Finance
Pre-MBA
2010-2011
Dr Abdeldjelil Ferhat
BOUDAH
Business School
Management
Department
King Faisal University [
1]
1
CHAPTER 6
RISK AND RETURN
King Faisal University [
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Dr Abdeldjelil Ferhat BOUDAH
CHAPTER 6: RISK AND RETURN
Introduction
I- Risk and Return Fundamentals
II- Risk of a Single Asset
Conclusion
King Faisal University [
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Dr Abdeldjelil Ferhat BOUDAH
CHAPTER 6: RISK AND RETURN
Introduction
To achieve the goal of share price
maximization, the financial manager must
learn to assess the two key determinants of
share price, and all major financial decisions
must be viewed in terms of expected risk,
expected returns, and their combined impact
on share price.
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CHAPTER 6: RISK AND RETURN
Risk can be viewed as it relates either
to a single asset held in isolation or to
a portfolio- a collection or group of
assets. In this shortly chapter the
main concern is to concentrate on the
general concept of risk in terms of a
single asset.
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Dr Abdeldjelil Ferhat BOUDAH
CHAPTER 6: RISK AND RETURN
I- Risk and Return Fundamentals
RISK DEFINED
Risk can be defined as the chance of financial loss.
Assets having greater chances of loss are viewed as
more risky than those with lesser chances of loss.
More formally, the term risk is used interchangeably
with uncertainty to refer to the variability of returns
associated with a given asset.
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CHAPTER 6: RISK AND RETURN
For instance, a government bond that guarantees its
holder $100 interest after 30 days has no risk,
because there is no variability associated with the
return.
An equivalent investment in a firm’s common stock
that may earn over the same period anywhere from
$0 to $200 is very risky due to the high variability of
its return. The more certain the return from an asset,
the less variability and therefore the less risk.
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CHAPTER 6: RISK AND RETURN
RETURN DEFINED
The return on investment is measured as the total gain
or loss experienced on behalf of its owner over a given
period of time. It is usually stated as the change in
value plus any cash distribution during the period,
expressed as a percentage of the beginning-of-period
investment value.
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Dr Abdeldjelil Ferhat BOUDAH
CHAPTER 6: RISK AND RETURN
The expression for calculating the rate of return
earned on any asset over period t, kt is commonly
defined as :
King Faisal University [
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Dr Abdeldjelil Ferhat BOUDAH
CHAPTER 6: RISK AND RETURN
WHERE,
= actual, expected, or required rate of return
during period t
= price value of asset at time t
= price (value ) of asset at time t-1
= cash (flow) received from the asset
investment in the time period t-1 to t.
King Faisal University [
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CHAPTER 6: RISK AND RETURN
EXAMPLE
An investor wines to determine the actual rate of return on
two of its video machines, Conqueror and Demolition.
Conqueror was purchased exactly 1 year ago for $20,000
and currently has a market value of $ 21, 500. During the
year, it generated $800 of after-tax cash receipts.
Demolition was purchased 4 years ago, and its value at the
beginning and end of the year just completed declined from
$ 12000 to $ 11800. During the year, it generated $ 1700 of
after-tax cash receipts.
King Faisal University [
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Dr Abdeldjelil Ferhat BOUDAH
CHAPTER 6: RISK AND RETURN
Substituting into the above equation, then the annual
rate of return, k, for each video machine is calculated:
King Faisal University [
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Dr Abdeldjelil Ferhat BOUDAH
CHAPTER 6: RISK AND RETURN
Comment : Although the value of Demolition declined
during the year, its relatively high cash flow caused it
to earn a higher rate of return than that earned by
Conqueror during the same period. Clearly the
combined impact of changes in value and cash flow
measured by the rate of return is important.
King Faisal University [
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Dr Abdeldjelil Ferhat BOUDAH
CHAPTER 6: RISK AND RETURN
RISK PREFERENCES
Because of differing managerial preferences, it is
important to specify a generally acceptable level of
risk.
The three basic risk preference behaviours can be
explained as follows: risk-averse manager, riskseeking manager, and risk-indifferent manager.
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CHAPTER 6: RISK AND RETURN
RISK AVERSE MANAGER
Risk-averse can be defined as the attitude toward risk
in which an increased return would be required for an
increase in risk. Most manager are risk-averse,
because for a given increase in risk, they require an
increase in return. Although in theory the risk
disposition of each manager could be measured, in
practice managers tend to be conservative rather than
aggressive when accepting risk.
King Faisal University [
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CHAPTER 6: RISK AND RETURN
RISK SEEKING MANAGER
For the risk-seeking manager, the required return
decreases for an increase of risk. Theoretically,
because they enjoy risk, these managers are willing to
give up some return to take more risk.
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CHAPTER 6: RISK AND RETURN
RISK INDIFFERENT MANAGER
In case of the risk-different manager, the required
return does not change. In essence, no change in
return in return would be required for the increase in
risk.
See figure 6.1
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CHAPTER 6: RISK AND RETURN
II- Risk of a single asset
The concept of risk is mostly developed by first
considering a single asset held in isolation. Behavioral
approaches can be used to assess risk and statistics
can be used to measure risk.
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CHAPTER 6: RISK AND RETURN
RISK ASSESSMENT
Risk can be assessed from a behavioral point of view
using sensitivity analysis and probability distributions.
These approaches provide a feel for the level of
embodied in a given asset.
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CHAPTER 6: RISK AND RETURN
sensitivity analysis
Sensitivity analysis is a behavioral approach that uses a
number of possible return estimates to obtain a sense
of the variability among outcomes.
One common method involves the estimation of the
pessimistic (worst), the most likely (expected), and the
optimistic (best) returns associated with a given asset.
King Faisal University [
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Dr Abdeldjelil Ferhat BOUDAH
CHAPTER 6: RISK AND RETURN
In this case, the asset’s risk can be measured by the
range, which is found by subtracting the pessimistic
outcome from the optimistic. The greater the range
for a given asset, the more variability, or risk, it is
said to have.
King Faisal University [
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CHAPTER 6: RISK AND RETURN
EXAMPLE
Assets A and B
Initial
Investment
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Asset A
Asset B
$10000
$10000
Dr Abdeldjelil Ferhat BOUDAH
CHAPTER 6: RISK AND RETURN
EXAMPLE
Assets A and B
Pessimistic
Most likely
Optimistic
Range
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13%
15
17
4%
Dr Abdeldjelil Ferhat BOUDAH
7%
15
23
16%
CHAPTER 6: RISK AND RETURN
Probability Distributions
Probability means a chance for that a given outcome
which will occur. Yet, probability distribution provide a
more quantitative insight into an asset’s risk. If an
outcome has 80% probability of occurrence, the given
outcome would be expected to occur 8 out of 10 times.
If an outcome has a probability of 100%, it is then
certain to occur. Outcomes having a probability of zero
will never occur.
King Faisal University [
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Dr Abdeldjelil Ferhat BOUDAH
CHAPTER 6: RISK AND RETURN
EXAMPLE
An evaluation of Norman company’s past estimates
indicates the probabilities of the pessimistic, most
likely, and optimistic outcomes’ occurring are 25, 50 ,
and 25 percent, respectively. The sum of these
probabilities must equal 100 %; that is they must be
based on all the alternatives considered.
See figure 6.2 , and figure 6.3
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Dr Abdeldjelil Ferhat BOUDAH
CHAPTER 6: RISK AND RETURN
BAR CHART
The simplest type of probability distribution is the bar
chart, which shows only a limited number of outcomeprobability coordinates. See figure 6.2
CONTINUOUS PROBABILITY DISTRIBUTION
This type of distribution can be thought of as a bar chart for
a very large number of outcome. figure 6.3
King Faisal University [
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CHAPTER 6: RISK AND RETURN
RISK MEASUREMENT
The risk of an asset can be measured quantitatively by
using statistics. Here we consider two statistics- the
standard deviation and the coefficient of variation- that
can be used to measure the risk (that is variability) of
asset returns.
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CHAPTER 6: RISK AND RETURN
Standard Deviation
The most common statistical indicator of an asset’s
risk is the standard deviation
, which measures
the dispersion around the expected value. The
expected value of return , , is the most likely return
on an asset. This can be calculated by the following
equation:
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Dr Abdeldjelil Ferhat BOUDAH
CHAPTER 6: RISK AND RETURN
The expected value of a return
Where:
= The expected value of a return
= return for the
outcome
= probability of occurrence of the
outcome
= number of outcomes considered
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Dr Abdeldjelil Ferhat BOUDAH
CHAPTER 6: RISK AND RETURN
Standard Deviation ( the equation)
Where:
= The expected value of a return
= return for the
outcome
= probability of occurrence of the
outcome
= number of outcomes considered
King Faisal University [
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Dr Abdeldjelil Ferhat BOUDAH
CHAPTER 6: RISK AND RETURN
EXAMPLE
Expected value of return -asset APossible
outcomes
Probability
(1)
Returns %
(2)
Weighted value
%
[(1)×(2)=(3)]
Pessimistic
0.25
13
3.25
Most likely
0.50
15
7.50
Optimistic
0.25
17
4.25
Total
1.00
Expected return
15.00
King Faisal University [
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Dr Abdeldjelil Ferhat BOUDAH
CHAPTER 6: RISK AND RETURN
EXAMPLE
Expected value of return -asset BPossible
outcomes
Probability
(1)
Returns %
(2)
Weighted value
%
[(1)×(2)=(3)]
Pessimistic
0.25
7
1.75
Most likely
0.50
15
7.50
Optimistic
0.25
23
5.75
Total
1.00
Expected return
15.00
King Faisal University [
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Dr Abdeldjelil Ferhat BOUDAH
CHAPTER 6: RISK AND RETURN
EXAMPLE (Calculation of standard deviation)
The calculation of the standard deviation -asset Ai
1
13%
15%
-2%
4%
0.25
1%
2
15
15
0
0
0.50
0
3
17
15
2
4
0.25
1
=
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Dr Abdeldjelil Ferhat BOUDAH
2%
CHAPTER 6: RISK AND RETURN
EXAMPLE (Calculation of standard deviation)
The calculation of the standard deviation -asset Bi
1
7%
?
?
?
?
?
2
15
?
?
?
?
?
3
23
?
?
?
?
?
=
Conclusion: The higher the standard deviation, the greater the risk
King Faisal University [
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Dr Abdeldjelil Ferhat BOUDAH
CHAPTER 6: RISK AND RETURN
coefficient of variation
coefficient of variation is a measure of a relative
dispersion that is useful in comparing the risk of assets
with different expected returns.
The higher the coefficient of variation, the greater the
risk.
King Faisal University [
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Dr Abdeldjelil Ferhat BOUDAH
CHAPTER 6: RISK AND RETURN
Conclusion
It can be said from what have been preceded that
dealing with risk matters should be refer to as two
main important approaches. First, it can be viewed
from managers’ behaviors and their preferences.
Second, risk assessment and measurement are so
crucial when it comes to make a decision .
King Faisal University [
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Dr Abdeldjelil Ferhat BOUDAH
‫بحمد هللا‬
King Faisal University [
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