RETURN

Return

Return is the income received on an investment plus any
change in market price, usually expressed as a percentage
of the begging market price of the investment.

Basically return is classified into two categories:
Ex-post return (Historical Return)
Ex-ante return (Anticipated Return/Future Return)



Ex-post Return (Historical Return)
The historical returns or ex-post return are derived from the cash flows
received as well as the price changes that occur during the holding
period of that asset.

Rate of Return = Annual income + Ending price-Beginning price
Beginning price Beginning price

Current yield Capital gains /loss
yield

Ex-ante Return (Anticipated Return/Future Return)
Ex-ante is the expected return for a future time period calculated with
the help of probability, which describes the likelihood occurrence of an
event.
n
E(R) = pi Ri
i=1



RETURN OF A SINGLE ASSET
Rate of Return = Annual Income + Ending Price - Beginning Price
Beginning Price Beginning Price

Current Yield Capital Gains /loss Yield
Mr. A share price on February 28, 2008 was Rs. 401 and the price
on December 10, 2008 was Rs. 480. Dividend received Rs. 35.
What is the rate of return earned by MR. A
35 + 480 401
401 401
= 8.73 + 19.70
= 28.43%

Assignment
Tata Indicom share is currently market price is Rs.
250. An investor who have already purchased 100
shares of Tata Indicom last year at a rate of Rs. 425
per share got Rs. 5 as divided in this month. Calculate
t he hol di ng per i od r et ur n of t he i nvest or.
PROBABILITY DISTRIBUTION AND EXPECTED
RATE OF RETURN
n
E(R) = p
i
R
i

i=1
The expected rate of return on Oriental Shipping stock is:

E(Ro) = (0.30) (40%) + (0.50) (10%) + (0.20) (-20%) = 13.0%


EXPECTED RETURN ON A PORTFOLIO

Portfolio is the combination of different type of the
securities.

E(Rp) = E wi E(Ri)

Suppose if the expected returns on two securities are 16
and 14 per cent and an investor wants to create a portfolio
of two asset with equal weight age.
Then the return would be

= 0.5 x 14 + 0.5 x 16 = 15 percent
Assignment
Security Return
(percentage)
Proportion of
Investment
A 12 0.20
B 17 0.30
C 23 0.10
D 20 0.40
Calculate the portfolio return by using the above data.
Risk:
Possibility of loss or injury.
Risk refers to the possibility that the actual outcome of an
investment will differ form expected outcomes. More
specially, most investors are concerned about the actual
outcome being less than the expected outcomes. The wider
the range of possible outcomes , the greater the risk.
Sources of Risk
Interest Rate Risk Financial Risk
Market Risk Liquidity Risk
Inflation Risk Exchange Rate Risk
Business Risk Country Risk

Element of Risk

Risk

Systematic Risk Unsystematic Risk

Interest Rate Risk Business Risk Financial Risk
Market Risk
Purchasing Power Risk

STANDARD DEVIATION
Illustration of the Calculation of Standard Deviation
Assignment
Possible return (in percentage) Probability of occurrence
-25 .05
-10 .10
0 .10
15 .15
20 .25
30 .20
35 .15
Calculate the security expected return and risk.
DIVERSIFICATION AND PORTFOLIO RISK
Probability Distribution of Returns

State of the Probability Return on Return on Return on
Economy Stock A Stock B Portfolio

1 0.20 15% -5% 5%
2 0.20 -5% 15 5%
3 0.20 5 25 15%
4 0.20 35 5 20%
5 0.20 25 35 30%

Expected Return

Stock A : 0.2(15%) + 0.2(-5%) + 0.2(5%) +0.2(35%) + 0.2(25%) = 15%
Stock B : 0.2(-5%) + 0.2(15%) + 0.2(25%) + 0.2(5%) + 0.2(35%) = 15%
Portfolio of A and B : 15*.50+15*.50 = 15%

Standard Deviation

Stock A :
2
A
= 0.2(15-15)
2
+ 0.2(-5-15)
2
+ 0.2(5-15)
2
+ 0.2(35-15)
2
+ 0.20 (25-15)
2

= 200

A
= (200)
1/2
= 14.14%
Stock B :
2
B
= 0.2(-5-15)
2
+ 0.2(15-15)
2
+ 0.2(25-15)
2
+ 0.2(5-15)
2
+ 0.2 (35-15)
2

= 200

B
= (200)
1/2
= 14.14%
Portfolio :
2
(A+B)
= 0.2(5-15)
2
+ 0.2(5-15)
2
+ 0.2(15-15)
2
+ 0.2(20-15)
2
+ 0.2(30-15)
2

= 90

A+B
= (90)
1/2
= 9.49%
RELATIONSHIP BETWEEN
DIVERSIFICATION AND RISK
Standard Deviation of the Two Securities
Portfolio

xy y x y y x x p
ar w w w w cov 2
2 2 2
+ + =
2 2
o o o
SD = (14.14)
2
* (.50)
2
+ (14.14)
2
* (.50)
2
+ 2* .50 * .50 * -.35 .14.14 * 14.14


= 9.49 %

Assignment
Use the following data to calculate portfolio return,
variance and standard deviation.
R1 = 15%
R2 = 8%
W1 = .70
W2 = .30
R12 = .65
1 = 13
2 = 10
Standard Deviation of the more than Two
Securities Portfolio
Variance Covariance Matrix
A
w11
B
w2 2
C
w3 3
A
W11
r11 r12 r13
B
W22
r12 R22 r23
C
w33
r13 R23 R33

= =
=
n
i
n
j
ij j i p
x x
1 1
2
. cov o
Standard Deviation of the more than Two
Securities Portfolio
Variance Covariance Matrix
A
w11
B
w2 2
C
w3 3
A
W11
W1w111r11 w1 w212r12 W1w313r13
B
W22
w2 w121r12 w2 w222r22 W2w313r23
C
w33
W3w131r13 W3w232r23 w3w333r33
Assignment
Security Standard
Deviation
Proportion of
investment
A 12 .20
B 8 .30
C 16 .50
Correlation Coefficient of returns between
A and B = 0.8
B and C = 0.6
A and C = 0.5
Calculate the Portfolio Risk.
MEASUREMENT OF MARKET RISK
THE SENSITIVITY OF A SECURITY TO MARKET MOVEMENTS IS
CALLED BETA .
BETA REFLECTS THE SLOPE OF A LINEAR REGRESSION RELATIONSHIP
BETWEEN THE RETURN ON THE SECURITY AND THE RETURN ON THE
PORTFOLIO

Relationship between Security Return and Market Return
Security
Return




Market return
CALCULATION OF BETA
Beta reflects the slope of the above regression relationship. It is equal
to:
Cov (R
j
, R
M
)
jM

j

M

j
M

j

|
j
= = =

2
M

2
M

M

where Cov = covariance between the return on security j and the
return on market portfolio M. It is equal to:

n
_ _
E (R
jt
R
j
)(R
Mt
R
M
)/n-1

i=1
( )( ) ( ) 1
1
=

=
n r r r r
n
t
m m r r ij
o
CALCULATION OF BETA
Historical Market Data
_ _ _ _ _
Year R
jt
R
Mt
R
jt
-R
j
R
Mt
-R
M
(R
jt
- R
j
) (R
Mt
-R
M
) (R
Mt
-R
M
)
2

1 10 12 -2 -1 2 1
2 6 5 -6 -8 48 64
3 13 18 1 5 5 25
4 -4 -8 -16 -21 336 441
5 13 10 1 -3 -3 9
6 14 16 2 3 6 9
7 4 7 -8 -6 48 36
8 18 15 6 2 12 4
9 24 30 12 17 204 289
10 22 25 10 12 120 144
_ _ _
R
jt
= 120 R
Mt
= 130 (R
jt
- Rj) (R
Mt
- R
M
) = 778 (R
Mt
- R
M
)
2
= 1022
_ _
R
j
= 12 R
M
= 13 Cov (R
jt
, R
Mt
) = 778/= 86.4
M
= 1022/9=113.6

Cov (R
jt
, R
Mt
) 86.4
Beta : j = = = 0.76

2
M
113.6

- -
= Rx - Rm


m i
r r | + o =
Assignment
Month ONGC NSE
1 -0.75 -0.35
2 5.45 -0.49
3 -3.05 -1.03
4 3.41 1.64
5 9.13 6.67
6 2.36 1.13
7 -0.42 0.72
8 5.51 0.84
9 6.80 4.05
10 2.60 1.21
11 -3.81 0.29
12 -1.91 1.96
With the help of the 12 month return data of ONGC and Market calculate
systematic risk of ONGC. Suppose NSE return moves up by 15 percent what
will be the return of ONGC.
o
2

= b
2
o
2
+ o
e
2
.


o
2
= variance
= stand-alone risk of Stock j.

b
2
o
2
= market risk of Stock j.

o
e
2
= variance of error term
= diversifiable risk of Stock j.
What is the relationship between stand-
alone, market, and diversifiable risk.
j j
M j
j
j
j
M
Minimum Variance Portfolio


Problem
Here are returns and standard deviations for four investments.
Return Standard Deviation
Treasury Bills 6% 0%
Stock P 10% 14%
Stock Q 14% 28%
Stock R 21% 26%
Calculate the return and standard deviation of the following portfolios:
50 per cent in Treasury Bills and 50 per cent in stock P
50 per cent each in Q and R assuming the shares have i) Perfect
Positive Correlation ii) Perfect Negative Correlation iii) No
Correlation
30 per cent in Q , 20 percent in R and rest 50 per cent in P by
assuming RPQ is .36, RPR is .65 and RQR is .78.
Problem
Problem
Problem
Problem
The returns of two assets under four possible state of nature are given
below:
State of Nature Probability Return on Asset 1 Return on Asset 2

1 0.10 5%
0%
2 0.30 10%
8%
3 0.50 15%
18%
4 0.10 20%
16%
What is the standard deviation of the return on asset 1 and asset 2?
What is the covariance between the return on assets 1 and 2?
What is the coefficient of correlation between the return on assets 1
and 2?