Topic 5

Risk and Return I –

The trade-off between
risk and return
Chapter 6
Finance T3 2017
Department of Finance
1
Recap – Topic 4
• Preferred share valuation
• Ordinary share valuation
• Dividend discount models, free cash flow
approach, book value, liquidation value,
comparable multiples
• Investment banking functions
• Long term financing [Initial public offering
(IPO), Seasoned equity offering (SEO), Rights
Offering, Private placements]
2
Recap
• Ordinary share: Residual claimants, voting right
• Preference share: Hybrid security, between bonds and ordinary
shares, no voting right
Dp
• Valuation of preference share: PS 0 =
rp
• Valuation of ordinary share
• Discounted dividend approach
• Zero growth model D1
P0 
r
D (1  g) D1
• Constant growth model P̂0  0 
rs  g rs  g

• Variable growth model

Recap
• Growth rate g = retention rate × ROE = (1- dividend rate) × ROE
• Free cash flow approach

Vshare = Vcompany – Vdebt – Vpreferred

• Book value, liquidation value, comparable multiples, eg. P/E ratio
• Functions of investment banking
• Underwriter, issue IPOs (primary market) vs SEOs (secondary market)
• Negotiated offer vs a competitively bid offer (sealed bids)
• Best effort vs firm commitment (purchase and sell)
• Long-term financing
• Internal vs external
• IPOs, SEOs, Right offerings, Private placement
• Underpricing vs negative reaction
Learning outcomes
After studying this topic, you will be able to
• Calculate Investment’s total return in dollar
and percentage terms.
• Measure return and risk of a financial asset
• Distinguish between systematic and
unsystematic risk
• Describe the concept of diversification and
the link between systematic risk and return
5
 Risk and Return Defined
Risk
• According to Webster’s dictionary, risk is “the
chance that an investment (such as a stock or
commodity) will lose value”.
• Risk measures the uncertainty that an investor is
willing to take to realize a gain from an investment

Return
• Return is a measure of earnings on an investment
In finance, risk generally refers to the probability that an
actual return on an investment will be lower than the 6
expected return.
Understanding risks and returns
• Risk represents the cost of investing whereas
return earned on investments represents the
benefit of investing.
• A trade-off always arises between expected risk
and expected return.
• But not all risks are compensated.
• Risk is neither good nor bad.
• Business should invest in a good risk-return trade-
off investment.
7
Figure 6.1 The trade-off between
risk and return

8
Total returns
Total return: the total gain or loss experienced
on an investment over a given period of time.

Income stream from the investment

Components
of the total
return Capital gain or loss due to changes
in asset prices

Total return can be expressed either in dollar

terms or in percentage terms.
9
Dollar returns
Total dollar return = income + capital gain or loss

For shares,

Income = Dividend per share

Capital gain or loss per share
= (Ending share price – Beginning share price)

Total dollar return  Divt 1  Pt 1  Pt 

10
 Example: Dollar returns
Dividend per share (Ending price ‐ Beginning price)

Total dollar return = income + capital gain or loss

Terrell bought 100 Dollar return

shares of Micro-Orb
shares for $25.
A year later:
• Dividend = $1/share
• Sold for $30/share
= [$1 + ($30-$25)] x (100 shares)
= ($1 + $5) x (100 shares)
= $600

Owen bought 50 Garcia Dollar return

Ltd shares for $15.
= [$0 + ($25-$15)] x (50 shares)
A year later: 11
• No dividends paid = ($10) x (50 shares)
• Sold for $25/share
= $500
6.1 Dollar returns and percentage
return
Terrell’s dollar return exceeded Owen’s by $100. Can we say that
Terrell was better off?

No, because Terrell and Owen’s initial investments were

different: Terrell spent $2500 in initial investment while
Owen spent $750.

total dollar return

Total percentage return 
initial investment
Dt 1  Pt 1  Pt
 12
Pt
Total return % = dividend yield + capital gain %
Percentage return

total dollar return

Total percentage return 
initial investment

Dividend per share = dividend per share received 
over the investment period 13
 Example: Percentage returns
Use the same example

total dollar return

Total percentage return 
initial investment

Terrell's percentage return 

$1  $5100shs
 $600 / $2500  24%
$25 100shs

Owen' s percentage return 

$0  $10 50shs
 $500 / $750  66.67%
$15  50shs

In percentage terms, Owen’s investment 14

performed better than Terrell’s did.
Example: Percentage returns
• Metropolis Limited paid a one-time special dividend of
$3.08 on 15 November 2010.
• Suppose you bought a Metropolis share for $28.08 on
1 November 2010 and sold it immediately after the
dividend was paid for $27.39.
• What was your realised return from holding the share?

1 Nov 15 Nov

15
Calculate the percentage return:
t t+1

Pt = $28.08 Pt+1 = $27.39

Dt+1 = $3.08

total dollar return

Total percentage return 
initial investment

Divt 1  Pt 1  Pt 
Total percentage return 
Pt

3.08  27.39  28.08

16
Rt 1   8.51%
28.08
Example: Calculate the dividend yield & capital gain yield:
t t+1

Pt = $28.08 Pt+1 = $27.39

Dt+1 = $3.08

Divt+1 3.08
Dividend yield = = = 10.97%
Pt 28.08
Pt+1 - Pt 27.39 -28.08
Capital gain yield = = = -2.46%
Pt 28.08
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Total yield = 10.97% + (- 2.46%) = 8.51%
Returns
Total dollar return = income + capital gain or loss
Total dollar return  Divt 1  Pt 1  Pt 
total dollar return
Total percentage return 
initial investment
Divt 1  Pt 1  Pt 
Total percentage return 
Pt
Total percentage return  Dividend yield  Capital gain yield
Div t 1 Pt 1  Pt
Total percentage return  
Pt Pt
18
R1  R2   RN N
Average return  R  R N
N t 1
 Risk
• Risk can be measured using the standard deviation of an investment’s
returns
• Standard deviation is a measure of the dispersion of possible outcomes
• The greater the standard deviation, the greater the risk
• Other things being equal, the vast majority of investors dislike risk.
• Therefore, investors demand a higher expected return from a risky
project or investment.
Sydney Melbourne
0.2 Investment 0.5 Investment
 =9% 0.4
 = 3%
0.15
Probability

0.3
0.1
0.2
0.05 0.1

0 0
19
-10 -5 0 5 10 15 20 25 30 4 8 12

return (%) return (%)

Figure 6.6 The relationship between average
(nominal) return and standard deviation 1900–2010

20

Investors who want higher returns have to take more risk.

 The variability of equity returns
• Risk premium: the additional return that an investment
must offer, relative to some alternative, because it is
more risky than the alternative.
• Asset classes with greater volatility pay higher average
returns.
• Average return on shares is more than double the
average return on bonds, but on average shares are
also twice as volatile. Therefore, on an average, shares
carry a bigger risk premium as compared to bonds.

Example: If the return on ordinary shares = 10%, risk free rate 
= 4%, what is risk premium? 21
Rate of return = Risk free rate + Risk premium
Risk premium = 10% ‐ 4% =6%
6.3 The variability of equity returns
N

 t
( R  R ) 2

Variance    2 t 1
N 1

1
N 1

R1  R 2  R2  R 2 ...  RN  R 2 
• Standard deviation – a statistical measure of volatility
(expressible in percentage terms)

Standard deviation    Variance

22
Comparing Standard Deviations

Expected Return
Prob.
T-bill HT 12.4%
USR 9.8%
T-Bill 5.5%

USR

HT

0 5.5 9.8 12.4 Rate of Return (%)

 Annual Returns on the Australian
All Ordinaries Index 2004-08
• The arithmetic average return provides an estimate of the
return in any given year. Calculate the standard deviation
of these returns.

24
Calculating historical volatility
•

2004 2005 2006 2007 2008

Actual Return 0.276 0.211 0.25 0.18 -0.43

R  ( R1  R2  R3  ...  RN ) / N

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Historical volatility
year Return Deviation from mean Squared deviation from
mean
2004 0.276 0.276-0.0974=0.1786 0.17862 =0.031898
2005 0.211 0.211-0.0974=0.1136 0.11362 =0.012905
2006 0.25 0.25-0.0974=0.1526 0.15262 =0.023287
2007 0.18 0.18-0.0974=0.0826 0.08262 =0.006823
2008 -0.43 -0.43-0.0974=-0.5274 -0.52742 =0.278151
0.0974 Sum = 0.353064

•Variance = 0.353064/(5-1) =0.0883

•Step 3: calculate the standard deviation:
Standard deviation = √variance = √0.0883 = 0.2972
= 29.72%. 26
Which security would you invest in?

• Which investment has a better risk-return

trade off? 25
 Coefficient of variation
• The ratio of the standard deviation of a distribution to
the mean of that distribution.
• A standardized measure that shows the amount of
risk per unit of return.
• The coefficient of variation allows the comparison of
different investments.

S tan dard Deviation 

CV  
Expected Re turn E ( R) 28
Example:
Expected Standard
Return Deviation
Rio 8.1% 11.14%
BHP 9.9% 13.16%

• Without the Coefficient of Variation information, which

security would you invest in?

• With the Coefficient of Variation information, which

security would you invest in?
29
6.4 The power of diversification
• Most individual share prices show higher volatility
than the price volatility of a portfolio of all ordinary
shares.
• How can the standard deviation for individual shares
be higher than the standard deviation of the portfolio?
• Diversification: The act of investing in many different
assets rather than just a few, so as to reduce volatility.
• The ups and downs of individual shares partially
cancel each other out.

30
 Correlation between 2 assets
• Negative correlation: Returns tend to
move in opposite directions
Perfect negative correlation
- Risk is minimised

• Positive correlation: Returns tend to

move in the same directions.

Perfect positive correlation

- Risk is not minimised

If returns on two assets are not positively correlated, combining

these assets in the same portfolio may reduce the portfolio’s risk. 31
Figure 6.7 Annual Returns on
Coca-Cola and Archer Daniels
Midland

• The two shares did not always move in sync.

33
• The net effect is that the portfolio is less volatile than either share
held in isolation.
 Risk and diversification
• A portfolio is a collection of single investments.
• Diversification: By investing in two or more assets whose
returns do not always move in the same direction at the
same time (negative correlation), investors can reduce risk
of investments or portfolio

Standard Coeff. of
Return Deviation Variation
Stock A 9.0% 13.15% 1.46
Stock B 8.0% 10.65% 1.33
Portfolio (A&B) 8.64% 10.91% 1.26
34
• The portfolio has the lowest coefficient of variation due to
diversification.
NAB Currency Trading Scandal
• Four NAB foreign exchange traders at the centre of a
trading scandal that cost the bank $360 million.
• If you are a shareholder of NAB, you lose money.
• Where did the money go to? NAB’s trading counter-
parties: other banks. The foreign currency trading is a
zero-sum game.
• Suppose that you hold a well-diversified portfolio which
includes all banks in the world.
• Then you do not lose money from this scandal, except
there might be some leakages in the form of traders’
bonuses.
• This is a lesson for diversification. 35
 The limits of diversification
• If returns do not all change the same way, increasing
number of shares in a portfolio will reduce standard
deviation of portfolio returns even further.
• Diversification reduces portfolio volatility, but only up to a
point. Portfolio of all shares still has a volatility of roughly
20%.

36
6.4 Systematic and unsystematic
risk
• Systematic risk: the volatility of the portfolio that
cannot be eliminated through diversification.
• Unsystematic risk: the proportion of risk of individual
assets that can be eliminated through diversification.
• What really matters is systematic risk … how a
group of assets move together.
• Total risk = systematic risk + unsystematic risk

37
Figure 6.8 The relationship between portfolio
SD and the number of stocks in the portfolio
Total risk = Systematic risk + Unsystematic risk

CAN be
eliminated by
diversification

CANNOT be
eliminated by
diversification
38
Illustrating Diversification Effects
of a Stock Portfolio

39
Again…Why systematic risk is all that matters

• Total Risk = Systematic Risk + Unsystematic Risk

• Standard deviation is a measure of total risk
• Unsystematic risk (also called unique risk) can be
diversified away, thus it is not rewarded in asset
markets.
• Only systematic risk is rewarded in asset
markets. We will learn a measure of systematic
risk next week. 40
Example: Systematic risk
Which one of the following is an example of
systematic risk?
1. Investors panic causing security prices
around the globe to fall precipitously.
2. A flood washes away a firm's warehouse
3. A city imposes an additional one percent
sales tax on all processed food products.
4. A toymaker has to recall its top-selling toy.
5. Corn prices increase due to increased 41
demand for alternative fuels.
 6.4 Risk and return revisited
• For the various asset classes, a trade-off arises
between total risk and return.
Fig.6.1 Fig.6.6

42
• Does this trade-off hold for individual securities?
Figure 6.9 Average returns and standard
deviations for 10 shares, 1993–2010

43

• No obvious pattern here!

6.4 Risk and return revisited
• The trade-off between standard deviation
and average returns that holds for asset
classes does not hold for individual shares!
• Total risk is measured by standard deviation,
which contains both systematic and
unsystematic risk.
Because investors can eliminate
unsystematic risk through diversification,
the market rewards only systematic risk!
44
Learning outcomes
After studying this topic, you will be able to
• Calculate Investment’s total return in dollar
and percentage terms.
• Measure return and risk of a financial asset
• Distinguish between systematic and
unsystematic risk
• Describe the concept of diversification and
the link between systematic risk and return
45
NOT COVERED IN CH.6
• Section 6-2a Nominal and Real Returns on Shares,
Bonds and Bills

46
End of Week 5 lecture

 Read Chapter 6 (relevant sections only) and revise

today’s lecture slides and your notes
 Remember to do your scheduled Aplia homework
 Keep working on your Assignment Part 2
Prepare Chapter 7 for next week

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