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Risk and Return: An Overview of Capital Market Theory

This document discusses key concepts in capital market theory and risk/return analysis, including: - Calculating average and expected rates of return on individual assets and portfolios - Defining and measuring risk using concepts like variance and standard deviation - Explaining how risk-averse, risk-neutral, and risk-seeking investors evaluate the relationship between risk and return when making investment decisions - Distinguishing between relevant risks that can be reduced through diversification versus irrelevant risks that cannot be eliminated by holding a diversified portfolio

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47 views11 pages

Risk and Return: An Overview of Capital Market Theory

This document discusses key concepts in capital market theory and risk/return analysis, including: - Calculating average and expected rates of return on individual assets and portfolios - Defining and measuring risk using concepts like variance and standard deviation - Explaining how risk-averse, risk-neutral, and risk-seeking investors evaluate the relationship between risk and return when making investment decisions - Distinguishing between relevant risks that can be reduced through diversification versus irrelevant risks that cannot be eliminated by holding a diversified portfolio

Uploaded by

tarunsoni88
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPT, PDF, TXT or read online on Scribd
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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.
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

T o ta l R e tu r n (% ) 140.00

 Year-to-
120.00
100.00 92.33

80.00 70.54

Year Total 60.00 49.52 52.64


36.13
40.00 22.71
16.52 12.95

Returns on
20.00 7.29
0.00
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

HLL Share Year


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    R n ] 
n n
R t
t =1
Risk of Rates of Return: Variance
and Standard Deviation
 Formulae for calculating variance and
standard deviation:
Standard deviation = Variance
1 n
 
2
 
2

n  1 t 1
Rt  R
10
10 0

1
1969-70

Index
1970-71
1971-72
1972-73
1973-74
1974-75
1975-76
1976-77
Inflation
1977-78 91-day TB
1978-79
1979-80
Call Money Market

1980-81
Stock Market Return

1981-82
Long-term Govt. Bonds

1982-83
1983-84
1984-85
1985-86
1986-87
1987-88
1988-89
1989-90
1990-91
1991-92
1992-93
1993-94
1994-95
Investment Worth of Different

1995-96
Portfolios, 1969–70 to 1997–98

1996-97
1997-98
Year
4.41
10.20
10.36
13.99
57.16
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.


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 Capital Gain
(4) (5)
Return
(6) = (4) + (5)

[E (R)] is the High growth


Expansion
Stagnation
305.50
285.50
261.25
4.00
3.25
2.50
0.015
0.012
0.010
0.169
0.093
0.000
0.185
0.105
0.010

sum of the
Decline 243.50 2.00 0.008 – 0.068 – 0.060

product of
each outcome
(return) and its RETURNS AND PROBABILITIES

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
Expected Risk and Preference
 The following formula can be used to
calculate the variance of returns:
 2   R1  E  R 2   P1   R2  E  R 2   P2  ...   Rn  E  R 2   Pn
n
   Ri  E  R 2  Pi
i 1
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.
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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