Chapter five

Risk and Return

Introduction
Risk and return are the most important concepts in finance and they are the foundations of modern
finance theory. The first is A dollar today is worth more than a dollar tomorrow, and is often called
the time value of money. The second is a safe dollar is worth more than a risky dollar. Anyone who
studies finance learns the universal application of these statements and rational decision making.
The trade-off between risk and return is the principles’ theme in the investment decision.
Most people are risk averse, which does not mean, however, they will not take a risk. It means the
only take a risk when they expect to be rewarded for taking it. People have different degrees of risk
aversion; some are more willing to take a chance than are others.
People invest because they hope to get a return from their investment. Return is the good stuff that
makes people feel better or improves their standard of living. Risk is the bad stuff of risk averse
person seeks to avoid. It is a fact of investment life and is unavoidable for anyone who seeks more
than a trivial rate of return. This chapter explores the fundamental principles underlying the
relationship between risk and return.
 Risk indicates the deviation/variability of expected outcome.
- It may be positive or negative
 Return indicates the expected reward for investors to their capital invested
- It can be trough dividend and the capital gain (can be get by the application of invested
capital).
Measuring historical rate of Return
If you buy an asset of any sort, your gain (loss) from that investment is called the return on your
investment. This return will usually have two components. First, you may receive some cash
directly while you own the investment. This is called the income component of your return. Second,
the value of the asset you purchase will often change. In this case, you have a capital gain or capital
loss on your investment.
Example: Suppose, at the beginning of the year, the stock for a company was selling for $37 per
share. If you had bought 100 shares, you would have a total out lay of $3700. Suppose, over the
year, the stock paid a dividend of $1.85per share. By the end of the year, then, you would have
received income of;
Dividend= $1.85 x 100= $185
Also, suppose the value of the stock has risen to $40.33per share by the end of the year. Your 100
shares are now worth $4,033, so you have a capital gain of:
Capital gain = ($40.33 - $37) x 100 = $333

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Therefore, the total return on your investment is the sum of the dividend and the capital gain.
Total return = dividend income + capital gain (loss)
= $185 + $333 = $ 518
Notice that, if you sold the stock at the end of the year, the total amount of cash you would have
would equal your initial investment plus total return. Then, total cash if the stock is sold is:
Total cash = initial investment + total return
$ 3700 + $ 518 = $ 4,218
As a check, notice that this is the same as the proceeds from the sale of the stock plus the dividends:
Proceeds from stock sale + dividends = $40.33 x 100 + 185= $ 4,218
It is usually more convenient to summarize information about returns in percentage terms, rather
than in dollar terms, because that way your return does not depend on how much you actually
invest. The question is, how much do we get for each dollar we invest?
To answer this question, let be the price of the stock at the beginning of the year and let
D t+1 be the dividend paid on the stock during the year.
In the example above, the price at the beginning of the year was $37 per share and the dividend paid
during the year on each share was $1.85. Therefore, dividend yield is:
Dividend yield=
= $1.85/37 = .05= 5%, this implies that for each dollar we invest, we get five
cents in dividends.
The second component of the return from investment is the capital gains yield. This is calculated as
the change in the price during the year (the capital gain) divided by the beginning price:
Capital gains yield =
= (40.33 -37)/37 = .09= 9%. This means that per dollar we invest, we get nine
cents in capital gain. Putting it together, per dollar invested, we get 5 cents in dividends and nine
cents in capital gains: so we get a total of 14 cents. Our percentage return is 14%. Simply, the total
percentage return of an investment can be calculated as:

Percentage return =

= $1.85 + (40.33 – 37)/ 37 = 5.18/37 = .14 = 14%

When we invest, we defer current consumption in order to add to our wealth so that we
can consume more in the future. Therefore, when we talk about a return on an investment,
we are concerned with the change in wealth resulting from this investment. This change in
wealth can be either due to cash inflows, such as interest or dividends, or caused by a change
in the price of the asset (positive or negative).

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If you commit $200 to an investment at the beginning of the year and you get back $220 at
the end of the year, what is your return for the period? The period during which you own an
investment is called its holding period, and the return for that period is the holding period return

(HPR).
In this example, the HPR is 1.10, calculated as follows:

This HPR value will always be zero or greater—that is, it can never be a negative value. A value
greater than 1.0 reflects an increase in your wealth, which means that you received a positive rate of
return during the period. A value less than 1.0 means that you suffered a decline in wealth, which
indicates that you had a negative return during the period. An HPR of zero indicates that you lost all
your money (wealth) invested in this asset.
Although HPR helps us express the change in value of an investment, investors generally evaluate
returns in percentage terms on an annual basis. This conversion to annual percentage rates makes it
easier to directly compare alternative investments that have markedly different characteristics. The
first step in converting an HPR to an annual percentage rate is to derive a percentage return, referred
to as the holding period yield (HPY). The HPY is equal to the HPR minus 1.
HPY = HPR – 1
In our example:
HPY = 1:10 − 1 = 0:10 = 10%
To derive an annual HPY, you compute an annual HPR and subtract 1. Annual HPR is
found by: Annual HPR = HPR1/n
Consider an investment that cost $250 and is worth $350 after being held for two years:

Computing Mean Historical Returns

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Now that we have calculated the HPY for a single investment for a single year, we want to consider
mean rates of return for a single investment and for a portfolio of investments. Over a number of
years, a single investment will likely give high rates of return during some years and low rates of
return, or possibly negative rates of return, during others. Your analysis should consider each of
these returns, but you also want a summary figure that indicates this investment’s typical
experience, or the rate of return you might expect to receive if you owned this investment over an
extended period of time. You can derive such a summary figure by computing the mean annual rate
of return (its HPY) for this investment over some period of time.
Alternatively, you might want to evaluate a portfolio of investments that might include similar
investments (for example, all stocks or all bonds) or a combination of investments (for example,
stocks, bonds, and real estate). In this instance, you would calculate the mean rate of return for this
portfolio of investments for an individual year or for a number of years.
Single Investment: Given a set of annual rates of return (HPY s) for an individual investment, there
are two summary measures of return performance. The first is the arithmetic mean return; the
second is the geometric mean return. To find the arithmetic mean (AM), the sum (Σ) of annual
HPYs is divided by the number of years (n) as follows:

Where:
ΣHPY= the sum of annual holding period yields
An alternative computation, the geometric mean (GM), is the nth root of the product of the
HPRs for n years minus one

To illustrate these alternatives, consider an investment with the following data:

Year Beginning value ending value HPR HPY
1 100.00 115.00 1.15 0.15
2 115.00 138.00 1.20 0.20
3 138.00 110.40 0.80 -0.20

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Investors are typically concerned with long-term performance when comparing alternative
investments. GM is considered a superior measure of the long-term mean rate of return because it
indicates the compound annual rate of return based on the ending value of the investment versus its
beginning value.
Specifically, using the prior example, if we compounded 3.353 percent for three years, (1.03353) 3
we would get an ending wealth value of 1.104.
Although the arithmetic average provides a good indication of the expected rate of return for an
investment during a future individual year, it is biased upward if you are attempting to measure an
asset’s long-term performance. This is obvious for a volatile security. Consider, for example, a
security that increases in price from $50 to $100 during year 1 and drops back to $50 during year 2.
The annual HPYs would be
Year Beginning value Ending Value HPR HPY
1 50 100 2.00 1.00
2 100 50 0.50 -0.50

This would give an AM rate of return of:

This investment brought no change in wealth and therefore no return, yet the AM rate of return is
computed to be 25 percent.
The GM rate of return would be:
= (2:00×0:50)1/2 −1= (1:00)1/2 −1
=1:00−1= 0%
This answer of a 0 percent rate of return accurately measures the fact that there was no change in
wealth from this investment over the two-year period.
MEASURING EXPECTED RETURN
The expected return of the investment is the probability weighted average of all the possible returns.
If the possible returns are denoted by and the related probabilities are , expected return may
be represented as and can be calculated as:

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It is the sum of the products of possible returns with their respective probabilities. Consider the
example below.

Possible return (in %): (Xi) Probability of occurrence: P (Xi)

30 0.10
40 0.30
50 0.40
60 0.10
70 0.10
The table above gives the probability distribution of possible returns from an investment in shares,
such a distribution can be developed by the investor by studying the past data and modifying it
appropriately for the changes he expects to occur in the future. The expected return of the share in
the example given above can be calculated as follows.
Possible return (in %): (Xi) Probability of occurrence: P (Xi) Xi P (Xi)
30 0.10 3.0
40 0.30 12.0
50 0.40 20.0
60 0.10 6.0
70 0.10 7.0
=48.0

Hence, the expected return is 48 percent.

Measuring the Risk of Expected Rates of Return

We have shown that we can calculate the expected rate of return and evaluate the uncertainty, or
risk, of an investment by identifying the range of possible returns from that investment and
assigning each possible return a weight based on the probability that it will occur. Although the
graphs help us visualize the dispersion of possible returns, most investors want to quantify this
dispersion using statistical techniques. These statistical measures allow you to compare the return
and risk measures for alternative investments directly. Two possible measures of risk (uncertainty)
have received support in theoretical work on portfolio theory: the variance and the standard
deviation of the estimated distribution of expected returns.

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 In this section, we demonstrate how variance and standard deviation measure the dispersion of
possible rates of return around the expected rate of return. We will work with the examples
discussed earlier. The formula for variance is as follows:

Variance: The larger the variances for an expected rate of return, the greater the dispersion of
expected returns and the greater the uncertainty, or risk, of the investment. The variance for the
perfect-certainty (risk-free) example would be:

Note that; in perfect certainty, there is no variance of return because there is no deviation from
expectations and therefore, no risk or uncertainty. The variance for the following example if
expected return is 7%:

Economic Conditions P Rj E(R) (Ri –E(R) (Ri – E(R)2 P(Ri – E(R)

Strong economy, no inflation 0.15 0.20 0.070 0.2-0.070=-0.13 0.0169 0.002535
Weak economy, above average inflation 0.15 -0.20 0.070 -0.2-.070=-0.27 0.0729 0.010935
No major change in economy 0.70 0.10 0.070 0.1-0.070=-0.03 0.0009 0.00063
0.0141

Standard

Deviation: The standard deviation is the square root of the variance:

For the second example, the standard deviation would be:

Therefore, when describing this investment example, you would contend that you expect a return of
7 percent, but the standard deviation of your expectations is 11.87 percent.

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A Relative Measure of Risk: In some cases, an unadjusted variance or standard deviation can be
misleading. If conditions for two or more investment alternatives are not similar—that is, if there
are major differences in the expected rates of return—it is necessary to use a measure of relative
variability to indicate risk per unit of expected return. A widely used relative measure of risk is the
coefficient of variation (CV), calculated as follows:

The CV for the preceding example would be:

This measure of relative variability and risk is used by financial analysts to compare alternative
investments with widely different rates of return and standard deviations of returns. As an
illustration, consider the following two investments:
Investment A Investment B
Expected Return 0.07 0.12
Standard Deviation 0.05 0.07
Comparing absolute measures of risk, investment B appears to be riskier because it has a standard
deviation of 7 percent versus 5 percent for investment A. In contrast, the CV figures show that
investment B has less relative variability or lower risk per unit of expected return because it has a
substantially higher expected rate of return:

Risk Measures for Historical Returns

To measure the risk for a series of historical rates of returns, we use the same measures as for
expected returns (variance and standard deviation) except that we consider the historical holding
period yields (HPYs) as follows:

Where:
σ2 = the variance of the series, HPYi = the holding period yield during period, E(HPY) = the
expected value of the holding period yield that is equal to the arithmetic mean (AM) of the series
n=the number of observations

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The standard deviation is the square root of the variance. Both measures indicate how much
the individual HPYs over time deviated from the expected value of the series.
TYPES OF RISK:
Thus far, our discussion has concerned the total risk of an asset, which is one important
consideration in investment analysis. However, modern investment analysis categorizes the
traditional sources of risk identified previously as .causing variability in returns into two general
types: those that are pervasive in nature, such as market risk or interest rate risk, and those that are
specific to a particular security issue, such as business or financial risk.
Therefore, we must consider these two categories of total risk. Dividing total risk into its two
components, a general (market) component and a specific (issuer) component, we have systematic
risk and nonsystematic risk, which are additive:
Total risk = General risk + Specific risk
= Market risk + Issuer risk
= Systematic risk + Nonsystematic risk
Systematic (Market) Risk: Risk attributable to broad macro factors affecting all securities
Systematic Risk is an investor can construct a diversified portfolio and eliminate pan of the total
risk, the diversifiable or non-market part. What is left is the non-diversifiable portion or the market
risk. Variability in a security's total returns that is directly associated with overall movements in the
general market or economy is called systematic (market) risk. Virtually all securities have some
systematic risk, whether bonds or stocks, because systematic risk directly encompasses the interest
rate, market, and inflation risks. The investor cannot escape this part of the risk, because no matter
how well he or she diversifies, the risk of the overall market cannot be avoided. If the stock market
declines sharply, most stocks will be adversely affected; if it rises strongly, as in the last few
months of 1982, most stocks will appreciate in value. These movements occur regardless of what
any single investor does. Clearly, market risk is critical to all investors.
Non systematic (Non-market) Risk: Risk attributable to factors unique to the security
Non systematic Risk is the variability in a security's total returns not related to overall market
variability is called the non systematic (non-market) risk. This risk 1s unique to a particular
security and is associated with such factors as business and financial risk as well as liquidity risk.
Although all securities tend to have some non-systematic risk, it is generally connected with
common stocks.
Student’s package: describe the following type of risk, categorize them as systematic or
unsystematic risk and analysis how they affect expected rate of return of an investment
1. Interest Rate Risk:
2. Market Risk:
3 . Inflation Risk:

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4. Business Risk:
5. Financial Risk:
6. Liquidity Risk:
7. Exchange Rate Risk
8. Country Risk:

Total variability in returns of a security represents the total risk of that security. Systematic risk and
unsystematic risk are the two components of total risk. Thus,
Total risk = Systematic risk + Unsystematic risk.
Figure 2.1: Systematic and Unsystematic risk

Capital Asset Pricing Model (CAPM)

The Capital Asset Pricing Model (CAPM) and the Security Market Line
Now let us shift the focus from the behaviour of individuals to the pricing of risky assets and we
introduce the assumption that investors can also invest in an asset that has no default risk. The
return on this risk-free asset is the risk-free interest rate, . Typically, this is regarded as the
interest rate on a government security, such as Treasury notes.
We continue to assume that all investors in a particular market behave according to portfolio theory,
and ask: How would prices of individual securities in that market be determined? Intuitively, we
would expect risky assets to provide a higher expected rate of return than the risk-free asset. In other
words, the expected return on a risky asset could be viewed as consisting of the risk-free rate plus a
premium for risk and this premium should be related to the risk of the asset.
However, part of the risk of any risky asset—unsystematic risk—can be eliminated by
diversification. It seems reasonable to suggest that in a competitive market, assets should be priced
so that investors are not rewarded for bearing risk that could easily be eliminated by diversification.
On the other hand, some risk—systematic risk—cannot be eliminated by diversification so it is
reasonable to suggest that investors will expect to be compensated for bearing that type of risk. In

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summary, intuition suggests that risky assets will be priced such that there is a relationship between
returns and systematic risk. The remaining question is: What sort of relationship will there be
between returns and systematic risk.
The capital asset pricing model (CAPM) is a model that provides a frame work to determine the
required rate of return on an asset and indicates the relationship between return and risk of the asset.
The required rate of return specified by the CAPM helps in valuing an asset. One can also compare
the expected (estimated) rate of return on an asset with its required rate of return and determine
whether the asset is fairly valued. Under the CAPM, the security market line (SML) exemplifies the
relationship between an asset’s risk and the required rate of return.

Assumptions of the CAPM

The capital asset pricing model envisages the relationship between risk and the expected rate of
return on a risky security. It provides a framework to price individual securities and determines the
required rate of return for individual securities. It is based on a number of simplifying assumptions.
These include:
Market efficiency the capital market efficiency implies that share prices reflect all available
information. Also, individual investors are not able to affect the prices of securities. This means that
there are large numbers of investors holding small amount of wealth.
Risk aversion and mean-variance optimization: investors are risk averse. They evaluate a
security’s return and risk in terms of the expected return and variance or standard deviation
respectively. They prefer the highest expected return for a given level of risk. This implies that
investors are mean variance optimizers and they form efficient portfolios.
Homogeneous expectations: all investors have the same expectations about the expected returns
and risks of risks of securities.
Single time period: all investor’s decisions are based on a single time period
Risk free rate: all investors can lend and borrow at free rate of interest. They form portfolios from
publicly owned securities like shares and bonds
Even though the capital market line holds for efficient portfolios, it does not describe the
relationship between expected return and risk for individual assets or inefficient portfolios. In
equilibrium, the expected return on a risky asset (or inefficient portfolio), i, can be shown to be:

Where = the expected return on the ith risky asset

= the covariance between the returns on the ith risky asset and the market

portfolio

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The above equation is often called the CAPM equation. The CAPM equation shows that the
expected return demanded by investors on a risky asset depends on the risk-free rate of interest, the
expected return on the market portfolio, the variance of the return on the market portfolio, and the
covariance of the return on the risky asset with the return on the market portfolio.
The covariance term is the only explanatory factor in the CAPM equation specific to

asset i. The other explanatory factors and are the same, regardless of which asset i is
being considered. Therefore, according to the CAPM equation, if two assets have different expected
returns, this is because they have different covariance’s with the market portfolio. In other words,
the measure of risk relevant to pricing a risky asset is , the covariance of its returns
with returns on the market portfolio, as this measures the contribution of the risky asset to the
riskiness of an efficient portfolio. In contrast, for the efficient portfolio itself the standard deviation
of the portfolio’s return is the relevant measure of risk.
As discussed above, the measure of risk for an investment in a risky asset i is often referred to as its
beta factor, βi, where:

Because is the risk of an asset held as part of the market portfolio, while is the
risk (in terms of variance) of the market portfolio, it follows that β i measures the risk of i relative to
the risk of the market as a whole. The beta of the market portfolio is 1. The market portfolio is the
reference for measuring the volatility of individual risky securities. Since a risk-free security has no
volatility, it has zero beta. We can re write the equation for CAPM as follows;

Example
The risk free rate of return is 8% and the market rate of return is 17%. Betas for shares P, Q, and R,
are respectively 0.6, 1 and 1.2. What are the required rates of return on these shares?

E (RP) = 0.08 + (0.17 – 0.08) x 0.6 = 13.4%

E (RQ) = 0.08 + (0.17 – 0.08) x1.0 = 17%
E (RR) = 0.08 + (0.17 – 0.08) x 1.2 = 18.8%
Q with beta of 1 has a return equal to the market return. P has beta lower than 1 and hence its
required rate of return is lower than the market return. R has a return greater than the market return
since its beta is greater than 1.00.
When graphed, the above equation is called the Security Market Line (SML) and is illustrated in
the Figure below.

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Figure 2.2: The Security Market Line.
E( )

SML

E( )= + [E ( )- ] βi:

1.0 β

The significance of the security market line is that in equilibrium each risky asset should be priced
so that it plots exactly on the line. The above equation shows that according to the capital asset
pricing model, the expected return on a risky asset consists of two components: the risk-free rate of
interest plus a risk premium. The risk premium on a risky security equals the market risk premium,
i.e. the difference between the expected market return and the risk free rate. The risk premium for
each asset depends on the asset’s beta and on the market risk premium . The betas of
individual assets will be distributed around the beta value of the market portfolio, which is 1. A
security’s beta of 1 indicates systematic risk equal to the aggregate market risk and the required rate
of return will be equal to the market rate of return. If the security’s beta is greater than 1, then its
systematic risk is greater than the aggregate market. This implies that the security’s returns fluctuate
more than the market returns, and the security’s required rate of return will be more than the market
return. On the other hand, a security’s beta of less than 1 means that the security’s risk is lower than
the aggregate market risks. This implies that the securities returns are less sensitive to the changes
in market returns. The security’s required rate of return will be less than the market rate of return.
The capital asset pricing model applies to individual assets and to portfolios. The beta factor for a
portfolio p is simply:

Where Cov ( ) = the covariance between the returns on portfolio p and the market portfolio.
This equation is simply rewritten in terms of a portfolio P, instead of a particular asset i.

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Implementation of the CAPM
Use of the CAPM requires estimation of the risk-free interest rate, , the systematic risk of equity,
and the market risk premium, . Each of these variables is discussed in turn.
The Risk-free Interest Rate ( )
The assets closest to being risk free are government debt securities, so interest rates on these
securities are normally used as a measure of the risk-free rate. However, unless the term structure of
interest rates is flat, the various government securities will offer different interest rates. The
appropriate risk-free rate is the current yield on a government security whose term to maturity
matches the life of the proposed projects to be undertaken by the company. Since these activities
undertaken by the company typically provide returns over many years, the rate on long-term
securities is generally used.
The Securities’ Systematic Bisk ( )
The betas of securities are usually estimated by applying regression analysis to estimate the
following equation from time series data:

Where; = the rate of return for asset i during period t

= a constant, specific to asset i
= an error term
= the rate of return for the market portfolio M during period t
the systematic risk (beta) of asset i equal to
=

The above equation is generally called the market model. Its relationship to the security market
line can be readily seen by rewriting the SML equation as follows:

The market model is often used to obtain an estimate of ex-post systematic risk. To use the market
model, it is necessary to obtain time series data on the rates of return on the share and on the market
portfolio—that is, a series of observations for both and is needed. However, when using the
market model, choices must be made about two factors. First, the model may be estimated over
periods of different length. For example, data for the past 1, 2, 3 or more years may be used. Five
years of data are commonly used, but the choice is somewhat arbitrary. Second, the returns used in
the market model may be calculated over periods of different length. For example, daily, weekly,
monthly, quarterly or yearly returns may be used. Again this choice is subject to a considerable
degree of judgment.

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From a statistical perspective, it is generally better to have more rather than fewer observations,
because using more observations generally leads to greater statistical confidence. However, the
greater the number of years of data that are used, the more likely it is that the firm’s riskiness will
have changed. This fact highlights a fundamental problem of using the market model. The market
model provides a measure of how risky a firm’s equity was in the past. What we are seeking to
obtain is an estimate of future risk. Therefore, the choice of both the number of years of data and the
length of the period over which returns are calculated involves a trade-off between the desire to
have many observations and the need to have recent and consequently more relevant data.
The Market Risk Premium [ ]
The market portfolio specified in the CAPM consists of every risky asset in existence.
Consequently, it is impossible in practice to calculate its expected rate of return and hence
impossible to also calculate the market risk premium. Instead, a share market index is generally
used as a substitute for the market portfolio. As the rate of return on a share market index is highly
variable from year to year, it is usual to calculate the average return on the index over a relatively
long period. Suppose that the average rate of return on a share market index over the past 10 years
was 18.5 per cent per annum. If this rate were used as the estimate of and today’s risk-free
rate is 8.5 per cent, the market risk premium would be 10 per cent.
A problem with using this approach is that the estimate of reflects the market’s current
expectations of the future, whereas is an average of past returns. In other words, the two
values may not match, and some unacceptable estimates may result. For example,
estimated in this way may be negative if the rate of inflation expected now, which should be
reflected in , is greater than the realized rate of inflation during the period used to estimate
.
Risk, Return and the CAPM
The distinction between systematic and unsystematic risk is important in explaining why the CAPM
should represent the risk–return relationship for assets such as shares. The returns on a firm’s shares
can vary for many reasons: for example, interest rates may change, or the firm may develop a new
product, attract important new customers or change its chief executive.
These factors can be divided into two categories: those related only to an individual firm (firm-
specific factors) and those that affect all firms (market-wide factors). As the shares of different
firms are combined in a portfolio, the effects of the firm-specific factors will tend to cancel each
other out; this is how diversification reduces risk. However, the effects of the market-wide factors
will remain, no matter how many different shares are included in the portfolio. Therefore,
systematic risk reflects the influence of market-wide factors, while unsystematic risk reflects the
influence of firm-specific factors.

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Because unsystematic risk can be eliminated by diversification, the capital market will not reward
investors for bearing this type of risk. The capital market will only reward investors for bearing risk
that cannot be eliminated by diversification—that is, the risk inherent in the market portfolio. There
are cases when, with hindsight, we can identify investors who have reaped large rewards from
taking on unsystematic risk. These cases do not imply that the CAPM is invalid: the model simply
says that such rewards cannot be expected in a competitive market. The reward for bearing
systematic risk is a higher expected return and, according to the CAPM, there is a simple linear
relationship between expected return and systematic risk as measured by beta.

Individual Assignment
1. A share is currently selling at birr 50. It is expected that a dividend of birr 2 per share would be
paid during the year and the share could be sold at birr 54 at the end of year. Calculate the
expected return from the share.
2. Calculate the expected return and standard deviation of returns (risk) for a stock having the
following probability distribution

Probable returns (%) Probability of occurrence

-24 0.05
-10 0.15
0 0.15
12 0.20
18 0.20
22 0.15
30 0.10

3. A stock costing Br 250 pays no dividends. The possible prices that the stock might sell for at the
end of the year and the probability of each are:

Possible prices Probability

200 0.10
230 0.25
250 0.35
280 0.20
310 0.10

a. What is the expected return?

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 b. What is the standard deviation of the return?
4. An investor has analyzed a stock for a one year holding period. There is a fifty- fifty chance that
the stock, currently selling at Br 60, will sell for Br 55 or Br 70 by the year end. The investor
can borrow from his bank at 10% rate of interest per annum.
a) What is the investor’s holding period yield and risk if he buys 100 shares and does not
borrow?
b) What would be his expected yield and risk if he buys 200 shares paying 60% of the cost with
borrowed fund?
5. Calculate the expected rate of return for security x from the following information.
Risk free rate=10%, Market return=18%, and systematic risk = 1.35.

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