Chapter 5: Risk and Return

Chapter 5: Risk and Return

Learning Objectives:

1.Explain the concept and relationship between risk and return.

2.Identify the formula to measure risk and return

Fundamentals of risk and return

i. Different investment have different return and risk characteristics.

ii. Some investments will give you immediate returns with little risk, while others may give higher returns with high risk.

iii. Identifying investments on the basis of their return and risk characteristics is not easy. 

Poll

The higher the return the higher the risk

• True

• False

Types of return:

• Return can be classified as current return and future return. Current returns are those benefits that you expect to get on a regular basis. Dividends paid by the company to the investors or interest payment made to the bondholder annually is an example of current returns.

• When an investment appreciates in value over time, this is referred to as future return. For example, RM200 investment that pays RM10 in cash dividend and worth RM208 one year late. When your investment increased in value from RM200 to RM208 the additional RM8 is said to be your future return.

Poll

Current and fixed return are the types of return.

• True

• False

Types of risk (Unsystematic risk)

• The portion of total risk that is unique to a firm or industry.

• It results in the uncertainty of possible returns on the investment due to factors: incompetence of management, labour difficulties and changes in consumers’ preferences.

• Can be reduced or eliminated through a well-diversified portfolio of investments.

Systematic risk

• The portion of total risk that affects the overall market.

• Example: Changes in the country’s economy, inflation rates and interest rates. Cannot be reduced or eliminated by holding well-diversified portfolio of investments. 

• 
  

Poll

Unsystematic risk also known as non diversifiable risk.

• True

• False

Poll

Systematic risk also known as diversifiable risk.

• True

• False

Measuring risk

- Using standard deviation (a statistical measure of the variability of a distribution around its mean, Van Home, 1995).

- Measures the differences between the possible returns and the expected return.

- Mathematically, the standard deviation of a particular investment can be written as: 

σ =  √  ∑ Ri P (Ri - Ṝ)2 Pi

Coefficient of Variation

- Used to differentiate investments with different expected returns.

- It is “ the ratio of the standard deviation to the expected return” (Winger, 1993) and measures the amount of risk for every unit of expected return.

Capital Asset Pricing Model (CAPM)

- Was developed by Sharpe (1964), Lintner (1965) and Mossin (1966). 

- A model was generated to predict about the risk and return characteristics of individual assets by specifying how they could covary with the market portfolio of all risky assets.

- Therefore the specific measure of systematic risk use in CAPM is called asset’s beta, ßi , and is defined as the correlation of the asset’s return with the return on the market portfolio, Rm

Multiple Select

What is (are) the method(s) of measuring risk?

• Standard deviation

• Coefficient of Variation

• Capital Asset Pricing Model

• Holding period return