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RISK AND RETURN –

INTRODUCTION

BY: PROGRAM PASCASARJANA


UNIVERSITAS TERBUKA
Outline
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 Introduction
 What is risk?
 An overview of market performance
 Measuring performance
 Return and risk measures

 Summary and Conclusions


Introduction
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 It is important to understand the relation between risk


and return so we can determine appropriate risk-
adjusted discount rates for our NPV analysis.
 At least as important, the relation between risk and
return is useful for investors (who buy securities),
corporations (that sell securities to finance
themselves), and for financial intermediaries (that
invest, borrow, lend, and price securities on behalf of
their clients).
What is risk?
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 Definition: risk is the potential for divergence


between the actual outcome and what is expected.
 In finance, risk is usually related to whether expected
cash flows will materialize, whether security prices
will fluctuate unexpectedly, or whether returns will
be as expected.
An overview of market performance – is there
risk?
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DJIA (Dow 30)


January 1930 to October 2002

12000
10000
8000

6000
4000
2000
0
Jan-30
Jan-35
Jan-40
Jan-45
Jan-50
Jan-55
Jan-60
Jan-65
Jan-70
Jan-75
Jan-80
Jan-85
Jan-90
Jan-95
Jan-00
An overview of market performance – is there
risk?
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Monthly % Change in DJIA (Dow 30)


January 1930 to October 2002

40%
30%
20%
10%
0%
-10%
-20%
-30%
-40%
Jan-30

Jan-35

Jan-40

Jan-45

Jan-50

Jan-55

Jan-60

Jan-65

Jan-70

Jan-75

Jan-80

Jan-85

Jan-90

Jan-95

Jan-00
An overview of market performance – is there
risk?
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NASDAQ Composite Index


November 1984-October 2002

5200
4700
4200
3700
3200
2700
2200
1700
1200
700
200
Nov-84

Nov-86

Nov-88

Nov-90

Nov-92

Nov-94

Nov-96

Nov-98

Nov-00
An overview of market performance – is there
risk?
8

Monthly % Change in
NASDAQ Composite Index
October 1984 to October 2002

30%
20%
10%
0%
-10%
-20%
-30%
Nov-84

Nov-86

Nov-88

Nov-90

Nov-92

Nov-94

Nov-96

Nov-98

Nov-00
An overview of market performance – is there
risk?
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S&P/TSX Composite Index


April 1984 - October 2002

12000
11000
10000
9000
8000
7000
6000
5000
4000
3000
2000
Apr-84
Apr-85
Apr-86
Apr-87
Apr-88
Apr-89
Apr-90
Apr-91
Apr-92
Apr-93
Apr-94
Apr-95
Apr-96
Apr-97
Apr-98
Apr-99
Apr-00
Apr-01
Apr-02
An overview of market performance – is there
risk?
10

Monthly % Changes of
S&P/TSX Composite Index
April 1984-October 2002

20.0%

10.0%

0.0%

-10.0%

-20.0%

-30.0%
May-84
May-85
May-86
May-87
May-88
May-89
May-90
May-91
May-92
May-93
May-94
May-95
May-96
May-97
May-98
May-99
May-00
May-01
May-02
Measuring Performance: Returns
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 Dollar return (over one period):


= Dividends + End of Period Price – Beginning of Period Price

 Percentage return (over one period):


=Dollar return/Beginning of Period Price
=(Dividends + End of Period Price)/Beginning of Period Price -1

 Examples: calculate both $ and % returns


1. P0=$50, Div1=$2, P1=$55.50
2. P0=$20, Div1=$0.25, P1=$12.75
3. P0 = $30, Div1=$1, Capital Gain=$5
4. P0 = $130, Div1=$0, Capital Loss=$128
Holding Period Returns
 Let Rt be the observed return
T
1  HPR 1 to T   1  R t 
earned in year t, then the
holding period return over a T-
period time frame is as follows: t 1

 The average compound rate of


return or geometric average rate
of return (GAR) just converts
the HPR to an equivalent
effective annual rate:

1
 T 
1  GAR 1 to T   1  HPR 1 to T 
1
   (1  R t ) 
T
T
 t 1 
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Mean returns
 The mean return is the T
arithmetic average rate of
return and is calculated as
R t
Mean return  R  t 1
follows: T

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The risk premium
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 Definition: the risk premium is the return on a risky


security minus the return on a risk-free security (often
T-bills are used as the risk-free security)
 Another name for a security’s risk premium is the excess
return of the risky security.
 The market risk premium is the return on the market
(as a whole) minus the risk-free rate of return.
 We may talk about the past observed risk premium,
the average risk premium, or the expected risk
premium.
Risk Measures
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 Studies of stock returns indicate they are approximately normally


distributed. Two statistics describe a normal distribution, the mean
and the standard deviation (which is the square root of the
variance). The standard deviation shows how spread out is the
distribution.
 For stock returns, a more spread out distribution means there is a
higher probability of returns being farther away from the mean (or
expected return).
 For our estimate of the expected return, we can use the mean of
returns from a sample of stock returns.
 For our estimate of the risk, we can use the standard deviation or
variance calculated from a sample of stock returns.
Sample standard deviation and variance
 Sample variance is a
measure of the squared
deviations from the
mean and is calculated
as follows:
s 2  Var 
1 T

 Rt - R 
2

 Sample standard and


T  1 t 1

deviation is just the s  SD  Var

square root of the


sample variance:

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How to interpret the standard deviation as a measure
of risk
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 Given a normal distribution of stock returns …


 there is about a 68.26% probability that the actual return will
be within 1 standard deviation of the mean.
 there is about a 95.44% probability that the actual return will
be within 2 standard deviations of the mean.
 There is about a 99.74% probability that the actual return will
be within 3 standard deviations of the mean.
Summary and conclusions
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 We can easily calculate $, %, holding period, geometric


average, and mean returns from a sample of returns
data.
 We can also do the same for a security’s risk premium.
 The mean and standard deviation calculated from
sample returns data are often used as estimates of
expected returns and the risk measure for a security or
for the market as a whole.