PRINCIPLES OF FINANCE

Structure of the Course

• Chapter 1: Introduction to Finance

• Chapter 2: Time Value of Money

• Chapter 3: Financial Markets

• Chapter 4: Risk and Return

• Chapter 5: Corporate Finance

Materials
• Chapter 6, Keown, A., Martin, J. and Petty, J. (2019).
Foundations of Finance, Global Edition, (10th ed.), Pearson.

• Chapter 12 & 13, Ross, S. A., Westerfield, R. W., & Jordan, B.

D. (2022). Fundamentals of corporate finance (13th ed.).
McGraw-Hill Professional.
Chapter 4: Risk and Return
1. Revision of Statistics

2. Risk and Return

3. Portfolio Diversification
1. Revision of Statistics
v Concept:
• Population vs. Sample:
A population is a collection of units being studied.
This might be the set of all people in a country.
Units can be people, places, objects, years, drugs, or many other things.
A sample is a group of units, selected from a larger group (the
population). By studying the sample it is hoped to draw valid
conclusions (inferences) about the population.
The sample should be representative of the population. This is best achieved
by random sampling. The sample is then called a random sample.
1. Revision of Statistics
v Concept:
• Parameter vs. Estimator:
A parameter is a numerical value of a population. The population
values are often modelled from a distribution. The shape of the
distribution depends on its parameters.
• For example: The parameters of the normal distribution are the mean, μ
and the standard deviation, 𝜎 ! .
An estimator is a quantity calculated from the sample data, which
is used to give information about an unknown quantity (usually a
parameter) in the population.
• For example, the sample mean is an estimator of the population mean.
1. Revision of Statistics
v Concept:
• Univariate vs. Multivariate:
- When one measurement is made on each observation,
univariate analysis is applied.
q Mean
q Variance
q Standard Deviation

- If more than one measurement is made on each observation,

multivariate analysis is applied.
q Covariance
q Correlation coefficient
q Beta
1. Revision of Statistics
v Univariate Statistics:
• Mean:
- The mean is a measure of central tendency of a probability
distribution. It is also referred to as an expected value.
- The mean (arithmetic mean) of a dataset is the sum of all values
divided by the total number of values.
Mean is the most commonly used measure of central tendency and is often
referred to as the “average.”
𝒏
𝟏
"=
𝒙 ' 𝒙𝒊
𝒏
𝒊#𝟏
1. Revision of Statistics
v Univariate Statistics:
• Variance:
- The variance is the measure of central dispersion that takes into
account the spread of all data points in a data set.
- The variance of the data set is the average squared of the
distances from each data point to the mean.
Variance is expressed in squared units.
𝒏
𝟏
s!𝟐 = ) )𝟐
&(𝒙𝒊 − 𝒙
𝒏−𝟏
𝒊$𝟏
1. Revision of Statistics
v Univariate Statistics:
• Standard Deviation:
- Standard deviation is another measure of dispersion from the
mean of the data set.
- The standard deviation is the square root of variance.
Standard deviation is expressed in the same units as the original values,
hence it is often preferred as a main measure of variability.

𝒔𝒙 = s!𝟐
1. Revision of Statistics
Exercise 1:
The following data are the monthly salaries y and the grade point
averages x for students who obtained a bachelor’s degree in banking
and finance with a major in investment finance:
Student GPA Monthly Salary Student GPA Monthly Salary
No. ($) No. ($)
1 2.6 3300 4 3.2 3500
2 3.4 3600 5 3.5 3900
3 3.6 4000 6 2.9 3600

a. Calculate the mean, variance and standard deviation of sample

GPA?
b. Calculate the mean, variance and standard deviation of sample
monthly salary?
1. Revision of Statistics
v Multivariate Statistics:
- In this section, we focus on bivariate statistics, where exactly
two measurements are made on each observation.
- Bivariate statistics describe the paired relation between
observations of two different variables:
• Positive relation

• Negative relation

• No relation
1. Revision of Statistics
v Multivariate Statistics:
• Covariance:
- Covariance is a statistic representing the direction of the
relationship between two variables.

∑,(,*$+(𝑥( − 𝑥)(𝑦
̅ * − 𝑦)
4
𝐶𝑜𝑣 𝑥, 𝑦 =
𝑛−1
- The covariance reflects the sign of relationship between two
variables:
• Covariance > 0 => 02 variables are said to be positively correlated.
• Covariance < 0 => 02 variables are said to be negatively correlated.
• Covariance = 0 => 02 variables are said to be uncorrelated.
1. Revision of Statistics
v Multivariate Statistics:
• Correlation coefficient:
- The correlation coefficient is a statistical measure of the
strength of the relationship between two variables.

𝐶𝑜𝑣 (𝑥, 𝑦)
𝜌(.,/) =
𝜎. 𝜎/

- The correlation coefficient reflects the magnitude of the

correlation between two variables:
• 𝜌 = −1 => perfectly negative correlation.
• 𝜌 = 0 => zero correlation
• 𝜌 = 1 => perfectly positive correlation.
1. Revision of Statistics
v Multivariate Statistics:
• Correlation coefficient:
- The value of 𝜌 always ranges
in [1; -1].
The greater the absolute value, the
stronger the correlation.
1. Revision of Statistics
v Multivariate Statistics:
Beta:
•
- The beta coefficient measures the degree of change in the
outcome variable for every 1-unit of change in the predictor
variable.
𝐶𝑜𝑣 (𝑦, 𝑥) 𝐶𝑜𝑣 (𝑦, 𝑥)
𝛽(/,.) = =
𝜎. 𝜎. 𝑉𝑎𝑟 (𝑥)
𝐶𝑜𝑣 (𝑥, 𝑦) 𝐶𝑜𝑣 (𝑥, 𝑦)
𝛽(.,/) = =
𝜎/ 𝜎/ 𝑉𝑎𝑟 (𝑦)

Exercise 2: Estimate the relationship between GPA and monthly

salaries of data from Exercise 1 and draw your own conclusion.
2. Risk and Return
v Return:
• Return on investment:
- The gain (or loss) from buying an investment asset.
- 02 components:
• Income component: cash directly paid to the investor during the times of
owning the investment (in the form of interest payment or dividends).
• Capital gain (loss): the change in asset value over time.

Total Dollar Return = Dividend Income + Capital Gain (Loss)

2. Risk and Return
v Return:
• Return on investment:
Exercise 3:
Suppose the Video Concept Company has several thousand shares
of stock outstanding. You purchased some of these shares of stock
in the company at the beginning of the year. It is now year-end, and
you want to determine how well you have done on your investment.
At the beginning of the year, the stock was selling for $37 per share.
Suppose that, over the year, the stock paid a dividend of $1.85 per
share. Also, the value of the stock has risen to $40.33 per share by
the end of the year. What is the total dollar return on your
investment?
2. Risk and Return
v Return:
• Return on investment:
- Holding period return: the rate of return earned on an
investment as percentage, which equals the total dollar return
divided by the amount invested.
Other names: total percentage return, realized return, historical return,…

P123 + Dividend − P415622625

HPR =
P415622625

𝑯𝒐𝒍𝒅𝒊𝒏𝒈 − 𝒑𝒆𝒓𝒊𝒐𝒅 𝑫𝒊𝒗𝒊𝒅𝒆𝒏𝒅 𝑪𝒂𝒑𝒊𝒕𝒂𝒍 𝑮𝒂𝒊𝒏 (𝑳𝒐𝒔𝒔)

= +
𝑹𝒆𝒕𝒖𝒓𝒏 𝒀𝒊𝒆𝒍𝒅 𝒀𝒊𝒆𝒍𝒅
2. Risk and Return
v Return:
• Return on investment:
Exercise 4:
Suppose you bought some stock at the beginning of the year for $25
per share. At the end of the year, the price is $35 per share. During
the year, you got a $2 dividend per share. What is the dividend
yield? The capital gains yield? The percentage return? If your total
investment was $1,000, how much do you have at the end of the
year?
2. Risk and Return
v Return:
• Return on investment:
Exercise 5:
Calculate the average daily holding-period return for the investor
holding common stock with the following data:
Date Stock price
23/06 $20
24/06 $20.9
25/06 $22.1
26/06 $21.1
27/06 $21.8
2. Risk and Return
v Return:
• Return on investment:
Exercise 6:
Calculate the average daily holding-period return for the investor
holding common stock with the following data:

Date Stock price

20/10 $10
21/10 $20
22/10 $10

Using arithmetic mean vs. geometric mean?

2. Risk and Return
v Risk:
• Risk inherent in an investment:
- Risk: the potential variability in investor’s cash flows. The risk of
an investment measures how volatile the return on investment is.
2. Risk and Return
v Risk and Return:
- The average return on an investment is measured by the mean,
μ, of the historical rate of return.
- The risk of an investment measures how much the actual return
deviates from the average value in a typical year and is
represented by the standard deviation, σ.

- One important principle in Finance:

“Risk requires a Reward”
Exercise 7: Calculate and compare the risk and return among large
company stocks, long-term government bonds, and US T-Bills. (Link)
2. Risk and Return
v Risk and Return:
Exercise 8:
Suppose the Supertech Company and the Hyperdrive Company have
experienced the following returns in the last four years:

Year Supertech Return Hyperdrive Return

2001 - 0.20 0.05
2002 0.50 0.09
2003 0.30 - 0.12
2004 0.10 0.20

What are the average returns? The variances? The standard deviations?
Which investment was more volatile? What are the relationship of these
two investments?
2. Risk and Return
v Potential Investment:
- The risk–return trade-off that investors face on a day-to-day basis is
based not on realized rates of return but on what the investor expects to
earn on an investment in the future.
Example:
Assume you are considering an investment costing $10,000, for which the
future cash flows from owning the security depend on the state of the
economy, as follows:
Cash Flows from the
State of the Economy Probability of the States
Investment
Economic recession 20% $1,000
Moderate economic growth 30% 1,200
Strong economic growth 50% 1,400
2. Risk and Return
v Potential Investment:

- Expected Return: 𝑬 𝑹𝒙 = ∑𝒏𝒊$𝟏 𝒑𝒊 𝒙𝒊

- Variance: 𝑽𝒂𝒓 [𝑬 𝑹𝒙 ] = ∑𝒏𝒊$𝟏 𝒑𝒊 ( 𝒙𝒊 −𝑬(𝑹𝒙 ))𝟐

- Covariance: 𝑪𝒐𝒗 𝒙, 𝒚 = ∑𝒏𝒊$𝟏 𝒑𝒊 (𝒙𝒊 − 𝑬(𝑹𝒙 )) (𝒚𝒊 − 𝑬(𝑹𝒚 ))

Exercise 9:
Calculate the risk and return of the investment in previous example.
2. Risk and Return
v Potential Investment:
Exercise 10:
You are considering two investments, X and Y. The distributions of
possible returns are shown below:

Possible Returns
Compute the expected return
Probability
Investment X Investment Y and standard deviation for each
0.05 -10% 0% investment. Would you have a
0.25 5% 5% preference for one investment
0.4 20% 16% over the other if you were
0.25 30% 24%
making the decision?
0.05 40% 32%
2. Risk and Return
v Risk Appetite:
Risk appetite refers to the amount of risk that investors are willing
to accept in pursuit of potential profit of the investment.
• A risk averse investor will generally take a guaranteed outcome
even if it has a lower expected pay-out than a gamble.
• A risk neutral investor is indifferent to risk when making an
investment decision (only considers the expected return of each
investment and ignores the potential downside risk).
• A risk lover will choose a higher risk option with an expectation
of receiving higher return.
3. Portfolio Diversification
v Diversification:
Diversification is the concept of putting your money into various
types of investments that often do not react the same way and at the
same time.
3. Portfolio Diversification
v Investment Portfolio:
A portfolio is a grouping of financial assets such as stocks, bonds
and cash equivalents.
Consider a portfolio comprised of 02 assets: A and B.
- Portfolio Return:
𝑬 𝒓𝑷 = 𝒘𝑨𝑬(𝒓𝑨) + 𝒘𝑩𝑬(𝒓𝑩)
- Portfolio Risk:

𝝈𝑷 = 𝒘𝟐𝑨𝝈𝟐𝑨 + 𝒘𝟐𝑩𝝈𝟐𝑩 + 𝟐𝒘𝑨𝒘𝑩𝒄𝒐𝒗 𝑨, 𝑩

3. Portfolio Diversification
v Investment Portfolio:
How can using portfolio reduce investment’s risk?
Exercise 11:
Assume that you are holding 60% of your asset in X and consider
investing the remaining in either Y or Z. Which investment should you
choose?
Possible Returns
Probability
Investment X Investment Y Investment Z

0.05 -10% 0% 30%

0.25 5% 5% 25%
0.4 20% 16% 22%
0.25 30% 24% -3.0%
0.05 40% 32% -11%
3. Portfolio Diversification
v Investment Portfolio:
Under normal market conditions, diversification is an effective way
to reduce risk:
• If you hold just one investment and it performs badly, you could lose
all of your money.
• If you hold a diversified portfolio with a variety of different
investments, it’s much less likely that all of your investments will
perform badly at the same time. The profits you earn on the
investments that perform well offset the losses on those that perform
poorly.
3. Portfolio Diversification
v Investment Portfolio:

- The variability of portfolio

returns will decrease as we
add additional stocks to the
portfolio.
- The reduction occurs because
some of the volatility in
returns of a stock are unique
to that security.
3. Portfolio Diversification
v Total Risk:
- Total Risk of an investment:
Total risk = Systematic risk + Unsystematic risk

- The systematic risk principle:

“The reward for bearing risk depends only on the systematic risk of
an investment”

Implication: The expected return (and risk premium) on an asset

depends only on the systematic risk of that asset.
3. Portfolio Diversification
v Measuring Market risk:
- Market Risk: measured by a beta coefficient (beta), showing
how much systematic risk a particular asset has relative to an
average asset.
By definition, an average asset has a beta of 1.0 relative to itself.

Exercise 12:
Consider the following information about two securities. Which has
greater total risk? Which has
Std. Dev. Beta
greater systematic risk? Greater
Asset A 40% 0.5
unsystematic risk? Which asset Asset B 20% 1.5
will have a higher risk premium?
3. Portfolio Diversification
v Measuring Market risk:
- Beta coefficient (𝜷) of a specific asset measures the relationship
between the returns of that asset and the returns of an average
asset.
In practice, an average asset is normally the market index.

- Calculation of Asset Beta:

𝐶𝑜𝑣 (X, m) 𝐶𝑜𝑣 (X, m)
𝛽(;,<) = =
𝜎<𝜎< 𝑉𝑎𝑟 (m)
In which:
• X: the specific asset that is under consideration.
• m: the market index
3. Portfolio Diversification
v Measuring Market risk:
Exercise 13:
You are considering investing some part of your money in eBay
stock (an American multinational e-commerce company) and
wonder about the market risk of the stock. Given the data in link,
estimate the relationship of the returns for eBay and the S&P 500
Index. What do you conclude?

Practice exercise:
Go to the website and compute the market risk of a specific
company (Hint: using 1-year period for daily price of the stock).
3. Portfolio Diversification
v Measuring Market risk:
- Portfolio Beta:
𝜷𝑷 = 𝒘𝑨𝜷𝑨 + 𝒘𝑩𝜷𝑩 + 𝒘𝑪𝜷𝑪 + ⋯
Exercise 14:
Suppose we had the following investments:

Security Amount Invested Expected Return Beta

Stock A $1,000 8% 0.80
Stock B 2,000 12 0.95
Stock C 3,000 15 1.10
Stock D 4,000 18 1.40

What is the expected return on this portfolio? What is the beta of this portfolio?
Does this portfolio have more or less systematic risk than an average asset?