Risks and Rates of Returns

➔ Stand-Alone Risk
➔ Portfolio Risk
➔ Risk and Return: CAPM / SML

Investment Returns
The rate of return on an investment can be calculated as follows:

Return = (Amount received – A m o un t invested)

A mo u nt invested

Example 1
If P1,000 is invested and P1,100 is returned after 1 year.
(1,100- 1,000)/ 1,000=10%.

A rate of return (RoR) is the net gain or loss of an investment over a specified time period,
expressed as a percentage of the investment's initial cost. When calculating the rate of
return, you are determining the percentage change from the beginning of the period until
the end.

What is Investment risk?

2 types of investment risk
1. Stand-alone risk
2. Portfolio risk

Investment risk is related to the probability of earning a low or negative actual return.

The greater the chance of lower than expected or negative returns, the riskier the
investment.

Probability distributions- A listing of all possible outcomes, and the probability of each
occurrence.
Expected Return

Investment Risks

Individual:

Standard Deviation (SD)= Square root of [Probability x (Expected Average return –

Expected individual return ) 2]

Coefficient of variation (CV)= Standard Deviation / Expected average return

Portfolio
Portfolio Standard Deviation=

WHERE:
W2A= = weighted invested in asset A
O2A= variance of asset A
OAB= the correlation coefficient between A and B
Capital Asset Pricing Model

The security market line (SML) is a line drawn on a chart that serves as a graphical
representation of the capital asset pricing model (CAPM)—which shows different levels of
systematic, or market risk, of various marketable securities, plotted against the expected
return of the entire market at any given time.

A beta coefficient measures how likely the price of a security or a stock will change to a
movement in the market price.
11.1
1. Expected Return on Stock X= (A x B) State A B C
+ (A x B).......... 13.39% Pro Return Retu
ba on rn on
bili Stock X Stock
ty Y
2. Variance of the returns on Stock X= 1 4% 46% -2% 0.04(0.46-.1339)
0.0236 (-.02-0.271)

3. SD of the returns on Stock X= 2 73 14% 31% 0.73 ( .14-.1339)

0.1537 or 15.37% % (.31-.271)

4. Expected Return on Stock Y= (A x C) 3 11 35% 1% .11 (.35 - .1339) (.01

+ (A X C)........... 27.1% % -.271)

5. Variance of the returns on Stock Y= 4 12 -21% 37% .12 (-.21-.1339)

0.0132 % (.37-.271)

6. SD of the returns on Stock Y= Sum= -0.0139

0.1147 or 11.47%

7. Covariance between the returns on

Stock X and Y= -0.0139
8. Correlation Coefficient between the returns on Stock X and Y= -0.789= Covariance/ SDx times
SD y= -0.0139 / (0.1537 x 0.1147)
11.2
40% ---> jollibee, expected return of 15% and SD of 15%

60%----> kfc, expected return of 9% and SD of 14%.

1. expected average return=11.4% = .4 (.15) + .6 (.09)
2. portfolio SD= sq of [(.4)2 x (.15)2 ] + [(.6)2 x (.14)2] + [2 (.4 ) (.6) (0.5) (.15) (.14)] = 12.53%
3. 67%
13%= (15 x J) + (9 x [1-J])
4. portfolio SD= sq of [(.67)2 x (.15)2 ] + [(.33)2 x (.14)2] + [2 (.67) (.33) (0.5) (.15 ) (.14)]= 13%

11.3
Stock Amout Invested Beta
GM 10,000 25% 1.0
IBM 10,000 25% 1.2
WMT 20,000 50% 0.7
40,000
1. expected market return= 9%, risk
free rate 3%. What is expected return
for each stock?
CAPM expected return= risk free rate
+ beta (market rate – risk free rate)
(GM)= 3%+ 1(9%-3%)= 9%
(IBM) = 3% + 1.2 (9%-3%)= 10.2%
(WMT)= 3% + 0.7 (9%-3%)= 7.2%
2. beta= 0.25 (1) + 0.25 (1.2) + 0.5 (0.7)= 0.9
3. return of portfolio= 3% + 0.9 (9%-3%)= 8.4%

11.4
State of Pro A B
economy ba
bili
ty
Poor .25 -5% -8%
Normal .5 8% 10%
Good .25 12% 22%
1. Expected return of A= (.25 x -0.05) + (.50 x 0.08) + (.25 x .12)= 5.75%
Expected return of B= (0.25 x -0.08) + (.50 x 0.10) + (.25 x .22)= 8.5%
2. SD of A= square of [(0.25 x (-5%-5.75%)2] + [( 0.5 x (8%-5.75)2 ]+ [(0.25 x (12%-5.75%)2] = 6.42%
SD of B= square of [(0.25 x (-8%-8.5%)2 ] + [( 0.5 x (10%-8.5)2 ]+ [(0.25 x (22%-8.5%)2] =10.62%
3. Riskier= Stock B
4. A = 5.75% -----------6.42%
B= 8.5% ------------------10.62%

11.5
You manage a risky portfolio with an expected rate of return of 17% and a SD of 27%. The Treasury
Bill rate is 7%.
1. 70%
30%= T bill
Expected rate of return = (0.7 x .17) + (0.3 x .07)= 14%
SD= 0.70 x .27= 18.9%
2. a . 15%= 7% + (17%-7%)y= 0.8 Portfolio, 20% Tbills
b. Portfolio : Stock A (27%), B (33%,
and C (40%)
Tbills 20%
Stock A 21.6%
Stock B 26.4%
Stock C 32%
100%
3.
a. 20%= y x 27%= 20%/27%= 74.07%
b. Expected return= 7% + (17%-7%)y= 14.41%

10.6
Items Share 1 Share 2
(1/3) (2/3)
Expected return (%) 12 18
SD 15 20
Correlation between the returns 0.5

a. expected return= (0.33 x 12%) + (.67 x 18%)= 16%

SD= portfolio SD= sq of [(.33)2 x (.15)2 ] + [(.67)2 x (.20)2] + [2 (.33) (.67) (0.50) (.15 ) (.20)]= 0.13437096
or 13.44%
b. SD= portfolio SD= sq of [(.33)2 x (.15)2 ] + [(.67)2 x (.20)2] + [2 (.33) (.67) (0) (.15 ) (.20)]= 10.67%
b. SD= portfolio SD= sq of [(.33)2 x (.15)2 ] + [(.67)2 x (.20)2] + [2 (.33) (.67) (1) (.15 ) (.20)]= 17.56%
c. depends on the correlation

10.7
Selling price of stock 16-----> 18
Dividend 0.60 per share
a. expected rate of return= (18.60 – 16 )/ 16= 16.25%
b. expected rate of return= (20.25– 16 )/ 16= 26.56%
c. expected rate of return= (13.1– 16 )/ 16= -18.13%

10.8
 Return Probabi
lity
5% .20
10% .50
20% .30
a. expected return= 12%
b. SD= sq root of 30= 5.48%
c. CV= 5.48%/ 12%= 45.67%

11.9 Investe Rate

d of
retur
n
1 5,000 7% X17% 0.011
9
2 10,000 9% X 33% 0.029
7
3 15,000 12% X 50% 0.06
a. 5/30= 17% 30,000 10.16
%
b. 10/30= 33%
c. 15/30= 50%
d. 10.16%

11.10
Stock A has a beta of 1.2 and Stock B has a beta of 0.8. RF= 2%, RP= 12%
a. Expected return A= 2% + 1.2 ( 12%)= 16.4%

Expected return B= 2% + 0.8( 12%)= 11.6%

b. 0.5 (16.4%) + 0.5 (11.6)= 14%

c. beta= 0.5 (1.2) + 0.5 (0.8)= 1.0