RISK AND RETURN: AN OVERVIEW

OF CAPITAL MARKET THEORY

By
Vaishnav Kumar
vaishnav@marcbschool.com
LEARNING OBJECTIVES
Discuss the concepts of average and expected rates of
return.
Define and measure risk for individual assets.
Show the steps in the calculation of standard deviation
and variance of returns.
Explain the concept of normal distribution and the
importance of standard deviation.
Compute historical average return of securities and
market premium.
Determine the relationship between risk and return.
Highlight the difference between relevant and
irrelevant risks.
2
Return on a Single Asset

Total return = Dividend + Capital gain

3
( )
1 1 0
1 0 1
1
0 0 0
Rate of return Dividend yield Capital gain yield
DIV
DIV

P P
P P
R
P P P
= +
+

= + =
Return on a Single Asset
21.84
36.99
-6.73
10.81
-16.43
15.65
-27.45
40.94
12.83
2.93
-40
-30
-20
-10
0
10
20
30
40
50
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
Year
T
o
t
a
l

R
e
t
u
r
n

(
%
)
4
Year-to-Year Total Returns on HUL Share
Average Rate of Return
The average rate of return is the sum of the various one-period rates of
return divided by the number of period.
Formula for the average rate of return is as follows:
5
1 2
=1
1 1
= [ ]
n
n t
t
R R R R R
n n
+ + + =

Risk of Rates of Return: Variance and
Standard Deviation
Formulae for calculating variance and standard deviation:
6
Standard deviation = Variance
( )
2
2
1
1
1
n
t
t
Variance R R
n
o
=
= =

7
Investment Worth of Different
Portfolios, 1980-81 to 200708
8
HISTORICAL CAPITAL MARKET RETURNS
Year-by-
Year
Returns
in India:
1981-2008
Averages and Standard Deviations,
198081 to 200708
9
*Relative to 91-Days T-bills.
Historical Risk Premium
The 28-year average return on the stock market is higher
by about 15 per cent in comparison with the average
return on 91-day T-bills.

The 28-year average return on the stock market is higher
by about 12 per cent in comparison with the average
return on the long-term government bonds.

This excess return is a compensation for the higher risk
of the return on the stock market; it is commonly
referred to as risk premium.
10
11
The expected rate of return [E (R)] is the sum of the product of each
outcome (return) and its associated probability:
Expected Return : Incorporating
Probabilities in Estimates
Rates of Returns Under Various Economic Conditions
Returns and Probabilities
Cont
The following formula can be used to calculate the variance of returns:
12
( ) ( ) ( )
( )
2 2 2 2
1 1 2 2
2
1
...
n n
n
i i
i
R E R P R E R P R E R P
R E R P
o
=
( ( (
= + + +

(
=

Example
13
Expected Risk and Preference
A risk-averse investor will choose among investments
with the equal rates of return, the investment with
lowest standard deviation and among investments with
equal risk she would prefer the one with higher return.

A risk-neutral investor does not consider risk, and
would always prefer investments with higher returns.

A risk-seeking investor likes investments with higher
risk irrespective of the rates of return. In reality, most
(if not all) investors are risk-averse.
14
Risk preferences
15
Normal Distribution and Standard Deviation
In explaining the risk-return relationship, we assume that returns are
normally distributed.
The spread of the normal distribution is characterized by the standard
deviation.
Normal distribution is a population-based, theoretical distribution.
16
17
Normal distribution
Properties of a Normal Distribution
The area under the curve sums to1.
The curve reaches its maximum at the expected value
(mean) of the distribution and one-half of the area lies
on either side of the mean.
Approximately 50 per cent of the area lies within
0.67 standard deviations of the expected value; about
68 per cent of the area lies within 1.0 standard
deviations of the expected value; 95 per cent of the
area lies within 1.96 standard deviation of the
expected value and 99 per cent of the area lies within
3.0 standard deviations of the expected value.

18
Probability of Expected Returns
The normal probability table, can be used to
determine the area under the normal curve for various
standard deviations.
The distribution tabulated is a normal distribution with
mean zero and standard deviation of 1. Such a
distribution is known as a standard normal
distribution.
Any normal distribution can be standardised and hence
the table of normal probabilities will serve for any
normal distribution. The formula to standardise is:
S =
19
( ) R E R -
s
Example
An asset has an expected return of 29.32 per cent and the
standard deviation of the possible returns is 13.52 per cent.
To find the probability that the return of the asset will be zero or
less, we can divide the difference between zero and the expected
value of the return by standard deviation of possible net present
value as follows:

S = = 2.17

The probability of being less than 2.17 standard deviations from
the expected value, according to the normal probability
distribution table is 0.015. This means that there is 0.015 or 1.5%
probability that the return of the asset will be zero or less.


20
0 29.32
13.52
-