C

P
T
E Risk and Return Analysis
R

LEARNING OBJECTIVES

After reading this Chapter, you should be able to:

Tell the need for learning risk and return computation
Define, classify and explain risk
Bring out the sources of risk
Define return and compute rate of return

Explain the risk preference behaviour

Say the application of sensitivity analysis and probability distribution in assessing risk
Give the application of SD and CV in measuring risk.
Explain CAPM in measuring expected returnOne of the limitations of profit maximisation
is ignoring the time value of money. At the same time it does not consider the magnitude

AS Slated in Chapter 1. portfolio management is one ofthe tasks ofthe financial manager.
That
atsis this task is managed by the treasurer, who is one of the hands ofthe financial manager.

o managers
current asset,
need to know the risk and return of
investment in
an investment; whether it is fixed asset or
or
securities.
ASK 1S present in every decision, whether it is corporate decision or personal decision. For
Aple, selection of an asset for production department, or developing a new product, or inanca
deci
ke-developing capital structure, working capital management, and dividend decision.
Crelore, the decision-makers have to assess risk and return ofsecurity before taking any financial
decision.
54 Inancial JManage
Financia
of risk is not to eliminate o anageme
One should keep in mind that the objective measuring or avoidi
because it is not feasible to do so. But it helps us in assessing and determining
whether the odj
investment is worth or not. In other words, assessing risk helps come up with theOp propa
expected retum on investment, by applying appropriate
an risk adjusted discount rataOpri
ate to conve propria
future cash inflows into present values. There is a relationship1between risk and return.
next chapterof the risk and retum relationship.
Rea
To do so the financial manger must leam to assess risk and return. Risk can be
measured
different ways. This chapter is naturally quantitative and may confuse. But it is very important
the financial manager. It is worth remembering the following before learning
and retum.
computation of tis
1. Cash flows: Financial assets are expected to
generate cash flows, and the risk of
financial asset assessed in terms of the variations of its
expected cash inflows.
2. Types of Assessing Risk: Risk of a financial asset
may be measured either on a stand-
alone basis or in a potfolio context. There exists an
asset may appear
important difference between these two.An
very risky if held by itself, but may be much less risky if it is held as a
larger portfolio. For example, asset 'X's standard deviation (SD) is 15 cent, and asset part ofa
20%. Standard deviation of per Y's is
portfolio of assets 'X' and Y is 13 per cent. Individual asset SDis
higher than the portfolio of assets SD.
3. Classification of Risk: In a context of aportfolio, the risk of an asset is divided into two
parts: (a) Diversifiable risk, and (b) Market risk. Diversifiable
be completely eliminated
risk is company specific and it can
through diversification. On the other hand, market risk, arises from marke
moments and which cannot be
eliminated through diversification (See Figure 6.1) For an invest0
market risk is relevant and not
diversifiable risk, because it can be eliminated.
4. investors are Risk
Averse: Generally, investors are risk averse. It does not mean tna
investors do not buy risk
assets, they buy risk assets, when they promise extra return for bearing
extrarisk. Risky investments
provides relatively high return.
5.Financial Assets: In this chapter, we measure the risk and return of
Sock and bonds, financial asse
however the concepts learned here are also useful in risk of
assets-plant and machinery, equipment, trucks or even corporates. computing physi

NATURE OF RISK AND RETURN

Risk is the chance of financial loss, or the variability of returns associated with a given assee
ASSets that have higher chances of loss are viewed as more risky, than those with lesser chances
loss. For example, government bond is less
risky because the principal amount and returm (interes
are guaranteed. On the other hand, investment o n a
company's stock is risky, because of the hig"
variability (0 to above zero) of returns.
 Retum Analysis
Risk and 55

There are different sources of risk, that affects financial managers and shareholders
(See
3.1]. Financial manager shows greatest interest on business and financial risk because they
omure

fm specific. Interest rate, liquidity and market risk are more shareholder-specific and therefore,
e af greatest interest to the shareholders. Event, exchange rate, purchasing power and tax risk
directly affect both company and shareholders. Moral risks also affect both company and
shareholders.

Projectsmay do Competition Entire sector Interest rate

better or worse may bestronger Exchange rate inflationand
thanexpected orweaker than may beaffected and political
Newsabout
anticipated by action risk
economy

Fim-specific Market

Actions/Risk
Actions/Risk
that affect that affect all
only one fim Affect few Affect many investment
firms firms
Figure 3.1 Classification of Risk
(Source: Damodarn A, Corporate Finance-Theory and Practice, New York: John Wiley and Sons,

Therefore, the financial manager, and sharehólders must assess risk while taking investment
decisions.

RETURN
We need to know what a return is? and how to measure it? because all investors assess risk
o an investment on the basis of the variability of the retums expected from it over a maturity period
or life period or expected holding period. Returm on an investment is an annual income received
during the period plus change in value. For example, an investor 'A' invested Rs. 1,000 on a fim's
share and received Rs. 100 as dividend, at the end of the year, and share is
selling at Rs. 1,200.
Here the return is Rs. 300 [Dividend + Increase in Share price]. Retum is expressed in terms of
percentage on the beginning of the investment.
Risk Preference Behaviour
As stated above risk is a financial loss, How many managers (companies) would be interested
to accept risk? The answer is, there exists difference
among managers (companies). The managers
Companies) are categorised into three groups.
1. Risk-Indifferent
56
Financial
2. Risk-Averse and anagemen
3 Risk-Seeking
A brief discussion of risk
preference behaviour follows:
1. Risk-Indifferent: Managers with this type of behaviour do not expect the
chanoa
required rate of return,
with a given change in risk. For example, if risk increases
from
to X,,
managers expect no change in return. This type of attitude nonsensical, and itis
is
almost any business context.
2. Risk-Averse: Required return increases for an increased risk (See Figure
with this type of risk preference behaviour 3.2). Managen
risk.
expect higherreturn to compensate the higher
3. Risk-Seelking: Risk-seeking behaviour type of managers enjoy the risk by not
an risk assumed. Instead they give up some return and expecting
extra return for extra
risk. This type of behaviour is rare accept more
among firms or managers because it would not benefit
the firm.

Risk-Averse
Averse

Indiff
erent Risk-Indifferent

Seeking
Risk-Seeking
Risk
X
Figure 3.2 Risk Preference
Behaviour
(Source: Gitman, L.J., Principles of
Most managers (companies) and
Managerial Finance Singapore: Pearson education, 2003, p. 21
shareholders have risk-averse behaviour
generally tend to be conservative, and they group. Mana gers
expect greater return for the greater risk
Risk and Return ofa
Single Asset
assumeu
Return: As stated earlier, returm on
period plus change in value of investment for a given period, is the income re
an
over the
current yield and capital investment (asset). In other words, rate or
gain/loss component. Symbolically:
Rate of Return= +-V] Income + [Selling Price Purchase Pr ice
VE-1 Purchase Price
where = Income at the end of period 't
Risk and
Retum Analysis 57
V, Price of asset (security) attime t [ending or seiing price)

VPrice of asset at time 't-1'[opening or purchase price]

Rate of return is expressed in terms of percentage.
lustration 1: Gopi wishesto determine return on his inyestrnen: Hepurchasedan equity
share ofInfosys 1 year back for Rs. 100, and the share iscurrent: ing Rs. 120. Infosys
declared a dividend of Rs. 20 per share at the endofthe year.
Solution:

Income+SaleablePrice-Puuchiasc i

100
Rate of Return Purchase Price

Rs.20+[Rs.120-Rs.l00
Rs.100

40 per cent
The above return on investment comprises current yieldp!s t ain. The following

explanation gives details about it.

Current Yield: =. Income
P Current price
Table above illustration

Current Yield= x100=21percent

Rs.120
Saleable Price- Purchase Price
Capital Gain yield Purchse Price

Rs.120-Rs.10
Rs.100
20 per cent
Rate of Return= Current yield +Capital Gains yield
= 16.67 per cent + 20 per cent

36.67 percent
from an investment
Risk: Asstated risk is afinancial loss or the variability ofretums expected
or both.
The risk associated with a single asset can be assessed or measured,

a. Risk Assessment
and probabi!ity distribution.
Behavioural viewofrisk can be assessed with sensitivity analysis
 58
Sensitivity Analysis (See Risk Analysis in capital budgeting) nancial Manag
mustration 2: Green Health Company wants to choose the better ofi two.
Q'. Each project requires an investment of Rs. 2,00,000 and each has a twop rojects
of 20 per cent. Management has come up with pessimistic and optimistic likelv
most
ely rate oofn'P
digassociated with each project are as follows: estimates
mates of the
ProjecetP Project Q
Pessimistic (%) 21 14
Optimistic (%) 26 31
You are required to identify
risky project.
Solution:

Choosing a project depends on the variation in the expected returm.

for deciding riskiness of a Range has to be calcule
project.
Range= Higher Return-Lower Retum
Project P's Range = 26 per cent-21 per cent 15 per cent
Project Q's Range = 31 per cent- 14 per cent = 17 per cent
From the above analysis, we can conclude that project Qis risky when
compared to proj
P,because the return on project Qshows huge variation. Hence, Green Health
project P'. should chos
Probability Distribution [refer risk analysis in capital budgeting for detailed discussion

Expected Return 2 RixP'i

Where: R=Return for the i" possible outcome

Pi Probability associated with it possible outcome
N= Number of outcomes considered.
Illustration3: From the following information determine expected rate of retum.
Risk end Retum Analysis 59

Project P Project Q
Rs. Pro Rs. Pro
Investment (Rs) 2,00,000 2.00,000
Retum (%)

Pessimistic 21 020 14 020

Most likely 20 0.50 20 0.50

Optimistic 26 030 31 0.30

Solution: Expected Return
Return ( ) Probability Expected Return
Project P
Pessimistic 21 02 42
Most likely 20 0.5 10.0
Optimistic 26 0.3 7.8

22
Project Q
Pessimistic 14 02 2.8
Most likely 20 0.5 10.0
Optimistic 31 03 9.3
22.1
The following figures 3.3a and3.3b-clearlyshows which project is
risky.
0.6 0.6
0.5 0.5
0.4 0.4

0.3 0.3

0.2 0.2

10 .10

0 10 15 20 25 30 35 10 15 20 25 30 35
Retum (6) Rcturm (%)

Flgure 3.3a and 3.3b Variablty of Returns of project p' and project Q'
ork

60
Financial Managen.
RISK MEASUREMENT

Assessment of risk based on sensitivity analysis and probability distribution

realistic one. Standard deviation and coefficient of variation are the two measures availno
may
precisely measure risk. availabl
Standard deviation
Coefficient of variations.
Refer chapter, Risk analysis in capital budgeting for detailed discussion.
Risk and Return of a Portfolio
In the previous section, we have learned computation of risk and return for a
single as
(security). Generally, financial institutions park their surplus funds in portfolios. Banks, Insura
companies, pension funds, mutual funds and otherfinancial institutions are required by lawtoho
portfolio, particularly diversified one. Most of the individual investors generally hold
Because, an asset that has great deal of risk, if held by itself may be of much less portfolio
risk, if it is helds
part of a larger portfolio. Investors [firms or individuals] who invest in
interested in knowing portfolio risk and return; and not risk and portfolio of assetsan
returm of asingle asset. An investon
who prefers to invest in
portfolio, constructs different portfolios with a given set of assets. But nl
one portfolio (efficient) is chosen.
Efficient portfolio is the one that maximises return for a
level of riskor minimises risk for a given
given level of return. Development of efficient
manager. Therefore, he/she needs to learm measurement portfolio
the goals ofa financial is one o

ofportfolio of assets. of and retum

risk
Return of Portfolio
The return of a
assets in the
portfolio is the weighted average of the expected returns on
portfolio. Portfolio return is determined by the the individual
and the relative
weight (share) of each asset in the portfolio.expected
Sum of
return on an individual assets
all assets investment
should be equal to one.
Symbolically, weig
ER, Wi E(Ri)
Where

ER)=Expected return portfolio

on

Wi=Proportion of investment in security 'i'

EXRi)= Expected return
n= number security i'
on

of securities (assets) in
Illustration 4: [Portfolio return-Two portfolio
securities]
 Relun Analysis 61
Risk and
Rama createda portfolio oftwo assets A' and B', with 15 per cent and 18 per cent expeciea
espectively.
He has decided to invest 60 and the
returns respe
lums per cent of investment in
maining on asset"A. Determine the expected retum on portfolio.
asset°B
rem

Solution:

EXR)- W, E(R,)+W, E(R,)

=
(0.40 x 15)+ (0.6 x 18)
=
16.8 per cent
Tllustration S: Aninvestor developed an efficient potfolio with four companie stocks. I ne

expected return on stocks is as follows:

(1) Infosys 16%, (2) Toyota 20%, (3) SBI 17%, and (4) SAIL 10%
Investor has decided to allocate the available amount equally on all companies stocks. Detemine
the expected retum on portfolio.

Solution:
E(R) W, (EXR,)+ W, E(R,) +W, (R,)+W, E(R,)
(0.25 x 16) + (0.25 x 20)+ (0.25 x 17) + (0.25 x 10).

15.75 per cent

Portfolio Risk [Two - Asset Portfolio]

As we have stated in the above that return on portfolio is simply the weighted average of the
cxpected retums on the individual asets in the portfolio. Unlike returm on portfolio, the portfolio
riskis not the weighted averageofthe standard deviations of the individual assets in the portfolio.
Porfolio risk will always be less than the weighted average of the assets standard deviation.
Overall risk of portfolio depends on the SD, and investment proportion of each asset in the
portfolio and covariance. Covariance is computed, based on the corelation between expected
retums on assets comprising in portfolio. The portiolio risk developed using two assets is computed
with the following formula.:

op = /Wo+ WË o +2W, W, P ,
Where s,=Standard deviation ofthe portfolio returm.

W, =Proportion ofthe portfolio invested in security 1"

W, =Proportion ofthe portfolio invested in security 2'
o Standarddeviation ofsecurity'1
o,Standarddeviation ofsecurity 2'
62 Financial Managemen
o=Variance ofsecurity 1'

o =Variance of security 2'

PCoefficientcorrelation between the retums oftwo securities (pronounced Rho
Tlustration 6: Krishnadeveloped a portfolio with twosecurities A' and 'B'. Hedecided
invest 0.40 [W] in security Aand 0.60 [W,] in security 'B'. The standard deviation (9) ofretums
on securities A' and B' are:
Security 'A' (o)=15, securityB(0,)=12.The coefficientofcorelation betweentheretum
f security Aand Bis 0.6. Compute portfolio risk.
Solution:
o, = y[040 x15 +0.6 x122 +2x04x06x0.6x 15x 12]

O.16x225+036x144+2x04x0.6x 06x 15x 12]

36+5184 +5184
139.68
= 11.82

The above given two securities 'A' and 'B°would be quite risky ifthey were held in isolation
but when they are combined risk has came down. The tendencyoftwo variables to move together
is called correlation and the correlation coefficient measures this tendency. If the stocks are perfectly
negatively corelated then the p value would be negative, and vice-versa. Risk cannot be reduced
by usingtwoor more securities which are perfectly positively cormelated. Risk can be avoided or
minimised when securities are perfectly negatively cormelated.
Portfolio Risk: The n Security Ca[e
Variance and SD of the expected returm as a portfolio with n-security case

Where s,:Standard deviation of the portfolio returm

W=Proportion of the portfolio invested in securityi
W, =Proportion of the portfolio invested in security"j'
sCovariance between the return on security is 'i' and j'
Asstated earlier,
portfolioconstructionminimises or
if covariance is
negative then investor can eliminate eliminate risk. I depends on the covariance,
covariance is always posjitive and it is
not possible to
(completely diversify) risk. But in general,
expected returns on all security is affected completely diversify risk. This is because
by certain economic factors. Therefore,
irrespective or
 Retum Analysis 53
Rist and
e nurnberofdiferent industry securities, and the propórtionofinvestment on them the potfolio
ther

riskdo not fall below a certain level.

Mode
Risk in a Contemporary
investor has
Investors demand a premium for investing on a risky security. For example, an
an optionofinvesting on a fixed deposit (at 10%) and equity stock (SD 10%) ofa company. Here
retum for investing on equity stock, because it is risky and bank deposit
the investor expects extra
if investors are primarily concerved with his portfolio, rather than the risk of
is risk free. However,
should the risk of an individual stock be
the individual secunties in the portfolio. In this case how costof
measured?2 One answeris provided by the Capital Asset Pricing Model (CAPM) [See

capital Chapter, for more information on CAPM]

CAPM links non-diversifiable risk and return for all assets. It will help detemine equilibrium
expected returm for a risky asset. Symbolically,
ER)-R+(R-R)b
Where ER)=Expected retum

R, =
Risk-free rate
b The beta coefficient

RRequired rate ofreturn on a market portfolio of assets.

m
determine expected rate of return.
lhustration 7: From the following information
on market portfolio=14 per cent
Risk-free Rate 9 per cent; beta= 1.5; Return
=

Solution:
EXR)= 9%+ [14-9] 1.5

=9%+[5]1.5
=9%+7.5
16.5 per cent
therefore, require 16.5 per cent return on this
In the above illustration the investor should
non-diversifiable risk assumed.
nvestment as a compensation for the

Security Market Line (SML)

it is called the security market line
When CAPM model is depicted (See Fig. 3.4) graphically,returm for individual and inefflicient
between risk and
ML).The line represents the relationship
portfolio.
 Financial Managerme
64

204 SML

18
ECR)- Market Risk
6 Rmf Market
Premium
14*
Risk (7.5%)
12 Premiu
10
Rf 9

1.5 2.0
0.5 1.0
Non-diversifiable Risk [Beta)
Model
Figure 3.4 CAPM

(Source: Gitman. op.cil: p.

240)
for any levelof
should eam in the market place
us the required
return an investment is
SML tells rate ofreturn (9 per cent) equl
then the required
(beta) risk. If beta is
zero
also increases
the required rate ofreturn
non-diversification

beta increases from °' to 1.0,

to risk-free rate. When
difference (14-9) per cent is
the risk premium for bearing isk
cent, the
from 9 per cent to 14 per investor's expected rate of return is isk-free
beta is 1.5, at which an
In the above illustration, given indicates that
cent. To put in simple words, SML
7.5 per cent risk premium, i.e.,
16.5per
rate plus returm and vice versa.
the risk increases so does the required
The slope ofSML is affected (parallel)
by
market line is not stable over time.
Thus, security aversion. With the change in inflation,
risk-free rate moves
factors- inflation and risk
twoprime
upward. Symbolically,

AR, R,+
risk-free rate
Where: AR, =Adjusted
R Risk-free rate

=Inflation premium
Illustration 8: Consider above illustration 7. Compute
the expected rate ofreturm assuming
4 per cent inflation premium
and Rmfby 4 per cent.

Solution:
AR,= 9%+4%
=
13%

E(R) =13 + [18-13] 1.5

= 13% +7.5

20.5%