Chapter 5

Risk and
Return
Pearson Education Limited 2004
Fundamentals of Financial Management, 12/e
Created by: Gregory A. Kuhlemeyer, Ph.D.
Carroll College, Waukesha, WI
5-1
 Defining Return
Income received on an investment
plus any change in market price,
price
usually expressed as a percent of
the beginning market price of the
investment.
Dt + (Pt - Pt-1 )
R=
Pt-1
5-2
 Return Example
The stock price for Stock A was $10 per
share 1 year ago. The stock is currently
trading at $9.50 per share and shareholders
just received a $1 dividend.
dividend What return
was earned over the past year?

5-3
 Return Example
The stock price for Stock A was $10 per
share 1 year ago. The stock is currently
trading at $9.50 per share and shareholders
just received a $1 dividend.
dividend What return
was earned over the past year?

$1.00 + ($9.50 - $10.00 )

R= = 5%
$10.00
5-4
 Defining Risk
The variability of returns from
those that are expected.
What rate of return do you expect on your
investment (savings) this year?
What rate will you actually earn?
Does it matter if it is a bank CD or a share
of stock?
5-5
 Determining Expected
Return (Discrete Dist.)
n
R = ( Ri )( Pi )
i=1

R is the expected return for the asset,

Ri is the return for the ith possibility,
Pi is the probability of that return
occurring,

5-6
n is the total number of possibilities.
 How to Determine the Expected
Return and Standard Deviation

Stock BW
Ri Pi (Ri)(Pi)
The
-.15 .10 -.015 expected
-.03 .20 -.006 return, R,
.09 .40 .036 for Stock
BW is .09
.21 .20 .042
or 9%
.33 .10 .033
Sum 1.00 .090
5-7
 Determining Standard
Deviation (Risk Measure)
n
= ( Ri - R )2( Pi )
i=1

Deviation , is a statistical
Standard Deviation,
measure of the variability of a distribution
around its mean.
It is the square root of variance.
Note, this is for a discrete distribution.
5-8
 How to Determine the Expected
Return and Standard Deviation

Stock BW
Ri Pi (Ri)(Pi) (Ri - R )2(Pi)
-.15 .10 -.015 .00576
-.03 .20 -.006 .00288
.09 .40 .036 .00000
.21 .20 .042 .00288
.33 .10 .033 .00576
Sum 1.00 .090 .01728
5-9
 Determining Standard
Deviation (Risk Measure)
n
=
i=1
( Ri - R ) ( Pi )
2

= .01728

= .1315 or 13.15%
5-10
 Coefficient of Variation
The ratio of the standard deviation of
a distribution to the mean of that
distribution.
It is a measure of RELATIVE risk.
CV = / R
CV of BW = .1315 / .09 = 1.46
5-11
 Discrete vs. Continuous
Distributions
Discrete Continuous
0.4 0.035
0.35 0.03
0.3 0.025
0.25 0.02
0.2 0.015
0.15 0.01
0.1 0.005
0.05
0
0

4%
-5%

13%
22%
31%
40%

58%
67%
49%
-50%

-32%
-23%
-41%

-14%
-15% -3% 9% 21% 33%

5-12
 Determining Exp. Return
Continuous Dist. (NO!)
n
R = ( Ri ) / ( n )
i=1
R is the expected return for the asset,
Ri is the return for the ith observation,
n is the number of observations = whole
population.
No, this is for a continuous dist.:
5-13
 Determining Standard
Deviation (Risk Measure)
n
=
i=1
( R i - R )
2

(n)
Note, this is for a continuous distribution (no!)
And the distribution is for a population.
In fact, this is a continuous dist.:

5-14
 Continuous (no)
Distribution Problem
Assume that the following list represents the
continuous distribution (no) of the entire
population returns for an investment (even
though there are only 10 returns).
9.6%, -15.4%, 26.7%, -0.2%, 20.9%, 28.3%,
-5.9%, 3.3%, 12.2%, 10.5%
Calculate the Expected Return and
Standard Deviation for the population
with a continuous distribution (no)
5-15