risk and rates of return - acm

7/29/2019 Risk and Rates of Return - ACM

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Investment

Can be delimited into

1. stand-alone as if invested only in one

type of asset

2. portfolioinvested in various kinds/types

of asset grouped in a set


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Return

Can be understood as earnings or profit

The rate of return on an investment can becalculated as follows:

(Amount receivedAmount invested)

Return = ________________________Amount invested

Return can be understood from the context ofinvestment


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How do returns behave?

Certain assets have fixed return (i.e. does not

change over the life of the asset)

Certain assets have non-fixed returns (i.e.

changes in response to various factors such as

market, internal governance, stability of

supply, etc.)


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So how do we show return in a single

numerical figure?

For fixed income assets/investments theexpected return is the promised return itself

take for instance the case of Treasury securities

For non-fixed income assets/investments theoverall expected return is the average ofexpected returns throughout the term of the

investment take the case of a share of stock from a start-up

company


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The proponents of the start-up company promisedthe following:

Therefore the expected return over 4 years is(12+12+14+18) / 4 = 14% or the average of theexpected returns of the life

Year Expected Return

1st

Year 12%2nd Year 12%

3rd Year 14%

4th Year 18%


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Sometimes, the expected return may be determined

in relation to certain factors. Taking the previous

example, the proponents showed that the returns

may be expected in this fashion:

Demand Equivalent /

Specific

Return

Probability of

Occurring

Expected

return

High 37% 17% 6.29%Normal 16% 56% 8.96%

Low -8% 27% -2.16

13.09


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Expected Return

Therefore, we can infer that the expected

return on an investment is based on the

average or the sum of the weighted-average of

the various specific possible returns.


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How is return related to risk?

Not all returns are fixed.

There are various instances when the return ishigh, normal or low (negative or loss).

Certain factors drive the return to becomehigh, normal or low.

Naturally, an investor would want a high or

normal return. However, what are thechances that an investment would have alow return or incur a negative profit?


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Look at various return factors

The following shows a table of some of the

possible factors that have impact on an

investments return:

Factors affecting profit, income or return

Supply and demand (market dynamics)

Local political environment

Regional political environment

Operations (production)

Governance issues

Brand recognition


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Now lets add specific situations

Factors affecting profit, income

or return

Specific situation

Supply and demand (market

dynamics)

Bleak or low demand

Local political environment Unstable political situationRegional political environment Regional deadlock on trade

issues

Operations (production) Work stoppage or labor strike

Governance issues BoD sanctioning top officers

Brand recognition Image model involved in

scandalous affairs


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The foregoing factors are summarily paired

with negative specific situations.

Such factors then take their toll on the

expected return (i.e. the return becomes low or

incurs losses).

Risk, then, can be inferred in laymans term as

what are the chances that a specific situation

create a negative factor?


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Merging the concepts of

risk and return

Therefore, RISK is a chance that a return

factor creates a NEGATIVE impact on the

expected investment RETURN.


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Investment Risks

Concepts of:

Investment + Risk = Investment Risks

Stand alone risk associated with an assetwhen such asset is held individually

Portfoliorisk associated with an asset when

such asset is held together with other assets ina particular set, group or portfolio


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Risk

Risk manifests in various ways as provided in

the previous example.

An essential element of risk is PROBABILITY

or the chance of an event to occur.

Mathematically, risk can be associated with

variance or the variability of a particular

distribution set.


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Risk For example:

Now find the average return of the pharmaceuticalcompany (assuming equal chances of earning each ofthe expected profits)

A

Interest rate on bonds issued by

a steel manufacturing company

18%

B

Expected profits of a

pharmaceutical company

developing dengue vaccines(investment in common stock)

-9%

9%

54%


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Risk

With the knowledge that risk can be stated interms of probability, several finance theorieshave utilized STANDARD DEVIATION as its

(risk) numerical manifestation. Descriptive statistics postulates that given two

sets of data with similar means but differentstandard deviation, the set with a higherstandard deviation has a higher degree ofvariability of data.


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Risk

Given the example above, various

circumstances, investment A has zero

standard deviation.

On the other hand, investment B has some

degree of standard deviation.


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How do we compute standard deviation

in a stand alone investment?

deviationStandard

2Variance

i

2n

1ii

P)kk(


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In our previous example, we assume that the

expected profits of the pharmaceutical

company occur in equal chances:

Conditions Expected

profits

Deviation Deviation

Squared

Deviation

Squared x

Probability

Weak -9% -27% 729 243

Normal 9% 9% 81 27

Strong 54% 36% 1,296 432

Average 18%

Sum

(Variance)

702


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We will now get the square-root of the sum of

the variances:

702

5.26


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Risk Aversion

Thinking rationally as an investor, which

investment option would you choose?

OF COURSE, THE PRIMARY OPTION

WOULD BE TO INVEST ON THE BONDS

EARNING ASSURED PROFIT RATHER

THAN THE STOCKS WITH CHANCES OF

LOSING.


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Risk Aversion

Given two investment options with similar

expected returns, a rational investor would

choose the investment option which is less

riskier (more assurance).

risk and rates of return - acm

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