FINANCIAL RISK

MANAGEMENT
Estimating Risk and Returns
on Assets

RISK MANAGEMENT
It is the process of measuring or assessing
risk and developing strategies to manage it.
According to International Organization of
Standardization (ISO 31000), it is the
identification, assessment, and prioritization
of risks followed by coordinated and
economical application of resources to
minimize, monitor and control the probability
and/or impact of unfortunate events and to
minimize the realization of opportunities.

ESTIMATING RISK AND RETURN ON

ASSETS
RISK variability of an assets future
returns
- chance that some unfavorable event
will occur
In an investors viewpoint, the uncertainty
of, or variability in, an assets future return
creates risk.
Thus, if an assets actual return could
differ from its expected return, the
investment involves risk
The greater the variability, the greater the risk.

RISK-RETURN RELATIONSHIP
Investment risk is related to the
probability of actually earning less
than the expected return.
The greater the chance of low or
negative returns, the riskier the
investment.
Both investor and business
sentiments create a _____
relationship between risk and
expected return.

RISK-RETURN RELATIONSHIP
Investment risk is related to the
probability of actually earning less
than the expected return.
The greater the chance of low or
negative returns, the riskier the
positiv
investment.
e
Both investor and business
sentiments create a _____
relationship between risk and
expected return.

RISK-RETURN RELATIONSHIP
In the short run, higher risk
investments often significantly
underperform lower risk investments.
Higher risk investments are expected
to earn higher returns only over the
long-term (many years).

EXPECTED PORTFOLIO RETURNS

Expected portfolio return is the
weighted average of the expected
returns from the individual assets in
the portfolio.

Formula:

EXPECTED PORTFOLIO RETURNS

Illustration :
Just Once Corporation is evaluating
two opportunities, each having the same
initial investment. Project E has a 10%
expected return while Project F has a
20% expected return.

EXPECTED PORTFOLIO RETURNS

Illustration :
The following projections are available for three
alternative investments in equity shares (stock).
Rate of Return if State
Occurs
State of Probabi Stock A
lity of
Econom State of
y
Econom
y

Stock B

Stock C

Boom

15%

20%

.40

10%

Portfolio
1: Equal
invested0%in each of the
Recessio
.60 amounts
8% are 4%
n stocks
three
Portfolio 2: Half of the portion were in Stock A and the
remainder equally divided between B and C

EXPECTED PORTFOLIO RETURNS

Illustration :
Compute for the expected return on portfolio 1
Rate of Return if State
Occurs
State of Probabi Stock A
lity of
Econom State of
y
Econom
y

Stock B

Stock C

Boom

10%

15%

20%

8%

4%

0%

.40

Recessio .60
n

EXPECTED PORTFOLIO RETURNS

Exercise :
Compute for the expected return on portfolio 2
Rate of Return if State
Occurs
State of Probabi Stock A
lity of
Econom State of
y
Econom
y

Stock B

Stock C

Boom

10%

15%

20%

8%

4%

0%

.40

Recessio .60
n

STANDARD DEVIATION
It is a statistical measure of the variability
of a probability distribution around its
expected value.
It can be used as a measure of the amount
of absolute risk associated with an
outcome.
The larger the standard deviation, the
greater chance that the expected return
will not be realized.

STANDARD DEVIATION
It is calculated as follows:
1. Compute the expected value.
2. Subtract the expected value from each
possible return to obtain the deviations.
3. Square each deviation.
4. Multiply each squared deviation by its
probability of occurrence and then add. The
result is the variance.
5. Take the square root of the variance to
get the deviation.

STANDARD DEVIATION
Illustration:
PURE LOVE PRODUCTS, INC
State of
the
Economy

Probability
of This
State
Occurring

Rate of
Return (%)

Boom

.3

100

Normal

.4

15

Recession

.3

(70)

Expected Value of Outcome

Expected
Rate of
Return (%)

STANDARD DEVIATION
Exercise:
HEBREWS PRODUCTS, INC
State of
the
Economy

Probability
of This
State
Occurring

Rate of
Return (%)

Boom

.3

20

Normal

.4

15

Recession

.3

10

Expected Value of Outcome

Expected
Rate of
Return (%)

PORTFOLIO STANDARD DEVIATION

Illustration :
The following projections are available for three
alternative investments in equity shares (stock).
Rate of Return if State
Occurs
State of Probabi Stock A
lity of
Econom State of
y
Econom
y

Stock B

Stock C

Boom

15%

20%

.40

10%

Portfolio
1: Equal
invested0%in each of the
Recessio
.60 amounts
8% are 4%
n stocks
three
Required: Compute for the portfolio standard
deviation

EXPECTED PORTFOLIO RETURNS

Exercise :
The following projections are available for three
alternative investments in equity shares (stock).
Rate of Return if State
Occurs
State of Probabi Stock A
lity of
Econom State of
y
Econom
y

Stock B

Stock C

Boom

15%

20%

.40

10%

Portfolio
2: Half.60of the 8%
portion were
in Stock
A and the
Recessio
4%
0%
n
remainder
equally divided between B and C
Required: Compute for the portfolio standard
deviation