Chapter Three: Risk and return

3.1 Concepts of Risk and Return

Risk and return are the most important concepts in finance and they are the foundations of modern finance
theory. The first is a dollar today is worth more than a dollar tomorrow, and is often called the time value of
money. The second is a safe dollar is worth more than a risky dollar. Most people are risk averse, which
does not mean, however, they will not take a risk. It means the only take a risk when they expect to be
rewarded for taking it. People have different degrees of risk aversion; some are more willing to take a
chance than are others.
People invest because they hope to get a return from their investment. Return is the good things that make
people feel better or improves their standard of living. Risk is the bad things of risk averse person seeks to
avoid. This chapter explores the fundamental principles underlying the relationship between risk and return.
 Risk indicates the deviation/variability of expected outcome.
 Return indicates the expected reward for investors to their capital invested
- It can be trough dividend and the capital gain (can be get by the capital appreciation).
3.2 Measuring historical return
The actual return over some past period is known as the realized/historical return. The anticipated return for
some future period is known as the expected return. If you buy an asset of any type, your gain (loss) from
that investment is called the return on your investment. This return will usually have two components. First,
you may receive some cash directly while you own the investment. This is called the income component of
your return. Second, the value of the asset you purchase will often change. In this case, you have a capital
gain or capital loss on your investment.
Example: Suppose, at the beginning of the year, the stock for a company was selling for birr 37 per share. If
you had bought 100 shares, you would have a total out lay of br.3700. Suppose, over the year, the stock paid
a dividend of br.1.85per share. By the end of the year, then, you would have received income of; Dividend=
br.1.85 x 100= br.185
Also, suppose the value of the stock has risen to br.40.33per share by the end of the year. Your 100 shares
are now worth br.4, 033, so you have a capital gain of:
Capital gain = (br.40.33 – br.37) x 100 = br.333
Therefore, the total return on your investment is the sum of the dividend and the capital gain.
Total return = dividend income + capital gain (loss)
= br.185 + br.333 = br. 518
Notice that, if you sold the stock at the end of the year, the total amount of cash you would have equal your
initial investment plus total return. Then, total cash if the stock is sold is:
Total cash = initial investment + total return
Br. 3700 + br. 518 = br. 4,218
As a check, notice that this is the same as the proceeds from the sale of the stock plus the dividends:
Proceeds from stock sale + dividends = br.40.33 x 100 + 185= br. 4,218
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It is usually more convenient to summarize information about returns in percentage terms, rather than in
dollar terms, because that way your return does not depend on how much you actually invest. The question
is, how much do we get for each dollar we invest?

To answer this question, let Pt be the price of the stock at the beginning of the year and let
D t+1 be the dividend paid on the stock during the year.
In the example above, the price at the beginning of the year was br.37 per share and the dividend paid during
the year on each share was br.1.85. Therefore, dividend yield is:

Dividend yield= ( Dt+1 )/ Pt = br.1.85/37 = .05 or 5%, this implies that for each birr we invest, we get five
cents in dividends.
The second component of the return from investment is the capital gains yield. This is calculated as the
change in the price during the year (the capital gain) divided by the beginning price:

Capital gains yield = ( Pt+1 −Pt )/ Pt

= (40.33 -37)/37 = .09 or 9%. This means that per birr we invest, we get nine cents in
capital gain. Putting it together, per dollar invested, we get 5 cents in dividends and nine cents in capital
gains: so we get a total of 14 cents. Our percentage return is 14%. Simply, the total percentage return of an
investment can be calculated as:
value
Dividend paid at end of period+Change∈market
Percentagereturn= period
Beginning market value
= $1.85 + (40.33 – 37)/ 37 = 5.18/37 = .14 = 14%
When we invest, we defer current consumption in order to add to our wealth so that we can consume more
in the future. Therefore, when we talk about a return on an investment, we are concerned with the change in
wealth resulting from this investment. This change in wealth can be either due to cash inflows, such as
interest or dividends, or caused by a change in the price of the asset (positive or negative).
If you commit/require $200 to an investment at the beginning of the year and you get back $220 at the end
of the year, what is your return for the period/the holding period return? The period during which you own
an investment is called its holding period, and the return for that period is the holding period return.

In this example, the HPR is 1.10, calculated as follows:

This HPR value will always be zero or greater—that is, it can never be a negative value. A HPR value
greater than 1.0 reflects an increase in your wealth, which means that you received a -positive rate of return
during the period. A value less than 1.0 means that you suffered a decline in wealth, which indicates that you
had a negative return during the period. The HPR of zero indicates that you lost all your money (wealth)
invested in this asset.
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Although HPR helps us express the change in value of an investment, investors generally evaluate returns in
percentage terms on an annual basis. This conversion to annual percentage rates makes it easier to directly
compare alternative investments that have markedly different characteristics. The first step in converting a
HPR to an annual percentage rate is to derive a percentage return, referred to as the holding period yield
(HPY). The HPY is equal to the HPR minus 1. HPY = HPR – 1

In our example: HPY = 1:10 − 1 = 0:10 = 10%

To derive an annual HPY, you compute an annual HPR and subtract 1. Annual HPR is
Found by: Annual HPR = HPR1/n

Consider an investment that cost $250 and is worth $350 after being held for two years:

Computing Mean Historical Returns

Now that we have calculated the HPY for a single investment for a single year, we want to consider mean
rates of return for a single investment. Over a number of years, a single investment will likely give high
rates of return during some years and low rates of return, or possibly negative rates of return, during others.
Your analysis should consider each of these returns, but you also want a summary figure that indicates this
investment’s typical experience, or the rate of return you might expect to receive if you owned this
investment over an extended period of time. You can derive such a summary figure by computing the mean
annual rate of return (it’s HPY) for this investment over some period of time.
Single Investment: Given a set of annual rates of return (HPY s) for an individual investment, there are two
summary measures of return performance. The first is the arithmetic mean return; the second is the
geometric mean return. To find the arithmetic mean (AM), the sum (Σ) of annual HPY s is divided by the
number of years (n) as follows:

AM =
∑ HPY
n
Where: ΣHPY= the sum of annual holding period yields
An alternative computation, the geometric mean (GM), is the nth root of the product of the HPRs for n
years minus one.

GM =[ ( 1+r 1 )( 1+r 2 ) .. . ( 1+r n ) ] −1

1/n

√n
GM = ( 1+r 1 )( 1+r 2 ) . .. ( 1+r n ) −1
To illustrate these alternatives, consider an investment with the following data:

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Year Beginning value ending value HPR HPY
1 100.00 115.00 1.15 0.15
2 115.00 138.00 1.20 0.20
3 138.00 110.40 0.80 -0.20
HPR 0 . 15+0 .20+(−0 .20 )
AM =∑ =
n 3
0. 15
=
3
= 0. 05
=5 %

√
GM = n ( 1+r 1 )( 1+ r 2 ) . .. ( 1+r n ) −1
3
Gm=√ ( 1. 15 )(1 . 20)( 0 . 80 )−1
3
GM =√ 1. 104=1. 03353−1
GM =0 . 03353=3 . 353 %
Investors are typically concerned with long-term performance when comparing alternative investments. GM
is considered a superior measure of the long-term mean rate of return because it indicates the compound
annual rate of return based on the ending value of the investment versus its beginning value.
Specifically, using the prior example, if we compounded 3.353 percent for three years, (1.03353) 3 we would
get an ending wealth value of 1.104.
Although the arithmetic average provides a good indication of the expected rate of return for an investment
during a future individual year, it is biased upward if you are attempting to measure an asset’s long-term
performance. This is obvious for a volatile security. Consider, for example, a security that increases in price
from $50 to $100 during year 1 and drops back to $50 during year 2. The annual HPYs would be
Year Beginning value Ending Value HPR HPY
1 50 100 2.00 1.00
2 100 50 0.50 -0.50
This would give an AM rate of return of:

AM =
∑ 1 . 00+(−0 . 50) = 0 .50 =0. 25=25 %
2 2
This investment brought no change in wealth and therefore no return, yet the AM rate of return is computed
to be 25 percent.
The GM rate of return would be:
= (2.00×0.50)1/2 −1= (1.00)1/2 −1
=1.00−1= 0%
This answer of a 0 percent rate of return accurately measures the fact that there was no change in wealth
from this investment over the two-year period.

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 3.3 Risk Measures for Historical Returns
To measure the risk for a series of historical rates of returns, we use the same measures as for expected
returns (variance and standard deviation) except that we consider the historical holding period yields (HPYs)
as follows:

Where: σ2 = the variance of the series, HPYi = the holding period yield during period, E(HPY) = the
expected value of the holding period yield that is equal to the arithmetic mean (AM) of the series, n=the
number of observations
The standard deviation is the square root of the variance. Both measures indicate how much the individual
HPYs over time deviated from the expected value of the series.
3.4 Measuring Expected Return
The expected return of the investment is the probability weighted average of all the possible returns. If the

possible returns are denoted by

x i and the related probabilities are P( x i ) , expected return may be

represented as x and can be calculated as follows:

x=Σxi P( x i )
It is the sum of the products of possible returns with their respective probabilities. Consider the example
below.
Possible return (in %): (Xi) Probability of occurrence: P (Xi)
30 0.10
40 0.30
50 0.40
60 0.10
70 0.10

The table above gives the probability distribution of possible returns from an investment in shares, such a
distribution can be developed by the investor by studying the past data and modifying it appropriately for the
changes he expects to occur in the future. The expected return of the share in the example given above can
be calculated as follows.
Possible return (in %): (Xi) Probability of occurrence: P (Xi) Xi P (Xi)
30 0.10 3.0
40 0.30 12.0
50 0.40 20.0
60 0.10 6.0
70 0.10 7.0

∑ X i . P( X i ) =48.0
Hence, the expected return is 48 present.
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3.5 Measuring the Risk of Expected Rates of Return
We have shown that we can calculate the expected rate of return and evaluate the uncertainty, or risk, of an
investment by identifying the range of possible returns from that investment and assigning each possible
return a weight based on the probability that it will occur. There are two possible measures of risk
a(uncertainty). Such as; the variance and the standard deviation of the expected returns.
In this section, we demonstrate how variance and standard deviation measure the dispersion of possible rates
of return around the expected rate of return. We will work with the examples discussed earlier. The formula
for variance is as follows:
n
Variance( σ 2 )=∑ ( probability ) x ¿ ¿ ¿
i=1
¿
Variance: The larger the variances for an expected rate of return, the greater the dispersion of expected
returns and the greater the uncertainty, or risk, of the investment. The variance for the perfect-certainty (risk-
free) example would be:
n
Variance( σ )=∑ ( Pi ) [ Ri−E ( Ri ) ]
2 2

i =1
σ =1. 0( 0 . 5−0 . 5)2
2

=1 . 0( 0 . 0)=0

Note that; in perfect certainty, there is no variance of return because there is no deviation from expectations
and therefore, no risk or uncertainty. The variance for the following example if expected return is 7%:

Economic Conditions P Rj E(R) (Ri –E(R) (Ri -E(R)2 P(Ri – E(R))2

Strong economy, no inflation 0.15 0.20 0.070 0.2-0.070=-0.13 0.0169 0.002535

Weak economy, above average 0.15 -0.20 0.070 -0.2-.070=-0.27 0.0729 0.010935
inflation
No major change in economy 0.70 0.10 0.070 0.1-0.070=-0.03 0.0009 0.00063
Total 1 0.0141

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Standard Deviation: The standard deviation is the square root of the variance:

√
n
2
S tan dard deviation (σ )= ∑ ( Pi ) [ R i−E ( Ri )]
i=1

For the second example, the standard deviation would be:

√
n
∑ ( Pi ) [ R i−E ( Ri )]
2
S tan dard deviation (σ )=
i =1

σ =√ 0 .0141=0 .11784=11.784 %
Therefore, when describing this investment example, you would contend that you expect a return of 7
peresent, but the standard deviation of your expectations is 11.87 persent.
The coefficient of variation; if a choice has to be made between two investments that have the same
expected returns but different standard deviations, most people would choose the one with the lower
standard deviation and, therefore, the lower risk. Similarly, given choice between two investments with the
same risk (standard deviation) but different expected returns, investors would generally prefer the
investment with the higher expected return.

But how do we choose between two investments if one has the higher expected return but the other the
lower standard deviation? To help answer this question, we use another measure of risk, the coefficient of
variation (CV), which is the standard deviation divided by the expected return:

The coefficient of variation shows the risk per unit of return, and it provides a more meaningful basis for
comparison when the expected returns on two alternatives are not the same.

 Consider Projects X and Y, these projects have different expected rates of return and different
standard deviations. Project X has a 60 percent expected rate of return and a 15 percent standard
deviation, while Project Y has an 8 percent expected return but only a 3 percent standard deviation.
Is Project X riskier?
 If we calculate the coefficients of variation for these two projects, we find that Project X has a
coefficient of variation of 15/60 =0.25, and Project Y has a coefficient of variation of 3/8 = 0.375.
Thus, we see that Project Y actually has more risk per unit of return than Project X, in spite of the
fact that X’s standard deviation is larger. Therefore, even though Project Y has the lower standard
deviation, according to the coefficient of variation it is riskier than Project X.
TYPES OF RISK
Thus far, our discussion has concerned the total risk of an asset, which is one important consideration in
investment analysis. However, modern investment analysis categorizes the sources of risk which is a cause

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of variability in returns into two general types: those that are pervasive/ general in nature, such as market
risk or interest rate risk, and those that are specific to a particular security issue, such as business or
financial risk.
Therefore, we must consider these two categories of total risk.
 Total risk = General risk + Specific risk
= Market risk + Issuer risk
= Systematic risk + Nonsystematic risk
1. Systematic (Market) Risk: Risk attributable to broad macro factors affecting all securities
Systematic risk is due to the influence of external factors on an organization. Such factors are normally
uncontrollable from an organization's point of view. It is a macro in nature as it affects a large number of
organizations operating under a similar stream or same domain. It cannot be planned by the organization.
Almost all securities have some systematic risk, whether bonds or stocks.
The investor cannot escape this part of the risk, because no matter how well he or she diversifies, the risk of
the overall market cannot be avoided. If the stock market declines sharply, most stocks will be adversely
affected; if it rises strongly, most stocks will appreciate in value. Clearly, market risk is critical to all
investors.
Example; natural disasters, weather events, inflation, change in interest rates, war, etc…

2. Non-systematic/ non market risk; risk attributable to factors unique to the security
Unsystematic risk is due to the influence of internal factors prevailing within an organization. Such factors
are normally controllable from an organization's point of view. It is a micro in nature as it affects only a
particular organization. It can be planned, so that necessary actions can be taken by the organization to
mitigate (reduce the effect of) the risk.
Example; management inefficiency, imperfect business models, liquidity issues or worker strikes.
Therefore the total variability in returns of a security represents the total risk of that security.

Figure 2.1: Systematic and Unsystematic risk

Capital Asset Pricing Model (CAPM)

The Capital Asset Pricing Model (CAPM) and the Security Market Line
Now let us shift the focus from the behaviour of individuals to the pricing of risky assets and we introduce
the assumption that investors can also invest in an asset that has no default risk. The return on this risk-free

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asset is the risk-free interest rate, Rf. Typically, this is regarded as the interest rate on a government security,
such as Treasury notes.

We continue to assume that all investors in a particular market behave according to portfolio theory, and
ask: How would prices of individual securities in that market be determined? we would expect risky assets
to provide a higher expected rate of return than the risk-free asset. In other words, the expected return on a
risky asset could be viewed as consisting of the risk-free rate plus a premium for risk and this premium
should be related to the risk of the asset.

However, part of the risk of any risky asset—unsystematic risk—can be eliminated by diversification. It
seems reasonable to suggest that in a competitive market, assets should be priced so that investors are not
rewarded for bearing risk that could easily be eliminated by diversification. On the other hand, some risk—
systematic risk—cannot be eliminated by diversification so it is reasonable to suggest that investors will
expect to be compensated for bearing that type of risk. In summary, risky assets will be priced by assuming
there is a relationship between returns and systematic risk. The remaining question is: What type of
relationship will there be between returns and systematic risk?
Capital asset pricing model estimates the expected return on an investment given its systematic risk. A
model provides a frame work to determine the required rate of return on an asset and indicates the
relationship between return and risk of the asset. The required rate of return specified by the CAPM helps in
valuing an asset. One can also compare the expected (estimated) rate of return on an asset with its required
rate of return and determine whether the asset is fairly valued. Under the CAPM, the security market line
(SML) represents the relationship between an asset’s risk and the required rate of return.
The capital asset pricing model shows the relationship between risk and the expected rate of return on a
risky security. It provides a framework to price individual securities and determines the required rate of
return for individual securities.

Implementation of the CAPM

 Use of the CAPM requires estimation of the risk-free interest rate,

R f , the systematic risk of equity, β i

and the market risk premium, E( R M −R f ) .

 The Risk-free Interest Rate (

R f ) The assets closest to being risk free are government debt securities, so
interest rates on these securities are normally used as a measure of the risk-free rate.
 βi measures the risk of i relative to the risk of the market as a whole. The beta of the market portfolio is
1. Beta of the market portfolio is the reference for measuring the volatility of individual risky securities.
 A security’s beta of 1 indicates systematic risk equal to the aggregate market risk and the required rate of
return will be equal to the market rate of return.
 If the security’s beta is greater than 1, then its systematic risk is greater than the aggregate market risk.
This implies that the security’s returns fluctuate more than the market returns, and the security’s required

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 rate of return will be more than the market return. Stocks with high betas are said to be high-risk
securities.
 On the other hand, a security’s beta of less than 1 means that the security’s risk is lower than the
aggregate market risks. This implies that the securities returns are less sensitive to the changes in market
returns. Therefore, the security’s required rate of return will be less than the market rate of return.
 We can re write the CAPM equation as follows;

Example; The risk free rate of return is 8% and the market rate of return is 17%. Betas for shares P, Q, and
R, are respectively 0.6, 1 and 1.2. What are the required rates of return on these shares?
E (RP) = 0.08 + (0.17 – 0.08) x 0.6 = 13.4%,
E (RQ) = 0.08 + (0.17 – 0.08) x1.0 = 17%
E (RR) = 0.08 + (0.17 – 0.08) x 1.2 = 18.8%
Q with beta of 1 has a return equal to the market return. P has beta lower than 1 and hence its required rate
of return is lower than the market return. R has a return greater than the market return since its beta is greater
than 1.00.

When graphed, the above equation is called the Security Market Line (SML) and is illustrated in the Figure below.
Figure 2.2: The Security Market Line.
E ( Ri )
SML
E ( Ri ) = R f + [E ( Rm) - R f ] βi:

Rf

1.0

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