Risk and Return

Financial Management

Risk and Return (Chapter 11 to 12)

Topics

1. Historical Performance
2. Expected returns
3. Risk
4. Risk and Return in a portfolio context
5. Diversification

1. Correlation Coefficient
2. Portfolio Theory

1. Market risk and Beta
2. Capital Asset Pricing Model & Security Market Line

I. Historical Performance: Rate of Return

Compare three different types of investment instruments in terms of their historical performance.  They are 3–month Treasury bill, long-term Treasury bonds and Common stocks of 500 large companies.

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Conclusion: In the long run, common stocks on average earn a higher return than Treasury bonds or Treasury bills. But at the same time, they are not equally risky.  The common stock is the riskiest of the three types of portfolios whereas the t-bill portfolio is a safe holding.  

Over a long study period, the average annual rate of return on treasury bills and common stocks are 4 percent and 11.4 percent respectively.

The historical record shows that investors have received a risk premium for holding risky assets.

Rate of Return     =     Interest Rate           +        Risk
on any security           on Treasury-bills                    Premium

II. Expected Rate of return

The weighted averages of all possible outcomes, where the weights are the probabilities that each outcome will occur.  It is the expected value or mean of probability distribution.

Exercise 1. An investment has the following possible returns and associated possibilities of individual outcomes.  What is the expected return?

III. Risk

What is Risk?

In finance, investment risk is defined as variability; the wider the range of possible outcomes, the greater the risk.

Variance is a statistical measure, showing how likely a return is to be some distance away from the expected return.   The higher the variance of return, the higher the risk.