Risk is directly related to potential returns from an investment. Investors provide capital today expecting a higher return in the future. Risk can be analyzed on a standalone basis for individual assets or on a portfolio basis considering multiple assets. Higher risk investments have a wider range of possible returns and the expected return depends on assigning probabilities to all potential outcomes and calculating a weighted average.
2. RISK ANALYSIS
Risk has a direct relationship with returns.
An individual or business spend money today with an
expectation to earn MORE money tomorrow
The concept of return provides investors with a
convenient way of expressing the financial
performance of an investment
For example, you buy 5000 shares of Safaricom today
for KSH 25,000. If we assume the company does not
pay dividends (they are paying 2 cents!), and you sell
the shared at the end of the year for KSH 29,500.
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3. What is the return on your 25,000
investment
The computation of your return on this
investment is as follows:
AMOUNT RECEIVED KSH 29,500
LESS AMOUNT PAID KSH 25,000
RETURN 4,500
However if you sold the shares for Ksh
23,000, your Kenya money return would be –ve
KSH 2000
But fair analysis of risk and return calls for:
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4. The size of the investment and the associated
return together with the waiting period ( you can
imagine a KSH 1million Investment for one year
and a return of Ksh 200!)
Thus you need as an investor to know the timing
of the in vestment
The solution to these issues is to express an
investment results as either
Rates of return
Percentage return
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5. Rate of return= Amount received- Amount Invested
Amount Invested
In our example above the rate of KSH return would be
RR= 29,500-25,000* 100= 18%
25,000
The problem of time is resolved by expressing the rates
of return on annual basis.
Thus rates of return are superior to KSH returns as
measure of an investment
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6. Risk is defined as an unfavourable event- which if
it occurs will expose an investor to a loss of either
part or the whole of his investment
An assets risk can be categorised in two ways
namely:
On a stand-alone basis where the asset is
considered in isolation
on a portfolio basis where the asset is held as
one of a number of assets in a portfolio
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7. An assets stand alone risk is the risk an investor
would be exposed to if he/she held only this
particular one asset
EXAMPLE
Imagine an investor buys Ksh 50,000 of short-term
T-Bills with expected return of 5%
What this means is that this assets return is
known to be 5% with certainty, and therefore this
particular asset is RISK FREE
But supposing this KSH 50,000 was in the stocks
of newly listed company-
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8. The implication here is that this investment is
absolutely not predictable.
Thus the investment’s returns can not be
determined with certainty
If the investor’s expected rate of return (which
may be worked out considering all the factors
that might affect this investment) is say 15%,
there is still the danger that the investor might
actually earn much less, or even more on this
investment.
This stock is definitely a risky investment
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9. Remember, an investment is:
The current commitment of KSH or capital for a
period of time in assets or financial instruments
in order to derive future returns which will
compensate the investor for:
The time the funds have been committed
The expected rate of inflation
The uncertainty of the future returns
Thus no investment should be undertaken unless
the expected rate of return is sufficient to
compensate the investor for the perceived risk
associated with the investment.
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10. Note that risky assets rarely generate sufficient
returns to meet their expected rates of returns
Risky assets either earn LESS or MORE than was
originally envisaged
Remember if assets earned their expected
returns, then they would not be risky at all
Investment RISK is thus closely linked to the
PROBABILITY that the investor could actually earn
less or more than the expected return
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11. RISK , PROBABILITY & EXPECTED
RETURN
The specification of a larger range of possible
returns from an investment reflects the investor’s
uncertainty in as far the actual return is
concerned
Thus a larger range of expected returns makes
the investment riskier
An investor basically determines how certain
these expected returns are by analysing
estimates of expected returns
This is done by the investor by assigning
probability values to ALL POSSIBLE RETURNS
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12. The probability ranges from ZERO i.e. no
change of the return to ONE i.e. complete
certainty that the investment will provide the
specified rate of return
These probabilities are subjective estimates
based on historical performance of the
investment or similar investments
The investor will simply make modifications to
suit his future expectations accordingly
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13. For example if an investor knows that about 20% of the
time the rate of return on his investment was say 12%,
using this information together with future
expectations regarding the economy, one can derive an
estimate of what might happen in the future
Thus if we multiply possible outcomes with their
probability occurrence, and SUM the products, this
results in what is known as the WEIGHTED AVEAGE of
outcomes.
This is because probabilities are basically weights (what
is a weight?)
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14. THUS
EXPECTED RETURN= Summation of probability of
return* possible return
ER= (P1)(R1) +(P2)(R2)+ ....(Pn)(Rn)
EXAMPLE
Demand prob rate of return
Strong 0.15 0.20
Normal 0.15 -0.20
Weak 0.70 0.10
Required
Calculate the Expected Return (ER)
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