Rish and Return of single asset class.ppt

About risk and return

1. Risk and Return: An
Overview of Capital Market
Theory

2. Chapter Objectives
Financial Management, Ninth Edition © I M Pandey
Vikas Publishing House Pvt. Ltd.

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.

3. Return on a Single Asset
Total return
= Dividend
+ Capital
gain
Year-to-Year
Total Returns
on HLL Share
149.70
70.54
16.52
22.71
49.52
92.33
36.13
52.64
7.29
12.95
0.00
20.00
40.00
60.00
80.00
100.00
120.00
140.00
160.00
1992199319941995199619971998199920002001
Year
T
o
t
a
l
R
e
t
u
r
n

(
%
)
Financial Management, Ninth Edition © I M Pandey
Vikas Publishing House Pvt. Ltd.
 
1 1 01 01
1
0 0 0
Rate of return Dividend yield Capital gain yield
DIVDIV

P PP P
R
P P P
 
 
  

4. Average Rate of Return
Financial Management, Ninth Edition © I M Pandey
Vikas Publishing House Pvt. Ltd.

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:
1 2
=1
1 1
= [ ]
n
n t
t
R R R R R
n n
    

5. Risk of Rates of Return: Variance
and Standard Deviation
Financial Management, Ninth Edition © I M Pandey
Vikas Publishing House Pvt. Ltd.

Formulae for calculating variance and standard
deviation:
Standard deviation = Variance
 
2
2
1
1
1
n
t
t
R R
n


 



6. Investment Worth of Different
Portfolios, 1969–70 to 1997–98
Financial Management, Ninth Edition © I M Pandey
Vikas Publishing House Pvt. Ltd.
57.16
13.99
10.36
10.20
4.41
1
10
100
1
9
6
9
-
7
0
1
9
7
0
-
7
1

1
9
7
1
-
7
2
1
9
7
2
-
7
3
1
9
7
3
-
7
4
1
9
7
4
-
7
5
1
9
7
5
-
7
6
1
9
7
6
-
7
7
1
9
7
7
-
7
8
1
9
7
8
-
7
9
1
9
7
9
-
8
0
1
9
8
0
-
8
1
1
9
8
1
-
8
2
1
9
8
2
-
8
3
1
9
8
3
-
8
4
1
9
8
4
-
8
5
1
9
8
5
-
8
6
1
9
8
6
-
8
7
1
9
8
7
-
8
8
1
9
8
8
-
8
9
1
9
8
9
-
9
0
1
9
9
0
-
9
1
1
9
9
1
-
9
2
1
9
9
2
-
9
3
1
9
9
3
-
9
4
1
9
9
4
-
9
5
1
9
9
5
-
9
6
1
9
9
6
-
9
7
1
9
9
7
-
9
8
Year
Index
Stock Market Return
Call Money Market
Long-term Govt. Bonds
Inflation
91-day TB

7. Averages and Standard Deviations,
1970–71 to 1997–98
Financial Management, Ninth Edition © I M Pandey
Vikas Publishing House Pvt. Ltd.


Securities
Arithmetic
mean
Standard
deviation
Risk
premium
*
Risk
premium
#
Ordinary shares (RBI Index) 17.50 22.34 12.04 8.76
Call money market 9.93 3.49 4.47 1.19
Long-term government bonds 8.74 2.59 3.28
91-Day treasury bills 5.46 2.05
Inflation 8.80 5.82
Relative to 91-Days T-bills. # Relative to long-term government bonds.

8. Expected Return : Incorporating
Probabilities in Estimates

The expected
rate of return [E
(R)] is the sum of
the product of
each outcome
(return) and its
associated
probability:
RETURNS UNDER VARIOUS ECONOMIC CONDITIONS
Economic Conditions Share Price Dividend Dividend Yield Capital Gain Return
(1) (2) (3) (4) (5) (6) = (4) + (5)
High growth 305.50 4.00 0.015 0.169 0.185
Expansion 285.50 3.25 0.012 0.093 0.105
Stagnation 261.25 2.50 0.010 0.000 0.010
Decline 243.50 2.00 0.008 – 0.068 – 0.060
RETURNS AND PROBABILITIES
Economic Conditions Rate of Return (%) Probability Expected Rate of Return (%)
(1) (2) (3) (4) = (2)

(3)
Growth 18.5 0.25 4.63
Expansion 10.5 0.25 2.62
Stagnation 1.0 0.25 0.25
Decline – 6.0 0.25 – 1.50
1.00 6.00
Financial Management, Ninth Edition © I M Pandey
Vikas Publishing House Pvt. Ltd.

9. Expected Risk and Preference

The following formula can be used to calculate
the variance of returns:
Financial Management, Ninth Edition © I M Pandey
Vikas Publishing House Pvt. Ltd.
  

2 2 2 2
1 1 2 2
2
1
...
n n
n
ii
i
R E R P R E R P R E R P
R E R P


           
     
  
 

10. Expected Risk and Preference
Financial Management, Ninth Edition © I M Pandey
Vikas Publishing House Pvt. Ltd.
A risk-averse investor will choose among investments
with the equal rates of return, the investment with
lowest standard deviation. Similarly, if investments
have equal risk (standard deviations), the investor
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.

11. Normal Distribution
Financial Management, Ninth Edition © I M Pandey
Vikas Publishing House Pvt. Ltd.

Normal distribution is an important concept in
statistics and finance. In explaining the risk-return
relationship, we assume that returns are normally
distributed.

Normal distribution is a population-based,
theoretical distribution.