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Risk & Return

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The principle that potential return rises with an increase in risk. Low levels of uncertainty (low-risk) are associated with low potential returns, whereas high levels of uncertainty (high-risk) are …

The principle that potential return rises with an increase in risk. Low levels of uncertainty (low-risk) are associated with low potential returns, whereas high levels of uncertainty (high-risk) are associated with high potential returns. According to the risk-return tradeoff, invested money can render higher profits only if it is subject to the possibility of being lost.

Published in: Business, Economy & Finance

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  • 1. Corporate Finance Risk & Return
  • 2. Rates of Return: A Review  Measuring Rate of Return  The total return on an investment is made up of:   Income (dividend or interest payments). Capital gains (or losses). Percentage Return = Capital Gain + Dividend Initial share Price
  • 3. Rates of Return: A Review Capital Gain Yield = Dividend Yield = Capital Gain Initial Share Price Dividend Initial Share Price 1 + nominal rate 1 + real rate = 1 + inflation rate
  • 4. Rates of Return: A Review  An Example: A Canadian Pacific Railway (CP) share had a value of $61.40 at the beginning of 2007. By the end of the year, the price went up to $64.22. In addition, during the year, CP paid a $0.90 dividend per share. % return = Capital gain+dividend/initial share price (64.22 – 61.40) + 0.90 = 6.06% 61.40 Dividend yield = 0.90/61.40 = 1.47% Capital gain yield = 2.82/61.40 = 4.59% Total return= 1.47% + 4.59% = 6.06%
  • 5. Rates of Return: A Review  Total     return= 1.47% + 4.59% = 6.06% This is the nominal return (how much more money you will have at the end of year if invested today) To convert from nominal return to real return with inflation of 4.1% (to find how much more you will be able to buy with your money at the end of year) 1+real rate of return=1+0.0606/1+0.04 real rate of return=1.019-1= 1.98%
  • 6. Systematic Risk & Unsystematic Risk Systematic Risk    Market Risk Interest Rate Risk Purchasing Power Risk Unsystematic Risk   Business Risk Financial Risk
  • 7. Financial Risk Assigning Risk Allowances (Premiums) R= i + p + b + f + m + o Where: i = real interest rate (riskless rate) P = purchasing power risk allowance B = business risk allowance F = financial risk allowance M = market risk allowance O = allowance for other risks
  • 8. Return & Probability Return Likelihood 7 1 chance in 20 8 2 chances in 20 9 4 chances in 20 10 6 chances in 20 11 4 chances in 20 12 2 chances in 20 13 1 chance in 20
  • 9. Starting Predictions “Scientifically” Return (1) Probability (2) (1) X (2) 7 .05 .35 8 .10 9 .20 10 .30 11 .20 12 .10 13 .05
  • 10. Variance & Standard Deviation Stock A Stock (1) (2) (3) (4) Return – Expected Return Difference Squared Probability (2) X (3) B (5) (6) (7) (8) Return – Expected Return Difference Squared Probability (6) X (7) 7 -10 = -3 8 -10 = -2 9-10 = -1 9-10 = -1 .30 10-10 = 0 10-10 = 0 .40 11-10 = 1 11-10 = 1 .30 12-10 = 2 13-10 = 3 1.00 2.10 1.00 .60 Variance 2.10 .60 S.D. 1.45 .77
  • 11. Risk In a Contemporary Mode Total Risk = Diversifiable risk + Non diversifiable Risk Diversifiable Risk = You can control Non Diversifiable Risk = You cannot control
  • 12. Thank you

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