CHAPTER 2 RISK AND RETURN

TOPIC 2 RISK AND
RETURN

https://www.investopedia.com/terms/r/risk.asp
Prepared by Aleza Rashid

RISK AND RETURN

Relationship Between Risk and Return
-One must be willing to accept greater risk if one wants
to pursue greater returns (trade-off)
-Risk is an opportunity for profit and loss.
-It should be emphasized as an effort to achieve the
objectives of the firm of enriching shareholder’s wealth.

Risk

- is a potential of losing something in value.
- risk is define as the probability of a result being

different from what is expected.
- the wider the range of possible events that

can occur, the greater the risk. Its uncertainty on
the expected return that we are going to
receive from our investment or from some of
our assets.

Eg. Having an investment in capital market is much
riskier compared to have a saving in bank.

Return

Total profit or loss that we received
from investment after certain period.

There are two types of return.

Two types of return:

1. Required rate of return:

- The minimum rate of return necessary to
attract an investor to purchase or hold a
security. It is also a discount rate that equates
the present value of the cash flows with the
value of the security.

- The investor has to consider on opportunity
cost while doing the investment which means
they will miss out the next best investment.

- Eg. Investment in Government Treasury Bills
has promised an annual return of 7%. If we
hold this bill, we are promised no more and no
less than 7%. Therefore, there is no risk of lost
because it is guaranteed by the government.

Two types of return:

2. Expected rate of return

The rate of return expected on an asset or
a portfolio.
- The expected rate of return on a single

asset is equal to the sum of each
possible rate of return multiplied by the
respective probability of earning on
each return.
- Cash flows should be used to measure
the return.

EXPECTED RATE OF RETURN

n

Ŕ = ∑ [Pi(Ri) X (Ri)]

i=1

or

Ŕ = P1(R1) + P2(R2) + ………….. + Pn(Rn)

where:

Ŕ = expected rate of return
Ri= the ith possible rate of return
P = the probability of the ith possible rate of returns

EXAMPLE:-

Jali is considering an investment of RM100,000. Projection of the return in

three conditions are as below;

% of

Economy Probability return Outcome

Conditions (P) (R) P*R

Recession 0.2 12% = 2.4%

Moderate 0.5 14% = 7%

Strong 0.3 16% = 4.8%

Total 14.2%

Calculate the expected rate of return.
n

Ŕ = ∑ [Pi(Ri) X (Ri)]
i=1

= (0.2)(12%) + (0.5)(14%) + (0.3)(16%)

= 14.2%

Calculating the Standard Deviation (RISK)
- To measure the investment’s volatility
- Risk is the potential for future cash flow with various

possible circumstances.

σ=

σ = Standard deviation
Ri = possible rate of return
P(Ri) = Probability of Ri
Ř = Expected rate of return.

EXAMPLE:-
Jali is considering an investment of RM100,000.
Projection of the return is as below;

State of the Probability Percentage Given Ř = 14.2%
economy 0.2 of return
Recession 0.5
Moderate 0.3 12%
Strong 14%
16%

Calculation for standard deviation:-

Ri - Ř (Ri - Ř)²* PiRi Total
12% - 14.2%= -2.2% (-2.2)²*0.2 0.968
14%-14.2% = -0.2% (-0.2)²*0.5 0.02
16%-14.2% = 1.8% (1.8)²*0.3 0.972
1.96
Varians √1.96

Standard Deviation 1.4 %

COEFFICIENT VARIATION (CO- VARIANCE)

-Coefficient Variation will use if there are two mutually
exclusive projects which one of the project given a high
return but also have a high risk (high standard deviation).

CV = σ
Ř

CV = Co-variance
σ = Standard Deviation
Ř = Expected return

COEFFICIENT VARIATION (CO- VARIANCE)

-Co-variants will show risk amount per ringgit based on
expected return.
-Lower CV is better for an asset.
-The higher the CV, the higher the risk of an asset.

Example :-

Given
Ř = 14.2%,
σ = 1.4%.

CV = σ / Ř
=1.4/14.2
= 0.099

Types of RISK and the relationship
between RISK and RETURN

1)Business Risk:
These types of risks are taken by business enterprises themselves in order to
maximize shareholder value and profits.As for example, Companies undertake high-
cost risks in marketing to launch a new product in order to gain higher sales.
2)Investment Risk
Most investments don’t have a guaranteed rate of return.This is because when you
are investing, you are taking on a certain level of risk. Each type of investment will
have different types of risk.
Generally, the more risk you take, the more the potential reward will be.
Alternatively, the lower the level of risk you take, the less the potential reward will
be.This can be referenced in the stock market with potential returns and in the
bond market with interest rates.You’ll also need to consider that an entirely risky
portfolio will take large dips with the stock market, which means potential losses.
Also, if you choose to take very little risk, you could miss out on potential gains.
Investment risk is the uncertainty of if an investment’s realized or actual rate of
return will equal its expected rate of return.The uncertainty is due to the many
types of risk discussed below.

Types of RISK and the relationship
between RISK and RETURN

3) Portfolio Risk
Portfolio risk is a chance that the combination of assets or units, within the
investments that you own, fail to meet financial objectives. Each investment within
a portfolio carries its own risk, with higher potential return typically meaning
higher risk.
Portfolio risk is just one of the risks that traders should be wary of. Most risks
apply to individual investments, but it is also important to ensure that your
portfolio as a whole doesn’t end up working against you.

4) Financial Risk: Financial Risk as the term suggests is the risk that involves
financial loss to firms. Financial risk generally arises due to instability and losses in
the financial market caused by movements in stock prices, currencies, interest
rates and more.

5) Political/Regulatory Risk:
The impact of political decisions and changes in
This type of risk can stem from a change in government, legislative bodies, other
foreign policy makers, or military control.Also known as geopolitical risk, the risk
becomes more of a factor as an investment’s time horizon gets longer.

EXERCISE