FINANCIAL MANAGEMENT: RISK AND RETURN CONCEPTS ODM

The relationship between risk and return is fundamental in finance, be it in personal or corporate financial management.
Choose between;
o LOW-RISK investment with 15% PROMISED RETURN, and
o HIGH-RISK investment with 15% PROMISED RETURN
Investors need the inducement of higher reward to take on perceived higher risk.

What determines the rate of RETURN? The RISK on it.

The higher the risk, the higher the return.

Get some idea from the past:

Total rate of return = Capital Gains Yield + Dividend Yield

Example: Assume that we purchased one share of a certain company at 25.00 and received 2.00 in dividends
during the year. From thereon, the share price has increased to 31.00. What is the percentage return that
we achieved?

(1 0 ) + 1 (31 25) + 2
= = = 32%
0 25

What if we expected 50%? or 20%? So theres a risk of not getting what we want from our investment.

Measuring Risks

Use of Variance (2) and Standard Deviation () - Measures of volatility

The probability distributions of returns for
two stocks, A and B. Which stock is riskier?

The larger the volatility (variance or standard deviation), the greater the risk.

Example: Using the following returns, calculate the average return, the variance, and the standard deviation of this
certain company.
Year 1 Year 2 Year 3 Year 4 Year 5
10% 4% -8% 13% 5%

Average Return = (0.10+0.04-0.08+0.13+0.05)/5 = 4.80%

2 = [(0.10-0.048) 2+(0.04-0.048) 2+(-0.08-0.048) 2+(0.13-0.048) 2+(0.05-0.048) 2]/(5-1) = 64.70%
= (0.6470)1/2 = 8.04%

Example: You have been given this probability distribution for the holding-period return for KMP stock:
Probability 30% 50% 20%
Return 18% 12% -5%
Expected holding return: 10.40%
Expected variance: 66.04%
Expected standard deviation: 8.13%

Risk and Return Concepts : Page 1 of 3

 Use of Beta ()

Portfolio management: Diversification

We are interested in purchasing shares of pharmaceutical company.
In a given year, a particular pharmaceutical company may fail in getting approval of a new drug, thus causing
its stock price to drop.
But it is unlikely that every pharmaceutical company will fail major drug trials in the same year.
On average, some are likely to be successful while others will fail.
Therefore, the returns for a portfolio that is comprised of all drug companies will have much less volatility
than that of a single drug company.
By holding shares of the entire sector of pharmaceutical companies we have eliminated quite a bit of risk as
just described.
But its possible there is sector-level risk that may impact all drug companies.
For example, if the FDA changes its drug approval policy and requires all new drugs to go through more strict
testing we would expect the entire sector to suffer.
But what if we held a portfolio of not just pharmaceuticals but also that of computer companies,
manufacturing companies, service companies, real estate, commodities and other major assets.
We would expect this expanded market-level portfolio to be even less risky than a portfolio comprised of
only one sector.
Such a market portfolio would still have uncertainty and risk but it would be greatly reduced compared to
just one-asset or even a group of related assets.

As we include more stocks in the portfolio the volatility of returns lessens.

If two stocks are perfect-positively correlated, diversification has no effect.

Two components of Total Portfolio Risk

Firm-specific risk the risk that can be eliminated through diversification.
Market-level risk the risk that cannot be eliminated.
Portfolio Risk

Number of Securities
Investors are only compensated for risks that they bear.
Any risks which can be diversified away will not be compensated.

Beta (), a measure of non-diversifiable risk.

= ( ) ; ( ) =

-A stocks volatility relative to the portfolio.

-A stocks contribution of risk to the portfolio.
A stock with a beta of 1 has roughly the same volatility as the market.
With a beta of >1, volatility is greater than the market.
With a beta of <1, volatility is less than the market.

Risk and Return Concepts : Page 2 of 3

The Capital Asset Pricing Model (CAPM)

Market Risk Premium

R asset = R risk-free + (R market - R risk-free ) asset

Risk Premium
-A measure of expected return for a certain asset, especially investment in stocks.
-when graphed, the linear relationship presentation between return and beta that will be formed is described as the
Security Market Line or SML.

SML
Required or Expected Return

Systematic Risk or Beta

-when total risk is used in a graph, the linear relationship presentation between return and total risk that will be formed
is described as the Capital Market Line or CML.

CML
Required or Expected Return

Standard Deviation

Every man has a right to risk his own life

for the preservation of it.
- Jean-Jacques Rousseau

Risk and Return Concepts : Page 3 of 3