Chapter - 4

Risk and Return: An

Overview of Capital
Market Theory
2
Chapter Objectives
Discuss the concepts of average and expected rates
of return.
Define and measure risk for individual assets.
Show the steps in the calculation of standard
deviation and variance of returns.
Explain the concept of normal distribution and the
importance of standard deviation.
Compute historical average return of securities and
market premium.
Determine the relationship between risk and return.
Highlight the difference between relevant and
irrelevant risks.
3
Return on a Single Asset
Total return
= Dividend
+ Capital
gain


Year-to-
Year Total
Returns on
HLL Share
149.70
70.54
16.52
22.71
49.52
92.33
36.13
52.64
7.29
12.95
0.00
20.00
40.00
60.00
80.00
100.00
120.00
140.00
160.00
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001
Year
T
o
t
a
l

R
e
t
u
r
n

(
%
)
( )
1 1 0
1 0 1
1
0 0 0
Rate of return Dividend yield Capital gain yield
DIV
DIV

P P
P P
R
P P P
= +
+

= + =
4
Average Rate of Return
The average rate of return is the sum of the
various one-period rates of return divided by
the number of period.
Formula for the average rate of return is as
follows:
1 2
=1
1 1
= [ ]
n
n t
t
R R R R R
n n
+ + + =

5
Risk of Rates of Return: Variance
and Standard Deviation
Formulae for calculating variance and
standard deviation:
Standard deviation = Variance
( )
2
2
1
1
1
n
t
t
R R
n
o
=
=

6
Investment Worth of Different
Portfolios, 196970 to 199798
57.16
13.99
10.36
10.20
4.41
1
10
100
1
9
6
9
-
7
0
1
9
7
0
-
7
1

1
9
7
1
-
7
2
1
9
7
2
-
7
3
1
9
7
3
-
7
4
1
9
7
4
-
7
5
1
9
7
5
-
7
6
1
9
7
6
-
7
7
1
9
7
7
-
7
8
1
9
7
8
-
7
9
1
9
7
9
-
8
0
1
9
8
0
-
8
1
1
9
8
1
-
8
2
1
9
8
2
-
8
3
1
9
8
3
-
8
4
1
9
8
4
-
8
5
1
9
8
5
-
8
6
1
9
8
6
-
8
7
1
9
8
7
-
8
8
1
9
8
8
-
8
9
1
9
8
9
-
9
0
1
9
9
0
-
9
1
1
9
9
1
-
9
2
1
9
9
2
-
9
3
1
9
9
3
-
9
4
1
9
9
4
-
9
5
1
9
9
5
-
9
6
1
9
9
6
-
9
7
1
9
9
7
-
9
8
Year
Index
Stock Market Return
Call Money Market
Long-term Govt. Bonds
Inf lation
91-day TB
7
Averages and Standard Deviations,
197071 to 199798


Securities
Arithmetic
mean
Standard
deviation
Risk
premium
*
Risk
premium
#
Ordinary shares (RBI Index) 17.50 22.34 12.04 8.76
Call money market 9.93 3.49 4.47 1.19
Long-term government bonds 8.74 2.59 3.28
91-Day treasury bills 5.46 2.05
Inflation 8.80 5.82
Relative to 91-Days T-bills. # Relative to long-term government bonds.
8
Expected Return : Incorporating
Probabilities in Estimates
The expected
rate of return
[E (R)] is the
sum of the
product of
each outcome
(return) and its
associated
probability:
RETURNS UNDER VARI OUS ECONOMI C CONDI TI ONS
Economic Conditions Share Price Dividend Dividend Yield Capital Gain Return
(1) (2) (3) (4) (5) (6) =(4) +(5)
High growth 305.50 4.00 0.015 0.169 0.185
Expansion 285.50 3.25 0.012 0.093 0.105
Stagnation 261.25 2.50 0.010 0.000 0.010
Decline 243.50 2.00 0.008 0.068 0.060
RETURNS AND PROBABI LI TI ES
Economic Conditions Rate of Return (%) Probability Expected Rate of Return (%)
(1) (2) (3) (4) =(2) (3)
Growth 18.5 0.25 4.63
Expansion 10.5 0.25 2.62
Stagnation 1.0 0.25 0.25
Decline 6.0 0.25 1.50
1.00 6.00
9
Expected Risk and Preference
The following formula can be used to
calculate the variance of returns:
( ) ( ) ( )
( )
2 2 2 2
1 1 2 2
2
1
...
n n
n
i
i
i
R E R P R E R P R E R P
R E R P
o
=
( ( (
= + + +

(
=

10
Expected Risk and Preference
A risk-averse investor will choose among
investments with the equal rates of return, the
investment with lowest standard deviation.
Similarly, if investments have equal risk
(standard deviations), the investor would prefer
the one with higher return.
A risk-neutral investor does not consider risk,
and would always prefer investments with higher
returns.
A risk-seeking investor likes investments with
higher risk irrespective of the rates of return. In
reality, most (if not all) investors are risk-averse.
11
Normal Distribution
Normal distribution is an important concept in
statistics and finance. In explaining the risk-
return relationship, we assume that returns
are normally distributed.
Normal distribution is a population-based,
theoretical distribution.