RETURN AND RISK

RETURN:
That an investor receives from an investment over the period of the investment. THE COMPONENTS OF RETURN: Total return = yield + price change
Where the yield component can be 0 or + The price change component cab be 0, +, or -

EXPENCTED RETURN:
Expected return is the return an investor expects to receive from an investment over the period of the investment.

REALIZED RETRN:
The realized return the actually earned over the period of the investment.

RISK:
An investors viewpoint, the uncertainty of or variability in, an assets future return creates risk . That the actual return on an investment will be different from the expected return

SOURCE OF RISK:
INTERST RATE RISK:
Variability in a security return resulting from changes in interest rates change.

EXCHANGE RATE RISK: COUNTRY RISK;

MARKET RISK:
Variability in a security return resulting from recession and depression, structural changes . INFLATION RISK: Variability in a security return resulting from fluctuation in the inflation . BUSINESS RISK:

FINANCIAL RISK:
LIQUIDTY RISK:

SYSTEMATIC RISK AND NONSYSTEMEMATIC RISK

SYSTEMATIC RISK
Risk attributable to broad macro factors affecting all securities. This type of risk is Non-diversifiable and sources of systematic risk are included interest rate risk, inflation risk, market risk.

NONSYSTEMATIC RISK:
Risk attributable to factors unique to a securities. This type of risk is Diversifiable and sources of nonsystematic risk are included financial etc, etc.

PROBABILITY
Probability is the parentage chance that an event will occur.

Probability will rage from 0 to 1.0

The sum of the probabilities of all possible outcome of any given set of circumstance is equal to 1.0 or 100 percent.

A probability distribution is a list of all possible

outcome and the probability associated with each. A probability distribution may be objective or subjective. In reality, probability distributions often combine both objective and subjective probabilities.

An objective probability:
Objective probability distribution is generally based on past outcome of similar events .

A subjective probability:
A subjective probability is based on opinions or educated guesses about the likelihood that an event will have a particular future outcome.

DISCREATE PROBABILITY:
A discrete probability is an arrangement of the probabilities associated with the values of a variable that can assume a limited of finite number of values (outcome).

0.4 0.35 0.3 0.25 0.2 0.15 0.1 0.05 0 -15% 9% 33%

CONTINUOUS PROBABILITY
A continuous probability distribution is an arrangement of probabilities associated with the values of a variable that can assume an infinite number of possible values

0.035 0.03 0.025 0.02 0.015 0.01 0.005 0

4% 13% 22% 31% 40% 49% 58% -50% -41% -32% -23% -14% 67% -5%

RISKT ANDREURN OF A

SINGEL ASSET:
Expected value or expected rate of return, r, is the weighted average of all possible returns from an investment, with the weights being the probability of each returns.

EXPECTED VALUE:

R = S ( Ri )( Pi)
R is the expected return for the asset, Ri is the return for the ith observation, n is the total number of observations. Pi is the probability of that return occurring,

Seldin Company plans to invest in one of two projects, each requiring the same initial investment; Estimates of next years dollar returns (cash flow) on these investments depend on the state of the economy. The firm estimates these return bases on a week moderate, and strong economy and attaches probabilities to each state of economy.

Returns

State of the Economy (i) Week

PROBABILI TY (pi) 0.2

Project Project A B (ri) (ri) 800 200 1,000 1,800

Moderate
Strong

0.6
0.2

1,000
1,200

Project A = (800)(0.2) + (1000)(0.6)+ (1200)(0.2) = (160) + (600) +(240) = 1000 (1000)(0.6) + (1800)(0.2) Project B =(200)(0.2) + = (40)+ (600) + (360) = 1000

Determining Standard Deviation (Risk Measure)

s=
i=1

S ( Ri - R )2( Pi )

Standard Deviation , s, is a statistical measure of the variability of a distribution

around its mean. It is the square root of variance. Note, this is for a discrete distribution.

s A=( $800 - $1,000 )2( 0.2 )+ ( $1,000 - $1,000 )2(0.6 ) + ( $1,200i - $1,000 )2( 0.2 ) = ( -$200)2( 0.2 )+ ( 0)2( 0.6)+ ( $200 )2( 0.2) = 16000 = $126.49

s B=( $200 - $1,000 )2( 0.2 )+ ( $1,000 - $1,000 )2(0.6 ) + ( $1,800- $1,000 )2( 0.2 ) = ( -$800)2( 0.2 )+ ( 0)2( 0.6)+ ( $800 )2( 0.2) = 56,000 = $505.96

COEFFICIENT OF VARIATION
Coefficient of variation ,CV, is defined mathematically s the ration as the ratio of the standard deviation to the expected value The coefficient of variation is a relative measured of risk measure for comparing projects in which the expected values differ and for which, therefore, using the standard deviation would be misleading

Coefficient of variation

CV=

s/

CV a = $126/$1000
C V b= $506/10000

= 0.13
= 0.05

RISK PREFERENCES:
Decision makers have different views about risk and return:
Decision makers wanted to be compensated for the risk associated with an investment. The greater the risk, the more the demanded return. The actual amount of compensation demanded, which is called the required rate of return, is influenced by the individual decisions makers attitude toward risk.

DECISION MAKERS MAY CLASSFIED INTO ONE OF THE FOLLOWING GROUP:

RISK AVERTERS:
Risk averters are unwilling to pay an amount as much as the expected value of an uncertain investment. Risk aversion does not imply complete avoidance of risk. Risk-averse investors are wiling to accept greater risk provided the return is sufficiently high. Most investor in socks and bonds are risk averse.

RISK NEUTRAL:

Risk neutral decision makers are willing to pay the expected value.
RISK TAKERS:
Risk takers are wiling to pay more than the expected value.

RISK AND REURN OF A PORTFOLIO

PORTFOLIO:
A portfolio is a collection of two or more assets or securities.

PORTFOLIO THEORY:
Portfolio theory involves the selection of efficient portfolios. An efficient portfolio provides the highest return for a given level of risk or the least risk for a given level of return.

THE EXPECTED PORTFOLIO RTURN, p is the weighted average of the expected return from the individual assets in the portfolio.

Determining Portfolio Expected Return

RP = j=1 ( Wj )( Rj ) S
RP is the expected return for the portfolio, Wj is the weight (investment proportion) for the jth asset in the portfolio, Rj is the expected return of the jth asset, m is the total number of assets in the portfolio.

Project E
Expected return (Rj) 0.10

Project F
0.20

Standard deviation (s i)
Proportion invested in each project (W) )

0.08
0.80

0.08
0.50

RP = S ( Wj )( Rj )

RP=(0.5)(0.10) + (0.5)(0.2)
= 0.15 or 15 %

Portfolio risk , (s p) ,is the variability

of returns of the portfolio as a whole
The riskiness f a portfolio may be less than the riskiness of any individual assets contained in the portfolio because of diversification.

DIVERSIFICATION :
Diversification is investing in more than one type of asset in order to reduce risk Diversification reduced risk by combining assets, such as securities with different risk return characteristics. This favorable interaction among assets is known as the portfolio effect.

The amount of risk and reduction achieved through diversification depends on the correlation of the individual assets returns with one another.

Correlation coefficient:
Correlation coefficient ,P or rho is a relative statistical measure of correlation in the degree and direction of change between tow variable . It range from +1 to 1.0 Risk reduction is achieved through diversification whenever the returns of the asset combined in portfolio are not perfectly positively correlated. In other words, greater benefits are achieved with less positive or more negative correlation among asset returns.

sp W
2

2
1

s + W s +2 w w
2 2 2
2 1 2 1

P 1,2 s 1 s

sp (0.5)(0.08) + (0.5)(0.08) + (2)(0.5)(1.0)(0.08)(0.08)

sp

= 0.0016 + 0.0016 + 0.0032

sp = 0.0064 sp = 0.0064 = 0.08

Capital Asset Pricing Model (CAPM)

CAPM is a model that describes the relationship between risk and expected (required) return; in this model, a securitys expected (required) return is the risk-free rate plus a premium based on the systematic risk of the security.