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11 | P age

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

12 | P age

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:

Return and Risk Chapter 2

13 | P age

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

Chapter 2 Return and Risk

14 | P age

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.

Return and Risk Chapter 2

15 | P age

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.

2.4.1 Business Risks

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.

Chapter 2 Return and Risk

16 | P age

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."

Return and Risk Chapter 2

17 | P age

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

Chapter 2 Return and Risk

18 | P age

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

Return and Risk Chapter 2

19 | P age

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

Chapter 2 Return and Risk

20 | P age

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

Return and Risk Chapter 2

21 | P age

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.

Chapter 2 Return and Risk

22 | P age

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%

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