Chapter 7.

Risk and Return

Subject: Corporate Finance 1
Lecturer: PhD. Anh Tram Luong
 Why do we learn
about risk and return?
 In almost all business decisions,
we need to know what risk is
and how it is rewarded in the market
 In investment, we need to know
what determines the appropriate
discount rate for future cash flows
Content

1. Expected returns

Risk and Return 2. Risk

3. Diversification and Portfolio risk

Content

1. Expected returns

Risk and Return 2. Risk

3. Diversification and Portfolio risk

 1. Expected returns
Returns
Two components of a security’s returns:
▪ Income component: money received directly while you own
the investment. Eg: Dividends, Interest on bonds
▪ Capital gains/loss: change in the value of the asset

Example
At the beginning of the year, the stock was selling for $37 per share. If you had bought 100 shares, you
would have had a total outlay of $3,700. Suppose that, over the year, the stock paid a dividend of
$1.85 per share. By the end of the year, the value of the stock has risen to $40.33 per share. Calculate:
a. Income of dividends?
b. Capital gains/losses?
c. Total returns?
1. Expected returns
Returns

Example
At the beginning of the year, the stock was selling for $37 per share. If you had bought 100
shares, you would have had a total outlay of $3,700. Suppose that, over the year, the stock paid
a dividend of $1.85 per share. By the end of the year, the value of the stock has risen to $40.33
per share. Calculate:
a. Income of dividends = $1.85 × 100 = $185
b. Capital gains = ($40.33 - $37) × 100 = $333
c. Total returns = $185 + $333 = $518
How much do we get for
each dollar we invest?
1. Expected returns
Returns

Rate of returns
Rate of returns is change in total return during a period of time (Eg: year, month…) divided by
the initial investment (Eg: price at the beginning of the period)
𝐷1 𝑃1 − 𝑃0
𝑅= +
𝑃0 𝑃0
Rate of retuns include dividend yield and capital gains/losses yield
Example
Rate of return of the stock
1.85 40.33 − 37
𝑅= +
37 37
1. Expected returns
Average Returns

Example
You buy a particular stock for $100.
Unfortunately, the fisrst year you own it, it falls
to $50. The second-year you own it, it rises
back to $100, leaving you where you started
(no dividends were paid). What was your
average return on this investment?
A. 0% B. 25%
 1. Expected returns
Average Returns

Two approaches to calculating average returns:

• Geometric average return: The average compound return earned per year over a multiyear period
The geometric average tells you what you actually earned per year on average, compounded annually
Geometric average return = [(1 + R1 ) × (1 + R 2 ) × … × (1 + R T )] 1/𝑇 − 1
• Arithmetic average return: The return earned in an average year over a multiyear period. The
arithmetic average tells you what you earned in a typical year

R1 + R 2 + ⋯ + R T
Arithmetic average return =
T
1. Expected returns
Expected Returns

Expected returns: The return on a risky asset expected in the future.

𝐄 𝐑 = ෍(𝐩𝐢 × 𝐑 𝐢 )
𝐢=𝟏

In which:
𝐩𝐢 : Probability of the i(th) situation
𝐑 𝐢 : The rate of returns in the i(th) situation
𝐧: The number of situations
1. Expected returns
Expected Returns

Example: We have two stocks, L and U. There are two states of the economy: a boom and a
recession are equally likely to happen, for a 50–50 chance of each.

States of the Probability of Stock L Stock X

economy State of Rate of Return (4) Rate of Return if (6)
(1) Economy if State Occurs = (2) × (3) State Occurs = (2) × (5)
(2) (3) (5)

Recession 0.5 - 20 % - 10 % 10 % 5%

Boom 0.5 70 % 35 % 30 % 15 %

E(RL) = 25% E(RL) = 20%

1. Expected returns
Portfolio Expected Returns

Portfolio: A group of assets such as stocks and bonds held by an investor

Portfolio Expected Returns: The weighted average of its individual components' returns
𝐧

𝐄 𝑹𝒑 = ෍[𝒘𝐢 × 𝑬 𝐑 𝐢 ]
𝐢=𝟏

In which:
𝒘𝐢 : Portfolio weight (The percentage of a portfolio’s total value that is in a particular asset)
𝑬(𝐑 𝐢 ): Expected returns in the i(th) asset
𝐧: The number of assets
1. Expected returns
Portfolio Expected Returns

Example: Suppose we have the following projections for three stocks:

States of the Probability Returns if state occurs

economy of State of Stock A Stock B Stock C
Economy

Recession 0.6 8% 4% 0%

Boom 0.4 10 % 15 % 20 %

a. What would be the expected return on a portfolio with equal

amounts invested in each of the three stocks?
b. What would be the expected return if half of the portfolio were in
A, with the remainder equally divided between B and C?
Content

1. Expected returns

Risk and Return 2. Risk

3. Diversification and Portfolio risk

2. Risk
Definition and Classification

Definition of Risk: the possibility that an outcome or investment's actual gains will differ from an
expected outcome
Classification of Risk:

Systematic risk/ Market A risk that influences a large number of

risk/ Undiversifiable risk assets, each to a greater or lesser extent
Risk
Unsystematic risk/ Unique
A risk that influences a single or a small
risk/ Asset-specific risk/
group of assets
Diversifiable risk
 2. Risk
Measures of Risk

Variance &
Standard deviation

Frequency Distribution of Returns on Large-Company Stocks: 1926–2007

 2. Risk
Measures of Risk

Variance &
Standard deviation

Historical Returns, Standard Deviations, and Frequency Distributions: 1926–2007

 2. Risk
Measure risk from historical returns

The total risk of an investment is measured by the variance or, more

commonly, the standard deviation of its return.
Variance &
Standard deviation Variance: The average squared difference between the actual return and
the average return.

𝐓
𝟏
𝟐
𝝈 = ഥ
× ෍ 𝐑𝐭 − 𝐑 𝟐
𝐓−𝟏
𝐭=𝟏

In which:
𝛔𝟐 : Variance of an asset
𝐑 𝒕 : The rate of returns in the i(th) period
ഥ : The average returns
𝐑
𝐓: Time
 2. Risk
Measure risk from historical returns

Standard deviation: The positive square root of the variance

Variance & 𝐓
Standard deviation 𝟏
𝛔= 𝝈𝟐 = ഥ
× ෍ 𝐑𝐢 − 𝐑 𝟐
𝐓−𝟏
𝐢=𝟏

In which:
𝛔: Variance of an asset
𝐑 𝒕 : The rate of returns in the i(th) period
ഥ : The average returns
𝐑
𝐓: Time
 2. Risk
Measure risk from historical returns

Example: Calculate the variance and standard deviation of stock A which has following historical
returns:

Year Actual rate of return

2000 - 20 %

2001 50 %

2002 30 %

2003 10 %
 2. Risk Interprete Actual return,
Average return, Variance
Measure risk from historical returns and Standard deviation?

Example: Calculate the variance and standard deviation of stock A :

Year Actual Return Average Return Deviation Squared Deviation

(1) (2) (3) (4) = (2) - (3) (5) = (4) * (4)

2000 -20% 18% -38% 0.140625

2001 50% 18% 33% 0.105625
2002 30% 18% 13% 0.015625
2003 10% 18% -8% 0.005625
Total 70% 0% 0.2675
Variance = 0.2675 / (4 -1) 0.0892
Standard deviation 0.2986
 2. Risk
Measure risk from projected future returns

Variance: The average squared difference between the actual return and
the expected return.
Variance &
Standard deviation 𝐧

𝝈𝟐 = ෍{𝒑𝐢 × 𝑹𝒊 − 𝑬 𝐑 𝐢 𝟐}

𝐢=𝟏

In which:
𝐩𝐢 : Probability of the i(th) situation
𝐑 𝐢 : The rate of returns in the i(th) situation
𝐄(𝐑 𝐢 ): The expected returns in the i(th) situation
𝐧: The number of situations
 2. Risk
Measure risk from projected future returns

Standard deviation: The positive square root of the variance

Variance & 𝐧
Standard deviation
𝛔= 𝝈𝟐 = ෍{𝒑𝐢 × 𝑹𝒊 − 𝑬 𝐑 𝐢 𝟐}

𝐢=𝟏

In which:
𝐩𝐢 : Probability of the i(th) situation
𝐑 𝐢 : The rate of returns in the i(th) situation
𝐄(𝐑 𝐢 ): The expected returns in the i(th) situation
𝐧: The number of situations
 2. Risk
Measure risk from projected future returns

Example 1: Risk of an individual asset

We have two stocks, L and U. There are two states of the economy: a boom and a recession

States of the Probability of Stock L Stock X

economy State of Economy Rate of Return if Rate of Return if
State Occurs State Occurs

Recession 0.2 - 20 % 10 %

Boom 0.8 70 % 30 %

Which asset is risker? Stock L or Stock U?

 2. Risk Should I buy stock L
or stock U?
Measure risk from projected future returns

Example 1: Risk of an individual asset We have two stocks, L and U.

Probability Rate of Squared

States of the Expected Deviation from
of State of Return if the Deviation from Product
economy Return Expected Return
Economy state occurs Expected Return
(1) (2) (3) (4) (5) = (3) - (4) (6) = (5) * (5) (6) = (2) * (5)
Stock L
Recession 0.2 -0.2 -0.72 0.5184 0.10368
0.52
Boom 0.8 0.7 0.18 0.0324 0.02592
Variance σ^2(L) = 0.1296
Standard deviation σ (L)= 36%
Stock X
Recession 0.2 0.10 - 0.16 0.0256 0.00512
0.26
Boom 0.8 0.30 0.04 0.0016 0.00128
Variance σ^2(U) = 0.0064
Standard deviation σ (U)= 8%
2. Risk
Measure risk from projected future returns

The greater the potential

reward from a risky investment,
the greater is the risk!
2. Risk
Measure risk from projected future returns

Example 2: Risk of a portfolio

We have an equally weighted portfolio including two stocks, L and U. There are two states of the
economy: a boom and a recession

States of the Probability of Stock L Stock X

economy State of Economy Rate of Return if Rate of Return if
State Occurs State Occurs

Recession 0.2 - 20 % 10 %

Boom 0.8 70 % 30 %

Calculate the variance and standard deviation of the portfolio

2. Risk
Measure risk from projected future returns

Example 2: Risk of a portfolio

Rate of Return if State Occurs Sum of

Squared
Probability of Expected
States of the Deviation
State of Returns of the Product
economy from
Economy Stock L Stock X Portfolio portfolio
Expected
Return

Recession 0.2 -20% 10% -5% 0.19 0.04

39%
Boom 0.8 70% 30% 50% 0.01 0.01
Variance σ^2 = 0. 05
Standard deviation σ= 22%
2. Risk
Other measures of portfolio risk

Variance
Measures of risk Individual asset
Standard Deviation

Variance

Standard Deviation (2 approaches to calculate)

Portfolio
Covariance

Correlation coefficient
 2. Risk
Other measures of portfolio risk

Covariance is a statistical measure of the directional relationship between two asset prices
𝐧

𝐂𝐨𝐯 𝐑 𝐀 , 𝐑 𝐁 = ෍{𝐩𝐢 × 𝐑 𝐀,𝐢 − 𝐄 𝐑 𝐀 × 𝐑 𝐁,𝐢 − 𝐄 𝐑 𝐁 }

𝐢=𝟏

In which: Interpretation: Covariance is a statistical tool

𝐩𝐢 : Probability of the i(th) situation investors use to measure the relationship
𝐑 𝐢 : The rate of returns in the i(th) situation between the movement of two asset prices
𝐑 𝑨 , 𝐑 𝑩 : The rate of returns of asset A, The rate of 𝑪𝒐𝒗 > 𝟎: Asset prices are moving in the same
returns of asset B general direction.
𝐄(𝐑 𝐢 ): The expected returns in the i(th) situation 𝑪𝒐𝒗 < 𝟎: Asset prices are moving in opposite
𝐧: The number of situations directions.
 2. Risk
Other measures of portfolio risk

Correlation coefficient is a statistic that measures the degree to which two securities move in
relation to each other
𝐂𝐨𝒗 𝐑 𝐀 , 𝐑 𝐁
𝐂𝐨𝐫𝐫 𝐑 𝐀 , 𝐑 𝐁 = 𝛒 𝐑 𝐀 , 𝐑 𝐁 =
𝝈(𝑹𝑨 ) × 𝝈(𝑹𝑩 )

In which: Interpretation: Correlation coefficients are used to

𝐑 𝑨 , 𝐑 𝑩 : The rate of returns of asset measure the strength of the relationship between two
A, The rate of returns of asset B variables.
𝑪𝒐𝒗(𝐑 𝑨 , 𝐑 𝑩 ): The covariance 𝛒 𝐑 𝐀 , 𝐑 𝐁 > 𝟎: Two assets move in the same direction,
between asset A and asset B with a +1.0 correlation when they move in tandem
𝝈(𝐑 𝑨 ): The standard deviation of 𝛒 𝐑 𝐀 , 𝐑 𝐁 < 𝟎: Two assets move in opposite directions
asset A 𝛒 𝐑 𝐀 , 𝐑 𝐁 = 𝟎: No correlation at all. Values close to zero
imply a weak or no linear relationship.
2. Risk
Other measures of portfolio risk

Portfolio variance
𝐧 𝒏 𝒏

𝝈𝑷 𝟐 = ෍ 𝒑𝐢 × 𝑹𝒊 − 𝑬 𝐑 𝐢 𝟐
= ෍ ෍ 𝒘𝑨 𝒘𝑩 𝒄𝒐𝒗𝑨,𝑩
𝐢=𝟏 𝒊=𝟏 𝒊=𝟏

In which:
𝐩𝐢 : Probability of the i(th) situation
𝐑 𝐢 : The portfolio returns in the i(th) situation
𝐄(𝐑 𝐢 ): The portfolio expected returns in the i(th) situation
𝐧: The number of portfolio
𝒘𝑨 , 𝒘𝑩 : The weight of asset A in the portfolio, The weight of asset B in the portfolio
𝒄𝒐𝒗𝐴,𝐵 : The covariance between asset A and asset B
2. Risk
Measure risk from projected future returns

Example : Risk of a portfolio

We have an equally weighted portfolio including two stocks, L and U. There are two states of the
economy: a boom and a recession
States of the Probability of Stock L Stock X
economy State of Economy Rate of Return if Rate of Return if
State Occurs State Occurs

Recession 0.2 - 20 % 10 %

Boom 0.8 70 % 30 %

Calculate:
a. The covariance between stock L and stock X
b. The correlation coefficient between stock L and stock X
c. The variance of the portfolio with 2 approaches
 2. Risk
Measure risk from projected future returns

Example : Risk of a portfolio

a. The covariance between stock L and stock X

States of the Probability of Rate of Return if Expected Deviation from Expected

economy State of Economy the state occurs Return Return
(1) (2) (3) (4) (5) = (3) - (4)
Stock L
Recession 0.2 -0.2 -0.72
0.52
Boom 0.8 0.7 0.18
Stock X
Recession 0.2 0.10 - 0.16
0.26
Boom 0.8 0.30 0.04
𝟐

𝐂𝐨𝐯 𝐑 𝑳 , 𝐑 𝑿 = ෍ 𝐩𝐢 × 𝐑 𝐋,𝐢 − 𝐄 𝐑 𝑳 × 𝐑 𝐗,𝐢 − 𝐄 𝐑 𝑿 = 𝟎. 𝟐 × −𝟎. 𝟕𝟐 × −𝟎. 𝟏𝟔 + 𝟎. 𝟖 × 𝟎. 𝟏𝟖 × 𝟎. 𝟎𝟒 = 𝟎. 𝟎𝟐𝟖𝟖

𝐢=𝟏
2. Risk
Measure risk from projected future returns
𝐂𝐨𝒗 𝐑 𝑳 , 𝐑 𝑿 𝟎. 𝟎𝟐𝟖𝟖
𝛒 𝐑𝑳, 𝐑𝑿 = = = 𝟏. 𝟎
𝝈(𝑹𝑳 ) × 𝝈(𝑹𝑿 ) 𝟎. 𝟑𝟔 × 𝟎. 𝟎𝟖
Example : Risk of a portfolio
b. The correlation coefficient between stock L and stock X
Probability Rate of Squared Deviation
States of the Expected Deviation from
of State of Return if the from Expected Product
economy Return Expected Return
Economy state occurs Return
(1) (2) (3) (4) (5) = (3) - (4) (6) = (5) * (5) (6) = (2) * (5)
Stock L
Recession 0.2 -0.2 -0.72 0.5184 0.10368
0.52
Boom 0.8 0.7 0.18 0.0324 0.02592
Variance σ^2(L) = 0.1296
Standard deviation σ (L)= 0.36
Stock X
Recession 0.2 0.10 -0.16 0.0256 0.00512
0.26
Boom 0.8 0.30 0.04 0.0016 0.00128
Variance σ^2(X) = 0.0064
Standard deviation σ (X)= 0.08
2. Risk
Measure risk from projected future returns

Example : Risk of a portfolio

c. The variance between stock L and stock X (Approach 1)
Sum of
Rate of Return if State Occurs
Squared
Probability of Expected
States of the Deviation
State of Returns of the Product
economy from
Economy Stock L Stock X Portfolio portfolio
Expected
Return
Recession 0.2 -20% 10% -5% 0.19 0.04
39%
Boom 0.8 70% 30% 50% 0.01 0.01
Variance σ^2 = 0. 05
Standard deviation σ= 22%
𝐧

𝝈𝑷 𝟐 = ෍ 𝒑 𝐢 × 𝑹 𝒊 − 𝑬 𝐑 𝐢 𝟐
= 𝟎. 𝟐 × (−𝟎. 𝟎𝟓 − 𝟎. 𝟑𝟗)𝟐 +𝟎. 𝟖 × (𝟎. 𝟓 − 𝟎. 𝟑𝟗)𝟐 = 𝟎. 𝟎𝟓
𝐢=𝟏
 2. Risk
Measure risk from projected future returns

Example : Risk of a portfolio

c. The variance between stock L and stock X (Approach 2)
Probability Rate of Squared Deviation
States of the Expected Deviation from
of State of Return if the from Expected Product
economy Return Expected Return
Economy state occurs Return
(1) (2) (3) (4) (5) = (3) - (4) (6) = (5) * (5) (6) = (2) * (5)
Stock L
Recession 0.2 -0.2 -0.72 0.5184 0.10368
0.52
Boom 0.8 0.7 0.18 0.0324 0.02592
Variance σ^2(L) = 0.1296
Standard deviation σ (L)= 0.36
Stock X
Recession 0.2 0.10 -0.16 0.0256 0.00512
0.26
Boom 0.8 0.30 0.04 0.0016 0.00128
Variance σ^2(X) = 0.0064
Standard deviation σ (X)= 0.08
𝟐 𝟐

𝝈𝑷 𝟐 = ෍ ෍ 𝒘𝑳 𝒘𝑿 𝒄𝒐𝒗𝑳,𝑿 = 𝒘𝑳 𝟐 𝝈𝑳 𝟐 + 𝒘𝑿 𝟐 𝝈𝑿 𝟐 + 𝟐𝒘𝑳 𝒘𝑿 𝒄𝒐𝒗𝑳,𝑿 = 𝟎. 𝟓𝟐 × 𝟎. 𝟑𝟔 + 𝟎. 𝟓𝟐 × 𝟎. 𝟖 + 𝟐 × 𝟎. 𝟓 × 𝟎. 𝟓 × 𝟎. 𝟎𝟐𝟖𝟖 = 𝟎. 𝟎𝟓

𝒊=𝟏 𝒊=𝟏
Summary
• Two components of a security’s returns
• Average returns (Geometric average return,
1. Expected returns Arithmetic average return)
• Expected returns, Portfolio expected returns

• Systematic risk/ Unsystematic risk

• Two data sources to measure risks: Historical
returns & Projected future returns
Risk and • 2 measures for risks of an individual security:
2. Risk
Return Variance & Standard Deviation
• 4 measures for risks of a porfolio: Variance,
Standard Deviation, Covariance & Correlation
coefficient

• Principle of diversification
• Systematic risk principle
3. Diversification and
Portfolio risk • Beta coefficient (β)
• Risk premium
• SML