Financial Management

(PGDM- 2017-19)

Session -13: Concept of Risk and Return

Sriranga Vishnu
Faculty (F&A Area)
 Risk and Return
• Risk- A chance that an unfavorable event may occur

• Business Risk – Future viability of Investments

• Financial Risk – Concerned with financing of the

investments

• Riskiness of an Asset – Standalone risk and Portfolio risk

 Risk and Return
• Risk Management – Efforts to identify, analyze & control risk

• Various steps in risk management-

– Anticipating the uncertainties and its intensity
– Channelizing events to happen as per the plan
– Mitigating the plan deviations
– Back-up Plans; Damage Control Mechanisms
 Risk Diversification
• When more and more securities are included in a portfolio, the
risk of individual securities in the portfolio is reduced.

• This risk totally vanishes when the number of securities is very

large.

• But the risk represented by uncontrollable factors remains.

• Risk has two parts:

 Diversifiable (unsystematic)

 Non-diversifiable (systematic)
 Systematic Risk
• Systematic risk arises on account of the economy-wide
uncertainties and the tendency of individual securities to move
together with changes in the market.

• This part of risk cannot be reduced through diversification.

• It is also known as market risk.

• Investors are exposed to market risk even when they hold

well-diversified portfolios of securities.
Systematic Risk- Example
 Unsystematic Risk
• Unsystematic risk arises from the unique uncertainties of
individual securities.

• It is also called unique risk.

• These uncertainties are diversifiable if a large numbers of

securities are combined to form well-diversified portfolios.

• Uncertainties of individual securities in a portfolio cancel out

each other.

• Unsystematic risk can be totally reduced through

diversification.
Unsystematic Risk - Example
 Risk Preferences
• A risk-averse investor will choose among investments with the
equal rates of return, the investment with lowest standard
deviation and among investments with equal risk she would
prefer the one with higher return.

• 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. In reality, most (if not all)
investors are risk-averse.
 Return - Concepts
• Total Return on a Share = Dividend + Capital Gain

• Dollar Return = Amount Received – Amount Invested

• Percentage Return- Dollar return expressed in % age

Rate of return  Dividend yield  Capital gain yield
DIV1 P1  P0 DIV1   P1  P0 
R1   
P0 P0 P0
• Average rate of return- average of single-period returns

• Expected rate of return – Sum of product of each outcome

(return) and the probability associated with it
 Risk & Return
• Concept of Mean, Variance and Standard Deviation

• Variance and Std. Dev. As measures of return

• Probability Distribution of the outcomes – The more

peaked the probability distribution, more likely it is that
the actual outcome will be closer to the expected value.

• Thus, the tighter the prob. Distribution, lower is the risk

assigned to a stock
 Risk & Return
• Use of Coefficient of Variation for risk measurement:

• Coeff. of Variation = Std. Dev. / Expected Return

• Coeff. of Variation is a measure of risk per unit of return

and is more meaningful basis of comparison

• Risk Aversion and Required Returns – Risk Premium

• Risk Premium – The difference between expected rate of

return on a risky asset and that on a less risky asset
 Risk & Return
• Measuring Portfolio Returns- Weighted average of
expected returns on the assets held in the portfolio

• Portfolio Risk – Unlike returns, the riskiness of portfolio

is normally not the weightage average of the Std. Dev. Of
individual assets.

• The risk of portfolio would be less than the risk of

individual securities, and that the risk of a security should
be judged by its contribution to the portfolio risk.
 Risk & Return
• Covariance- The portfolio variance depends on the co-
movement of returns on two assets.

• Correlation – Tendency of two variables to move together

• Correlation Coefficient – Measure of degree of

relationship between two variables
 Risk & Return
• Perfectly Negatively Correlated Stocks

• Perfectly Positively Correlated Stocks

• Addition of Stocks reduces the risk but not eliminates it

• Diversifiable (unsystematic) and Non-diversifiable

(systematic) risks

• A well diversified portfolio will eliminate half of the risk

• The risk that remains after diversification is market risk

 Risk & Return
• Riskiness of a particular stock is measured by its
contribution to a well-diversified portfolio
• A stock may be very risky, but in a portfolio, the relevant
risk is low
• The risk that remains after diversification is market risk
and it can be measured by the degree to which a given
stock tends to move up and down with market
• Beta Coefficient – A measure of market risk – extent to
which returns on a given stock move with market
 Risk & Return
• An average-risk stock is one which moves in tandem with
the general market as measured by some index. Such
stock will have a Beta of 1.0

• β- 2.0; β- 0.5

• Beta measures a stock’s volatility relative to an average

stock (β- 1.0)

• If a stock with β > 1.0 is added to a portfolio with β=1.0,

the riskiness of the portfolio will increase and vice versa
 Risk & Return
• Beta of a portfolio is the weighted average of its
individual securities’ betas

• βp = w1b1 + w2b2 + w3b3 + …….

• Portfolio with low-beta stocks will be less risky. If one

stock of this portfolio is replaced by a higher beta stock,
the riskiness would increase
 Risk and Return
• Capital Asset Pricing Model (CAPM) – provides a framework
to determine the RRR on a risky asset and indicates the
relationship return and risk of the asset

• Under CAPM, SML shows the relationship between expected

return of an asset given its risk

• Req. Return = Risk-free return + Premium for risk

• Required Return for Stock A=

Risk-free return + Premium for risk (Beta of Stock A)

 Risk and Return
• Beta as a measure of Risk -

• Beta of Market Portfolio, Beta of T-Bills, Negative Beta

• Since Rm is same for all securities, the total risk premium

varies with systematic risk measured by Beta

• Limitations of CAPM- Unrealistic assumptions; Testing of the

model is difficult; Beta can change over time
 Risk and Return
• Arbitrage Pricing Theory – Multi-factor Model

• Investors are rewarded for Systematic Risk

• Concept of Return – Predictable and Unpredictable

returns

• Predictable returns- Current info.

• Unpredictable returns – Future info.

• Concept of Risk – Beta sensitivity to each factor

 Risk and Return
• Fama-French Three Factor Model-
– Beta, Size of share holding and MB Value

• Size – Small Caps perform better; riskier

• MB Value – Value stocks perform better; riskier