CORPORATE FINANCE

BATCH:21(SEC-C)

RISK
&
RETURN

RELATIONSHIP: RISK & FINANCE

I. As there exists an uncertainty, the expected income will not happen.
II. It could result in some sort of loss or pain. This is risk.
III. Thus uncertainty is a pointer to risk.
IV. Evidently, one can not live without risk.
V. Risk is certain only its timing and impact is uncertain.
VI. Risk is present in virtually every decision.
VII.Assessing risk and incorporating the same in the final decision is an integral
part of financial analysis.

EXPECTED RETURN & STANDARD DEVIATION

The rate of return on an asset for a given period (usually a period of one year) is
defined as follows:
Annual income + Ending price Beginning price
Rate of return =
Beginning price
Expected RR is the weighted average of all possible returns multiplied by their
respective probabilities , E(R) = pi Ri

EXPECTED RETURN & STANDARD DEVIATION

Standard Deviation is employed in finance as a measure of risk. Reasons are
If a variable is normally distributed, its mean and standard deviation contain all the
information about its probability distribution.
If the utility of money is represented by a quadric function (function commonly
suggested to represent diminishing utility of wealth), then the expected utility is a
function of mean & standard deviation. It is analytically more easily tractable
Probability
Return
Variance square

Expected Return in percentage: E (

R)

Risk

Expected Return in percentage: E

( R)
Risk or Standard Deviation

Probability of Return

Variance

Variance Square

Probability of

EXPECTED RETURN & STANDARD DEVIATION

Return %

-20

-10

10

15

20

25

30

Probabilities

0.05

0.10

0.20

0.25

0.20

0.15

0.05

Expected Rate of Return is the weighted average of all possible returns multiplied by their
respective probabilities , E(R) = pi Ri, , Therefore

SD (% of Risk) is the square root of variance.

WHY RETURN VARIED ON

I.
Asymmetrical Distribution : Values of variables occur at irregular frequencies.
INVESTMENT

II. Mean, median and mode occur at different points.

III.Normal distribution is shaped like a bell curve and the two sides of the graph are
symmetrical.
IV.Investment return data commonly has an asymmetric distribution.
V. Investment performance is often skewed since investment experience periods of
abnormally high and abnormally low performance.

Longer left tail

Longer right tail

EXPECTED RISK & PREFERANCE

1. A risk-averse investor when faced with two investments with a similar expected
return (but different risks), will prefer the one with the lower risk. A risk-averse
investor dislikes risk, and therefore will stay away from adding high-risk
2. A risk-neutral investor is more concerned about the expected return on his
investment, not on the risk he may be taking on and always prefer higher returns.
3. Risk (seeker) lovers search for greater volatility and uncertainty in investments in
exchange for anticipated higher returns.
In general, investors are risk-averse.

(Return)

INVESTMENT-RISK & RETURN

Each Investment option has its own risk-return profile. However, there may be certain investment
alternatives with different yields at the same risk level and vice versa.
Investment

I.
II.
III.

Return(%)

Risk(%)

12

12

15

15

10

18

10

B is a better alternative than A and C, since at the same risk level, it gives higher returns than A
and at a lower risk level it gives the same returns of C.
Investment alternatives with entirely different risk & return profile can not be compared so
easily.
In the process inferior investment option identified and rejected. Superior alternatives B,D &F
are preferred to earn highest return through portfolio concept.

DIVERSIFICATION AND PORTFOLIO RISK: Probability Distribution of Returns

State of the on
Economy
1
2
3
4
5

Probability
Stock A

Return on
Stock B

Return on
Portfolio

Return

0.20

15%
-5%
5%
0.20
-5%
15
5%
0.20
5
25
15%
0.20
35
5
20%
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 of A and B : 0.2(5%) + 0.2(5%) + 0.2(15%) + 0.2(20%) + 0.2(30%) = 15%
Standard Deviation

Stock A :

2A = 0.2(15-15)2 + 0.2(-5-15)2 + 0.2(5-15)2 + 0.2(35-15)2 + 0.20 (25-15)2 = 200

A = (200)1/2 = 14.14%
Stock B : 2B
= 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
B
= (200)1/2 = 14.14%
Portfolio : 2(A+B) = 0.2(5-15)2 + 0.2(5-15)2 + 0.2(15-15)2 + 0.2(20-15)2 + 0.2(30-15)2 = 90
A+B = (90)1/2 = 9.49%
Diversification reduces risk on investing equal proportion of A &B.

PORTFOLIO RISK
As more and more securities are added to a portfolio, its risk decreases. The bulk of
the benefit of diversification is achieved by forming a portfolio.
The following relationship represents a basic insight of modern
portfolio theory:
Total risk =Unique risk + Market risk
A. Unique risk : Unsystematic risk
Firm specific factors
Can be washed away by combining
it with other securities .
Diversifiable risk
B. Market risk: Systematic risk

Risk attributable to economy-wide factors.

Affects all securities and non-diversifiable risk.

Reflects sensitivity of a security to market movements ,beta

MEASUREMENT OF MARKET RISK

The sensitivity of a security to market movement is called Beta. Beta reflects the slope of
a linear regression relationship between the return on the security and the return on the
portfolio.
For calculating the beta of a security, the following market model is employed:
RM t A bundle of investments, includes
Rjt = aj + bj RMt + ej
every type of asset available in the global
where Rjt = return of security j in period t
financial market with each asset
aj = intercept term alpha
weighted in proportion to its total
bj = regression coefficient, beta
presence in the market. Expected return
RMt = return on market portfolio in period t
of a market portfolio is identical to the
ej = random error term
expected return of the market as a
Beta reflects the slope of the regression relationship. It is equal to:
whole.
It is equal to:
Cov (Rj , RM)
2 M
(Square of Standard deviation of return on the market portfolio)
where Cov = Covariance between the return on security j and the return on market portfolio M. Therefore
_
_
n
Cov (Rj , RM)= S (Rjt Rj)(RMt RM)/(n-1), 2M =
i=1

CHARACTERISTIC LINE FOR SECURITY j

Say security j has a beta 0.76, means if the return on market portfolio rises/falls by 10%,
the return on security j would be expected to increase/decrease by 7.6%.The intercept
term i.e. the expected return on security when the return on the market portfolio is Zero,
for security j is equal to 2.12%. (Point A:Alpha)

The return
on security

A
The return on market portfolio

DETERMINANTS OF BETA
Cyclicality of revenues:
I. Do very well in the expansion phase of the business cycle.
II. Do very poorly in the contraction phase.
III. Auto & retail business fluctuates greatly on business cycles. Utilities, food &
pharma are less dependent on business cycle.
Operating leverage:
IV.Operating leverage shoots from fixed production costs.
V.Operating leverage amplifies the effect of cyclicality.
Financial leverage
VI.Financial leverage fires from the use of debt finance.
VII.Beta discussed earlier refers to equity beta.
VIII.Effect of financial leverage depends on the relationship with equity beta &
asset beta.
IV. Asset beta is the beta of the asset of the firm, equals to equity beta, if the
firm is having all equity finance.

OPTIMAL RISK
PORTFOLIO
How much
volatility you are willing to bear will be by picking any

point that falls on

the Efficient Frontier.

This will give you the maximum return for the amount of risk you wish to accept.
However, the optimal-risk portfolio is usually determined to be somewhere in the
middle of the curve.

RISK RETURN TRADEOFF

Low level of uncertainty/low risk/low standard deviation means low potential returns
and vice-versa.
The risk-return trade off is the balance between the desire for the lowest possible risk
and the highest possible return.
Higher risk gives us the
possibility of higher returnsno guarantees.
Just as risk means higher
potential returns, it also means
higher potential losses.
Risk tolerance differs from person to person, depend on goals, income and personal
situation etc.

CAPITAL ASSET PRICING MODEL

CAPM establish the relationship between the risk of security ,as measured by its beta, and its
expected return.
According to the CAPM, risk and return are related in a linear fashion,

E ( R j ) R f j [ E ( RM ) R f ]
E ( R j ),

Rf

, Where

expected return on security j

,the risk free return

j ,beta of the security j

E ( RM ) ,expected return on market portfolio

Required return consists of two components
1. Risk Free Return:
2. Risk Premium:

Rf

,
(Product of level of risk
and the
j [ E ( RM ) R f ]
j
compensation per unit of risk)
[ E ( RM ) R f ]

BETA (MARKET RISK) & EXPECTED RATE OF RETURN

Expected return on three securities A,B & C are shown below. A is having defensive
security (beta < 1) with a beta of 0.5 and expected return 12.5%. B is having neutral
security (Beta=1) with a beta of 1.0 and expected return 15.0%. C is having aggressive
(Beta>1) security with a beta of 1.5 and expected return 17.5%.

INTERFERENCE

Securities are risky because their returns are variable.

The most commonly used measure of risk or variability in finance is standard deviation.
Owning a portfolio with a small number of stocks is a risky proposition.
Diversification is important for reducing risk.
While diversification is desirable , an excess of it is not. There is hardly any gain in extending
diversification beyond 10 to 12 stocks.
Portfolio diversification washes away unique risk, but not market risk. Hence, the risk
of a fully diversified portfolio is its market risk.
The performance of well diversified portfolio more or less mirrors the performance of the
market as a whole.
To earn a higher expected rate on return, one has to bear a higher degree of market risk.

GOOD WISHES
TO ALL