UNIVERSITY OF DUBAI

BFIN 200 PRINCIPLES OF FINANCIAL

MANAGEMENT
RISK & RATES OF RETURN
KEOWN, MARTIN, PETTY - CHAPTER 6
Prof. Ketan Dhruv

Chapter Objectives
Rates of Return in the Financial Markets
Term Structure of Interest Rates
Expected Return
Risk and Risk Diversification
Measuring Market Risk
Measuring a Portfolios Beta

RETURN

The Concept of Return

Return
The level of profit from an investment, or
The reward for investing

Components of Return
Income: cash or near-cash that is received as a result of owning an
investment
Capital gains (or losses): the difference between the proceeds from
the sale of an investment and its original purchase price

Total Return: the sum of the income and the capital gain (or
loss) earned on an investment over a specified period of time

Why Return is Important

The rate of return indicates how rapidly an investor can build
wealth.
Allows us to keep score on how our investments are doing
compared to our expectations
Historical Performance
Provides a basis for future expectations
Does not guarantee future performance

Expected Return
Return an investor thinks an investment will earn in the future
Determines what an investor is willing to pay for an investment or if
they are willing to make an investment

Key Factors in Return

Internal Characteristics
Type or risk of investment
Issuers management
Issuers financing

External Forces

Political environment
Business environment
Economic environment
Inflation
Deflation

Holding-Period Return

Holding-period return = payoff during the holding period.

Holding period could be any unit of time such as one day, few weeks or few
years.

You bought 1 share of HPD for $19.70 in May 2011 and sold it for $32.32 in
May 2012. The company paid dividends of 8 cents every quarter during the
last two years.
Holding-period dollar gain = 32.32 + 0.08*4 19.70
= $12.94

Holding-period rate of return

= 12.94/19.70
= 0.6568 or 65.68%

HPR
Advantages of Holding Period Return
Easy to calculate
Easy to understand
Considers income and growth

Disadvantages of Holding Period Return

Does not consider time value of money
Rate may be inaccurate if time period is longer than one
year

End of Chapter Problem : 6 -10

TIME
1
2
3
4

STOCK PRICE
$10
13
11
15

HOLDING-PERIOD RETURN
($13 $10) 1 = 30.0%
($11 $13) 1 = 15.4%
($15 $11) 1 = 36.4%

End of Chapter Problem : 6 - 9

a.
Time
1
2
3
4

Jazman
Price
$9
11
10
13

Return
22.22%
9.09
30.00

Solomon
Price
$27
28
32
29

Return
3.70%
14.29
9.38

Return over multiple periods

Arithmetic average
Sum of returns in each period divided by number of periods

Geometric average
Single per-period return; gives same cumulative performance as

sequence of actual returns

Compound period-by-period returns; find per-period rate that

compounds to same final value

Dollar-weighted average return

Internal rate of return on investment

Rates of Return
Conventions for Annualizing Rates of Return
Annual Percentage Return (APR)
APR = Per-period rate Periods per year
APR ignores the compounding effect
Hence, we consider Effective Annual Rate (EAR) which considers the
compounding effect
1 + EAR = (1 + Rate per period)n = (1 + APR )n
n

Given EAR, we can calculate APR as under:

APR = [(1 + EAR)1/n 1]n
If we envision continuous compounding, we can write EAR as under
1 + EAR = eAPR
Or equivalently,
APR = ln(1+EAR)

Yield: Internal Rate of Return (IRR)

Internal Rate of Return: determines the compound annual rate of return
earned on an investment held for longer than one year
Yield (IRR) Example: What is
the yield (IRR) on an investment
costing $1,000 today that you
expect will be worth $1,400 at
the end of a 5-year holding period?

Calculating an Investments Yield Using Excel

Using IRR in Investment Decisions

Advantages of Internal Rate of Return
Uses the time value of money
Allows investments of different investment periods to be compared
with each other
If the yield is equal to or greater than the required return, the
investment is acceptable

Disadvantages of Internal Rate of Return

Calculation is complex

Yield (IRR) for a Stream of Income

Some investments, such as bonds, provide uneven streams of
income over the investment period
Calculate yield (IRR) by finding the discount rate that equates
the PV of the investments income stream to its market price
Present Value Applied to an Investment

Expected Return
Given a probability distribution of returns, the expected return can be
calculated using the following equation:
n

E ( R ) = p i Ri
i =1

Where:
E[R] = the expected return on the stock
N = the number of states
pi = the probability of state i
Ri = the return on the stock in state i.
In this example, the expected return for stock A would be calculated as
follows:
E[R]A = .2(5%) + .3(10%) + .3(15%) + .2(20%) = 12.5%
Calculate the expected return for stock B

Expected Return
The table below provides a probability distribution for the returns on
stocks A and B
State Probability Return On Return On
Stock A
Stock B
1
20%
5%
50%
2
30%
10%
30%
3
30%
15%
10%
4
20%
20%
-10%
The state represents the state of the economy one period in the future
i.e. state 1 could represent a recession and state 2 a growth economy.
The probability reflects how likely it is that the state will occur. The sum
of the probabilities must equal 100%.
The last two columns present the returns or outcomes for stocks A and
B that will occur in each of the four states.

RISK

Risk
Three important questions:
1. What is risk?
2. How do we measure risk?
3. Will diversification reduce the risk of portfolio?

Risk
Risk refers to potential variability in future cash flows.
The wider the range of possible future events that can occur,
the greater the risk.
Thus, the returns on common stock are more risky than
returns from investing in a savings account in a bank.

Risk Measure
Consider two investment options:
1.
2.

Invest in Treasury bond that offers a 2% annual return.

Invest in stock of a local publishing company with an expected return of
14% based on the payoffs (given on next slide).

Probability of Returns
Treasury Bill

Probability
100%

Rate of Return
2%

Stock
10%
20%
40%
20%
10%

-10%
5%
15%
25%
30%

Expected Rate of Return

Treasury bond = 1*2% =2%
Stock
= 0.1*-10 + 0.2*5% + 0.4*15% + 0.2*25% + 0.1*30%
= 14%

We observe that the stock of the publishing company is

more risky but it also offers the potential of a higher payoff.

Risk Measure - Standard Deviation (S.D.)

Standard deviation (S.D.) is one way to measure risk.
It measures the volatility or riskiness of portfolio returns.
S.D. = square root of the weighted average squared
deviation of each possible return from the
expected return.

Example Summarised

Expected Return and Risk - Example

Comments on S.D.
There is a 66.67% probability that the actual returns will fall
between 2.86% and 25.14% (= 14% 11.14%). So actual
returns are far from certain!
Risk is relative; to judge whether 11.14% is high or low risk,
we need to compare the S.D. of this stock to the S.D. of other
investment alternatives.
To get the full picture, we need to consider not only the S.D.
but also the expected return.
The choice of a particular investment depends on the
investors attitude toward risk.

Question 6 -1
Kaifu:
Average return =

4% + 6% + 0% + 2%
= 3%
4
[(4% 3%) 2
+ ( 6% 3% )

+ ( 0% 3% )

2
2

Standard deviation =

+ ( 2% 3% ) ]
= 2.58%
4 1

Market:
Average return:

2% + 3% +1% 1%
=1.25%
4
[(2% 1.25%) 2
+ ( 3% 1.25% )
+ (1% 1.25% )

2
2

Standard deviation =

+ ( 1% 1.25% ) ]
= 1.71%
4 1

Question 6 -3
Investment A:
(A)
Probability

(B)
Return

(A) x (B)
Expected Return

Weighted
Deviation

P(ri)

(ri)

(ri - r )2P(ri)

0.3
0.4
0.3

11%
15
19

r =

3.3%
6.0
5.7
15.0%

2 =
=

4.8%
0.0
4.8
9.6%
3.10%

Investment B
(A)
Probability

(B)
Return

(A) x (B)
Expected Return

Weighted
Deviation

P(ri)

(ri)

(ri r )2P(ri)

0.2
0.3
0.3
0.2

5%
6
14
22

r =

1.0%
1.8
4.2
4.4
9.4%

2 =
=

Investment A is better. It has a higher expected return with less risk.

41.472%
3.468
6.348
31.752
83.04%
9.11%