Risk And Return

By Dr.Archana
Introduction
 Investors are concerned with the two principal
properties inherent in securities:
 Return
 Risk
Return: Types and Elements
 Realized Return: Return that was returned
 Expected Return: Predicted return

Elements of TOTAL RETURN:

 Periodic Cash receipt

 Capital gain or loss

Return on Infosys Tech.
 Price on 22 Dec 2009 Rs 2502.40
 Price on 22 Dec 2010 Rs 3327.35
 Dividend per Share
 During 2010 Rs. 55.00

 Capital Gain Rs 824.95

 Return 35.16%
Statistical Average
 Arithmetical Average Return: appropriate as a
measure of central tendency of a number of
returns calculated for a particular time such a
year
 Geometric Average Return : measures
compound, cumulative return over time. It is
used to reflect realized change in wealth over
multiple periods.
Determinants of the rate of return
Therefore, three major determinants of the rate of return
expected by the investor are:
 The time preference risk-free real rate
 The expected rate of inflation
 The risk associated with the investment, which is
unique to the investment.
Hence,
 Required return = Risk-free real rate + Inflation
premium + Risk premium
RISK DEFINED

 Risk can be defined as the probability that the expected

return from the security will not materialize.
 Every investment involves uncertainties that make future
investment returns risk-prone. Uncertainties could be due to
the political, economic and industry factors.
 Risk could be systematic in future depending upon its
source. Systematic risk is for the market as a whole, while
unsystematic risk is specific to an industry or the company
individually.
 Political risk could be categorised depending on whether it
affects the market as whole, or just a particular industry.
Types of Investment Risk

 Systematic Risk: External to the firm

( Economic, political and sociological)
 Unsystematic Risk: Internal to the firm
( management capability, consumer preferences
and labour strikes)
Total Risk = Diversifiable risk + Non
Diversifiable Risk
Remember the difference:
 Systematic (market) risk is attributable to broad macro factors affecting
all securities. Non-systematic (non-market) risk is attributable to factors
unique to a security. Different types of systematic and unsystematic risk
are explained as under:
 Market Risk
 Interest Rate Risk
 Purchasing Power Risk
 Regulation Risk
 Business Risk
 Reinvestment Risk
 Management Risk
 Default Risk
 International Risk
Measurement of Risk
 Volatility
 Volatility may be described as the range of
movement (or price fluctuation) from the
expected level of return.
 Beta
 Beta is a measure of the systematic risk of a
security that cannot be avoided through
diversification.
Risk and Expected Return
The risk involved in investment depends on various factors such
as:
 The length of the maturity period - longer maturity
periods impart greater risk to investments.
 The credit-worthiness of the issuer of securities - the
ability of the borrower to make periodical interest payments
and pay back the principal amount will impart safety to the
investment and this reduces risk.
 The nature of the instrument or security also determines
the risk. Generally, corporate debt instruments like
debentures tend to be riskier than government bonds and
ownership instruments like equity shares tend to be the
riskiest.
 The relative ranking of instruments by risk is once again
connected to the safety of the investment.
Contd…
 Equity shares are considered to be the most risky investment
on account of the variability of the rates of returns and also
because the residual risk of bankruptcy has to be borne by
the equity holders.
 The liquidity of an investment also determines the risk
involved in that investment. Liquidity of an asset refers to
its quick saleability without a loss or with a minimum of
loss.
 In addition to the aforesaid factors, there are also various
others such as the economic, industry and firm specific
factors that affect the risk an investment.
PORTFOLIO AND SECURITY
RETURNS
 A portfolio is a collection of securities. Since
it is rarely desirable to invest the entire funds
of an individual or an institution in a single
security, it is essential that every security be
viewed in a portfolio context.
PORTFOLIO AND SECURITY
RETURNS
 A portfolio is a collection of securities. Since
it is rarely desirable to invest the entire funds
of an individual or an institution in a single
security, it is essential that every security be
viewed in a portfolio context.
Return and Risk of Portfolio
Return of Portfolio (Two Assets)
 The expected return from a portfolio of two or more securities
is equal to the weighted average of the expected returns from
the individual securities.
 = WA (RA) + WB (RB)
Where,
 = Expected return from a portfolio of two securities
 WA = Proportion of funds invested in Security A
 WB = Proportion of funds invested in Security B
 RA = Expected return of Security A
 RB = Expected return of Security B
 WA+ WB = 1
Risk of Portfolio (two assets)

 p= σ σ ρ σ σ

Where,
 σp =Standard deviation of portfolio consisting securities A and B
 WA WB =Proportion of funds invested in Security A and Security B
 σA σB =Standard deviation of returns of Security A and Security B
 ρAB =Correlation coefficient between returns of Security A and
Security B

The correlation coefficient ( AB) can be calculated as follows:

AB =
An Important Idea
 The risk of a well diversified portfolio
depends on the market risk of the securities
included in the portfolio.
 The contribution of an individual security to
the risk of the well diversified portolio can be
known by measuring MARKET RISK/ Beta
Illustration
 Mr. john forecasted 4 economic scenarios
which he believes are likely to occur with the
given prob. Based on these scenarios, he
made the following forecast of the returns of
stock Infosys,HUL and SAIL. calculate the
average mean return, the variance and std.
dev. Of each security as well as a portfolio if
the amount invested is equal in all the three.
Data
 Scenario Prob. Cond. Return
Infosys HUL SAIL
 High G .2 32 21 20
 Low G .15 16 18 14
 Stagnation .40 14 16 12
 Recession .25 -13 -12 -11