Risk and Return

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Risk
HUL- SHARE PRICE
2,700.00

2,650.00

2,600.00

2,550.00

2,500.00

2,450.00

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Risk
HUL- RETURNS
4.00%

3.00%

2.00%

1.00%

0.00%

-1.00%

-2.00%

-3.00%

-4.00%

-5.00%

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Return on a Single Asset
• The rate of return on a share would consist of the dividend yield and
the capital gain yield.
• Rate of return = Dividend yield + Capital gain yield

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Return on a Single Asset

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Example 1: On 1 January 2013, Mr Y.P. Sinha purchased 100 shares of
L&T at Rs 212 each. During the year, he received total dividends of Rs
700. Mr. Sinha sold all his shares at Rs 215 each on 31 December 2013.
Calculate Mr. Sinha’s capital gain, dividend gain, and total gain both in
rupee amount and %.

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Return on a Single Asset

• Unrealized capital gain or loss- If an investor holds a share and does

not sell it at the end of a period, the difference between the
beginning and ending share prices is the unrealized capital gain (or
loss).
• The investor could have sold the share and realized the capital gain
(or loss).

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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 periods.
• Simple arithmetic average rate

Where 𝑅ത is the average rate of return; 𝑅𝑡 the observed or realized rates

of return in periods 1, 2... t and n the total number of periods.

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Risk
• These fluctuations in returns were caused by the volatility of the
share prices.
• The changes in dividends also contributed to the variability of rates of
return.
• We can think of risk of returns as the variability in rates of return.
• How could one measure the variability of rates of return of a share (or
an asset)?

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Risk
• The variability of rates of return may be defined as the extent of the
deviations (or dispersions) of individual rates of return from the
average rate of return.
• There are two measures of this dispersion: variance and standard
deviation.
• Standard deviation is the square root of variance.

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How to Calculate Variance and Standard Deviation
• Calculate the average rate of return.

• Calculate the deviation of individual rates of return from the average rate of
return and square it.

• Calculate the sum of the squares of the deviations and divide it by the
number of periods (or observations) less one to obtain variance.

• Calculate the square root of the variance to determine the standard

deviation.
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Risk

• T-bills are generally taken for the risk-free government security.

• They are free from risk of default and the variability on its returns is the
lowest.
• An alternative to risk-free security can be the long-term government bonds.
• The excess return on stock market is a compensation for the higher risk of the
return on the stock market which is called risk premium.
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Expected Return & Risk
• Instead of using historical data for calculating return and risk, we may use
forecasted data.
• The outcome may depend on the economic conditions, the performance of the
company and other factors.
• You will have to think of the outcomes of dividend and the share price under
possible economic scenarios to arrive at a judgment about the expected return.
• The expected rate of return is the sum of the product of each outcome (return)
and its associated probability.
Expected rate of return = rate of return under scenario 1 × probability of scenario
1 + rate of return under scenario 2 × probability of scenario 2 +… + rate of return
under scenario n × probability of scenario n
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Expected Return & Risk

• E(R) is the expected rate of return, 𝑅𝑖 the outcome i, 𝑃𝑖 is the probability of the
occurrence of i and n is the total number of outcomes
• The following formulae can be used to calculate the variance and standard
deviation:

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Expected Return & Risk
Example 2: Suppose you are considering buying one share of India Cements,
which has a market price of Rs. 261.25 today. The company pays a dividend of
Rs. 2.50 per share. You want to hold the share for one year. What is your
expected rate of return?

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Expected Return & Risk
Example 3: The shares of Hypothetical Company Limited has the following
anticipated returns with associated probabilities. Calculate expected rate of
return and standard deviation.

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Risk Preference
• The information about the expected return and standard deviation helps an
investor to make decision about investments.
• This depends on the investor’s risk preference.
• Risk preference is the intention of investors of taking risks. Usually, higher
returns are associated with higher risk-taking capability, while lower risks yield
lower returns.
• Risk-averse investors are interested in the lowest risk securities. For them the
guarantee of returns weighs more than the rate of return from the
investment.
• They will choose from 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.
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Risk Preference
• A risk-neutral investor does not consider risk, and he would always
prefer investments with higher returns. They are interested in securities
that promise the best returns within a specified period of time.
• A risk-seeking investor likes investments with higher risk irrespective of
the rates of return. They have a high degree of risk tolerance.
• A common example to explain risk-seeking behaviour is; If offered two
choices; either $50 as a sure thing, or a 50% chance each of either $100
or nothing, a risk-seeking person would prefer the gamble.

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