SGJCH 4

Chapter 4
Return
and Risk
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
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Risk and return overview
• What’s risk?
– Risk is the magnitude of surprise from expectation.
– The commonly used statistical measure is called the standard
deviation.
• For financial investment, we often gauge and compare investment
opportunities based on the tradeoff between expected return to the
investment and the magnitude of the risk.
– Naturally, one wants to investment in projects that generate high
expected returns, with low risk (low magnitude of surprise).

Measuring expected return and
risk in a probability setting
• Let’s use coin flip as an example. There are only 2
possibilities, head or tail. The chance is 50% each.
• Example: If an investment is forecasted to generate 50%
return with 80% probability and -20% return with 20%
probability, what’s your expected return and standard
deviation?
– Expected Return, E[R], = sum(ProbxReturn) = 80%*50%+20%*(-
20%)=36%
– Variance (V) = sum (Probx (Return-E[R])^2)) = 80%x(50%-
36%)^2+20%*(-20%-36%)^2=0.0784
– Standard deviation (SD)=Sqrt(Variance)=28%

example
• You are investing $1m today, there are three possible

realizations next year. Case A with 40% probability you make
$1.6m, Case B with 30% probability, you make $1m back.
Case C with 30% probability you only make $0.8m.
• Returns are 60% in A, 0% in B, -20% in C.
• E[R]=0.4*60%+.3*0+.3*(-20%)=18%.
• Variance=0.4*(60%-18%)^2+.3*(0-
18%)^2+.3*(-20%-18%)^2=0.1236
• SD=sqrt(Variance)=sqrt(0.1236)=35.16%

Forecast risk and return based on history
• For stocks with price history, we first adjust the price history
with stock splits and dividends. Yahoo provides adjusted price
series.
• From the adjusted price series, we can compute simple daily
return at date t as R(t)= (P(t)-P(t-1))/P(t-1)
– Many people use continuous compounding return r(t)=ln(P(t)/P(t-1))
• Choose a sample period, for example one year (most recent)
for N=252 observations.
– Use one month N=21 to capture more timely variations.
• Assume each day’s return within the year has identical chance
of happening again in the future. Hence, prob=1/N for each
observation:
– E[R]=sum(ProbxR)=sum(R)/N
– SD=sqrt[ (R-E[R])^2/(N-1) ]  (N-1) instead of N is for bias correction
– See RiskMetrics for risk estimates with time-varying (exponentially
decaying) probabilities/weights. Also, search GARCH
Risk-return tradeoff measures
• For comparing investment opportunities in a stand-alone case

– SD/Mean – coefficient of variation (CV): Measures the magnitude of risk
per unit of expected return
• The smaller the better
– Mean/SD: Measures the expected return per unit of risk you take
• The larger the better
– Sharpe Ratio = (Mean-Rf)/SD: Measures the expected excess return per
unit of risk you take.
• If you do not take risk, your return is Rf (the risk-free rate of return).
• If you take some risk, Sharpe ratio measures how much extra return you expect to get for
each unit of (extra) risk you take.
– Extensions of Sharpe ratio: The ratio of Expected excess return over any
benchmark to the standard deviation of the excess return

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
– Issuer’s management
– Issuer’s financing
• External Forces
– Political environment
– Business environment
– Economic environment
– Inflation
– Deflation

Table 4.4 Historical Returns for Select
Asset Classes (1900-2011)

The Time Value of Money and
Returns
• The sooner you receive a positive return on

a given investment, the better
• A dollar received today is worth more than
a dollar received in the future
• The sooner your money can begin earning
interest, the faster it will grow
• Satisfactory Investment: one for which
the present value of benefits equals or
exceeds the present value of its costs

Measuring Return
• Required Return
– The rate of return an investor must earn on an
investment to be fully compensated for its risk
Required return Real rate Expected inflation Risk premium

= + +
on investment j of return premium for investment j
Required return Risk-free Risk premium

= +
on investment j rate for investment j

Measuring Return (cont’ d)
• Real Rate of Return

– Equals the nominal rate of return minus the inflation rate
– Measures the change in purchasing power provided by an
investment
• Expected Inflation Premium
– The average rate of inflation expected in the future

• Risk-free Rate
– The rate of return that can be earned on a
risk-free investment
– The most common “risk-free” investment is considered to
be the 3-month U.S. Treasury Bill
Real rate Expected inflation

Risk-free rate = +
of return premium
rF  r *  IP

• Risk Premium
– Additional return an investor requires on a risky
investment to compensate for risks based upon issue and
issuer characteristics
– Issue characteristics are the type, maturity and features
– Issuer characteristics are industry and company factors

Holding Period Return (HPR)
• Holding Period: the period of time over which an

investor wishes to measure the return on an
investment vehicle
• Realized Return: current return actually received

by an investor during the given return period
• Paper Return: return that has been achieved but

not yet realized (no sale has taken place)

Holding Period Return (HPR)
• Holding Period Return

– The total return earned from holding an investment for a
specified holding period (usually 1 year or less)
Income Capital gain (or loss)


during period during period
Holding period return 
Beginning investment value
Capital gain (or loss) Ending Beginning

= -
during period investment value investment value

Table 4.6 Key Financial Variables for Four
Investments

Using HPR in Investment Decisions
• 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

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?
• This is essentially the annual
compounding return

Calculating an Investments Yield
Using an Excel Spreadsheet

Using IRR in Investment Decisions
(cont’ d)
• 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 investment’s income
stream to its market price
Table 4.7 Present Value Applied to an Investment

Internal Rate of Return (IRR):

Interest on Interest:
The Critical Assumption
• Using yield (IRR) to measure return assumes

that all income earned over the investment
horizon is reinvested at the same rate as the
original investment.
• Reinvestment Rate is the rate of return earned
on interest or other income received from an
investment over its investment horizon.
• Fully compounded rate of return is the rate of
return that includes interest earned on interest.

Finding Growth Rates
• Rate of Growth
– The compound annual rate of change in the
value of a stream of income
– Used to see how quickly a stream of income,
such as dividends, is growing

Finding Growth Rates
• Growth Rate Example:

Stock paid $0.92 dividend
in 2002 and $1.85 in 2011.
What’s the average annual
growth rate over this period?
• Again an annual compounding
growth rate

Finding Growth Rates:

Sources of Risk
• Risk-Return Tradeoff is the relationship

between risk and return, in which
investments with more risk should provide
higher returns, and vice versa
• Risk is the chance that the actual return
from an investment may differ from what
is expected

Sources of Risk (cont’ d)
• Business Risk is the degree of uncertainty

associated with an investment’s earnings and
the investment’ s ability to pay the returns
owed to investors.
• Types of Investments Affected
– Common stocks
– Preferred stocks
• Examples of Business Risk
– Decline in company profits or market share
– Bad management decisions

• Financial Risk is the degree of uncertainty

of payment resulting from a firm’s mix of
debt and equity; the larger the proportion
of debt financing, the greater this risk.
– Common stocks
– Corporate bonds
• Examples of Financial Risk
– Company can’t get additional loans for growth or
to fund operations
– Company defaults on bonds

• Purchasing Power Risk is the chance that

changing price levels (inflation or deflation)
will adversely affect investment returns.
– Bonds (fixed income)
– Certificates of deposit
• Examples of Purchasing Power Risk

– Movie that was $8.00 last year is $9.00 this year

• Interest Rate Risk is the chance that changes

in interest rates will adversely affect a security’s
value.
– Bonds (fixed income)
– Preferred stocks
• Examples of Interest Rate Risk
– Market values of existing bonds decrease as market
interest rates increase
– Income from an investment is reinvested at a lower
interest rate than the original rate

• Liquidity Risk is the risk of not being able to

liquidate an investment conveniently and at a
reasonable price.
– Some small company stocks
– Real estate
• Examples of Liquidity Risk

– The price of a house has to be lowered for a quick sale

• Tax Risk is the chance that Congress will make

unfavorable changes in tax laws, driving down
the after-tax returns and market values of
certain investments.
– Municipal bonds
– Real estate
• Examples of Tax Risk
– Lower tax rates reduce the tax benefit of municipal bond
interest
– Limits on deductions from real estate losses

• Event Risk comes from an unexpected event that

has a significant and unusually immediate effect on
the underlying value of an investment.
– All types of investments
• Examples of Event Risk
– Decrease in value of insurance company stock after
a major hurricane
– Decrease in value of real estate after a major earthquake

• Market Risk is the risk of decline in

investment returns because of market
factors independent of the given
investment.
– All types of investments
• Examples of Market Risk

– Stock market decline on bad news
– Political upheaval
– Changes in economic conditions

• Currency Exchange Risk is the risk

caused by the varying exchange rates
between the currencies of two countries.
(Discussed in Chapter 2)
– International stocks or ADRs
– International bonds
• Examples of Currency Exchange Risk
– U.S. dollar gets “stronger” against foreign
currency, reducing value of foreign investment

Measures of Risk: Single Asset
• Standard deviation is a statistic used to measure

the dispersion (variation) of returns around an
asset’s average or expected return
• Coefficient of variation is a statistic used to
measure the relative dispersion of an asset’s
returns; it is useful in comparing the risk of assets
with differing average or expected returns
• Higher values for both indicate higher risk

Table 4.10 Historical Returns and Standard
Deviations for Select Asset Classes (1900–2011)

Figure 4.2 Risk-Return Tradeoffs
for Various Investments

Acceptable Levels of Risk Depend
Upon the Individual Investor
• Risk-indifferent describes an investor who does not

require a change in return as compensation for
greater risk
• Risk-averse describes an investor who requires

greater return in exchange for greater risk
• Risk-seeking describes an investor who will accept

a lower return in exchange for greater risk

Figure 4.3 Risk Preferences

Steps in the Decision Process:
Combining Return and Risk
• Estimate the expected return using present value methods

and historical/projected return rates
• Assess the risk of the investment by looking at
historical/projected returns using standard deviation or
coefficient of variation of returns
• Evaluate the risk-return of each investment alternative to
make sure the return is reasonable given the level of risk
• Select the investments that offer the highest expected
returns associated with the level of risk you are willing to
accept

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Chapter 4

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• You are investing $1m today, there are three possible

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• For comparing investment opportunities in a stand-alone case

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• The rate of return indicates how rapidly an investor

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• The sooner you receive a positive return on

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Required return Real rate Expected inflation Risk premium

Required return Risk-free Risk premium

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• Real Rate of Return

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Real rate Expected inflation

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• Holding Period: the period of time over which an

• Realized Return: current return actually received

• Paper Return: return that has been achieved but

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• Holding Period Return

Income Capital gain (or loss)

Capital gain (or loss) Ending Beginning

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• Advantages of Holding Period Return

• Disadvantages of Holding Period Return

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• Internal Rate of Return: determines the compound annual

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• Advantages of Internal Rate of Return

• Disadvantages of Internal Rate of Return

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• Some investments, such as bonds, provide uneven

Table 4.7 Present Value Applied to an Investment

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• Using yield (IRR) to measure return assumes

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• Growth Rate Example:

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• Risk-Return Tradeoff is the relationship

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• Business Risk is the degree of uncertainty

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• Financial Risk is the degree of uncertainty

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• Purchasing Power Risk is the chance that

• Examples of Purchasing Power Risk

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• Interest Rate Risk is the chance that changes

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• Liquidity Risk is the risk of not being able to

• Examples of Liquidity Risk