RISK AND RATES OF

RETURN
BFINMA2: FINANCIAL MANAGEMENT PART 2
 RETURN or RETURN ON INVESTMENT

• It is the total gain or loss or benefit expected for a decision to

acquire an asset or to invest any project.

In general, it comes from two sources:

1. Income
2. Capital appreciation
 RETURN
To compute a return the following formula is used:

Return =
𝑠𝑒𝑙𝑙𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒− 𝑎𝑚𝑜𝑢𝑛𝑡 𝑖𝑛𝑣𝑒𝑠𝑡𝑒𝑑+𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝑟𝑒𝑐𝑒𝑖𝑣𝑒𝑑 𝑖𝑓 𝑎𝑛𝑦
𝑎𝑚𝑜𝑢𝑛𝑡 𝑖𝑛𝑣𝑒𝑠𝑡𝑒𝑑

Or
𝑐𝑎𝑠ℎ 𝑟𝑒𝑐𝑒𝑖𝑣𝑒𝑑 + (𝑠𝑒𝑙𝑙𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒 − 𝑎𝑚𝑜𝑢𝑛𝑡 𝑖𝑛𝑣𝑒𝑠𝑡𝑒𝑑)
𝑎𝑚𝑜𝑢𝑛𝑡 𝑖𝑛𝑣𝑒𝑠𝑡𝑒𝑑
 RETURN

Example 1
Suppose Spaghetti Corporation invested in a time
deposit amounting to P1,000,000 for three months. The
deposit earns at 12% per annum. What is the return on
investment?

Interest= P1,000,000 x 12% x 3/12 = P30,000

Return = P30,000/P1,000,000 = 3%
 RETURN
Example 2
Suppose Fries Co. bought 100 shares of stock for P50,000.
The shares paid dividends amounting to P10 per share at
the end of the year. Upon receipt of the dividends, Fries
sold the stock at P55,000. What is the return on
investment?
𝑃55,000 + 𝑃10 𝑥 100 −𝑃50,000
Return =
𝑃50,000
= 12%
 PROBABILITY DISTRIBUTION

• Probability is the occurrence or non-occurrence of an

event.
• If all the possible outcomes are considered and a
probability is taken into consideration for each outcome,
then a probability distribution can be listed.
 EXPECTED AND REALIZED RETURN

• EXPECTED RETURN- is the return made after the

probabilities of occurrence, the state of economy
and the individual’s expected outcomes are
considered.
 Expected Return
Example
Siomai Corp. plans to invest in Stock A. The firm expects
that the possible returns are dependent with the state of
the economy. Determine the expected return on their
planned investment.
State of Economy Possible returns Probability
Recession 10% 0.20
Normal 15% 0.60
Prosperity 20% 0.20
Expected return = (10%x.20)+(15%x.60)+(20%x.20) = 15%
 REALIZED RETURN

• Realized return is return that is actually earned over a

given period of time.
 PORTFOLIO RETURN
• Portfolio-
is a collection of investments which are all
owned by single individual or a firm.
• Portfolio investment is a way of avoiding risk.
• Portfolio expected return is computed by obtaining the
weighted average return of the individual assets.

Portfolio expected return = 𝑤1 𝑟1 + 𝑤2 𝑟2 +…. 𝑤n 𝑟n

 PORTFOLIO RETURN
Example
Burger Inc. plans to invest in three stocks. Listed below are
the expected return for each investment:
Stock Individual expected Amount Invested
returns (%) (in pesos)
JFC 10 20,000
MCDO 15 50,000
KFC 18 30,000

What is the expected portfolio return?

 RISK
• It is the chance of financial loss or more formally, the
variability of returns associated with a given asset.
• It is the exposure to uncertainty of danger resulting in
changes in the expected return in a given investment.
• It is measured by calculating the standard deviation of
historical returns or the expected returns of specific
investments.
• The fundamental concept of risk is that as it increases,
the expected return on an investment should also
increase.
 CLASSIFICATION OF RISK
1.Systematic Risk – market, non-controllable or
undiversifiable risk.
a.Currency risk
b.Inflation risk
c.Country risk
d.Interest rate risk
e.Purchasing power risk
f.Event risk
g.Tax risk
 CLASSIFICATION OF RISK
2. Unsystematic Risk –controllable or diversifiable risk.
a.Principal risk
b.Credit risk
c.Liquidity risk
d.Call risk
e.Business risk
f.Financial risk
 Three Basic Risk Preference Behavior

1.Risk-indifferent
2.Risk-averse
3.Risk-seeking
 Measuring Risk

STANDARD DEVIATION
- use to measure risk.
- is a widely used of measure of volatility which shows
how much variation exists from the average return of an
investment.
- dispersion around the expected value.
 Standard Deviation

𝛿= ෍(𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑖𝑛𝑑𝑖𝑣𝑖𝑑𝑢𝑎𝑙 𝑟𝑒𝑡𝑢𝑟𝑛 − 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑟𝑒𝑡𝑢𝑟𝑛)2 𝑥 𝑝𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛

𝑡=1
 Steps in Computing the Standard Deviation
1.Multiply the expected individual return by the
probability distribution.
2.Subtract the expected average return from the return.
3.Square the difference.
4.Multiply the squared difference and probability
distribution.
5.Sum up the products in step 4.
6.Square root the sum in step 5.
 Standard Deviation : Example
Assume that Pizza Corp. is considering the possible rates of
return it might earn next year on a P100,000 investment on the
stocks of Shakeys or a P75,000 on those of Yellow Cab. The
future return depend on the state of the economy with their
corresponding probability distribution.
State of Shakeys’ Stocks Yellow Cab’s Stock
the Return Probability Return Probability
Economy
Recession -8.00% 0.15 -10.00% 0.20
Normal 15.00% 0.70 20.00% 0.60
Prosperity 35.00% 0.15 40.00% 0.20
 Coefficient of Variation
• is a statistical measure of the distribution of the data
points in a data series around the mean.
• is a measure of relative dispersion that is useful in
comparing the risk of assets with differing expected
return.
• The higher the coefficient of variation the higher the
risk.
𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑑𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛
𝐶𝑜𝑒𝑓𝑓𝑖𝑐𝑖𝑒𝑛𝑡 𝑜𝑓 𝑉𝑎𝑟𝑖𝑎𝑡𝑖𝑜𝑛 =
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑅𝑒𝑡𝑢𝑟𝑛
 PORTFOLIO RISK

• It is associated with the total risks of portfolio which

consists of systematic and unsystematic risk.
• It is the weighted average of the asset in the portfolio as
well as its correlation coefficient.
• CORRELATION COEFFICIENT- measure the degree of
relationship between assets in the portfolio.
 PORTFOLIO RISK
• When two or more assets move up and down exactly
together they are said to have positive correlation.
Stock M Stock N

25 25

15 15

0 0

-10 -10
 PORTFOLIO RISK
• When two or more assets move up and down exactly
opposite to each other they are said to have negative
correlation.
Stock W Stock M

25

15

0 0

-10
PORTFOLIO RISK
 Capital Asset Pricing Model (CAPM)

• Model based upon concept that a stock’s required rate of return

is equal to the risk-free rate of return plus a risk premium that
reflects the riskiness of the stock after diversification.
• Primary conclusion: The relevant riskiness of a stock is its
contribution to the riskiness of a well-diversified portfolio.
 The Security Market Line (SML):
Calculating required rates of return

SML: ki = kRF + β(kM – kRF)

 Beta

• Measures a stock’s market risk, and shows a

stock’s volatility relative to the market.
• Indicates how risky a stock is if the stock is held in
a well-diversified portfolio.
 Comments on Beta

• If beta = 1.0, the security is just as risky as the average

stock.
• If beta > 1.0, the security is riskier than average.
• If beta < 1.0, the security is less risky than average.
• Most stocks have betas in the range of 0.5 to 1.5.
 What is the market risk premium?

• Additional return over the risk-free rate needed to compensate investors for
assuming an average amount of risk.
• Its size depends on the perceived risk of the stock market and investors’
degree of risk aversion.
• Varies from year to year, but most estimates suggest that it ranges between
4% and 8% per year.
 Example

Mr. Pesto plans to invest in Stock A. The risk free

rate is 9%, the expected return on the market is
12%; and the stock has a beta of 0.75. What is the
required rate of return of Stock A?
 CAPM as SML

• Describes the relationship between the beta and

expected required rate of return of an asset or individual
assets.
• Betais found on the x-axis while expected return is
found in the y-axis.
 11.25%
12%
Risk Premium

9%

6%
Risk-free
Rate of
3%

0 0.25 0.50 0.75 1.00

• Based on the graph, it can be concluded that as the beta
increases, the required return also increases. To further
clarify the concept, below is an example table.
Required Rate of
Beta CAPM Model Return
0.00 .09+ 0(.12-.09) 9.00%
0.25 .09+ 0.25(.12-.09) 9.75%
0.50 .09+ 0.5(.12-.09) 10.50%
0.75 .09+ 0.75(.12-.09) 11.25%
1.00 .09+ 1.00(.12-.09) 12.00%
1.25 .09+ 1.25(.12-.09) 12.75%
 Portfolio Beta
• Is computed as the weighted average of the beta of all individual
assets in the portfolio.
• If the beta is greater than 1 is added to a portfolio with a beta
equivalent to 1, the beta and riskiness of the portfolio will
increase.
• If the beta is less than 1 is added to a portfolio with a beta
equivalent to 1, the beta and riskiness of the portfolio will
increase.
THANK YOU! 
/NABergonia2018