RISK AND RETURN

Investment decisions are influenced by various motives. some people invest in a business to acquire control and enjoy the prestige associated with it. some people invest in expensive yatchs and famous villas to display their wealth. Most investors, however , are largely guided by the pecuniary motive of earning a return on their investment. For earning returns investors have to almost invariably bear some risk. In general , risk and return go hand in hand, while investors like returns they abhor risk.

RETURN:
Return is the primary motivating force that drives investment. It represents the reward for undertaking investment. Since the game of investing is about returns , measurement of realised returns is necessary to assess how well the investment manager has done . In addition , historical returns are often used as an important input in , such as dividend estimating future returns. CURRENT RETURN: The first component that often comes to mind when one is thinking about return is the periodic cash flow , such as dividend or interest, generated by the investment, current return is measured as the periodic income in relation to the beginning price of the investment.

CAPITAL RETURN: The second component of return is reflected in the price changes called the capital return-it is simply the price appreciation divided by the beginning price of the asset. For assets like equity stocks, the capital returns predominates. Thus , the total return for any security is defined as : Total return= current return+ capital return. The current return can be zero or positive , whereas the capital return can be negative, zero, or positive.

RISK:
We cannot talk about investment return without talking about risk because investment decisions invariably involve a trade-off between the two.risk refers to the possibility that actual outcome of an investment will differ from its expected outcome.More specifically, most investors are concerned about the actual outcome being less than the expected outcome.The wider the range of possible outcomes ,the greater the risk. Risk emanates from from several sources.The three major ones are business risk , interest rate risk ,and market risk. They are in detail: BUSINESS RISK: As a holder of corporate securities, you are exposed to the risk of poor business performance. This may be caused by a variety of factors like heightened competition ,emergence of new technologies development of substitute products, shifts in consumer preferences , inadequate supply of essential inputs , changes in governmental policies. INTEREST RATE RISK: The changes in interest rate have a bearing on the welfare of investors. As the interest rate goes up , the market prices of existing fixed income securities fall , and vice versa. This happens because the buyer of a fixed income securities fall , and vice

versa.This happens because the buyer of a fixed income security would not buy it at its par value or face value if its fixed income security would not buy it at its par value or face value if its fixed interest rate is lower than the prevailing interest rate on a similar security. MARKET RISK: Even if the earning power of the corporate sector and the interest rate structure remain more or less unchanged, prices of securities, equity shares in particular, tend to fluctuate. While there can be several reasons for this fluctuation , a major cause appears to be the changing sentiment of the investors. There are periods when investors become bullish and their investment horizons lengthen.

TYPES OF RISK:
Modern portfolio theory looks at risk from a different perspective. It divides total risk as follows. Total risk=unique risk+ market risk. The unique risk represents that portion of its total risk which stems from firm-specific factors like the development of a new product, a labour strike, or the emergence of a new competitor. In a diversified portfolio, unique risks of different stocks tend to cancel each other-a favourable development in one firm may offset an adverse happening in another and viceversa. Hence, unique risk is also referred to as diversifiable risk or unsystematic risk. The market risk of a security represents that portion of its risk which is attributable to economy-wide factors like the growth rate of GDP, the level of government spending money ,interest rate structure, and inflation rate, since these factors affect all firms to a greater or lesser degree, investors cannot avoid the risk arising from them, however diversified their portfolios may be.

MEASURING HISTORICAL RETURN:

The total return on an investment for a given period is: Total return =cash payment received during the period + price change over the period/ price of the investment at the beginning. All items are measured in rupees. The rupee cash payment received during the period may be positive or zero. The rupee price change over the period is simply the difference between the ending price and the beginning price. This can be positive or zero or negative. In formal terms, R=C+(PE-PB)/PB Where R is the total return over the period , C is the cash payment received during the period , PE the ending price of the investment, the PB is the beginning price.

RETURN RELATIVE:
Often it is necessary to measure returns in a slightly different manner. This is particularly true when a cumulative wealth index or a geometric mean has to be calculated, because in such calculations negative returns cannot be used. The concept of return relative is used in such cases. The return relative is defined as: Return relative=C+PE/PB. Put differently Return relative = 1+ total return in decimals.

CUMULATIVE WEALTH INDEX:

A return measure like total return reflects changes in the level of wealth .For some purpose it is more useful to measure the level of wealth rather than the change in the levels of wealth. To do this, we must measure the cumulative effect of returns of returns over time, given some initial amount, which is typically one rupee. The cumulative wealth index captures the cumulative effect of total returns. It is calculated as follows: CWI=WI0(1+R1)(1+R2) .....(1+Rn) Where CWI is the cumulative wealth index at the end of n years.WIO is the beginning index value which is typically one rupee and Rj is the total return of year I (i=l,.. .n) REAL RETURN: The returns so far discussed are nominal returns , or money returns. To convert nominal returns into real returns , an adjustment has to be made for the factor of inflator: Real return=l+nominal return/1+inflation rate-1. GLOBAL EQUITY RETURNS: A study titled triumph of the optimists: 101 years of global investment returns authored by P.Marsh and M.Staunton and published by Princeton university press in 2002 found that in the first half of the 20th century the arithmetic average annual real return on the world equity index was 5.1 % whereas it was 8.4 % over the period 1950-2002. What explains larger equity returns in the second half of the 20th century compared to the first half P.Marsh and M.Staunton attribute it to the following factors:

Unpredicted growth in productivity and efficiency, thanks to rapid technological changes.

2 3 4 5

Enhancement in the quality of management and corporate governance. Reduced transaction and monitoring costs. Decline in inflation rates... Fall in the required rate of return , thanks to diminished business and investment risks.

Risk refers to the possibility that actual outcome of an investment will differ from the expected outcome. Put differently, risk refers to variability or dispersion. If an asset's return has no variability, it is riskless. Suppose you are analyzing the total return of an equity stock over a period of time. Apart from knowing the mean return, you would also like to know about the variability in returns.

VARIANCE AND STANDARD DEVIATION:

The most commonly used measure of risk in finance is variance or its square root the standard deviation. The variance and the standard deviation of a historical return series are defined as follows: 2= [(Ri-R)2/n-l] 0 is the variance of return, sigma is the standard deviation of return, RI is the return from the stock in period I, R is the arithmetic return, and n is the number of periods. CRITICISM OF VARIANCE (AND STANDARD DEVIATION) AS A MEASURE OF RISK: Though widely used in finance , there are two conditions of the variance as a measure of risk. 1 .Variance considers all deviations, negative as well as positive, investors , however, do not view positive deviations unfavorably -infact ,they welcome it. However some researchers have argued that only negative deviations should be considered while measuring risk.

SUMMARY STATISTICS: while total return , return relative and wealth index are useful measures of return for a given period of time, in investment analysis we also need statistics are arithmetic mean and geometric mean. ARITHMETIC MEAN: The most popular summary statistic is the arithmetic mean. Hence the word mean refers to the arithmetic mean, unless otherwise specified. The arithmetic mean of a series of total returns is defined as; R= i=1 Ri/n Where R is the arithmetic mean, Ri is the value of total return(i=l, ........ n) and n is the number of total returns. GEOMETRIC MEAN: It represents the typical performance for a single period. However when you want to know the average compound rate of growth that has actually occurred over multiple periods , the arithmetic mean is not appropriate. The Geometric mean is defined as follows: GM=[(1+R1)(1+R2) .... (l+Rn)]1/n-l 2.When the probability distribution is not symmetrical around its expected value, variance alone does not suffice. In addition to variance, the skewness of the distribution should also be used. Markowitz does not consider skewness in developing portfolio theory. Proponents of the Markowitz model rely only on variance on the grounds that the historical returns of stocks have been approximately symmetrical. RATIONALE FOR STANDARD DEVIATION: Notwithstanding the above criticism, standard deviation is commonly employed in finance as a measure of risk. Why? The principal reasons for using standard deviation appear to be as follows:

l.If a variable is normally distributed , its mean and standard deviation contain all the information about its probability distribution. 2. If the utility of money is represented by a quadratic function (a function commonly suggested to represent diminishing marginal utility of wealth), then the expected utility is a function of mean and standard deviation. 3. Standard deviation is analytically more easily tractable. MEASURING EXPECT EP (EX ANTE) RETURN AND RISK: So far we looked at the historical(ex post facto) return and risk. We now discuss expected (ex ante) return and risk. PROBABILITY DISTRIBUTION: when you invest in a stock you know that the return from it can take various possible values. For example, it may be -5 percent, or 15percent,or 35 percent. Further the likelihood of these possible returns can vary. Hence, you should think in terms of a probability distribution. The probability of an event represents the likelihood of its occurrence. Suppose you say that there is a 4 to 1 chance that the market price of a stock A will increase and a 20percent chance that it will not increase during the next fortnight. Your judgment can be represented in the form of a probability distribution as follows OUTCOME Stock price will rise Stock price will not rise PROBABILITY 0.80 0.20

When you define the probability distribution of rate of returns(or for that matter any other variable) remember that: The possible outcomes must be mutually exclusive and collectively

exhaustive. The probability assigned to an outcome may vary between o and l(an

impossible event is assigned a probability 0, a certain event a probability of 1, and an uncertain event a probability somewhere between 0 and 1). The some of the probabilities assigned to various possible outcomes is 1.

EXPECTED RATE OF RETURN: The expected rate of return is the weighted average of all possible returns multiplied by their respective probabilities, In symbols, E(R) = RiPi Where E(R) is the expected return from the stock Rl is the return from stock under state I, pi is the probability that state I occurs, and n is the number of possible states of the world. STANDARD DEVIATION OF RETURN: Risk refers to the dispersion of a variable. It is commonly measured by the variance or the standard deviation. The variance of a probability distribution is the sumof the squares of the deviations of actual returns from the expected return , weighted by the associated probabilities. In symbols, 2 = pi (Ri-E(R)2 Where a = is the variance, Rj is the return for the Ith possible outcome, pi is the probability associated with the I th possible outcome, and E(R) is the expected return. Since variance is expressed as squared returns , it is somewhat difficult to grasp. So its square root, the standard deviation, is employed as an equivalent measure. 2=(2) Where sigma is the standard deviation. Continuous probability distribution: The probability distribution of returns on bharat foods stock is a discrete distribution because probabilities have been assigned to a finite number of specific values. In finance , however , probability distributions are commonly regarded as continuous ,

even though they may actually be discrete. In a continuously probability distribution , probabilities are not assigned to individual points as in case of a discrete distribution. Instead , probabilities are assigned to intervals between two points on a continuous curve. Hence,, when a continuous probability distribution is used , the following kinds of questions are answered. What is the probability that the rate of the return will fall between , say , 10% and 20% ? What is the probability that the rate of return will be less than 0% or more than 25% ?

THE NORMAL DISTRIBUTION:

The normal distribution , a continuous probability distribution, is the most commonly used probability distribution in finance. The normal distribution resembles a bell shaped curve. It appears that stock returns, atleast over short time intervals, are approximately normally distributed. The following features of normal distribution may be noted: l.It is completely characterized by just two parameters , viz.,expected return and standard deviation of return 2.A bell-shaped distribution, it is perfectly symmetric around the expected return. 3.The probability for values lying within certain bands are as follows: Band probability -one standard deviation -two standard deviation -three standard deviation 68.3% 95.4% 99.7%