RISK AND
RETURN
Muzzamil Shaikh
Topics Covered
Basic concept of return
Components of Return
Expected Return
Relative Return
Real Rate of Return
Types of Risk
Standard Deviation
Coefficient if Variation
Risk and Return of Portfolio
Capital Asset Pricing Model
Return
Income received on an investment plus any
change in market price, usually expressed as
a percent of the beginning market price of the
investment
Components of Return
Yields
The most common form of return for investors
is the periodic cash flows (income) on the
investment, either interest from bonds or
dividends from stocks.
Capital Gain
The appreciation (or depreciation) in the price
of the asset, commonly called the Capital Gain
(Loss).
Total Stock Return
Example
Ali purchased a stock for Rs. 6,000. At the
end of the year the stock is worth Rs. 7,500.
Ali was paid dividends of Rs. 260. Calculate
the total return received by Ali.
[260 + (7,500 − 6,000) ]
Total Return =
6,000
= 0.293
= 29.3%
Expected Return
The investor cannot be sure of the amount of
return he/she is going to receive.
Expected return is the weighted average of
possible returns, with the weights being the
probabilities of occurrence.
Formula
E( R) = X * P(X)
Where X will represent the various values of return,
P(X) shows the probability of various return
Example
Suppose, if you knew a given investment had
a 50% chance of earning return of Rs.10, a
25% chance of earning a return of Rs. 20 and
there is a 25% chance of bearing a loss of
Rs.10. What is your expected return?
Relative Return
The relative return is the difference between
absolute return achieved by the investment
and the return achieved by the benchmark.
Example
The return on a stock is 8% over a given
period of time. BUT, If the return on the
designated benchmark is 20% over the same
period of time, then the relative return on that
stock is in fact -12%.
Real Rate of Return
Also called Inflation adjusted return
Inflation adjusted return reveals the return on
an investment after removing the effects of
inflation.
Example
Return on Investment R = 7%, Inflation rate IR
= 3%, Inflation Adjusted Return =?
Solution:
Inflation Adjusted Return = [(1+ R)/(1+IR)] – 1
= [(1+0.07)/(1+0.03)]-1
= 1.03883 – 1
= 0.0388
= 4% approximately
Inflation Adjusted Return = R – IR = 7% - 3 % =
4%
Risk and its Types
Risk is the variability between the expected
and actual returns.
o Interest Rate Risk
o Market Risk
o Financial Risk
o Liquidity Risk
o Foreign Exchange Risk
o Country Risk
Interest Rate Risk
It is the risk that an investment’s value will
change as a result of change in interest rates.
This risk affects the value of bonds more directly
than stocks.
Market Risk
Market Risk refers to the variability in returns
resulting from fluctuations in the overall market
conditions
Financial Risk
It is the risk associated with the use of debt
financing. The larger proportion of assets
financed by debt, the larger variability in returns,
other things remaining equal.
Liquidity Risk
An investment that can be bought or sold quickly
without significant price concession is
considered liquid. The more uncertainty about
time element and the price concession, the
greater the liquidity risk.
Foreign Exchange Risk
When investing in foreign countries one must consider
the fact that currency exchange rates can change the
price of the asset as well. This risk applies to all
financial instruments that are in a currency other than
your domestic currency.
Country Risk
This is also termed political risk, because it is the
risk of investing funds in another country whereby a
major change in the political or economic
environment could occur. This could devalue your
investment and reduce its overall return. This type of
risk is usually restricted to emerging or developing
countries that do not have stable economic or
political arenas.
Standard Deviation
Standard deviation is a tool for assessing risk
associated with a particular investment.
Standard deviation measures the dispersion or
variability around a mean/expected value.
Formula:
= X2 ∗ P(X) – [ X∗P(X)]2
Coefficient of Variation
CV is a measure of relative risk.
It tells us the risk associated with each unit of
money invested.
Formula:
CV= (x) / E(X)
Portfolio
A grouping of financial assets such as
stocks, bonds, etc
A good portfolio consists of financial
assets that are not strongly positively
correlated
A portfolio should contain some high-risk
and some low-risk securities
Portfolio
A diversified portfolio should consist of securities
that are not perfectly positively correlated.
For an individual, a portfolio of almost 7
different securities is considered good.
For a company, a portfolio containing 20-25
securities is suitable.
Systematic Risk
Systematic risk is the one that affects the
overall market such as change in the
country's economic position, tax reforms or a
change in the world energy
Unsystematic Risk
The risk which is independent of economic,
political and all other such factors. It is
associated with a particular company or
industry.
Capital Asset Pricing Model
This model states the relationship between
expected return, the systematic return and the
valuation of securities.
R= Rf + (Rm – Rf)
• R = Required Rate of Return of Security
• Rf = Risk free rate
• Rm = Expected Market Return
• = Beta of the security
