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Risk and Rates of Return

Return Presented By:

Ruchi Tyagi
Manjari Mishra
Suhrid Sarkar
Risk Apaar Sharma
Anmol Bajwa
Vikas Dubey
Ikwinder Dhawan
Aman Datta
Vishant Tyagi
What is Return?
 Total return = Dividend + Capital gain
R ate of return = D ividend yield + C ap ital gain yield
D IV 1 P1 − P0 D IV 1 + ( P1 − P0 )
R1 = + =
P0 P0 P0
Example:
 Hind manufacturing company data
Year Dividend
Per share
Closing
share
Calculate Rate of
Price
Return
2000 3.50 23.50

2001 3.50 27.75

2002 3.50 25.50

2003 3.75 27.95

2004 3.75 31.30


Year Dividend Per Closing Rate of Return
share share Price R=Dividend Yield + Capital Gain
2000 3.50 23.50

2001 3.50 27.75 [3.50+(27.75-23.50)]/23.50=32.98

2002 3.50 25.50 [3.50+(25.50-27.75)]/27.75=4.50

2003 3.75 27.95 [3.75+(27.95-25.50)]/25.50=24.31

2004 3.75 31.30 [3.75+(31.30-27.95)]/27.95=25.40

Avg = 87.19 / 4=21.79


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.
Expected Return
RETURNS AND PROBABILITIES
Economic Conditions Rate of Return (%) Probability Expected Rate of Return (%)
(1) (2) (3) (4) = (2) × (3)
Growth 18.5 0.25 4.63
Expansion 10.5 0.25 2.62
Stagnation 1.0 0.25 0.25
Decline – 6.0 0.25 – 1.50
1.00 6.00

E(R)=Probability*Rate of Return
Portfolio
 Combination of more than one security.
Year Return on Return on
stock stock
A(%) B(%)

2000 15 -5
2001 -5 15
2002 5 25
2003 35 5
2004 25 35
•Suppose we have stock A and stock B. The
returns on these stocks do not tend to move
together over time.

rate kA
of
return
rate kA
of
return

kB

time
rate kA
of
return kp

kB

time
Based only on your
expected return
calculations, which
stock would you
prefer?
Have you considered
RISK?
What is Risk?
 Risk exists if there is something you
don’t want to happen – having a chance
to happen!!!

 The probability that some event will


cause an undesirable outcome on the
financial health of your business and/or
other business/family goals
What is Risk?
 Uncertainty in the distribution of
possible outcomes.

Company A Company B
0. 5
0.2
0.45 0.18
0. 4 0.16
0.35 0.14
0. 3
0.12
0.25
0.1
0. 2
0.08
0.15 0.06
0. 1
0.04
0.05
0.02
0
4 8 12 0
-10 -5 0 5 10 15 20 25 30

return return
Sources of risk
 Business Risk
 Financial Risk
Business Risk
 That risk arising from the nature of the
business -- affects all producers.
 Production or technical risk
 Price or market risk
 Casualty risk
 Technological risk
 Political, social, & individual risk f.
Personal risk
Financial Risk
 Financial risk - variation brought about
by the way the business is financed.
 e.g.,
the use of nonequity capital in the
business.
 Financial risk might be measured as
the variation (e.g., Variance, Std. Dev,)
in the rate of return to equity.
Principle of Increasing Risk
 As the relative amount of nonequity
capital used in the business increases,
financial risk increases at an increasing
rate.
Expected Risk and Preference
 A risk-averse investor will choose among
investments with the equal rates of return,
the investment with lowest standard
deviation.
 A risk-neutral investor does not consider
risk, and would always prefer investments
with higher returns.
 A risk-seeking investor likes investments
with higher risk irrespective of the rates of
return.
Some risk can be diversified away
and some can not

 Market Risk (Non-diversifiable risk)


This type of risk can not be diversified
away.
 Firm-Specific risk (diversifiable risk)
This type of risk can be reduced
through diversification.
Total Risk =Unique Risk + Market Risk
Market Risk Firm-Specific risk
Risk which is attributable Risk which stems from a
to economy wide factors firm specific factors
Like: Growth rate of Like: Development of a
GNP,level of governmet new product,a labour
spending,interest rate. strike,emergence of new
competitor
These factors affect all These factors affect the
firms specific firm
As you add stocks to your portfolio,
firm-specific risk is reduced.

portfolio
risk

Firm-
Firm-
specific
risk
Market risk
number of stocks
How do we Measure Risk?

 To get a general idea of a stock’s price


variability, we could look at the stock’s
price range over the past year.
 Methods of Risk measurement
 Variance
 standard deviation
 beta
Method 1
Variance & Standard Deviation
Standard deviation is a measure of the dispersion of possible
outcomes.

Standard deviation = V ariance


n 2
1
σ 2
=
n −1
∑ (R
t =1
t −R )
Example
 Hind manufacturing company data
Year Dividend Closing Rate of Return
Per share share Price
2000 3.50 23.50
2001 3.50 27.75 32.98
2002 3.50 25.50 4.50
2003 3.75 27.95 24.31
2004 3.75 31.30 25.40
Average 21.79
Rate of
Return

Calculate variance and Standard Deviation


n 2
1
Formula used: σ 2 = ∑
n −1 t =1
(
Rt − R )
Year Rate of Standard Deviation=
Return
2000 2
1 n
2
σ = ∑
n −1 t =1
(Rt − R)
2001 32.98 11.19 125.21

2002 4.50 -17.29 298.94


=116.315 / (5-1)
2003 24.31 2.52 6.30 =29.07
Variance=29.07^2
2004 25.40 -5.9 34.81
=845.06
Avg=87.19 / 4 Avg = 465.26 / 4
=21.79 =116.315
Portfolio Risk
Example
 Suppose you have Rs.100,000 to invest
and you want to invest it equally in two
stocks, A and B. Return on stocks
depends on the state of economy.
Probability Distribution of Returns
State of Probability Return on Return Return on
economy stock A(%) on stock portfolio(%)
B(%)
1 0.20 15 -5 5

2 0.20 -5 15 5

3 0.20 5 25 15

4 0.20 35 5 20

5 0.20 25 35 30
Expected Return
Stock A:
0.2(15%)+0.2(-5%)+ 0.2(5%)+ 0.2(35%)+0.2(25%)=15%
Stock B:
0.2(-5%)+0.2(15%)+0.2(25%)+0.2(5%)+ 0.2(35%)=15%
Portfolio:
0.2(5%)+0.2(5%)+0.2(15%)+0.2(20%)+ 0.2(30%)=15%
Standard Deviation
Stock A:
=0.2(15-15)^2+0.2(-5-15)^2+ 0.2(5-15)^2+ 0.2(35-
15)^2+0.2(25-15)^2=200
=sqrt(200)=14.14%
Stock B:
=0.2(-5-15)^2+0.2(15-15)^2+0.2(25-15)^2+0.2(5-15)^2+
0.2(35-15)^2=200
=sqrt(200)=14.14%
Portfolio:
=0.2(5-15)+0.2(5-15)+0.2(15-15)+0.2(20-15)+ 0.2(30-
15)=90
=sqrt(90)=9.49%
Compare the values

State of Expected Expected Expected


economy Return on Return on Return on
stock A(%) stock B(%) portfolio
15 15 15

State of Standard Standard Standard


economy Deviation of Deviation of Deviatiof
stock A(%) stock B(%) portfolio
14.14 14.14 9.49
BETA
Beta: a measure of market risk.
 Specifically, it is a measure of how
an individual stock’s returns vary
with market returns.

 It’s
a measure of the sensitivity of a
security to market movements
Formula
 Rjt = aj + bjRmt + ej
 Beta,bj=Cov(Rjt,Rmt)/standard Deviation
Where,
Rjt : Return of security J in period t
aj : Intercept
bj :Regression Coeff. Beta
Rmt:Return on market Portfolio
ej :Random error Term
Calculating Beta
Return of security
. . . Beta =slope
Equation used: 15
Rjt = aj + bjRmt + ej . .
10 . . . .
. .
.. . .
.. . .
5
.. . .
-15 -10
.
-5 -5
. . 5
. 10 15
.. . . Market Return
. . . . -10
.. . .
. . . -15.
beta Values
 beta = 1
 Firmhas average market risk. The stock is no
more or less volatile than the market.
 beta > 1
A firm is more volatile than the market
(ex: computer firms)
 beta < 1
A firm is less volatile than the market
(ex: utilities).
How to reduce risk
Diversification
 Investing in more than one security
to reduce risk.
 Portfolio
Portfolio Risk-Return
Analysis(two asset case)
 Portfolio return depends on proportion of wealth
invested in two asset.

Portfolio
return in no way is affected by corelation
between two asset.

Itdepends on both correlation and proportion of


asset forming the portfolio.
 The correlation coefficient will always lie between
+1.0 and -1.0 .

 Return on asset vary according to the correlation


coefficient .

 For example two securities, logrow and rapidex


have following characterstics.
Logrow Rapidex
Expected return(%) 12.00 18.00
Standard variation(%) 16.00 24.00
Variance 256.00 576.00
Possible Correlations

perfect Perfect zero positive


positive negative

 Perfect positive correlation:


• It is rare to find two asset having perfect positive
correlation.
• In this correlation portfolio risk and return are linearly
related i.e high expected return high standard deviation
and vice versa.
• It is always +1.0.
Note:- If two stocks are perfectly positively correlated, diversification has no
effect on risk.
 Perfect negative correlation:
• In this the correlation between risk and return is -1.0.
•If two stocks are perfectly negatively correlated, the portfolio is perfectly
diversified.

 Zero correlation:
• In zero correlation the returns of two asset are
independent of each other.
• The two asset can go for diversification and the benefit is
that it is without any cost.
• The investor can invest in high risk security and improve
their return by keeping the portfolio risk low.
 Positive correlation:
• In reality returns of most asset have positive but less than
1.0 correlation.
• In this the correlation between risk and return is 0.5.
How to price risk?
 Capital Asset Pricing Model(CAPM)
 Arbitrage Pricing Theory (APT)
 The CAPM equation:
Rj = krf + j (Rm - krf)
where:
Rj = the Required Return on security j,
krf = the risk-free rate of interest,
j = the beta of security j, and
Rm = the return on the market index.
CML v/s SML
 CML represent the risk premiums of efficient portfolios
together.

 It is measured in terms of function of standard


deviations.

 SML depicts individual security risk premium.

 All fairly valued assets lie on SML.

 It is measured in terms of function of beta.

Beta= contribution of security to portfolio risk


The Arbitrage Pricing Theory
(APT)
 In APT, the return of an asset is assumed to
have two components:
 predictable (expected) and unpredictable
(uncertain) return. Thus, return on asset j will be:
E ( R j ) = R f + UR
where
Rf : predictable return (risk-free return on a zero-beta asset)
UR: unanticipated part of the return. The uncertain return may
come from the firm specific information and the market related
information:
E ( R j ) = R f + ( β1 F1 + β 2 F2 + β 3 F3 + L + β n Fn ) + URs

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