Risk and Return Fundamentals

Risk
a measure of the uncertainty surrounding the return that an investment will earn
the variability (likely to change or be changed) of returns associated with a given
asset
To risk something means you are placing it in a situation where it can be lost or
damaged.
Return
gain or loss experienced on an investment
total rate of return-the total gain or loss experienced on an investment over a
given period of time
Calculating the Total Rate Of Return
Ct = cash (flow) received from the asset investment in the time period
rt = actual, expected, or required rate of return during period t
Pt - 1 = price (value) of asset at time t 1 (beg)
Pt = price (value) of asset at time t - 1 to t (end)
The return, rt , reflects the combined effect of cash flow, Ct , and changes in value,
Pt - Pt - 1, over the period
Example:
Market Value, January 1, 2016
Market Value, December 31, 2016
Cash flow within the year

Investment X
Ct = 6,800
Pt - 1 = 55,000
Pt = 55,000

Investment X
55,000
55,000
6,800

Investment Y
20,000
21,000
1,500

Investment Y
Ct = 1,500
Pt - 1 = 20,000
Pt = 21,000

Investment Y has as higher rate of return than Investment X.

Risk Preferences
Three Categories To Describe How Investors Respond To Risk:
risk-averse - preference of less risky over more risky investments, holding the
rate of return fixed
risk-neutral - chooses investments based solely on their expected returns,
disregarding the risks

risk-seeking preference of investments with higher risk and may even sacrifice
some expected return when choosing a riskier investment

Risk of a Single Asset

Assessment of Risk
Scenario analysis - An approach for assessing risk that uses several possible
alternative outcomes (scenarios) to obtain a sense of the variability among
returns. Examples: worst, expected, best; pessimistic, most likely, optimistic
Probability(chance that something will happen)distribution - A model that
relates probabilities to the associated outcomes.
o Bar chart - The simplest type of probability distribution; shows only a
limited number of outcomes and associated probabilities for a given event.
o Continuous probability distribution - A probability distribution showing
all the possible outcomes and associated probabilities for a given event.
Risk Measurement
Standard Deviation(r)- The most common statistical indicator of an assets risk;
it measures the dispersion around the expected value.
o Expected return() - the average return that an investment is expected to
produce over time.
ASSET J
Market acceptance
Very poor
Poor
Average
Good
Excellent

ASSET K
Market
acceptance
Very poor
Poor
Average
Good
Excellent

Probability
0.05
0.15
0.60
0.15
0.05

Returns
0.75%
1.25%
8.50%
14.75%
16.25%

Weighed value
0.0375%
0.1875%
5.1%
2.2125%
0.8125%
Expected
Return:
8.35%

Probability

Returns

Weighed value

0.05
0.15
0.60
0.15
0.05

1%
2.5%
8%
13.5%
15%

0.05%
0.375%
4.8%
2.025%
0.75%
Expected
Return: 8%

ASSET J
(r-)

Market
acceptanc
e
Very poor
Poor
Average
Good
Excellent

Returns

0.75%
1.25%
8.50%
14.75%
16.25%

8.35%
8.35%
8.35%
8.35%
8.35%

Market
acceptanc
e
Very poor
Poor
Average
Good
Excellent

Returns

1%
2.5%
8%
13.5%
15%

8%
8%
8%
8%
8%

-7.6%
-7.1%
0.15%
6.4%
7.9%

ASSET K
(r-

-7%
-5.5%
0%
5.5%%
7%

(r-)2

Pr

(r-)2 x Pr

57.76%
50.41%
0.225%
40.96%
62.41%

0.05
0.15
0.60
0.15
0.05

2.88%
7.562%
0.135%
6.144%
3.121%

(r-)2

Pr

(r-)2 x Pr

49%
30.25%
0%
30.25%
49%

0.05
0.15
0.60
0.15
0.05

2.45%
4.538%
0%
2.45%
4.538%

o Coefficient of Variation - A measure of relative dispersion that is useful in

comparing the risks of assets with differing expected returns. A higher
coefficient of variation means that an investment has more
volatility(likely to change in a very sudden or extreme way) relative to
its expected return.
Asset J

Asset K