5-1

5-2
Investment Returns
To make a meaningful judgment about the return
we need to know the scale (size) and the timing of
the return.
The solution to scale and timing problem is to
express investment results as rates of return, or
percentage return.
Important concepts:
1. k = (FV/PV)
1/n
1
2. Total return % = (Capital gain + Dividend) / Initial Investment
3. Internal rate of return (IRR)
4. Return conversion

5-3
What is Risk?
One definition: Uncertainty of future outcomes
Alternative definition: The probability of an adverse
outcome
We will discuss several measures of risk that are used
in developing portfolio theory
5-4
Overview of Risk
All financial assets are expected to produce cash flows and the risk of
an asset is judged in terms of the riskiness of its cash flows

The risk of an asset can be considerer in two ways:
(1) on a stand-alone basis, where the assets cash flows are analyzed by
themselves or
(2) in a portfolio context, where the cash flows from a number of assets
are combined and then the consolidated cash flows are analyzed

5-5
Overview of Risk
An asset with a high degree of risk must provide a
relatively high expected rate of return to attract
investors.

Investors in general are averse to risk, so they will not
buy risky assets unless those assets have high expected
returns.
5-6
Estimating Return Statistics
Year Stock X (r
x
) Stock Y (r
y
)
1 110% 23%
2 22% 16%
3 -60% 10%
4 -20% 8%
5 30% 25%
Calculate expected return for stock X and Y.
Expected return () = r
i
/ T
5-7
Estimating Risk
Standard deviation (
i
) measures total, or stand-
alone, risk.
Calculate standard deviations of Stock X and Y.

Formula:
Variance = (
i
)
2
= [r
i
2
(r
i
)
2
/T ] (T -1) and

Standard Deviation (
i
) = Variance
5-8
Estimating Coefficient of Variation (CV)
A standardized measure of dispersion about the
expected value, that shows the risk per unit of return.
Calculate the CV of Stock X and Y.

Formula:
CV = Standard Deviation (i) / Expected return ()
5-9
Estimating Return and Risk Statistics
Year Stock X (r
x
) r
x
2

Stock Y (r
y
) r
y
2

1 110% 12100% 23% 529%
2 22% 484% 16% 256%
3 -60% 3600% 10% 100%
4 -20% 400% 8% 64%
5 30% 900% 25% 625%
T = 5 r
x
= 82% r
x
2
=
17484%
r
y
= 82% r
y
2
=
1574%
16.4% 16.4%

i
63.52% 7.57%
CV 3.87 0.46
5-10
Expected Rate of Return
Expected rate of return: If we multiply each possible outcome by its
probability of occurrence and then sum these products, we have a
weighted average of outcomes. The weights are the probabilities , and
the weighted average is the expected rate of return,

=
=
+ + + =
n
1 i
i i
^
n n 2 2 1 1
^
r P r
r P .... r P r P r
5-11
Calculating the Expected Return:
^
n
^
i i
i 1
^
X
^
Y
r expected rate of return
r r P
r = (110%) (0.2) (22%)(0.5) + (-60%)(0.3) = 15%
r = (20%) (0.2) (16%)(0.5) + (10%)(0.3) = 15%
=
=
=
+
+

Scenario Probability Company X Company Y

Good 0.2 110% 20%
Average 0.5 22% 16%
Bad 0.3 -60% 10%
5-12
Calculating the Standard Deviation :
deviation Standard = o
2
Variance o = = o
2
1
( )

n
i i
i
r r P o
=
=

5-13
Standard Deviation Calculation
1
2 2
2
X
2
X
1
2 2
2
Y
2
Y
(110% - 15%) (0.2) (22% - 15%) (0.5)

(-60% - 15%) (0.3)
0.5930 or 59.3%
(20% - 15%) (0.2) (16% - 15%) (0.5)

(10% - 15%) (0.3)
0.0361 or 3.61%
( +
o =
(
+

o =
( +
o =
(
+

o =
5-14
Comments on Standard Deviation
Standard deviation (
i
) measures total, or stand-alone, risk.
The larger
i
is, the lower the probability that actual returns
will be closer to expected returns.
Larger
i
is associated with a wider probability distribution
of returns.
Difficult to compare standard deviations, because return
has not been accounted for.
5-15
Coefficient of Variation (CV)
A standardized measure of dispersion about the
expected value, that shows the risk per unit of return.
^
X
Y
Std dev
CV
Mean return
r
59.3%
CV 3.95
15%
3.61%
CV 0.24
15%
o
= =
= =
= =
5-16
Scenario Probability Company X Company Y
Good 0.2 110% 20%
Average 0.5 22% 16%
Bad 0.3 -60% 10%

15% 15%

i

59.3% 3.61%
CV
3.95 0.24
Estimating Return and Risk Statistics
5-17
Investor attitude towards risk
Risk aversion assumes investors dislike risk and
require higher rates of return to encourage them to
hold riskier securities.
Risk premium the difference between the return
on a risky asset and less risky asset, which serves as
compensation for investors to hold riskier
securities.
5-18
Investment Decision Making Under Risk
Risk = Probability of loosing money or probability of
earning less then certain amount/percentage.

If returns have a normal distribution, we can make
decision based on expected return and standard
deviation.
Investments by Ravi Shukla, page 38-40.

5-19
Normal Distribution and Z value
Z Formula:

Z = [X - Expected return] / Standard Deviation
Where, X = Percentage return defined as risk.
5-20
Z Table
5-21