King Faisal University [ ] 1 Business School Management Department Finance Pre-MBA Dr Abdeldjelil Ferhat BOUDAH 1

King Faisal University [ ] CHAPTER 6 RISK AND RETURN 2 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 6: RISK AND RETURN CHAPTER 6: RISK AND RETURN Introduction I- Risk and Return Fundamentals II- Risk of a Single Asset Conclusion 3 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 6: RISK AND RETURN CHAPTER 6: RISK AND RETURN Introduction To achieve the goal of share price maximization, the financial manager must learn to assess the two key determinants of share price, and all major financial decisions must be viewed in terms of expected risk, expected returns, and their combined impact on share price. 4 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 6: RISK AND RETURN CHAPTER 6: RISK AND RETURN Risk can be viewed as it relates either to a single asset held in isolation or to a portfolio- a collection or group of assets. In this shortly chapter the main concern is to concentrate on the general concept of risk in terms of a single asset. 5 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 6: RISK AND RETURN CHAPTER 6: RISK AND RETURN I- Risk and Return Fundamentals RISK DEFINED Risk can be defined as the chance of financial loss. Assets having greater chances of loss are viewed as more risky than those with lesser chances of loss. More formally, the term risk is used interchangeably with uncertainty to refer to the variability of returns associated with a given asset. 6 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 6: RISK AND RETURN CHAPTER 6: RISK AND RETURN For instance, a government bond that guarantees its holder $100 interest after 30 days has no risk, because there is no variability associated with the return. An equivalent investment in a firm’s common stock that may earn over the same period anywhere from $0 to $200 is very risky due to the high variability of its return. The more certain the return from an asset, the less variability and therefore the less risk. 7 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 6: RISK AND RETURN CHAPTER 6: RISK AND RETURN RETURN DEFINED The return on investment is measured as the total gain or loss experienced on behalf of its owner over a given period of time. It is usually stated as the change in value plus any cash distribution during the period, expressed as a percentage of the beginning-of-period investment value. 8 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 6: RISK AND RETURN CHAPTER 6: RISK AND RETURN The expression for calculating the rate of return earned on any asset over period t, k t is commonly defined as : 9 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 6: RISK AND RETURN CHAPTER 6: RISK AND RETURN WHERE, = actual, expected, or required rate of return during period t = price value of asset at time t = price (value ) of asset at time t -1 = cash (flow) received from the asset investment in the time period t -1 to t. 10 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 6: RISK AND RETURN CHAPTER 6: RISK AND RETURN EXAMPLE An investor wines to determine the actual rate of return on two of its video machines, Conqueror and Demolition. Conqueror was purchased exactly 1 year ago for $20,000 and currently has a market value of $ 21, 500. During the year, it generated $800 of after-tax cash receipts. Demolition was purchased 4 years ago, and its value at the beginning and end of the year just completed declined from $ to $ During the year, it generated $ 1700 of after-tax cash receipts. 11 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 6: RISK AND RETURN CHAPTER 6: RISK AND RETURN Substituting into the above equation, then the annual rate of return, k, for each video machine is calculated: 12 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 6: RISK AND RETURN CHAPTER 6: RISK AND RETURN Comment : Although the value of Demolition declined during the year, its relatively high cash flow caused it to earn a higher rate of return than that earned by Conqueror during the same period. Clearly the combined impact of changes in value and cash flow measured by the rate of return is important. 13 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 6: RISK AND RETURN CHAPTER 6: RISK AND RETURN RISK PREFERENCES Because of differing managerial preferences, it is important to specify a generally acceptable level of risk. The three basic risk preference behaviours can be explained as follows: risk-averse manager, risk- seeking manager, and risk-indifferent manager. 14 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 6: RISK AND RETURN CHAPTER 6: RISK AND RETURN RISK AVERSE MANAGER Risk-averse can be defined as the attitude toward risk in which an increased return would be required for an increase in risk. Most manager are risk-averse, because for a given increase in risk, they require an increase in return. Although in theory the risk disposition of each manager could be measured, in practice managers tend to be conservative rather than aggressive when accepting risk. 15 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 6: RISK AND RETURN CHAPTER 6: RISK AND RETURN RISK SEEKING MANAGER For the risk-seeking manager, the required return decreases for an increase of risk. Theoretically, because they enjoy risk, these managers are willing to give up some return to take more risk. 16 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 6: RISK AND RETURN CHAPTER 6: RISK AND RETURN RISK INDIFFERENT MANAGER In case of the risk-different manager, the required return does not change. In essence, no change in return in return would be required for the increase in risk. See figure Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 6: RISK AND RETURN CHAPTER 6: RISK AND RETURN II- Risk of a single asset The concept of risk is mostly developed by first considering a single asset held in isolation. Behavioral approaches can be used to assess risk and statistics can be used to measure risk. 18 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 6: RISK AND RETURN CHAPTER 6: RISK AND RETURN RISK ASSESSMENT Risk can be assessed from a behavioral point of view using sensitivity analysis and probability distributions. These approaches provide a feel for the level of embodied in a given asset. 19 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 6: RISK AND RETURN CHAPTER 6: RISK AND RETURN sensitivity analysis Sensitivity analysis is a behavioral approach that uses a number of possible return estimates to obtain a sense of the variability among outcomes. One common method involves the estimation of the pessimistic (worst), the most likely (expected), and the optimistic (best) returns associated with a given asset. 20 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 6: RISK AND RETURN CHAPTER 6: RISK AND RETURN In this case, the asset’s risk can be measured by the range, which is found by subtracting the pessimistic outcome from the optimistic. The greater the range for a given asset, the more variability, or risk, it is said to have. 21 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 6: RISK AND RETURN CHAPTER 6: RISK AND RETURN EXAMPLE 22 Dr Abdeldjelil Ferhat BOUDAH Assets A and B Asset BAsset A Initial Investment $10000

King Faisal University [ ] CHAPTER 6: RISK AND RETURN CHAPTER 6: RISK AND RETURN EXAMPLE 23 Dr Abdeldjelil Ferhat BOUDAH Assets A and B 7%13%Pessimistic 15 Most likely 2317Optimistic 16%4%Range

King Faisal University [ ] CHAPTER 6: RISK AND RETURN CHAPTER 6: RISK AND RETURN Probability Distributions Probability means a chance for that a given outcome which will occur. Yet, probability distribution provide a more quantitative insight into an asset’s risk. If an outcome has 80% probability of occurrence, the given outcome would be expected to occur 8 out of 10 times. If an outcome has a probability of 100%, it is then certain to occur. Outcomes having a probability of zero will never occur. 24 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 6: RISK AND RETURN CHAPTER 6: RISK AND RETURN EXAMPLE An evaluation of Norman company’s past estimates indicates the probabilities of the pessimistic, most likely, and optimistic outcomes’ occurring are 25, 50, and 25 percent, respectively. The sum of these probabilities must equal 100 %; that is they must be based on all the alternatives considered. See figure 6.2, and figure Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 6: RISK AND RETURN CHAPTER 6: RISK AND RETURN BAR CHART The simplest type of probability distribution is the bar chart, which shows only a limited number of outcome- probability coordinates. See figure 6.2 CONTINUOUS PROBABILITY DISTRIBUTION This type of distribution can be thought of as a bar chart for a very large number of outcome. figure Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 6: RISK AND RETURN CHAPTER 6: RISK AND RETURN RISK MEASUREMENT The risk of an asset can be measured quantitatively by using statistics. Here we consider two statistics- the standard deviation and the coefficient of variation- that can be used to measure the risk (that is variability) of asset returns. 27 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 6: RISK AND RETURN CHAPTER 6: RISK AND RETURN Standard Deviation The most common statistical indicator of an asset’s risk is the standard deviation, which measures the dispersion around the expected value. The expected value of return,, is the most likely return on an asset. This can be calculated by the following equation: 28 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 6: RISK AND RETURN CHAPTER 6: RISK AND RETURN The expected value of a return Where: = The expected value of a return = return for the outcome = probability of occurrence of the outcome = number of outcomes considered 29 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 6: RISK AND RETURN CHAPTER 6: RISK AND RETURN Standard Deviation ( the equation) Where: = The expected value of a return = return for the outcome = probability of occurrence of the outcome = number of outcomes considered 30 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 6: RISK AND RETURN CHAPTER 6: RISK AND RETURN EXAMPLE 31 Dr Abdeldjelil Ferhat BOUDAH Expected value of return -asset A- Weighted value % [(1)×(2)=(3)] Returns % (2) Probability (1) Possible outcomes Pessimistic Most likely Optimistic 15.00Expected return1.00Total

King Faisal University [ ] CHAPTER 6: RISK AND RETURN CHAPTER 6: RISK AND RETURN EXAMPLE 32 Dr Abdeldjelil Ferhat BOUDAH Expected value of return -asset B- Weighted value % [(1)×(2)=(3)] Returns % (2) Probability (1) Possible outcomes Pessimistic Most likely Optimistic 15.00Expected return1.00Total

King Faisal University [ ] CHAPTER 6: RISK AND RETURN CHAPTER 6: RISK AND RETURN EXAMPLE (Calculation of standard deviation) 33 Dr Abdeldjelil Ferhat BOUDAH The calculation of the standard deviation -asset A- i 1 %0.254%- 2 %15%13% % =

King Faisal University [ ] CHAPTER 6: RISK AND RETURN CHAPTER 6: RISK AND RETURN EXAMPLE (Calculation of standard deviation) 34 Dr Abdeldjelil Ferhat BOUDAH The calculation of the standard deviation -asset B- i ?????7%1 ?????152 ?????233 = Conclusion: The higher the standard deviation, the greater the risk

King Faisal University [ ] CHAPTER 6: RISK AND RETURN CHAPTER 6: RISK AND RETURN coefficient of variation coefficient of variation is a measure of a relative dispersion that is useful in comparing the risk of assets with different expected returns. The higher the coefficient of variation, the greater the risk. 35 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 6: RISK AND RETURN CHAPTER 6: RISK AND RETURN Conclusion It can be said from what have been preceded that dealing with risk matters should be refer to as two main important approaches. First, it can be viewed from managers’ behaviors and their preferences. Second, risk assessment and measurement are so crucial when it comes to make a decision. 36 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] 37 بحمد الله