Risk & Return analysis in

investment decisions

Ajay Kumar Chauhan
Return
Risk
For a Treasury security, what
is the required rate of return?

= Risk-free rate of return

Since Treasurys are essentially free of
default risk, the rate of return on a Treasury
security is considered the risk-free rate of
return.

For a corporate stock or bond, what is
the required rate of return?


Required Risk-free Risk
rate of = rate of + Premium
return return


How large of a risk premium should we
require to buy a corporate security?


Returns


Expected Return - the return that an investor
expects to earn on an asset, given its price,
growth potential, etc.

Required Return - the return that an investor
requires on an asset given its risk.

Return Calculations

Returns = Selling price Buying price + CB
Buying Price

Expected Return of a Portfolio is the weighted sum of
the individual returns from the securities making up
the portfolio:

Nominal & Real Rate of Return

r = R i

The exact relationship can be expressed
as:

r = (R i) / (1 + i)

Arithmetic vs. Geometric Return

20%, -10%, 30%, -20%, 10%, 20%, -30%

AM = 20 10 + 30 - 20 + 10 + 20 30
7
= 3%
Net Value of the portfolio = Rs 103
Discrete vs. Continously Compounded
Return

DR = (P
1
-p
0
)/P
0

CCR = ln (P
1
/p
0
)
Risk

Investors are willing to take some amount of risk since it is the
only way to earn higher return.

In Normal Life, Risk often means a negative return.

Three scenarios of Future investment

Certainty

Uncertainty

Risk
Risk : in holding the securities is generally associated
that realised returns will be less that the expected
returns.
Risk


Systematic Unsystematic
Risk Risk

External to the firm => internal to the firm
Cannot be controlled => Controllable to large extent
=> Known as non-diversifiable risk => also known as diversifiable risk
Affect large no of securities




Market Interest Purchasing Business Financial
Risk rate risk power risk risk risk
Market Risk


Stock variability due to the changes in investor's attitude and expectations.

Caused by investors reaction towards tangible and intangible events.


real basis psychological basis





political events emotional instability
Social events fear of loss
International reasons excessive selling pressure
Economic reasons market sentiments



Interest rate risk

Refers to uncertainty of future markets values and of the size
of future income caused by the fluctuations in the general
level of interest rates.

Increase in interest rates

Increase in cost of capital ( cost of borrowed capital)

Lower earnings , dividends

Decline in the share prices
Purchasing power risk

Refers to the impact of inflation or deflation on an investment

Unsystematic risk

Is that portion of total risk that is unique to a firm or an industry
and affecting securities market in general.

Factors such as management capability, consumer preferences
and labour strikes can cause unsystematic variability of
returns for a cos stock

Examined separately for each company

Two sources of unsystematic risk:
Business risk
Financial risk
Business Risk

Is a function of operating conditions faced by the firm and the
variability these conditions injects into operating and income
and expected dividends.

Internal business risk : wrong mgmt decisions, strikes
and lockouts, obsolete products, dependence on few large
customers.

External business risk : Fiscal policy, monetary policy,
exchange rates, political environments.

Financial risk

Arises when the firm uses the debt in the capital
structure

Create problems in recessions or period of low
demands.

Spread of bad words/news in the market.

Higher employee turn over

Buyers dilemma.
Assigning risk premiums


R = I + p + b + f + m + o


Where R = required rate of return
I = risk free rate of return
P = purchasing power allowance
B = business risk allowance
F = financial risk allowance
O = allowance for other risk

Stating predictions scientifically

Analyst must try to quantify the risk that a given stock will fail to realize its expected
return. Quantification of risk is necessary to ensure uniform interpretation and
comparison.

Example : Consider two stocks A & B. Expected return of both the stocks is 10%. The
security analyst assign probabilities to different returns to stock A & B. The
probability distribution of stock A & B are as follows:

Stock A Stock B
Return Probability R * P Return Probability R * P
7
8
9
10
11
12
13
Total
0.05
0.10
0.20
0.30
0.20
0.10
0.05
0.35
0.80
1.80
3
2.20
1.20
0.65
10

9
10
11



Total

0.30
0.40
0.30

2.7
4
3.3



10
Stocks A & B have identical expected average returns of 10%. But the spreads for
stocks A & B are not the same.

Range (A) = 7 to 13 %
Range (B) = 9 to 11 %

Higher the dispersion , higher the risk
Stock A Stock B
Return
expected
return
Square of
the
difference
Prob 2 * 3 Return
expected
return
Square of
the
difference
Prob 2 * 3
7-10
8-10
9-10
10-10
11-10
12-10
13-10
Variance
S.D
9
4
1
0
1
4
9

0.05
0.10
0.20
0.30
0.20
0.10
0.05
0.45
0.40
0.20
0
0.20
0.40
0.45
2.10
1.45



9-10
10-10
11-10


Variance
S.D


1
0
1


.3
.4
.3


.3
0
.3


0.60
.77
Total Risk

Total risk of investment consists of two components:
1. Diversifiable risk
2. Non-diversifiable risk


Total risk = Diversifiable risk + Non-diversifiable risk



Can be eliminated by proper diversification managed with the help of Beta
Markowitz model
What Beta means

Beta is a risk measure comparing the volatility of a stock's price movement to the
general market.

Beta measures systematic risk. It shows how the price of a security responds to
market forces.

The beta of the market is one and other betas are viewed in relation to this
value.

Beta can be positive and negative.

Beta = Covariace ( Xi, Yi)
Variance (yi)

Where, Xi is the stock return
Yi is the index return



Beta = n XY x y
n y
2
y




Calculating Beta
bhel
Value At Risk

Quantile of a distribution

q is the value below which lie q% of the values.

ie with a prob of p% we can expect a loss equal to
or greator than the VAR.

Conditional Tail Expectation
Assuming the terminal value of the portfolio falls in the
bottom 5% of possible outcome , what is its expected
value ?
Lower Partial Standard Deviation


Is an appropriate measure of risk for non-normal
distributions

Is the SD computed solely from values below the
Expected Return

measure of downside risk


Volatility

SD in the error terms

Where,

Error terms = Actual Return Expected return