CHAPTER 3: Risk and Return

Concept of return and risk

Types of return and risk
Measures of return and risk
Risk-return relationship
Risk premium and sources of this
Determinants of required rate of
return
3-1

Return
Return: Percentage form of earnings
from an investment or asset including
normal income and capital gain or loss
is called return. Return may be the
following three types:
1. Risk-free rate of return rate of
return can be earned by making
investment in government securities
of a country is known as risk-free rate
of return.

3-2

Return
2. Nominal rate of return rate of
return
calculated
by
ignoring
existing level of inflation is known as
nominal rate of return.
3. Real rate of return - rate of return
determined by considering/adjusting
existing level of inflation is known as
real rate of return.
3-3

Risk

Risk is the concept of fluctuations. This fluctuations

can be
(i) a deviation of the actual return from the expected
return, or
(ii) a deviation of average return from the year to year
return. Higher the fluctuations, higher is the risk.

Types of risk
i. Systematic risk risk that can not be avoided or minimized and
that is out of control of an individual or a business enterprise.
ii. Unsystematic risk - risk that can not be avoided but can be
minimized by making intellectual decision and that is to some
extent under the
control of an individual or a business
enterprise.

3-4

Risk
iii. Business risk risk related to overall business activities
of a particular business enterprise that is mostly out of
control of that business enterprise.
iv. Financial risk - risk related to using of fund from debt
sources for forming and running business operations or
making investments by a particular party that is under
the control of that party.
Measures of risk
i. Standard Deviation absolute measurement of total risk
ii. Coefficient of Variation - relative measurement of total
risk
iii. Beta Coefficient - absolute measurement of systematic
risk
3-5

Formula for calculating of RiskReturn

Expected Return E ( R ) R
(R * P )
n
i

Risk
Risk

2
(
R

R
)
i

n 1

( P )( R R )
i

( For time series data )

2

( for probabilit y distribution)

3-6

Calculation of Risk-Return (Historical

Data)
Year

Return (%)

Dev. (Ri-E(R))

Dev. Square

2004

20

49

2005

-8

64

2006

-5

-18

324

2007

15

2008

30

17

289

13%

Sum of Dev sq=

730

Stand.Deviation2

730/(5-1)=

182.5

Stand.Deviation=

Square root (182.5)

13.5%

Mean Return=

3-7

Calculation of Risk-Return (Probability

Distribution)

Weather
Rain
Moderate
Dry

Probability
(Pi)
0.25
0.5
0.25

Return (Ri) Exp. Value

(Pi*Ri)
(%)
25
14
0

Deviation
(Ri-E(R))

Deviation
Square

Dev sq* Pi

6.25

(25-13.25)
=11.75

(11.25)2
=138.0625

(138*.25)
=34.52

(14-13.25)
=0.75

(0.75)2
=0.5625

(.56*.5)
=0.28

(0-13.25)
=-13.25

(-13.25)2
=175.5625

(175*.25)
=43.89

E(R)=

13.25%

Stand
Dev2=

Risk=

8.87%

Stand Dev

78.69
8.87

3-8

Comments on standard deviation

Standard deviation (i) measures total, or

stand-alone, risk.
The larger i is, the lower the probability
that actual returns will be closer to
expected returns.
Larger i is associated with a wider
probability distribution of returns.
It is difficult to compare standard
deviations, because return has not been
accounted for.
3-9

Coefficient of Variation
(CV)
A standardized measure of dispersion
about the expected value, that shows
the risk per unit of return. When, both
return and risk increase then coefficient
of variation (CV) should be used.
Std dev
CV
^
Mean
k

3-10

Use of coefficient of
variance

Example: We have 2 alternatives to invest.

Security A has a mean return of 10% and a
standard deviation of 6%, and security B has a
mean return of 13% with a standard deviation of
8%. Which investment is better.
6%
CV A
*100 60%
10%
8%
CVB
*100 61.5%
13%

So, security A is better as the Coefficient of

variance of A is less than the that of B.
3-11

Risk-return relationship i.e.

Security Market Line (SML)
Return [E(R)]
SML
E(Rj)
E(Rm)
Rf=5%

m=1

j=1.9

Systematic Risk
(Beta)
3-12

Comments on beta

If beta = 1.0, the security is just as risky

as the average stock.
If beta > 1.0, the security is riskier than
average.
If beta < 1.0, the security is less risky
than average.
Most stocks have betas in the range of
0.5 to 1.5.
3-13

Risk premium
The rate of return can be earned by making
investment in risk-free asset is called risk
free rate of return and the rate of return can
be earned by making investment in risky
asset is called nominal risky rate of return.
Generally the nominal risky rate of return is
higher that risk-free rate of return. The
increased required rate of return over riskfree rate of return is called risk premium.
3-14

Sources of risk premium

1.
2.
3.
4.
5.

Business risk- related to normal business

operations.
Financial risk- related to capital structure or
financing decision.
Liquidity risk- related to convert the investment
into cash easily and quickly.
Foreign exchange rate risk- related to increase or
decrease foreign exchange rate.
Country risk- related to mainly overall political
situation of the country.
3-15

Determinants of required rate of

return
1. The real risk-free rate: The rate of return can be
earned by making investment in risk-free sector
in absence of inflation is known as real risk-free
rate. The government sector of any country is
considered as risk-free sector.
2. Nominal risk-free rate: The rate of return can be
earned by making investment in risk-free sector
at presence of inflation is known as nominal riskfree rate. It is also known as inflation premium.
3-16

Determinants of required rate of

return:
3. Expected risk premium: The additional rate
of return to be required for compensating
additional level of risk for making
investment in risky asset or for doing risky
business.
4. Conditions in the capital market: The impact
of the existing monetary and fiscal policies
of the government applicable within the
country and the probable change of these.
3-17