Risk and Return-1

Risk and Return (part 1)

Fundamental question: What is the relationship between risk and return?

Key issues:

1) Riskier investments tend to have higher average returns

=> compensates investors for risk

2) Some risk disappears in a portfolio

=> investors should not be compensated for this risk
=> need to measure relationship between return and risk that does not disappear in a
portfolio

I. Estimating Risk and Return

Basic approaches:

1) peer into the future

2) look at the past and assume future will be like the past.

A. Estimates based on forecasts

Key: need probability distributions for investments

=> probability (pR) of each possible return (R)

1. Expected return: E [R ] = ∑ R p R × R (1)

=> return expect to earn on average if invest in assets over and over and if the
distribution does not change
=> the higher the number, the greater the return you can expect to earn

2. Variance and Standard deviation:

Var (R ) = ∑ R p R × (R − E (R ))2 (2)

SD(R ) = Var (R ) (3)

=> measure of how widely scattered are the possible returns

=> the higher the number, the more widely scattered the possible returns

Frameworks: Finance
 Risk and Return-2

Ex. Given the following possible returns on General Electric (GE) stock, what is the
expected return and standard deviation of returns on GE stock?

Prob Return
.25 -26%
.40 11%
.35 44%

E[R] =

Var(R) =

SD(R) =

Ex. Assume that the expected return on General Mills (GIS) is 5% and that the standard
deviation of returns on GIS is 10%.

=> General Mills has a lower expected return but less volatility than GE.

Note: if returns were normally distributed, then can compare distributions of GE and
GIS.

=> problem with this approach => must forecast possible returns and probability of
each

Frameworks: Finance
 Risk and Return-3

B. Estimates based on historical returns

Key assumption: future will be like the past

=> likely not the case

Divt +1 Pt +1 − Pt
1. Realized return: Rt +1 = + (4)
Pt Pt

Notes:

1) Rt+1 = return actually earned between t and t+1 expressed as percent of what
invested
2) Divt+1 = dividend at t+1
3) Pt = stock price at t
4) Pt+1 = stock price at t+1
Divt +1
5) = dividend yield
Pt
P −P
6) t +1 t = capital gains yield
Pt

7)

8)

Ex. Assume the following prices and dividends for General Electric (GE) stock

Date Dividend Price

12/31 $0.00 $15.13
2/25 $0.10 $15.92
6/17 $0.10 $15.91
9/16 $0.12 $16.23
12/22 $0.14 $18.06
12/31 $0.00 $18.29

What is return between 9/16 and 12/22?

R9/16-2/22 =

Q: What does this tell us about GE?

Frameworks: Finance
 Risk and Return-4

2. Realized return over longer periods

Key: usually think in terms of annual returns

a.

=> 1+RL = (1+RS1) (1+RS2) (1+RS3)…. (5)

Note:

Ex. Returns per period (previous GE example):

Date Dividend Price Return

12/31 $0.00 $15.13 n.a.
2/25 $0.10 $15.92 5.88%
6/17 $0.10 $15.91 0.57%
9/16 $0.12 $16.23 2.77%
12/22 $0.14 $18.06 12.14%
12/31 $0.00 $18.29 1.27%

1+Ryear =

=> Ryear =

b.

=>

Frameworks: Finance
 Risk and Return-5

Notes:

1) gives return on funds as long as invested in stock

=> between time invested in stock and time cash flows thrown off as
dividends or sale of stock

2)

3)

4)

Ex.

Date Dividend Price Days

12/31 $0.00 $15.13 0
2/25 $0.10 $15.92 56
6/17 $0.10 $15.91 168
9/16 $0.12 $16.23 259
12/22 $0.14 $18.06 356
12/31 $0.00 $18.29 365

NPV =

=> r =

Note: Should solve with Excel

1 T
3. Average Annual Returns: R = ∑ Rt (6)
T t =1
=> difficult to get your mind wrapped around a list of returns => need to summarize
data
where: T = number of historical returns
Rt = return over year t

=> return around which past returns are scattered

Frameworks: Finance
 Risk and Return-6

4. Variance and Standard Deviation of Returns

Note: variance and standard deviation measure the spread of past returns

=> standard deviation is in same units as average return

1 T
Var (R ) = ∑ (Rt − R )2 (7)
T − 1 t =1

Note: dividing by T-1 rather than T gives unbiased estimator

Standard Deviation = SD (R ) = Var (R ) (8)

=> gives spread of possible returns

=> the higher the volatility, the more spread out the returns

Ex. Assume that the returns on General Electric (GE) over the last 6 years were as
follows: +1%, -64%, +39%, 29%, -4%, +23%. How did the returns on GE
compare to those of General Mills (GIS) which had an average return of 9% and a
standard deviation of returns of 9%?

𝑅𝑅̄𝐺𝐺𝐺𝐺 =

Var (RGE) =

SD(RGE) =

Q: What can we conclude about GE and General Mills?

=>

Q: Why would anyone invest in GE rather than General Mills?

Frameworks: Finance
 Risk and Return-7

II. Information, risk, and return

1) Firm-specific news: good or bad news about company itself

Risk from firm-specific news called: firm-specific, idiosyncratic, unsystematic, unique,
diversifiable risk

2) Market-wide news: about economy and thus impacts all stocks

Risk from market-wide news called: systematic, undiversifiable, market risk

Notes:

1) individual stocks contain firm-specific risk that averages out in large portfolios
2) investors will only earn a premium for systematic risk

=> no premium for firm-specific risk since diversifies away in a portfolio

Frameworks: Finance