectation towards the price of the company's
securities in the market, or the consumers' expectation towards the price of
the company's products in the market. For example, if the investor expects
that the price of the company's shares will to go up in the near future, he or
she will buy the shares now in expectation of higher return.

2.3.2 Interest Rate Risk
It is the price mechanism for supply and demands for funds in the market, and
therefore any fluctuations or movements in the current interest rate represent
risk to both investors and firms alike. Higher interest rate will increase the
interest expense and hence, lowering the company's profit and reduce the
value of return received by investors.

2.3.3 Purchasing Power Risk
It relates to the increasing inflation rate; that is the purchasing power of the
consumers will decline due to rapid increase in prices. It will lead to lower
sales for the company as well as the profits, especially those that are dealing
with non-durable goods. The effect, however, will be lesser on companies that
produce basic needs' products, such as foods, drinks, and textiles compared
to luxury goods' manufacturers.

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2.4 UNSYSTEMATIC RISKS
Unsystematic risk is a diversifiable risk that is unique only to a particular company. These
are the risks that occur inside or within the company, and thus within the financial manager's
control. As word of cautions, risks cannot be eliminated but can be reduced to some extend
with proper mix of securities in the investment portfolios.

Risk in a well-diversified portfolio is much lower than the risk of the security held in isolation.
The lower risk results from holding securities that have negative correlation that reduces the
impact of certain negative events. To eliminate the diversifiable risk totally, is quite
impossible as it requires investors to hold securities that have a perfect negative correlation
in their portfolios. The upcoming materials will give some insight of how unsystematic risks
are measured.

The risks are caused due to the mismanagement of the company's asset. A
normal company may comprise of several departments, such as the
personnel, marketing, production, and etceteras. All these departments must
be able to cooperate with each other so as the company can achieve its
stated objectives. A failure to manage any of the assets and/or one of the
departments in the company will leads to lower performances and hence
lower profits. For example, if management of the production department is
poor, the output produced by the company will be lower. This leads to lower
sales and consequently lower profits.

2.4.2 Financial Risks

It is caused by the improper financing mix used by the company to finance its
investment activities. For example, if the firm depends too much on debts, it
will have to incur higher amount of interest expense and increase the firm
risks of insolvency. The company is perceived to be highly risky by the
investors if the company has too much fix obligations of principal and interest
payments on debt. This leads to future difficulty in the event that the company
is trying to raise more funds externally.

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Risk reflects the uncertainty of future outcomes. In the financial context, risk is
the probability that earnings will be less than some expected return. Normally,
there are two ways to measure risk:

1. the risk of a single project, or
2. the risk of a portfolio of projects.

The use of the probability distribution of expected returns provide the basis for
measurement of risk for a particular project. This assumes that:

1. the probabilities to various states of economy can be assigned and;
2. the return associated with a particular state of economy is known with
relative certainty.

2.5 RISK, UNCERTAINTY AND PROBABILITIES

Risks have something to do with uncertainty and probabilities. A decision is subjected to risk
in event of more than one possible outcome and that the relative likelihood of each is known.
On the other hand, uncertainty refers to an event of which its possible outcomes and relative
likelihood are unknown. Thus, uncertainty represents an unsatisfactory condition for a firm to
operate with since it may result in ineffective decision-making.

Consequently, probabilities are a measure of relative likelihood that certain events will
occurs. For example, one would say that the probability of getting a "head" when a coin is
tossed is 0.5 or 50%; and getting a "tail" is also 0.50 or 50%. Similarly, if the coin is tossed
10 times, then about 5 out of 10 will show a "head." This is because there are two sides of a
coin, and there is 50/50 chance of getting either head or tail. Thus, the sum of probabilities
must equal one.

2.5.1 Measures of Expectation

Expectations or returns as a measurement can be stated as expected rate of
return in percent (%) or Ringgit (RM). There are two measures associate with
the distribution of possible outcomes:

1. central tendency, that is an average value; and
2. dispersion that is the variability of the possible outcomes around the
"average value."
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In measuring the central tendency, the mean or the expected value is most
widely used compared to two other measures; median and mode; and
variance or its square root will be used to measure dispersion. The terms
related to risk measurements are as follows:

1. Mean or expected value (EV); is the weighted average of the possible
outcomes, with probabilities' serve as the weights.

2. Median (ME); is the value of outcome that divides the probability
distribution into two equal parts.

3. Mode (MO); is the outcome of which the probability of occurrence is the
greatest.

4. Variance (V); is the weighted average of the squared deviations of
possible outcomes around the expected value. It measures the variability
of the returns.

5. Standard deviation (SD); is the square root of variance.

6. Coefficient variance (CV); is the standardized measure of risk per unit of
return; that equals to standard deviation divided by expected return.

To illustrate the above terms, consider the financial data for the following two companies:
Rate of return
State of Economy Probability Company A Company B
Recession 0.10 60% 10%
Downturn 0.20 5 10
Normal 0.40 20 20
Upturn 0.20 35 30
Boom 0.10 100 50

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The expected value (EV) is defined by the formula:

n
EV = Probability (Value)
i=1
= P
1
(V
1
) + P
2
(V
2
) + P
3
(V
3
) + ... + P
n
(V
n
)

Where i : Possible outcome

Substituting the financial data for company A and B, the computations for expected return be
as follows:

EV
A
= 0.10(60) + 0.20(5) + 0.40(20) + 0.20(35) + 0.10(100)
= 6 + 1 + 8 + 7 + 10
= 20%

EV
B
= 0.10(10) + 0.20(10) + 0.40(20) + 0.20(30) + 0.10(50)
= 1 + 2 + 8 + 6 + 5
= 20%

The median (ME) and modes (MO) for company A and B respectively:

ME
A
= 20% ME
B

= 20%

MO
A

= 20% MO
B
= 20%

The variance (V) for company A and B are:

n
V = Probability (Value Expected value)
2
Where V:
2

i=1

= P
1
( V
1

EV)
2
+ P
2
( V
2

EV)
2
+ P
3
( V
3

EV)
2
+ + P
n
( V
n

EV)
2

V
A

= 0.10(60 20)
2
+ 0.20(5 20)
2
+ 0.40(20 20)
2
+ 0.20(35 20)
2
+ 0.10(100 20)
2

= 1,370

V
B
= 0.10(10 20)
2
+ 0.20(10 20)
2
+ 0.40(20 20)
2
+ 0.20(30 20)
2
+ 0.10(50 20)
2

= 220

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Therefore, the standard deviations (SD); that is square root of variance for both
companies equals to:

SD = Variance Where SD :

SD
A

= 1,370
= 37.01%

SD
B

= 220
= 14.83%

The above example shows that both companies have the same expected return, but with
different variance and standard deviation. Risk for the company can be measured in terms of
its variance or standard deviation; that is lower standard deviation translates to tighter
probability distribution, and hence lower risk associate with the stock or returns.

The significance of the value calculated for the standard deviation is illustrated in Figure 2-1,
in the bell-shaped normal probability distribution. Approximately:

1. 68.26% of the probability lie within 1 standard deviation of the mean,
2. 95.46% lies within 2 standard deviation, and
3. 99.74% lies within 3 standard deviation.

Figure 2-1 Probability Ranges for Normal Distributions

Probability

Expected rate of return

99.74% chance
95.46% chance
68.26% chance
3 2 1 +1 +2 +3
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A larger standard deviation implies that the dispersion of possible outcomes appears to be
greater or further spread out.
Thus, company A with standard deviation of 37.01% indicates a greater variation of returns,
and thus the greater the chance the expected return will not be realized. Therefore,
compared to company B, company A is considered riskier due to higher standard deviation.

Under normal distribution as shown in Figure 2-1, there is a 68.26% probability that the
actual return will be + or 1 standard deviation of its mean that is:

1. For Company A within the range of 20% (EV) plus or minus 37.01% (SD); that is from
17.01 (=37.01 20) to 57.01% (=37.01 + 20).

2. For the company B within the range is 20% (EV) plus or minus 14.83% (SD); that is
from5.17 (=14.83 20) to 34.83% (=14.83 + 20).

This shows that company's B actual return will not deviate much from the expected return of
20% and, thus it represents lower risk.

Another measure of risk is coefficient variance (CV); that is the standardized measure of
risk per unit of return. It is useful in analyzing the risk between alternatives when the
expected return is not the same. Dividing the standard deviation by the expected return can
solve coefficient variance:

CV = SD / EV

CV
A

= SD
A
/ EV
A

= 37.01/20
= 1.8505

CV
B
= SD
B
/ EV
B

= 14.83 / 20
= 0.7415

The above calculations indicate that company 'A' is almost 2.5 times (=1.8505 / 0.7415)
riskier than company 'B.' In actual sense, there is no need to determine coefficient variance
for company 'A' and 'B' in analysis as the expected return for both companies is the same.
Under this condition, both standard deviation and coefficient variance criterion will result in
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the same conclusion. However, if the expected returns are different, it may not be the case.
To illustrate let assume the following data for two projects:

Project X Project Y
Expected return 35 10
Standard deviation 15 5

Under standard deviation criterion, project 'X' represents higher risk due to higher standard
deviation compared to 'Y.' Coefficient variance for project 'X' and 'Y' is 0.4286 (=15 / 35) and
0.50 (=5 / 10), respectively. Thus, although project 'Y' has a lower standard deviation,
coefficient variance shows otherwise and is not preferred because its risk and per unit of
return relationship is higher. Therefore, not favorable compared to project 'X.' The coefficient
variance is a better measure for evaluating risk the event of alternative investments differs in
risk and expected return.

The above measures of risk are important for investors to aid their decision making process
for which securities should be purchased as part of their investment portfolio. Under normal
conditions, most investors are risk-averse and they will choose to invest in company's B
shares due to the presence of lower risk. As most investors in the market are buying more of
company's 'B' shares, the market price of the shares will increase and hence reducing the
return on the shares. On the other hand, the price for company's 'A' shares will decline due
to lack of demand as more and more investors are buying company's 'B' shares in the
market. This lead to increasing return to firm's 'A' stockholders.

This set forth an example of how risk-return tradeoff works in the free market system such as
ours. Eventually, the market will reach equilibrium where the investors are compensated
accordingly to the risks absorbed or from holding the securities. At the market equilibrium,
the average investor would be indifferent to hold either companies stock due to the existence
of appropriate compensation available.

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1. Consider a Malaysian firm making an investment that produces cash flows in
British pounds. If the firm invested RM10,000 today and expects to get
RM12,000 one year from today, what is the firma HPR?

2. Chicken Soup Inc. is evaluating an investment. With the following information,
calculate the investments expected return and risk. Should Chicken Soup
Inc. invest if the Treasury bill carries a return of 9.40%?
Probability Return

0.15 5%
0.30 7%
0.40 10%
0.15 15%

3. Simex Inc. is considering an investment in one of the two common stocks.
Given the information that follows, which investment is better, based on risk
and return?

Common Stock X Common Stock Y

Probability

Return

Probability

Return

.30
.40
.30

11%
15%
19%

.20
.30
.30
.20

-5%
6%
14%
22%