RISKS AND RETURN

INTRODUCTION
While investing money in any security or assets, a rational investor is
concerned with two of investment i.e. Return expected to be earned from the
security and at same time the risk associated with such expected returns. Any
rational investor will not just look at returns he is offered by an investment, he
will also be concerned with the risk associated with such returns promised
form the investment.
To understand the above concept let us take a simple example, suppose
you have a childhood friends Mr. Z a very good person by nature but at the
same time your past experience show that whenever you helped him y lending
some money he never repaid it on time and sometime you even lost some
money because he never repaid the same at all. Let us further assume that this
experience of your has been true from last 20 year with as small amount as $10
or $50. Now, this friend of yours is starting a new business and wants $100000
from you as a loan, he promises you that he will give you 36% interest per
annum. Whether you would lend him the money.
The answer to above question for a rational person will be a straight on;
this is because a rational investor knows that the person asking money from
him has never kept his promise in past and there is no guarantee that he will
keep his promise this time. Instead of earning 36% interest you may lose the
whole principal of $100000 and end empty handed.
The point to be understood here is that unlike normal thinking that
while investing money an investor only considers the returns offered is not
correct, any rational investor, while investing his money will only considers
the returns offered by the security but at the same time will also consider the
risk associated with such investment.
After careful examination of risk and returns associated with the
investment at hand, the investor will invest money only if the return offered
are good enough as compared to the level of risk associated with investment.
Therefore, for selecting any investment avenue an investor will evaluate
the investment form two angles, (i) Returns Expected and (ii) Risk associated
with the expected returns. Let us examine the in detail:

RETURNS
Returns from any security depend on how well the security has done in
the past and based on performance we can forecast the future performance of
the company. This concept of forecasting future performance based on past can
be correlated to a result expected from a student (say Mr. M), if this student
has been scoring very low marks (say 40 to 45%) consistently in every exam
that he ever appeared in his life we cannot expect him to score a 95% in the
forthcoming exam, rather, at best we expect him score around 50% mark.
Similarly if any other student (say Mr. N) has been consistently scoring 90%+
marks in every exam and has coming first in the class, we can safely place a
bet on him that he will score atleast 85%+ marks in the forthcoming exam.
Therefore, to forecast future returns (i.e. expected returns) we should
first understand how to calculate past return (i.e. realised returns), and after
calculating past return we will use the same to forecast future returns.
Diagram given below explain various type of returns.
Types of Returns

Past Return/Realised Returns

Future Return/Expected Return

Holding Period Returns

With Probabilities
Annualised Returns
Without Probabilities
As can be seen in above figure 3.1, Holding Period returns is prominently
highlighted, this is because every formula of returns and risk starts from this
formula and if this formula is not understood properly, student will find it very
difficult to understand the whole chapter.

Past Returns/ Realised returns:

Past returns are the returns that are already earned by the investor in the past,
therefore they are known as Realised returns. Past returns can be further
classified into: (i) Holding Period Returns and (ii) Annualised Returns.

Holding Period Returns:

Holding period returns are the total returns earned by the investor
during the time period for which the investment is held. Returns from a
security are earned in two forms:
Revenue receipts (Interest, Dividends etc.) and
Capital gain (i.e. change in the value of the security as compared to the price
for which the security was purchased).
These returns can be compared with the initial amount paid to purchase the
security, and such returns can be converted in percentage terms.
Let us take an example to understand the above concept, suppose you
purchase share of X Ltd. Today at a price of $ 50 per share, during the year the
company pays a dividend of $ 5 on the share and at the end of the year you
sold the share at $ 55.
From the example we can easily conclude that you earned $ 5 as dividend
and $ 5 [i.e. $ 55 (Price at the end of year) - $50 (purchasing price) as capital
gains (i.e. appreciation in the value of share), therefore your total earning is
$10 per share ($ 5 dividend + $ 5 capital gains).
Now, this $ 10 is earned by you by investing $ 50 at the beginning of the
year. Therefore, if we want to convert this return of $ 10 in terms of percentage
we can easily do so as follows: 10/50*100=20%. Therefore our holding period
returns is $10 or 20%.
We can denote the above discussion in terms of formula as follows:
D+( PtPt 1)
100
HPRt =
Pt1
Where,
HPRt = Holding period returns for timet.
Dt = Dividend received during the timet.
Pt = Price of the security at the end of timet.
Pt-1 = Price of the security at the beginning of timet.
Let us apply the above formula to the example we just discussed:
Here,
HPRt = To be found.
Dt = $ 5
Pt= $ 55

Pt-1 = $ 50
5+ (5550 )
100
HPRt =
50
= 20%
Illustration 1: (Holding Period Return Simple)
Mr. Deepak purchase 10 share of Xavier Ltd. on 01/01/2009 for $75 per share,
during the year 2009 Xavier Ltd. paid dividend of $12 per share. The market
price of share of 31/12/2009 was $93 per share. You are required to find out
the returns earned by Mr. Deepak during the year 2009.
Solution:
HPRt = To be found.
Dt= $12 [i.e. dividend paid during 2009]
Pt = $93 [i.e. price at the end of the year 2009]
Pt-1 = $75 [i.e. price at the beginning of the year 2009]
t = 12 Month/1 year
12+ [ 9375 ]
100
HPRt =
75
= 40%
Illustration 2: (Holding Period Return Simple)
Jones purchased 12 share of Liverpool Ltd. for $190 per share on 01/01/2007,
during the time span of 3 year Liverpool Ltd. paid following dividends per
share 2007- $7, 2008-$9, 2009-$12. Jones sold the shares on 31/12/2009 for
$225 per share, find out the holding period returns earned by Jones.
Solution:
DT = $28 [(7+9+12) (i.e. dividend paid during 2007, 2008 and 2009)]
Pt = $225[i.e. price as on 31/12/2009]
Pt-1 = $190[i.e. price as on 01/01/2007]
t = 36 Month/ 3 years
D+[Pt Pt 1]
HPRt =
*100
Pt 1
HPRt =

28+[225190 ]
100
190

= 33.16%
Illustration 3: (Holding Period Return Simple)

Torres purchased shares some of Ronaldo Ltd. for $1770 per share
on01/04/2010, he sold the shares on 30/09/2010 for $2550 per share, during
this time period Ronaldo Ltd. paid normal dividend of $70 per share and paid
capital gains dividend of $80 per share. Find out the holding period of Torres.

Solution:
HPRt =

D+[Pt Pt 1]
100
Pt 1

Dt = $150[(70+80) (i.e. normal dividend + capital gains dividend)

Pt = $2550[i.e. price as on 30/09/2010]
Pt-1= $1770[i.e. price as on 01/04/2010]
t = 6 Months
150+[25501770]
100
HPRt =
1770
=52.54%
Illustration 4: (Holding Period Return Simple)
Ms. Jyoti purchase 10 share of Xavier Ltd. on 01/01/2009 for $75 per share,
during the year 2009 Xavier Ltd. paid dividend of $12 per share. The market
price of share o 31/12/2009 was $93 per share. You are required to find out the
returns earned by Ms. Jyoti during the year 2009.
Solution:
HPRt = To be found.
Dt= $12 [i.e. dividend paid during 2009]
Pt = $93 [i.e. price at the end of the year 2009]
Pt-1 = $75 [i.e. price at the beginning of the year 2009]
t = 12 Month/1 year
12+ [ 9375 ]
100
HPRt =
75
= 40%
Illustration 5: (Holding Period Return Simple)
Tom purchased shares some of Ronaldo Ltd. for $1770 per share
on01/04/2010, he sold the shares on 30/09/2010 for $2550 per share, during
this time period Ronaldo Ltd. paid normal dividend of $70 per share and paid
capital gains dividend of $80 per share. Find out the holding period of Tom.
Solution:

HPRt =

D+[Pt Pt 1]
100
Pt 1

Dt = $150[(70+80) (i.e. normal dividend + capital gains dividend)

Pt = $2550[i.e. price as on 30/09/2010]
Pt-1= $1770[i.e. price as on 01/04/2010]
t = 6 Months
150+[25501770]
100
HPRt =
1770
=52.54%

Annualised Returns:
Taking a decision to buy a particular security only based the returns
offered by it, without taking into account the time period during which the
returns are earned would not be a good investment decision.
Just imagine a situation where shares of A ltd. earned a return of 12%
during a span of 3 months as compared to this B Ltd. earned a return of 20%
during a span of 6 months. If no regards is given to the time span during which
the returns are earned, we would select B Ltd. but we know that B Ltd. earned
20% returns in a span of 6 months, whereas A Ltd. earned only 12%, but it
earned it in a span of 3 month. As time period of which the returns are not
same, the security are not comparable.
To make the two security comparable we should evaluate them for the
same time span, therefore, in financial world, returns are normally expressed
in terms of % p.a. (i.e. in term of percentage returns eared on yearly basis).
This also makes the evaluation of returns offered by various securities much
easier for an analyst.
Returns offered by any security can easily be converted into Annualised
Returns [i.e. % p.a.] using the following formula,
HPRt
AR =
Mt *12 [i.e. number of months in an year]
Where,
AR = Annualised Returns
HPRt = Holding period returns during the time t
Mt = No. of months during the holding period.
Above formula can be used in question where information about
holding period is given in the question is in months, if information about
holding period is given in terms of weeks or days the formula can be modified
and instead of using the number 12 [i.e. no. of months], number 52[i.e. no. of

weeks in an year] or number 365[i.e. no. of days in an year] can be used

respectively for weeks and days information given in the question.
Illustration 6: [Annualised Returns]
Ms. Jyoti purchase 10 share of Xavier Ltd. on 01/01/2009 for $75 per share,
during the year 2009 Xavier Ltd. paid dividend of $12 per share. The market
price of share o 31/12/2009 was $93 per share. You are required to find out the
returns earned by Ms. Jyoti during the year 2009.
Solution:
HPRt =

D+[ Pt Pt 1]
100
Pt 1

HPRt = To be found.
Dt= $12 [i.e. dividend paid during 2009]
Pt = $93 [i.e. price at the end of the year 2009]
Pt-1 = $75 [i.e. price at the beginning of the year 2009]
t = 12 Month/1 year
12+ [ 9375 ]
100
HPRt =
75
= 40%
HPRt
X 12
AR =
[i.e. number of months in an year]
Mt
HPRt = 40%
Mt (Months) = 12
40
12
AR = 12
AR = 40%

Illustration 7: [Annualised Returns]

Torres purchased shares some of Ronaldo Ltd. for $1770 per share
on01/04/2010, he sold the shares on 30/09/2010 for $2550 per share, during
this time period Ronaldo Ltd. paid normal dividend of $70 per share and paid
capital gains dividend of $80 per share. Find out the holding period of Torres.
Solution:
D+[Pt Pt 1]
100
HPRt =
Pt 1
Dt = $150[(70+80) (i.e. normal dividend + capital gains dividend)
Pt = $2550[i.e. price as on 30/09/2010]

Pt-1= $1770[i.e. price as on 01/04/2010]

t = 6 Months
150+[25501770]
100
HPRt =
1770
=52.54%
HPRt
12
AR =
Mt
HPRt = 33.16
Mt [Months] = 36
33.16
AR =
36 *12
AR = 11.053

Illustration 8: [Annualised Returns-with year wise information]

ABC Ltd. paid the following dividend per share and had following market
price per share during 2004-09.
YEAR
2004
2005
2006
2007
2008
2009

DIVIDEND PER SHARE

1.53
1.53
1.53
2.00
2.00
3.00
Calculation the annual rate of return for last 5 years.

MARKET PRICE PER

SHARE
31.25
20.75
30.88
67.00
100.00
154.00

Solution:
HPRt =

Dt + [ Pt Pt1 ]
100
Pt 1

Here,
Year

Dividend during
the year [Dt]

Opening
[Pt-1]

price

Closing
[Pt]

price

2004
2005
2006
2007
2008
2009

1.53
1.53
1.53
2.00
2.00
3.00

Returns for the year

1.53+ [ 20.7531.25 ]
100
2005 =
31.25
1.53+ [10.50 ]
100
31.25

=28.70%
1.53+ [ 30.8820.75 ]
100
20.75

2006 =

1.53+10.13
100
=
20.75
=56.19%
2.00+[67.0030.88 ]
100
2007 =
30.88

2.00+ 36.12
100
30.88

= 123.45%
2.00+ [ 10067.00 ]
100
2008 =
67.00
=

2.00=33.00
100
67.00

=52.24%

2008 =

3.00+ [ 154100 ]
100
100

3.00+ 54
100
=
100
=57%

Not Given
31.25
20.75
30.88
67.00
100.00

31.25
20.75
30.88
67.00
100.00
154.00

Illustration 9: [Annualised Returns]

Ms. Preeti purchase 10 share of Xavier Ltd. on 01/01/2009 for $75 per share,
during the year 2009 Xavier Ltd. paid dividend of $12 per share. The market
price of share on 31/12/2009 was $93 per share. You are required to find out
the returns earned by Ms. Preeti during the year 2009.
Solution:
HPRt =

D+[ Pt Pt 1]
100
Pt 1

HPRt = To be found.
Dt= $12 [i.e. dividend paid during 2009]
Pt = $93 [i.e. price at the end of the year 2009]
Pt-1 = $75 [i.e. price at the beginning of the year 2009]
t = 12 Month/1 year
12+ [ 9375 ]
100
HPRt =
75
= 40%
HPRt
X 12
AR =
[i.e. number of months in an year]
Mt
HPRt = 40%
Mt (Months) = 12
40
12
AR = 12
AR = 40%

Expected returns:
As the world suggests Expected Returns are future returns and as
mentioned earlier, future is generally based on past returns. In the given

example earlier Mr. M who consistently scored low marks would be expected
to score low marks, whereas Mr. N who consistently scored 90%+ would be
expected to repeat his performance in any upcoming exam. The point is that
this principle of future being based on past is true for virtually everything that
exists, be it a person or a company.
Therefore, to calculate future/expected returns, we can simply take an
average of the past returns; this average would be treated as returns expected
to be earned from the security.
Averages are of two types, namely:
Simple average (i.e. without probabilities) and
Weighted average (i.e. with probabilities)
Expected returns without probabilities (Simple average)
We already know the concept of Simple average from the subject of
statistics that we have learned in the earlier semesters. The formula for
Expected Returns without probabilities is same as the formula for Simple
average i.e.
SPx
Rx =
n
Where,
Rx = Expected returns or average returns of the security.47
Rx = Annual returns of the security for past years
n = number of years.
Illustration 10: [Expected Returns Without Probabilities]
Find expected returns of ABC Ltd.
Statement showing expected Return of ABC Ltd.
Year
2005
2006
2007
2008
2009

Return%
-28.7
56.19
123.45
52.24
57

Solution:
Year
2005
2006

Return%
-28.7
56.19

2007
2008
2009
Total

123.45
52.24
57
260.18

RABC =

SRABC
n

Were,
RABC = To be found
RABC = Annual returns of the security for past years
n = 5 Years
260.18
RABC =
5
= 52.04%
Therefore, on an average, share of ABC Ltd. is expected to give a return of
52.44% in future.
Illustration 11: [Expected Return Without Probabilities (months data)]
Calculate expected returns from the following information for GEC Ltd.
Months
January
February
March
April
May
June
July
August
September
October
November
December

Returns
0.034
-0.06
-0.118
0.067
-0.0063
-0.079
-0.059
0.268
0.178
0.191
-0.071
-0.055

Solution:
Statement showing expected returns of GEC Ltd.
Months

Returns

January
February
March
April
May
June
July
August
September
October
November
December
Total

RGEC =

0.034
-0.06
-0.118
0.067
-0.0063
-0.079
-0.059
0.268
0.178
0.191
-0.071
-0.055
0.233

SRGEC
n

Were,
RGEC = To be found
RGEC = Annual returns of the security for past Months.
n = 12 month
0.2330
RGEC =
12
= 0.019417
= 1.9417%
Illustration 12: [Expected Returns Without Probabilities]
Find expected returns of ABC Ltd.
Statement showing expected Return of ABC Ltd.
Year
2005
2006
2007
2008
2009

Return%
-28.7
56.19
123.45
52.24
57

Solution:
Year

Return%

2005
2006
2007
2008
2009
Total

-28.7
56.19
123.45
52.24
57
260.18

RABC =

SRABC
n

Were,
RABC = To be found
RABC = Annual returns of the security for past years
n = 5 Years
260.18
RABC =
5
= 52.04%
Therefore, on an average, share of ABC Ltd. is expected to give a return of
52.44% in future.

Expected Returns With Probabilities (Weighted average):

Probability Introduction
Probability is defined as a chance of occurrence of an event. Higher the
chance of occurrence of an event, higher is the probability assigned to it,
number assigned to an event varies between 0 and 1. 1 being the highest
number and 0 being the lowest.
For example, if the put six chits in a box each with name written on it and you
draw one of them, there is 100% chance that the chit you will draw will have
your name written on it, therefore the event that you will draw a chit with
your name written on it will assigned a probability of 1. As against this, as
there is no chit with your friends name on it in the box, the chance that the
chit you draw will have his name on it is 0%, therefore the number assigned to
the event that you will draw a chit with your friends name on it will be
assigned a probability of 0.
Similarly, if you are flipping a coin with two sides, the probability that you
will get heads is 50% (i.e. ), therefore the number assigned to the event that
you will heads on flipping the coin will be 0.50, similarly, the chance of
getting tails will also be 50% (i.e. the other ), therefore probability that you
will get tails on flipping the coin will also be assigned a probability of 0.50.
Notice two points here.
The total of probabilities of both the events is 1 (i.e. 0.50 + 0.50) and

There is no chance of any third even occurring (assuming that the coin will not
remain in standing position upon being flipped). Therefore the probability for
this even (i.e. of any third occurrence) is 0.
Let us take one final example, suppose you are playing snakes and ladders
with a die having six sides, what is the chance that you will get No. 2 on
flipping the die? The answer is 1/6 th, this is because there is equal chance of
any number between 1 to 6 coming up once the die is flipped, therefore, the
probability assigned to this event (i.e. No. 2 coming up) will be assigned the
probability of 0.16667 (i.e. 1/6th). But what is the chance of you getting a
number between 1 and 6, the answer is 100%, therefore the probability
assigned to the event that you will get a number between 1 and 6 upon
flipping a die with six sides is 1, the chance of any other number (i.e. other
than 1 to 6) is zero, therefore probability assigned to it will be 0.
Notice following points from above example and discussion,
Probability of all events taken together cannot be more than 1 (i.e. maximum
probability that can be assigned to an event to 1).
The sum total of all probability must be equal to 1.
A probability cannot be negative.
If an outcome is certain to occur, it is assigned a probability of 1, which
impossible outcome are assigned a probability of 0.
The possible outcome are mutually exclusive(i.e. if any one of the events
occur, all the other events will not occur, for example in case of flipping a die,
if number 3 come up, it implies that number 1,2,4,5 and 6 has not come).
All possible outcomes are collectively exhaustive. (i.e. all the events taken
together are the only possible event, the possibility of any other event
occurring is zero, for example in case of flipping a die, the possible events
taken together are that any of the number between 1 and 6 will come up, the
possibility of any other number coming up (say No. 7 and 8) is zero).
2. Probability How it is used in measuring returns?
We know that Expected returns or future returns are based on past, now if after
studying the past if we see a pattern in the returns of the security, we can use
such pattern to assign probability to the possible returns the security can earn
in future. Consider following example for better understanding.
Suppose, after studying a shares performance for last 30 years, you observed
following pattern:

No

Year

State

of

the

Returns

earned

.
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22

198
0
198
1
198
2
198
3
198
4
198
5
198
6
198
7
198
8
198
9
199
0
199
1
199
2
199
3
199
4
199
5
199
6
199
7
199
8
199
9
200
0
200

Economy
Normal

by the share (%)

20

Normal

20

Recession

10

Normal

20

Boom

30

Normal

20

Normal

20

Normal

20

Normal

20

Boom

30

Normal

20

Normal

20

Boom

30

Normal

20

Normal

20

Normal

20

Boom

30

Recession

10

Normal

20

Normal

20

Normal

20

Normal

20

23
24
25
26
27
28
29
30

1
200
2
200
3
200
4
200
5
200
6
200
7
200
8
200
9

Normal

20

Normal

20

Boom

30

Normal

20

Recession

10

Normal

20

Boom

30

Normal

20

As can be seen from above table, during the last 30 year of study, the economy
has gone through 3 phases, viz. Boom, Normal and recession during the
security earned a return of 10%, 20% and 30% respectively.
Now to calculate expected or future ret5urns, we can add the annual
returns offered during last 30 years and divide it by 30 to get the answer,
which would be 630/30=21%, this process may look easy, but it is very time
consuming, therefore instead of following this we can use the concept of
probability as follows:
After looking at above table we can make see that out of 30 year Boom
state of economy occurred for 6 years i.e. 20% (6/30*100). Therefore, there is

20% chance that we will have Boom situation in next year, accordingly we
can say that probability of occurrence of Boom next years 0.20.
As compared to this Normal state of economy occurred for 21 years
i.e. 70% (21/30*100). Therefore, there is 70% chance that we will have
Normal situation in next year, accordingly we can say that probability of
occurrence of Normal next year is 0.70.
Lastly, Recession state of economy occurred for 3 years i.e. 10%
(3/30*100). Therefore, there is 10% chance that we will have Recession
situation in next year, accordingly we can say that probability of occurrence of
Recession next year is 0.10.
Therefore, Normal state of economy has highest probability of
occurrence and Recession has lowest probability of occurrence.
The table given below shows how probability is assigned to various events
State of
Economy

the

No. of years
% as compared
Probabilities
for which it
to the study of
occurred
all the years
Boom
6
20
0.20
Normal
21
70
0.70
Recession
3
10
0.10
Total
30
100
1.00
As can be seen from the above table, that there is 20% chance of Boom
coming up next year in the economy, similarly there is 70% and 10% chance
for Normal and Recession in the economy in the next year.
But one point should be noted, that if Boom comes up in the economy
next year, then Normal and Recession will not occur, similarly, if Normal
occurs then Boom and Recession shall not occur and lastly, if Recession
occurs, than Boom and Recession shall not occur. In simple words, occurrence
of one event automatically cancels the occurrence of the other events.
Once the probabilities are assigned, we can simply multiply the same
with the expected returns offered during each state of economy to calculate the
expected returns as follows:
Statement showing expected returns
State of the
Probabilities
economy
(P)
Boom
0.20
Normal
0.70
Recession
0.10
Total
In term of formula,
n

Rx =
Where,

PiRi
i=1

Returns (R)

P*R

30
20
10

6.00
14.00
1.00
21.00

Rx = Expected Returns or Future Returns

i = number of possible events, lowest number of events possible being 1 (i.e.
at least on event will occur) and highest number being n.
P = Probabilities of occurrence of events.
R = Returns earned under a particular event.
In case of above example number of event occurring are 3(i.e. Boom,
Normal and Recession), whereas the sing denotes addition of product of P*R
of all the events, therefore, in current case, n=3 and

PiRi

=21.00%.

Illustration 13: [Expected Returns with probabilities]

Investors assessment of return on a share of X Ltd. under three different
situation is as follows:
Economy
Chance (P)
situation
1
0.25
2
0.50
3
0.25
Calculate the expected rate of return.

Returns (%)
35
30
15

Solution:
Statement showing expected return of share of X Ltd.
Economic
Chance (P)
Situation
1
0.25
2
0.50
3
0.25
Total
In the terms of formula:
n

Rx =
Where,

PiRi
i=1

Return
(%)

(Rx)
36
30
15

P*R
8.75
15
3.75
27.50

Rx = Expected Returns or Future Returns

i = number of possible events, lowest number of events possible being 1 (i.e.
at least on event will occur) and highest number being n
P = Probability of occurrence of events.
R = Returns earned under a particular event.
Here,
Rx = To be found
n = 3 events.
n

Rx =

PiRi
i=1

= 27.50%
Illustration 14: [Expected Returns with Probability]
Farooq recently forecasted four economic situation which he believes
are likely to occur with the given probability. Based on these situation, an
analyst made the following forecasts of the return of the return of stocks M, N
and O.
Situation

Probability

Returns%

M
High growth
0.15
17
Low growth
0.25
15
Stagnation
0.35
10
Recession
0.25
-05
Calculated the mean returns of stocks M, N and O

N
21
18
07
-08

O
25
16
05
-12

Solution:
Statement showing expected returns for security M, N and O
Situation
High growth
Low growth
Stagnation
Recession
Total

Probabilit
y (P)
0.15
0.25
0.35
0.25

R
M
17
15
10
-05

In the term of formula:

R
N
21
18
07
-08

R
O
25
16
05
-12

P*R
M
2.55
3.75
3.50
-0.125
8.55

P*R
N
3.15
4.50
2.45
-2
8.10

P*RO
3.75
4
1.75
-3
6.50

Rx =

PiRi
i=1

RM= 8.55%
RN = 8.10%
RO = 6.50%
Illustration15: [Expected Returns with probabilities]
Investors assessment of return on a share of X Ltd. under three different
situation is as follows:
Economy
Chance (P)
situation
1
0.25
2
0.50
3
0.25
Calculate the expected rate of return.

Returns (%)
35
30
15

Solution:
Statement showing expected return of share of X Ltd.
Economic
Chance (P)
Situation
1
0.25
2
0.50
3
0.25
Total
In the terms of formula:

Return
(%)
36
30
15

(Rx)

P*R
8.75
15
3.75
27.50

Rx =

PiRi
i=1

Where,
Rx = Expected Returns or Future Returns
i = number of possible events, lowest number of events possible being 1 (i.e.
at least on event will occur) and highest number being n
P = Probability of occurrence of events.
R = Returns earned under a particular event.
Here,
Rx = To be found
n = 3 events.
n

Rx =

PiRi
i=1

= 27.50%

RISK
Risk:
Future is always uncertain; no matter how much we analyse a particular
situation, we cannot predict future with 100% certainty. Risk means a chance
that the outcome you expect will not happen. Risk can be define as the chance
that the actual outcome from an investment will differ from the expected
outcome. Risk is only associated with the expected return because they are to
be realized in future, as against this, there is no risk in past returns. This is
because past returns have already occurred and therefore cannot chance and
accordingly there is no chance of it being altered and as a result there is no risk
associated with past returns and that means that risk is only associated with
Future return.
For example, you are watching a cricket match between India and
Australia assuming that the match was not fixed, no one can predict with
100% certainty which team will win, or who will be the highest scorer or for
that matter will someone scorer a century or get out on a score of zero. Even if
a particular Batsman has scorer a century in his previous 10 matches no one
can predict with 100% certainty that he will again score a century in the
current match.
There will always be a chance that the Batsman will get out before scoring a
century no matter how good he is and at the same time there is a possibility
that a number 11 Batsman scores a century and leads his team to victory. But
the chance of an opening or a top order Batsman scoring a century is very high
as compared to a number 11 Batsman scoring a century. This is what any
normal cricket fan will think and will be correct for most of the time.
Now, if you want to place a bet on who will score a century and you
have a choice between a top order batsman and a number 11 batsman, you
would normally place your bet on the top order batsman and not the number
11.
Compare this situation with a cricket match that has already happened,
in this match the opening pair and the top order batsman failed miserably, but
number 11 scored a century and won the match for his team. Can you change
the number of run score by any of the batsman in this match? The point is, in
past whatever happened, happened, it cannot be changed, therefore there is no
scope of any change happening in past and accordingly there is no risk
associated with past returns.

Now, let as compare this situation with an investment avenue. Before we

take decision to buy a companys share, we can study companys past
performance and based we can try to forecast the returns expected in future,
although we cannot be 100% sure that we will end up earning the expected
returns, but at the same time it will surely reduce the risk we may end up
taking.
Following points can be noted from above discussion:
Risk is a situation where the possible outcome is uncertain.
As past is certain, there is no associated with it.
As future is uncertain, there is risk that what we think may or may not happen.
But even future is based on past and therefore we can forecast the future
although not with 100% certainly.
Even though we cannot be 100% sure about the future, we can study the past
and help ourselves to take such decisions that will reduce our risk to a
considerably low level and at the same time maximize our returns.
Higher the fluctuation in the past returns, higher will be the risk associated
with the future returns and vice versa.
Imagine a situation where a company has in past 10 years given returns up to
200% in some years but in some other year it gave returns as low as 300%,
these are wide fluctuations and makes the returns of the company highly
unpredictable and risky.
If you dont understand above paragraph, try this: you are a cricket fan, who
would you trust more on scoring a century,
A time tested batsman (Say, Mr. X) who have consistently been scoring huge
pile of runs from last 24 years or
A batsman (Say Mr. Y) who over the years has been very unpredictable, in a
sense that if he will score big runs but at the same time he also has a tendency
of getting out without scoring or in single digits.
Any rational person will selected for the first batsman to place a bet of scoring
a century.
Any rational person will take extra risk only if he is offered higher returns for
the same, in point No. (iv) above, suppose the odds of scoring a century for
Mr. X is 1:1.5 (i.e. if he scores a century you will get $1.50 for every rupee
that you place the bet for) and the odds of scoring a century for Mr. Y is also
same at 1: 1.5.
People will place bet on Mr. Y only if the odds are increased say to 1: 2.5(i.e.
you will get $ 2.5 for every rupee of bet place Mr. Y scores a century).
Therefore, people will place bet on Mr. Y only if they are offered higher
returns.
Illustration 16: [Expected returns How to measure risk?]
Find out the expected returns for Security X, Y & Z from following
information:

If you are asked to select one security for investment, which one would you
select?

Solution:
Statement showing expected returns for security X, Y & Z
Situation
Recessio
n
Normal
Boom

Probabilit
y (P)
0.25

R
X
10

0.50

20

R
Y
10
25

0.25

30

40

Total

RZ
-20
27.5
0
45

P*R
X
2.5

P*R
Y
-2.5

P*R
Z
-5

10

12.5

7.5

10

20

20

13.7
5
11.2
5
20

In term of formula:
n

RX =

PiRi
i=1

RX = 20%
RY = 20%
RZ = 20%
As can be seen from above, all the three security have expected returns
of 20%, therefore if we look only at expected returns we cannot take any
decision as to which security should be selected.
But after a closer look at past performance of all the companies, we can
easily conclude that X Ltd. has been most consistent giving positive ( +ev)
returns under every economic situation.
As against this T Ltd. returns fluctuate with chance in the economic
situation, although it gives higher returns as compare to X Ltd. in Boom
situation, it (i.e. Y Ltd.) givens negative (-ve) returns in case of recession
which not so in case of X Ltd.
Finally, Z Ltd. has been most inconsistent and unpredictable because it is
giving highest returns in case of Boom period but at the same time it gives us
highest negative returns in case of Recession.
There is a possibility that any of the economic situation can arise in the
coming year, but in case we select security X we can be rest assured of
positive return in any economic situation, therefore security X is least risky
and should be selected for investment.
Although security Y and Z give higher returns in case of Boom state of
economic, they also have risk of negative returns in case recession comes up
and given the fact that all the three security are offering same expected returns,

any rational investor would not like a situation where he may end up losing
money by earning negative returns and therefore, as security X, Y and Z offer
same returns there is no use taking extra risk by selecting security Y or Z and
accordingly they both are rejected.

Measuring Risk
In above Illustration11, it was clearly visible that security X is least
risky and security Z is most risky, but in practical situation it is not so easy to
locate a risky security or to select a security with least risk. Therefore, as an
analyst we should know how to measure risk.
Measuring risk means quantifying it in terms of number, this can be
done by using various Measure of Risk; various measure of risk covered in
BMS portion are:
Range
Variance
Standard Deviation and
Co-efficient of variation.
Let us now study them one by one in detail
Range
Range refers to spread of the various possible future returns, in other words,
Range refers to the difference between the highest possible return and lowest
possible return expected from the security. It is the percentage between which
the future returns and expected to fluctuate, higher the fluctuation higher is the
risk and therefore higher the range higher is the risk.
In terms of formula,
Range = highest possible return lowest possible return.
For illustration 12 above, we can calculate range for security X, Y and Z as
follows:
Range x +30-10 = 20%
Range y = 40-(-10) = 40+10 = 50%
Range z = 45-(-20) = 45+20 = 65%
Range for security Z is highest at 65%(i.e. future returns of security Z
are expected to fluctuate within 65%, where highest returns can be 45% and
lowest returns can be -20%), therefore security Z is most risky.

Variance
In case of variance we compare every possible return with the average or
expected return of the security, doing so we get how far are all the possible

returns lying from the expected returns (i.e. level of variance of all possible
returns from the average) after calculating the same of all the possible returns,
the number so calculated are squared to convert any negative number into
positive number, the number so squared are added to get variance in totality.
Higher the variance, higher will be the fluctuation of expected returns
and accordingly higher will be the risk.
In the term of formula,

Variance (without Probabilities)

(SRxRx)2
Varx =
n
E.S.

Prob
abilit
y (P)
0.25

Nor
mal

0.50

2
5

Boo
m

0.25

4
0

Rece
ssio
n

Tota
l

P*RY

(RRY)

1
0

2
.
5
1
2
.
5
1
0
2
0

(RRY)2

P(RRY)2

3
0

9
0
0

2
2
5

2
5

2
0

4
0
0

1
2
.
5
1
0
0
3
3
7
.
5
0

Variance (with Probabilities)

Var = P(RxRx)
X

For illustration 16 above, we can calculate variance for security X, Y and Z as

follows:
Statement showing expected returns and variance for security X
E.S.
Recession
Normal
Boom
Total

Probabilit
y (P)
0.25
0.50
0.25

Varx =

RX

P*RX

(R-RX)

(R-RX)2

10
20
30

2.5
10
7.5
20

-10
0
10

100
0
100

P( RxRx)

P(RRX)2
25
0
25
50

= 50
Statement showing expected returns and variance for security Y
Var = P(RY RY ) 2
Y

= 337.50
Statement showing expected returns and variance for security z
E
.
S
.

P
r
o
b
a
b

R
Z

P
*
R
Z

(
R
R
Z
)

(
R
R
Z
)

P
(
R
R
Z

i
l
i
t
y

(
P
)
0
.
2
5

R
e
c
e
s
s
i
o
n
N
o
r
m
a
l
B
o
o
m

2
0

4
0

1
6
0
0

4
0
0

0
.
5
0

2
7
.
5
0

1
3
.
7
5

7
.
5

5
6
.
2
5

0
.
2
5

4
5

1
1
.
2
5

2
5

6
2
5

2
8
.
1
2
5
1
5
6
.
2
5
5
8
4
.
3
7
5

T
o
t
a
l

2
0

VarZ =

P( RZRZ)

= 584.375
Advantage(s) and Shortcoming of variance as a measure of risk

Although variance takes into account probabilities, it is a squared number, and

therefore its direct comparison with expected return is not possible, therefore
we take the square root of variance which is Standard Deviation (s) to make
direct comparison between risk (i.e. Standard Deviation) and returns possible.
Standard Deviation
Standard deviation is nothing but square root of Variance. In terms of formula
Standard Deviation is denoted as follows:
Without Probabilities: 58

Co-efficient of variation
The coefficient of variation is a measure of risk per unit of return (i.e. risk
taken to earn every 1% of return). This can be used to compare the risk and
returns of alternative investments. A higher coefficient of variation indicates
that the investment is more risky because earn every unit of return we are more
and more risk. It is calculated as the ratio of the standard deviation divided by
returns on the investment.
In term of formula,
X
CVX= RX

For illustration 12 above, we can calculate coefficient of variation for security

X, Y and Z as follows:
7.07
CVX= 20
=0.3535:1
18.37
CVY= 20
= 0.9185:1
CVZ=

24.17
20

= 1.2085:1

As can be seen from above, that to earn every 1% of return we have to take 0.
3535% of risk in case of X Ltd. the same risk increases to 0.9183 & 1.2085 in
case of Y Ltd. And Z Ltd. respectively per unit of returns to be earned.
Therefore, security X is least risky, whereas security Z is most risky.
All the measures of risk calculated above for illustration 12 can be summarised
as follows:
S
e
c
u
r
i
t
y

R
e
t
u
r
n
s

R
a
n
g
e

V
a
r
i
a
n
c
e

(
%
)

S
t
a
n
d
a
r
d
D
e
v
i
a
t
i
o
n
(
%
)

2
0

2
0

5
0

7
.
0
7

2
0

5
0

3
3
7
.
5

1
8
.
3

C
o
e
f
f
i
c
i
e
n
t
o
f
v
a
r
i
a
t
i
o
n
0
.
3
5
3
5
:
1
0
.
9
1
8

2
0

6
5

5
8
4
.
3
7
5

2
4
.
1
7

5
:
1
1
.
2
0
8
5
:
1

As can be seen from above summary all the securities are offering same 20%
returns, but the risk is lowest in case of X Ltd. and is highest in case of Z Ltd.
any rational investor would not like to incur higher risk to earn same amount
of returns, therefore any rational investor will select security X for investment.
Illustration 17: [Selection of a security (with Probability)]
Farooq recently forecasted four economic situation which he believes are
likely to occur with the given probability. Based on these situation, an analyst
made the following forecasts of the return of the return of stocks M, N and O.
Situ
atio
n
Hig
h
gro
wth
Low
gro
wth
Stag
nati
on
Rec
essi
on

Proba
bilitie
s
0.15

Returns%
N

1
7

2
1

2
5

0.25

1
5

1
8

1
6

0.35

1
0

0
7

0
5

0.25

0
5

0
8

1
2

Calculate standard deviation for securities. Which security would you select
for investment?
Solution:
Statement showing expected returns and variance for security M

E
.
S
.

P
r
o
b

R
M

P
*
R

(
R

(
R

P
(
R

(
P
)

H
i
g
h
g
r
o
w
t
h
L
o
w
g
r
o
w
t
h
S
t
a
g
n
a
t
i
o
n
R
e
c

0
.
1
5

1
7

2
.
5
5

8
.
4
5

7
1
.
4
0

1
0
.
7
1

0
.
2
5

1
5

3
.
7
5

6
.
4
5

4
1
.
6
0

1
0
.
4
0

0
.
3
5

1
0

3
.
5

1
.
4
5

2
.
1
0

0
.
7
3
5

0
.
2

0
5

1
.

1
3

1
8
3

4
5
.

e
s
s
i
o
n

2
5

T
o
t
a
l

8
.
5
5

P ( RM RM ) 2

67.745

.
5
5

.
6
0

9
0

6
7
.
7
4
5

= 8.23
Statement showing expected returns and variance for security N
E
.
S
.

P
r
o
b

R
N

P
*
R
N

(
P
)

(
R

(
R

P
(
R

H
i
g
h

0
.
1
5

2
1

3
.
1
5

1
2
.
9
0

2
4
.
9
6

g
r
o
w
t
h
L
o
w

1
6
6
.
4
1

0
.
2

1
8

4
.
5

9
.
9

9
8
.

2
4
.

5
g
r
o
w
t
h
S
t
a
g
n
a
t
i
o
n
R
e
c
e
s
s
i
o
n

2
.
4
5

1
.
1
0

1
.
2
1

0
.
4
2

0
.
2
5

1
6
.
1
0

2
5
9
.
2
1

6
4
.
8
0

P ( RN RN ) 2

114.69

5
0

0
7

0
1

0
.
3
5

T
o
t
a
l

8
.
1
0

1
1
4
.
6
9

= 10.71
Statement showing expected returns and variance for security O
E
.

P
r

R
O

P
*

(
R

(
R

P
(

S
.

o
b

R
O

(
P
)

H
i
g
h
g
r
o
w
t
h
L
o
w
g
r
o
w
t
h
S
t
a
g
n
a
t
i
o
n
R
e
c
e
s
s

0
.
1
5

2
5

3
.
7
5

1
8
.
5
0

3
4
2
.
2
5

5
1
.
3
4

0
.
2
5

1
6

9
.
5
0

9
0
.
2
5

2
2
.
5
6

0
.
3
5

0
5

1
.
7
5

1
.
5
0

2
.
2
5

0
.
7
9

0
.
2
5

1
2

1
8
.
5
0

3
4
2
.
2
5

8
5
.
5
6

i
o
n
T
o
t
a
l

6
.
5

P ( RORO ) 2

160.25

1
6
0
.
2
5

= 12.66
SUMMARY
Security
M Ltd.

Expected
Returns (%)
8.55

Standard
Deviation (%)
8.23

N Ltd.

8.10

10.71

O Ltd.

6.50

12.66

From above summary it is clear that M Ltd. Is giving highest returns with
lowest risk, therefore M Ltd. should be chosen for investment.
Illustration 18: [Selection of a security (with Probability)]
Give below are the likely returns in case of shares of KKS Ltd. and GSS Ltd.
in the various economic conditions. Both the shares are presently quoted at
$250 per shares.
Econo
mic
Conditi
on

Probabili
ties

0.25

Retu
rns
of
KSS
Ltd.
(%)
110

Retu
rns
of
GSS
Ltd.
(%)
180

High
growth
Low
growth
Stagnat

0.25

130

150

0.30

160

100

ion
Recessi
0.20
190
70
on
Which of the company is risky investment?
Mr. Suraj has $ 2000 and wants you to recommend one of the above two
shares for investment.
Would your answer change if the probabilities change to 0.40, 0.30, 0.20, and
0.10 for various seniors.
Solution:
Statement showing expected returns and variance for KSS Ltd.
E
.
S
.

P
r
o
b

R
K

P
*
R
K

(
P
)

(
R

(
R

P
(
R

H
i
g
h
g
r
o
w
t
h
L
o
w
g
r
o
w
t
h
S
t
a

0
.
2
5

1
1
0

2
7
.
5

3
6

1
2
9
6

3
2
4

0
.
2
5

1
3
0

3
2
.
5

1
6

2
5
6

6
4

0
.
3

1
6
0

4
8
.

1
4

1
9
6

5
8
.

g
n
a
t
i
o
n

R
e
c
e
s
s
i
o
n

0
.
2
0

1
9
0

3
8
.
0

T
o
t
a
l

4
4

1
9
3
6

1
4
6

3
8
7
.
2

8
3
4

PiRi

RK=

i=1

RK= 146%

P ( RK RK ) 2

834

= 28.88
Statement showing expected returns and variance for GSS Ltd.
E
.
S
.

P
r
o
b
(

R
G

P
*
R
G

(
R

(
R

P
(
R
G

P
)

)
2

H
i
g
h
g
r
o
w
t
h
L
o
w
g
r
o
w
t
h
S
t
a
g
n
a
t
i
o
n
R
e
c
e
s
s
i
o
n

0
.
2
5

1
8
0

4
5

5
3
.
5

2
8
6
2
.
2
5

7
1
5
.
5
6

0
.
2
5

1
5
0

3
7
.
5

2
3
.
5

5
5
2
.
2
5

1
3
8
.
0
6

0
.
3
0

1
0
0

3
0

2
6
.
5

7
0
2
.
2
5

2
1
0
.
6
8

0
.
2
0

7
0

1
4

5
6
.
5

3
1
9
2
.
2
5

6
3
8
.
4
5

T
o
t
a
l

1
2
6
.
5

1
7
0
2
.
4
5

PiRi

RG=

i=1

RG= 126.50%

P ( RGRG ) 2

1702.75

= 41.25
SUMMARY
Security
KSS Ltd.

Expected
Returns (%)
146

GSS Ltd.

126.50

Standard
Deviation (%)
28.88
41.26

Answer to part (a): GSS Ltd. is a more risky investment

Answer to part (b): From above summary it is clear that KSS Ltd. is giving
higher returns with lower risk as compared to GSS Ltd. and therefore KSS Ltd.
should be selected for investment.
Answer to part (c):
Statement showing expected returns and variance for KSS Ltd. with change
probabilities
E
.
S
.

P
r
o
b

R
K

P
*
R
K

(
P
)

(
R

(
R

P
(
R

i
g
h
g
r
o
w
t
h
L
o
w
g
r
o
w
t
h
S
t
a
g
n
a
t
i
o
n
R
e
c
e
s
s
i
o
n

.
4
0

1
0

2
4

7
6

3
0
.
4

0
.
3
0

1
3
0

3
9

1
6

4
.
8

0
.
2
0

1
6
0

3
2

2
6

6
7
6

1
3
5
.
2

0
.
1
0

1
9
0

1
9

5
6

3
1
3
6

3
1
3
.
6

T
o
t

1
3
4

6
8
4

a
l
n

PiRi

RK=

i=1

RK= 134%

P ( RK RK ) 2

684

= 26.15
Statement showing expected returns and variance for GSS Ltd. with change
probabilities
E
.
S
.

P
r
o
b

R
G

P
*
R
G

(
P
)

(
R

(
R

P
(
R

H
i
g
h
g
r
o
w
t
h
L
o
w
g
r
o

0
.
4
0

1
8
0

7
2

3
6

1
2
9
6

5
1
8
.
4

0
.
3
0

1
5
0

4
5

3
6

1
0
.
8

w
t
h
S
t
a
g
n
a
t
i
o
n
R
e
c
e
s
s
i
o
n

0
.
2
0

1
0
0

2
0

4
4

1
9
3
6

3
8
7
.
2

0
.
1
0

7
0

7
4

5
4
7
6

5
4
7
.
6

T
o
t
a
l

1
4
4

1
4
6
4

PiRi

RG=

i=1

RG= 144%

P ( RGRG ) 2

1464

= 38.26
SUMMARY
Security

Expected

Standard

KSS Ltd.

Returns (%)
134

Deviation (%)
26.14

GSS Ltd.

144

hjhh
38.26

With change in probabilities, the expected returns for GSS Ltd. have become
more than KSS Ltd., but at the same time, the risk associated with the returns
is 26.14 38.26 for KSS Ltd. and GSS Ltd. respectively.
It implies that although GSS Ltd. has higher expected returns, but at the same
time it also has higher risk, not only this the extra risk associated with GSS
Ltd. is more than the extra return it is providing as compared to KSS Ltd. this
makes GSS Ltd. riskier as compared to KSS Ltd.
Therefore, the answer still remains the same, i.e. we should select KSS Ltd. for
investment.
Illustration 19: [Selection of a security (with Probability)]
The rate of return on stocks of MCC and NCC under different state of the
economy are presented below along with the probability of the occurrence of
each state of the economy.

Probabili
ty
of
occurren
ce
Rate of
return on
stocks
MCC
(%)
Rate of
return on
stock
NCC
(%)

Boo
m
0.3

Norm
al
0.4

Recessi
on
0.3

40.0

60.0

80.0

80.0

60.0

40.0

Calculate the expected rate of return and standard deviation of return on MCC
and NCC.
If you could invest in either MCC or NCC, but not the both which stock would
you prefer and why?

If the rate of return on MCC was revised as shown below, would your
preference in questions (b) above change? Why?
Rate of return on stock MCC (%)
Solution:
Statement showing expected returns and variance for security MCC
E
.
S
.

P
r
o
b

R
M

P
*
R
M

(
P
)

(
R

(
R

P
(
R

B
o
o
m
N
o
r
m
a
l
R
e
c
e
s
s
i
o
n

0
.
3
0
0
.
4
0

4
0

1
2

2
0

4
0
0

1
2
0

6
0

2
4

0
.
3
0

8
0

2
4

2
0

4
0
0

1
2
0

T
o
t
a
l

6
0

2
4
0

PiRi

RM=

i=1

RM=60%

P ( RM RM ) 2

240

= 15.49
Statement showing expected returns and variance for security NCC
E
.
S
.

P
r
o
b

R
N

P
*
R
N

(
P
)

(
R

(
R

P
(
R

B
o
o
m
N
o
r
m
a
l
R
e
c
e
s
s
i
o
n

0
.
3
0
0
.
4
0

8
0

2
4

2
0

4
0
0

1
2
0

6
0

2
4

0
.
3
0

4
0

1
2

2
0

4
0
0

1
2
0

T
o

6
0

2
4

t
a
l

PiRi

RN=

i=1

RN=60%

P ( RN RN ) 2

240

= 15.49
SUMMARY
Security
MCC Ltd.

Expected
Returns (%)
60

NCC Ltd.

60

Standard
Deviation (%)
15.49
15.49

Both securities have equal returns to offer with same risk, therefore any one of
them can be selected for investment.

Statement showing expected returns and variance for security MCC

E
.
S
.

P
r
o
b

R
M

P
*
R
M

(
P
)

(
R

(
R

P
(
R

B
o
o
m
N
o

0
.
3
0
0
.

9
0

2
7

1
3

1
6
9

8
0

3
2

5
0
.
7
3
.

r
m
a
l
R
e
c
e
s
s
i
o
n

4
0

0
.
3
0

6
0

T
o
t
a
l

1
8

1
7

2
8
9

7
7

1
4
1

PiRi

RM=

i=1

RM=77%

P ( RM RM ) 2

141

= 11.87
With changed returns the expected returns of MCC Ltd. increases to 77%,
whereas its risk reduces to 11.87 , therefore, MCC Ltd. should be selected
for investment.
Illustration 20: [Calculation of Returns and Risk (with probabilities)]
Mr. Pramod has a portfolio of two securities with 50% investment in A and
50% investment in B. the characteristics of return under three different
scenarios with different probabilities for the two securities and the portfolio
are given below:
Sc

Pro

8
6
.
7

Returns (%)

en
ari
o

babi
litie
s

B
oo
m
N
or
m
al
R
ec
es
si
on

0.25

5
0

2
0

P
o
rt
f
o
li
o
3
5

0.50

3
5

3
5

3
5

0.25

2
0

2
0

2
0

Calculate the expected returns and standard deviation of securities A, B and

portfolio.
Solution:
Statement showing expected returns and variance for security A
E
.
S
.

P
r
o
b

R
A

P
*
R
A

(
P
)

(
R

(
R

P
(
R

B
o
o
m

0
.
2
5

5
0

1
2
.
5

1
5

2
2
5

N
o
r

0
.
5

3
5

1
7
.

5
6
.
2
5
0

m
a
l
R
e
c
e
s
s
i
o
n

0
.
2
5

2
0

T
o
t
a
l

1
5

2
2
5

3
5

5
6
.
2
5

1
1
2
.
5
0

PiRi

RA=

i=1

RA=35%

P ( RARA ) 2

112.50

= 10.61

Statement showing expected returns and variance for security B

E
.
S
.

P
r
o
b

R
B

P
*
R
B

(
R

(
R

P
(
R
B

(
P
)

)
2

B
o
o
m

0
.
2
5

2
0

7
.
5

5
6
.
2
5

N
o
r
m
a
l
R
e
c
e
s
s
i
o
n

0
.
5
0

3
5

1
7
.
5

7
.
5

5
6
.
2
5

0
.
2
5

2
0

7
.
5

5
6
.
2
5

T
o
t
a
l
n

PiRi

RB =

i=1

RB=27.50%

P ( RBRB ) 2

= 56.25

= 7.50

2
7
.
5
0

1
4
.
0
6
2
5
2
8
.
1
2
5
1
4
.
0
6
2
5

5
6
.
2
5

Statement showing expected returns and variance for security Portfolio

E
.
S
.

P
r
o
b

R
P
F

P
*
R

(
R

(
R

P
(
R

(
P
)

B
o
o
m

0
.
2
5

3
5

8
.
7
5

3
.
7
5

N
o
r
m
a
l

0
.
5
0

3
5

1
7
.
5

3
.
7
5

R
e
c
e
s
s
i
o
n

0
.
2
5

2
5

1
1
.
2
5

T
o
t
a
l

3
1
.
2
5

1
4
.
0
6
2
5
1
4
.
0
6
2
5
1
2
6
.
5
6
2
5

3
.
5
1
5
6
7
.
0
3
1
3
3
1
.
6
4
0
6

4
2
.
1
8
7
5

PiRi

RPF=

i=1

RPF=31.25%

P ( RPF RPF ) 2

42.1875

PF

PF

= 6.50
SUMMARY
Security

Expected
Returns (%)

A Ltd.

35

B Ltd.

27.50

7.50

31.25

6.50

Portfolio

Standard
Deviation
(%)
10.61

From above summary, we can conclude that Portfolio consisting of 50% of A

Ltd. and 50% of B Ltd. share is the better option because lowest risk and at the
same time it also has returns of 31.25% which, although is lower than returns
of A Ltd. but at the same time the risk of A Ltd. is also very high as compared
to that of the portfolio, therefore portfolio is a way better investment option
than A Ltd.

Illustration 21: [Selection of a security (with Probability)]

Farooq recently forecasted four economic situation which he believes are
likely to occur with the given probability. Based on these situation, an analyst
made the following forecasts of the return of the return of stocks M, N and O.
Situ
atio
n
Hig
h
gro
wth
Low
gro

Proba
bilitie
s
0.15

0.25

Returns%
N

1
7

2
1

2
5

1
5

1
8

1
6

wth
Stag
nati
on
Rec
essi
on

0.35

1
0

0
7

0
5

0.25

0
5

0
8

1
2

Calculate standard deviation for securities. Which security would you select
for investment?
Solution:
Statement showing expected returns and variance for security M
E
.
S
.

P
r
o
b

R
M

P
*
R

(
R

(
R

P
(
R

(
P
)

H
i
g
h
g
r
o
w
t
h
L
o
w
g
r
o
w
t

0
.
1
5

1
7

2
.
5
5

8
.
4
5

7
1
.
4
0

1
0
.
7
1

0
.
2
5

1
5

3
.
7
5

6
.
4
5

4
1
.
6
0

1
0
.
4
0

h
S
t
a
g
n
a
t
i
o
n
R
e
c
e
s
s
i
o
n

0
.
3
5

1
0

3
.
5

1
.
4
5

2
.
1
0

0
.
7
3
5

0
.
2
5

0
5

1
.
2
5

1
3
.
5
5

1
8
3
.
6
0

4
5
.
9
0

T
o
t
a
l

P ( RM RM ) 2

67.745

8
.
5
5

6
7
.
7
4
5

= 8.23
Statement showing expected returns and variance for security N
E
.
S
.

P
r
o
b
(
P
)

R
N

P
*
R
N

(
R

(
R

P
(
R

H
i
g
h
g
r
o
w
t
h
L
o
w
g
r
o
w
t
h
S
t
a
g
n
a
t
i
o
n
R
e
c
e
s
s
i
o
n

0
.
1
5

2
1

3
.
1
5

1
2
.
9
0

1
6
6
.
4
1

2
4
.
9
6

0
.
2
5

1
8

4
.
5

9
.
9
0

9
8
.
0
1

2
4
.
5
0

0
.
3
5

0
7

2
.
4
5

1
.
1
0

1
.
2
1

0
.
4
2

0
.
2
5

1
6
.
1
0

2
5
9
.
2
1

6
4
.
8
0

T
o
t

8
.
1

1
1
4

a
l

P ( RN RN ) 2

114.69

.
6
9

= 10.71
Statement showing expected returns and variance for security O
E
.
S
.

P
r
o
b

R
O

P
*
R
O

(
P
)

(
R

(
R

P
(
R

H
i
g
h
g
r
o
w
t
h
L
o
w
g
r
o
w
t
h
S
t

0
.
1
5

2
5

3
.
7
5

1
8
.
5
0

3
4
2
.
2
5

5
1
.
3
4

0
.
2
5

1
6

9
.
5
0

9
0
.
2
5

2
2
.
5
6

0
.

0
5

1
.

2
.

0
.

a
g
n
a
t
i
o
n
R
e
c
e
s
s
i
o
n

3
5

0
.
2
5

1
2

T
o
t
a
l

P ( RORO ) 2

160.25

7
5

.
5
0

2
5

7
9

1
8
.
5
0

3
4
2
.
2
5

8
5
.
5
6

6
.
5

1
6
0
.
2
5

= 12.66
SUMMARY
Security
M Ltd.

Expected
Returns (%)
8.55

Standard
Deviation (%)
8.23

N Ltd.

8.10

10.71

O Ltd.

6.50

12.66

From above summary it is clear that M Ltd. Is giving highest returns with
lowest risk, therefore M Ltd. should be chosen for investment.
Illustration 22: [Selection of a security (with Probability)]

The rate of return on stocks of MCC and NCC under different state of the
economy are presented below along with the probability of the occurrence of
each state of the economy.

Probability of occurrence
Rate of return on stocks MCC (%)
Rate of return on stock NCC (%)

Boom

Normal

0.3
40.0
80.0

0.4
60.0
60.0

Recessi
on
0.3
80.0
40.0

Calculate the expected rate of return and standard deviation of return on MCC
and NCC.
If you could invest in either MCC or NCC, but not the both which stock would
you prefer and why?
If the rate of return on MCC was revised as shown below, would your
preference in questions (b) above change? Why?
Rate of return on stock MCC (%)
Solution:
Statement showing expected returns and variance for security MCC
E
.
S
.

P
r
o
b

R
M

P
*
R
M

(
P
)

(
R

(
R

P
(
R

B
o
o
m
N
o
r
m
a
l
R
e
c
e

0
.
3
0
0
.
4
0

4
0

1
2

2
0

4
0
0

1
2
0

6
0

2
4

0
.
3
0

8
0

2
4

2
0

4
0
0

1
2
0

s
s
i
o
n
T
o
t
a
l

6
0

2
4
0

PiRi

RM=

i=1

RM=60%

P ( RM RM ) 2

240

= 15.49
Statement showing expected returns and variance for security NCC
E
.
S
.

P
r
o
b

R
N

P
*
R
N

(
P
)

(
R

(
R

P
(
R

B
o
o
m
N
o
r
m
a

0
.
3
0
0
.
4
0

8
0

2
4

2
0

4
0
0

1
2
0

6
0

2
4

l
R
e
c
e
s
s
i
o
n

0
.
3
0

4
0

1
2

T
o
t
a
l

2
0

4
0
0

1
2
0

6
0

2
4
0

PiRi

RN=

i=1

RN=60%

P ( RN RN ) 2

240

= 15.49
SUMMARY
Security
MCC Ltd.

Expected
Returns (%)
60

NCC Ltd.

60

Standard
Deviation (%)
15.49
15.49

Both securities have equal returns to offer with same risk, therefore any one of
them can be selected for investment.

Statement showing expected returns and variance for security MCC

E
.
S

P
r
o

R
M

P
*
R

(
R

(
R

P
(
R

(
P
)

B
o
o
m
N
o
r
m
a
l
R
e
c
e
s
s
i
o
n

0
.
3
0
0
.
4
0

9
0

2
7

1
3

1
6
9

8
0

3
2

0
.
3
0

6
0

1
8

1
7

2
8
9

T
o
t
a
l

PiRi

RM=

i=1

RM=77%

P ( RM RM ) 2

141

= 11.87

7
7

5
0
.
7
3
.
6

8
6
.
7

1
4
1

With changed returns the expected returns of MCC Ltd. increases to 77%,
whereas its risk reduces to 11.87 , therefore, MCC Ltd. should be selected
for investment.

Illustration 23: [Calculation of returns and risk (with probabilities)

The probabilities distribution of annual returns of securities X is given below:
Returns on securities
Probabilities
-0.40
0.05
-0.30
0.07
-0.20
0.15
-0.10
0.16
0.10
0.25
0.20
0.19
0.30
0.10
0.40
0.03
Compute the expected returns on the securities.
Solution:
Statement showing expected returns and variance for X Ltd.
P
r
o
b
a
b
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i
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y
(
P
)

0
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0
5

R
e
t
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r
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s

P
*
R
X

(
R
R
X
)

(
R
R
X
)
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P
(
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R
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)
2

(
R
X

)
(
%
)
0
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4
0

4
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8

1
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4
7
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2
4

8
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3
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2
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5
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t
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l

.
8
0

5
4
.
7
7

PiRi

RX=

i=1

RX=1.80%
= P ( RXRX ) 2
X

454.77

= 21.32

Illustration 24: [Calculation of Returns and Risk (Without Probabilities)

From the information given below find out returns and standard deviation for
ABC Ltd.
Year
RABC (%)
2005
-28.7
2006
56.19
2007
123.45
2008
54.24
2009
57
Solution:
Statement showing expected returns and variance for ABC Ltd.
Year

RABC
(%)
-28.7

2005
2006
2007

56.19
123.4
5
54.24
57
262.4
8

2008
2009
Total

RABC =

RABC
n

(RABCRABC)
81.20
3.69
70.95

(RABCRABC)2
6593.44

1.74
4.5

3.03
20.25
11664.2
4

13.62
5033.90

RABC =

262.18
5

= 52.44%

ABC

b b 24 ac
2a

Illustration 25: [Calculation of Returns and Risk (without probabilities)]

Calculate expected returns from the following information for GEC Ltd.
Month
January
February
March
April
May
June
July
August
September
October
November
December

Returns
0.034
-0.06
-0.118
0.067
-0.063
-0.079
-0.059
0.268
0.178
0.191
-0.071
-0.055

Solution:

Statement showing expected returns and variance for GEC Ltd.

Month
January
February
March
April
May
June
July
August
September
October

RGEC (%)
0.034
-0.06
-0.118
0.067
-0.063
-0.079
-0.059
0.268
0.178
0.191

(RGEC-RGEC)
0.01458
-0.0794
-0.1374
0.0476
-0.0824
-0.0984
-0.0784
0.2486
0.1586
0.1716

(RGEC-RGEC)2
0.00021
0.00631
0.01888
0.00226
0.00679
0.00969
0.00615
0.06179
0.02515
0.02944

November
December
Total

-0.071
-0.055
0.233

RGEC =
RGEC =

-0.0904
-0.0744

0.00818
0.00554
0.18039

RGEC
n

0.233
12

= 1.94%

Illustration 26: [Calculation of Returns and risk (with Probabilities)]

The current price of stock Q is $150. The future prices with probabilities are
given below:
Future
prices ($)

12
0

15
0

1
2
2
8
1
4
0
0
0
Probabiliti
0.
0.
0.
0.
0.
es
1
2
4
2
1
Assuming that the company will not pay any dividend you are required to find
out expected returns and standard deviation of the stock.
Solution:
In the question instead of giving us the returns in terms of percentage, we have
been given the expected closing prices with the probabilities of occurrence for
the same. But by using Holding Period Returns formula we can easily
calculate the returns under each probabilities as follows:
As per Holding Period Returns formula:
Dt +[Pt Pt 1]
100
HPRt =
Pt1

3.3.3 Risk and Uncertainty

Risk refers to variability of expected returns associated with an
investment. Risk indicated the possibility that actual returns may not be same
as expected returns. Uncertainty and risk go hand-in-hand. Risk suggests that
the decision-maker known that there is a possibility of negative consequences
of an investment decision. Uncertainty is a situation where outcome is not
known to the decision-maker. In the context of investment analysis and
portfolio management, Risk is considered to comprise of all elements of
variability of return, uncertainty of outcome etc.
Risk refers to uncertainty involved in outcome of investment decision.
All investments involved some degree of risk. Future can never be 100%
certain. An investor has to take some chance when he makes investment. It is
possible that returns earned on investment may vary from expectations, though
risk and uncertainty has been that uncertainty cannot be quantified while risk
can be quantified by assigning different probabilities.
Since risk is an integral component of all investment decision. It
becomes essential to property study the concept of risk.
3.3.4 Types of Risk
Now that we know the meaning of risk let us understand how to classify
risk. The risk is categorized into two types: (i) systematic risk, (ii)
unsystematic risk. This is represented in figure, 3.2.
RISK

Systematic Risk

Market Risk
Financial Risk

Unsystematic Risk

Business Risk

Interest Rate Risk

Inflation Risk
Internal

External

Classification of Risk
Systematic Risk
A risk that affects the whole economic system and all the industry operating in
the economic system is a systematic manner is known as Systematic risk, such
risk affects the price of all the securities. The effect of systematic returns
causes the price of all individual shares/bonds to move in the same direction.
Some example of systematic risk are: (i) Chance in Political situation of nation
(say a communist dictator takes over the democratic government of a country),
(ii) War, (iii) chance in government policy to discourage free capital markets,
(iv) High degree of inflation, etc. As can be seen from preceding example, this
risk will affect income generating capacity of all company in the economy and
hence systematic risk cannot be avoided. It relates to economic trends which
affect the world market.
When the stock market is bullish, price of all stocks indicate rising trend
and in the bearish market, the prices of all stocks will be falling. As systematic
risk affects all the company, it cannot be eliminated by even by diversification
of portfolio it is called unavoidable risk. The type of risk will arise due to the
following reasons:
1. Market Risk: Variations in price sparked off due to social, political and
economic events is referred to as market risk.
2. Interest Rate Risk: The uncertainty of future market values and the size
of future incomes, caused by fluctuations in the general level of interest is
known as Interest Rate Risk. Generally, price of securities tend to move
inversely with changes in the rate of interest.
3. Purchasing Power Risk: Uncertainties of purchasing power is referred to
as risk due to inflation. If investment is considered as consumption
sacrificed, then a person purchasing securities foregoes the opportunity
to buy some goods or services for so long as he continues to hold the
securities. In case, the prices of goods and services, increases during this
period, the investor actually looses purchasing power.
Unsystematic Risk
Risk that affects specific companies or firms instead of the whole economic or
market system is known as Unsystematic risk, this risk is company specific
risk.

For example, if prices of crude oil reduce drastically, airline companies will
huge
profits (this is because there major cost is incurred on fuel and with reduction
in
prices they will save huge cost), but at the same time oil industry will be a
major
looser. The unsystematic risk is the change in the price of stocks due to the
factors which are particular to the stock. Normally such a risk for one
company creates an earning earning opportunity for some other company or
industry;
therefore
as
far as unsystematic risk is concerned loss of one company normally means
profit
of some other company. Therefore unsystematic risk can be eliminated
or