The return of any investment has an average, which is also

the expected return, but most returns will be different

from the average: some will be more and others will be
less than the average. The more individual returns deviate
from the expected return, the greater the risk and the
greater the potential reward. The degree to which all
returns for a particular investment or asset deviate from
the expected return of the investment is a measure of its
risk.

Standard Deviation: Measure Of Absolute Risk

If you recorded the returns of a sample population of

investors who invested in 5-year Treasury notes (T-notes),
you would note that everyone received a constant rate of
return that didn’t deviate, since, once bought, T-notes pay
a constant rate of interest with no credit risk. On the other
hand, if you had recorded the returns of a sample of
investors who had invested in small stocks at the same
time, you would see a much wider variation in their returns
—some would have done much better than the T-note
investors, while others would have done worse, and each of
their returns would vary over time.

This variability of returns is commensurate with the

investment’s risk, and this risk can be quantified by
calculating the standard deviation of this
variability. Standard deviation, as applied to
investment returns, is a quantitative statistical measure of
the variation of specific returns to the average of those
returns.

Standard Deviation Formula for Investment Returns

 s = Standard Deviation
rk = Specific Return
rexpected = Expected Return
n = Number of Returns (sample
size).

Coefficient Of Variation: Measure Of Relative Risk

The greater the standard deviation, the greater the risk of

an investment. However, the standard deviation cannot be
used to compare investments unless they have the same
expected return. For instance, consider the following table.

Sample 1 Sample 2

Return 1 6 9

Return 2 4 11

Return 3 6 9

Return 4 4 11
 Expected Return 5 10

Standard Deviation 1.154700538 1.154700538

Coefficient of Variation 0.230940108 0.115470054

On the left hand side, you have an investment with an

expected return of $5 where each specific return deviates
by $1 from the expected return. On the right hand side,
the specific returns also deviate by $1, but the expected
return is $10. Now because the difference between the
expected returns and the specific returns for each sample
is 1, the standard deviation is the same, but, nonetheless,
the risk is not the same, because $1 is only 10% of $10,
but 20% of $5.

The coefficient of variation is a better measure of

risk, quantifying the dispersion of an asset’s returns in
relation to the expected return, and, thus, the relative risk
of the investment. Hence, the coefficient of variation allows
the comparison of different investments.

Coefficient of Variation = Standard Deviation / Average Return

In the above case, both samples have the same standard

deviation, but have a significant difference in the coefficient
of variation. It is obvious that the investment with the
smaller return has the greater risk in this case.
 So while the standard deviation measures the dispersion of
returns, the coefficient of variation measures
their relative dispersion.

the Standard deviation is an absolute measure of risk while the coefficent of variation is a
relative measure. The coefficent is more useful when using it in terms of more than one
investment. The reason being that they have different returns on average which means the
standard deviation may understate the actual risk or overstate depending.

oK, back to standard deviation and investment risk. As I stated above, standard
deviation is used to measure the total risk of individual assets, which includes
specific risk. This is fine for comparing similar assets but it won't, by itself, tell you
the probable effect an asset will have on your portfolio. Remember, the standard
deviation is the absolute value of the average deviation from the mean, as such, it is
a measure of the variability of a variable with respect to its own mean.

When comparing two assets, it's sometimes helpful to use the coefficient of variation
(CV), which is the standard deviation divided by the mean, thus normalizing the
standard deviation and facilitating the comparison of assets on a risk-to-return basis.
This works well period-by-period but, because actual returns include the risk-free
rate, which varies over time, it is not appropriate for period-to-period comparisons.

Futures and Options are part of a risk management strategy. A good analogy would be to use
them as insurance instruments, where you hedge your inventory against a future stipulated set
price, that way you can create projections, increase your cash-flow, secure production and
leverage against your present cost of goods