Risk and Return: Investment and Portfolio Management

Risk and Return
ACFN 3201
Investment and Portfolio Management

Alemitu A.(MSc),
Introduction
• when you want to invest in a company, there is nothing to
see the simple or try out physically, just like purchasing
cloths. But It is difficult to find out exactly the risks associated
with the stock.
• Before make investment we need to study two things;
 Returns on the investment and
 the risks associated with investments.
So lets we know the concepts of Risk and Return

Return
The Concept of Return
• Return mean the level of profit from an investment, that is, the
reward for investing.
Components of Return
There are two sources of return
1. current Income : Current income may take the form of dividends
from stocks, interest received on bonds, rent received from real
estate, and so on. It is usually cash or near-cash that is periodically
received as a result of owning an investment.
2. capital Gain : appreciation in the value of investment that is the
gain from selling an investment for more than its original purchase
price. The sale value of an investment exceed its original purchase
price is called a “capital gain.” In the contrary, if an investment is
sold for less than its original purchase price, we have what is
called “capital loss.”
Sources of Risk
• Risk may result from a combination of a variety of possible sources.
1. Business Risk
• the degree of uncertainty associated with the earning power of an investment(profit) and
the ability to pay interest, principal, dividends, and any other returns owed investors.
Example;
 1. Business owners may receive no return if earnings are not adequate to meet
obligations.
 2. Debt holders, on the other hand, are likely to receive some, but not necessarily all
2. Financial Risk
 The degree of uncertainty of payment attributable to the mix of debt and equity used to
finance a firm or property is financial risk.
 The larger the proportion of debt used to finance, the greater its financial risk.
3. Purchasing Power Risk
 chance that changes in price levels within the economy (inflation or deflation) will
adversely affect purchasing power of investments.
 In period of rising price levels,(inflation) the purchasing power of the Birr decreases and
vice versa.
 For example, if last year one Birr could buy ten oranges, but this year ,1Birr can buy only
five oranges
4. Interest Rate Risk
• Securities are affected by interest rate risk.
• The chance that changes in interest rates will adversely affect the value of a security is called
Interest rate risk
• Eg; The price (value) of fixed income securities, such as, bonds and preferred stock drop
when interest rates rise.
5. Liquidity Risk
• The risk of not being able to liquidate an investment conveniently and at a reasonable price.
• Eg; In a thin market, where demand and supply are small-less liquidity and in broad markets
liquidity is more.
6. Tax Risk
• If tax rate increases --- after tax returns decreases i.e. (greater tax risk)
7. Market Risk
• The risk(chance) of a decline in investment returns because of market factors
• market risk include political, economic, and social events as well as changes in investor
tastes and preferences.
• Market risk leads to a number of different risks; purchasing power risk, interest rate risk, and
tax risk.
8. Event Risk
• unexpected event that has a significant and usually immediate effect on the value of an
investment like COVID 19
Components of risk
• Two components of risk- Diversifiable and Non-diversifiable risks
• Diversifiable risk
 Also called unsystematic risk,
 results from random events, such as labor strikes, lawsuits, and regulatory
actions.
 These risk that can be controllable or eliminated through diversification.
• Non-diversifiable risk
 also called systematic risk,
 results from war, inflation, and political events that affect all investments
 These risks cannot be controllable,
• Total risk
 Total Risk= Non-diversifiable risk + diversifiable risk
Measurement of Risk and Rate of Return:
• 1. First we need to examine ways to quantify ----Return and Risk.
• 2.Measurement process require;
 A . Historical Return
 B. Expected rate of return and Risk
– Steps in Measurement of risk and Return
• A. Historical Rate of Return
• Step 1:
• we need to measure historical Rate of return for the holding period (time
period during investment is held)
• A. Holding period return(HPR)= Ending Value of Investment/Beginning Value
of Investment
• Annual HPR= (HPR)1/n
• B. Holding period Yield (HPY) = converting HPR to annual percentage rate
• Annual holding period yield= annual HPR-1
• For example; If you commit $200 to an investment at the beginning of the year
and you get back $220 at the end of the year,. a) What is HPR b) what is HPY ?
• A) HPR= $220/$200
=1.10
B) HPY= HPR – 1
HPY= 1.10 – 1
=0.10 or 10%
• For example; Consider an investment that cost $250 and is worth $350 after being
held for two years, a) what is annual HPR b) Annual HPY ?
• HPR= $350 / $250
• =1.40
• Annual HPR= 1.40 1/ n
= 1.40 1/ 2
=1.1832
• Annual HPY= 1.1832 – 1
= 0.1832
= 18.32%

Step-2: Average Historical Rate of Return
1.Arithmetic mean return,
2.Geometric mean return.
a) Arithmetic mean (AM), the sum of annual HPYs is divided by the number of years (n) as follows:
AM = Sum of HPY/n
b)The geometric mean (GM), is the nth root of the product of the HPRs for n years-1.
GM= [product of HPR]1/n – 1
Consider an investment with the following data:
year HPR HPY
1 1.15 0.15
2 1.20 0.20
3 0.80 –0.20
AM = [(0.15) + (0.20) + (–0.20)]/3

= 0.15/3
= 0.05 = 5%
GM = [(1.15) × (1.20) × (0.80)]1/3 – 1
= (1.104)1/3 – 1
= 1.03353 – 1
= 0.03353 = 3.353%
Note: we have the traditional measures to measure historical of returns; 1.variance and 2.standard
deviation).
Risk and Rates of Return
• Expected Return Calculation
Example
You are evaluating ElCat Corporation’s common stock. You
estimate the following returns given different states of the
economy
State of Economy Probability(pi) Return(ki)
Economic Downturn .10 x –5% = –0.5%
Zero Growth .20 x 5% = 1%
Moderate Growth .40 x 10% = 4%
High Growth .30 x 20% = 6%
k = 10.5%
N
k  k iP(k i ) Expected
Expected(or
(oraverage)
average)rate
rateof
of
i 1 return
returnon
onstock
stockisis10.5%
10.5%
Relative Measure of Risk
• In some cases, an unadjusted variance or standard deviation can be
misleading.
• If there are major differences in the expected rates of return of two or more
investment alternatives — it is necessary to use relative measure of
variability to indicate risk per unit of expected return.
•
• Coefficient of variation (CV), is widely used as a relative measure of risk :
• Coefficient of Variation (CV) =

Standard Deviation of Returns / Expected Rate of Return
Risk and Rates of Return
• Measuring Risk
– Standard Deviation () measure the dispersion of
returns. N
Example   2
(k i  k ) P(k i )
i  1deviation on ElCat common stock. the
Compute the standard
mean (k) was previously computed as 10.5%
State of Economy Probability Return
Economic Downturn .10 x ( –5% – 10.5%)2 = 24.025%2
Zero Growth .20 x ( 5% – 10.5%)2 = 6.05%2
Moderate Growth .40 x ( 10% – 10.5%)2 = 0.10%2
High Growth .30 x ( 20% – 10.5%)2 = 27.075%2
2 = 57.25%2
Higher
Higherstandard
standarddeviation,
deviation,higher
higherrisk
risk  = 57.25%2
 = 7.57%
End of the Unit

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Risk and Return: Investment and Portfolio Management

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Risk and Return

Investment and Portfolio Management

• Before make investment we need to study two things;

 Returns on the investment and

 the risks associated with investments.

So lets we know the concepts of Risk and Return

AM = [(0.15) + (0.20) + (–0.20)]/3

• Coefficient of Variation (CV) =

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