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Chapter - 4

Risk and Return: An


Overview of Capital
Market Theory
Chapter Objectives
 Discuss the concepts of average and expected rates
of return.
 Define and measure risk for individual assets.
 Show the steps in the calculation of standard
deviation and variance of returns.
 Explain the concept of normal distribution and the
importance of standard deviation.
 Compute historical average return of securities and
market premium.
 Determine the relationship between risk and return.
 Highlight the difference between relevant and
irrelevant risks.

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Return on a Single Asset
 Total return
Rate of return = Dividend yield + Capital gain yield
= Dividend DIV1 P1 − P0 DIV1 + ( P1 − P0 )
+ Capital R1 =
P0
+
P0
=
P0
gain

160.00 149.70

Total Return (%)


140.00
120.00
100.00 92.33
70.54

 Year-to-
80.00
60.00 49.52 52.64
36.13
40.00 22.71
16.52 12.95
20.00 7.29

Year Total
0.00
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

Year

Returns on
HLL Share

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Average Rate of Return
 The average rate of return is the sum of the
various one-period rates of return divided by
the number of period.
 Formula for the average rate of return is as
follows:
n
1 1
R = [ R1 + R 2 + L + R n ] =
n n
∑R t
t =1

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Risk of Rates of Return: Variance
and Standard Deviation
 Formulae for calculating variance and
standard deviation:
Standard deviation = Variance

( )
n 2
1
σ2 = ∑
n − 1 t =1
Rt − R

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Investment Worth of Different
Portfolios, 1969–70 to 1997–98
Index
100

Stock Market Return


Call Money Market 57.16

Long-termGovt. Bonds
Inflation
91-day TB 13.99
10.36
10 10.20

4.41

1
Year
1972-73

1974-75

1976-77

1978-79

1980-81

1982-83

1990-91

1992-93
1993-94

1995-96

1997-98
1969-70

1971-72

1973-74

1975-76

1977-78

1979-80

1981-82

1983-84
1984-85
1985-86
1986-87
1987-88
1988-89
1989-90

1991-92

1994-95

1996-97
1970-71

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Averages and Standard Deviations,
1970–71 to 1997–98
Arithmetic Standard Risk Risk
Securities mean deviation premium* premium#

Ordinary shares (RBI Index) 17.50 22.34 12.04 8.76


Call money market 9.93 3.49 4.47 1.19
Long -term government bonds 8.74 2.59 3.28
91-Day treasury bills 5.46 2.05
Inflation 8.80 5.82

Relative to 91-Days T-bills. # Relative to long-term government bonds.

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Expected Return : Incorporating
Probabilities in Estimates
 The expected
RETURNS UNDER VARIOUS ECONOMIC CONDITIONS

rate of return Economic Conditions


(1)
Share Price
(2)
Dividend
(3)
Dividend Yield
(4)
Capital Gain
(5)
Return
(6) = (4) + (5)

[E (R)] is the
High growth 305.50 4.00 0.015 0.169 0.185
Expansion 285.50 3.25 0.012 0.093 0.105
Stagnation 261.25 2.50 0.010 0.000 0.010

sum of the
Decline 243.50 2.00 0.008 – 0.068 – 0.060

product of
each outcome
(return) and its RETURNS ANDPROBABILITIES

associated
Economic Conditions Rate of Return (%) Probability Expected Rate of Return (%)
(1) (2) (3) (4) = (2) × (3)
Growth 18.5 0.25 4.63

probability: Expansion
Stagnation
Decline
10.5
1.0
– 6.0
0.25
0.25
0.25
2.62
0.25
– 1.50
1.00 6.00

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Expected Risk and Preference
 The following formula can be used to
calculate the variance of returns:
σ 2 =  R1 − E ( R 2 )  P1 +  R2 − E ( R 2 )  P2 + ... +  Rn − E ( R 2 )  Pn
n
= ∑  Ri − E ( R 2 ) Pi
i =1

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Expected Risk and Preference
 A risk-averse investor will choose among
investments with the equal rates of return, the
investment with lowest standard deviation.
Similarly, if investments have equal risk
(standard deviations), the investor would prefer
the one with higher return.
 A risk-neutral investor does not consider risk,
and would always prefer investments with higher
returns.
 A risk-seeking investor likes investments with
higher risk irrespective of the rates of return. In
reality, most (if not all) investors are risk-averse.
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Normal Distribution
 Normal distribution is an important concept in
statistics and finance. In explaining the risk-
return relationship, we assume that returns
are normally distributed.
 Normal distribution is a population-based,
theoretical distribution.

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