Risk and Return
Financial Economics
Minor in Economics
Concepts of Risks and Returns
• Most important concepts of
Finance
• All financial decisions of a
firm are based on the
considerations of risks and
returns from the
investments done.
RETURN ON A SINGLE ASSET
• Let the Par value of a share of a company = Rs
10.
• You purchased 100 shares at a price of Rs. 225
per share.
• So your total investment on the share is:
• 225 x 100 = Rs 22500
Dividend returns
• Say the company pays you a dividend of 25% for
the year.
• Note: the dividend is always given on the par value
• So your dividend per share = 25% x 10 = Rs.2.50
• Total dividend to be received for the year =
• (Dividend x par value) x number of shares
• = 2.50 x 100 = Rs 250
Capital Gain or Losses on the
investment
• If the price of the share at the end of the year
increases to Rs 267.50, what is your capital gain
or loss?
• Capital gain/loss = (Selling price – Buying price)
• × Number of shares
Since the price has increased : you have made a
capital gain.
• Calculate >>> ??? How much it is ?
The capital gain is:
• Capital gain/loss = (267.50 – 225) × 100 = 4,250
What is your total return on your
investment?
•
• Total Return = Dividend income + capital Gain
• How much is it calculate ?
Total return =
• Rs. 250 + Rs. 4250 = Rs 4500
How much will you receive if you sold these 100
shares at the end of the year?
• The total receipts on selling these shares will be:
• Dividend income + the sell proceeds
• Calculate Now?
Total receipts on these shares =
Rs 250 + (267.50 x100) = Rs.27,000
You can mark, this is the summation
between your earlier investment and
the total return.
= 27000 – 22500 = 4500
What is the percentage return on your investment on
these shares?
• 1. Percentage return = total return / total initial
investment
• = 4500 / 22500 = 0.20 = 20%
2. Rate of return calculated on per share basis:
Rate of return(R1) = Dividend yield + capital gain
yield
• = [ Div1/P0] + [(P1-P0) /P0]
• Div1: Dividend received per share in year 1
• P0 : is the price of the share at the beginning of the
year
• P1 : Price of the share at the end of the year
• Calculate your % share Now? >>>
Percentage share .>>>
• = [ 2.50 / 225] + [(267.50 – 225)/ 225 ]
• = 0.011 + 0.189 = 0.20 = 20%
Now calculate your return on this same investment of share
assuming the price per share is Rs 200.
• Now you return has increased of decreased?
• What do you observe about the risk and return?
The return is now >>>
• R1 = [2.50 / 225 ] + [ (200 -225) /225 ] =
• 0.011 + (-0.111) = -0.10 = -10%
• Observation: You have a loss on your investment
because of the negative capital gain or capital
loss.
Risk involved >>
• The risk to the investment was due to the
volatility of the secondary market of the
fluctuating share prices.
• The dividend income is secured while the
volatility in the share prices determines the
capital gains / losses on the invested capital.
Unrealized capital gain or loss
• If the investor does not sell the
shares at the end of the period of
one year, his unrealised capital
gain/loss is the difference between
the beginning and ending share
prices , as part of his total returns.
Average Rate of Return
• The average rate of return of an
investment is the sum of the various one-
period rates of return divided by the number
of periods.
• Given the yearly returns of a company, we
can calculate the average or mean return
from investing in that company.
• Q. Given the data of the Yearly returns of
HUL , calculate the ARR on investment on its
share over the 10 years period from
Rates of Return and Holding Periods
• Investors may hold their investment in shares for
longer periods than for one year.
• How do we calculate holding period returns?
Suppose you invest `1 today in a company’s share
for five years.
• The rates of return are 18 per cent, 9 per cent, 0
per cent, –10 per cent and 14 per cent.
What is the worth of your holding
Period return?
• The worth of your investment after 5 years
(assuming your each year dividends were
reinvested in shares) =
= (1 + 0.18) × (1 + 0.09) × (1 + 0.0) × (1 – 0.10) × (1
+ 0.14)
= 1.18 × 1.09 × 1.00 × 0.90 × 1.14 = `1.32
So you have a return of 32% on your
investment.
What is the Annual Compound rate of
return?
• It is given by the geometric mean return
• [5√1. 18x 1.09 x1.00 x0 .90 x1. 14 ] -1
• = 1.057 – 1 = 0.057 or 5.7%
• This implies that Re 1 invested today at 5.7%
compound rate would grow to >>>
(1.057)5 = Rs. 1.32 after 5 years.
RISK OF RATES OF RETURN: VARIANCE AND STANDARD DEVIATION
• The rate of return of HUL as we saw shows wide
fluctuations .
• This is both due to variations in the given
dividend as well as the share prices volatility.
• This variability is viewed as the RISK TO RETURN
Year Returns
2009 -
2010 10.81
2011 -16.28
2012 15.65
2013 -27.45
2014 40.94
2015 12.83
2016 2.93
2017 14.54
2018 3.24
2019 21.95
2020 46.66
Risk to Return Measurement
• This variability is measured in terms of the
deviation of the returns from the Average rate of
return.
• It is measured in terms of
• 1. Variance and
• 2. Standard Deviation
Calculation of Variance:
1. Calculate the average rate of return(ARR) or R1
n
n
ARR = [ R1 +R2+...+ Rn] / n = ∑ Rt /n
t=1
• 2. Calculate the square deviation of the individual
returns from the R1, that is , ( Rt – ARR)2
• Where Rt are the periodic returns (t= 1....n)
Calculation of Variance(contd.)
• Step 3: The variance is calculated as the square of
the deviations from R1 divided by the number of
years (n) for a population and by (n-1) for a sample,
• Variance (σ2) = [ ∑( Rt – R1)2 ] / (n-1)
Calculation of Standard Deviation(σ)
• Standard deviation is the square root of the
variance.
• i.e., σ = √Variance = √ σ2 = σ
• This Std dev measures the volatility of the
returns and is a measure of the total risk.
Let us now calculate the Variance
and Std Deviation of the HUL’s rate
of return.
• How much is Variance?
• How much is the Std Deviation?
Results:
• Variance = 467.16
• Std Deviation = 21.61%
• Conclusion: The rate of return of HUL is
showing wide fluctuations and thus it cannot
be used as a prediction of the future returns
with certainty.
THANK YOU
•THANK YOU
