Risk & Return
Chapter Objectives
To understand the concept of risk
To know the various types of risk
To comprehend the tools of measuring the
risk
To understand the concept of stock return
Concept of Risk
Risk is expressed in terms of variability of
return.
An investor before investing in securities
must properly analyze the risks associated
with these securities.
There are two types of risks:
Systematic risk
Unsystematic risk
Systematic Risk
It is the risk that is caused by external factors
such as economic, political and sociological
conditions.
It affects the functioning of the entire market.
They are of three types:
Market risk
Interest rate risk
Purchasing power risk
Market Risk
Jack Francis has defined market risk as that portion of the total
variability of returns that is caused by the alternating forces of
bull and bear markets.
When the stock market moves upwards, it is known as bull
market. On the other hand, when the stock market moves
downwards, then it is known as bear market.
The two forces that affect the market are:
Tangible events: Earthquake, war, political uncertainty and decrease
in the value of money are some of the examples of tangible events.
Intangible events: It is related to market psychology. Political unrest
or fall of government affects the market sentiments.
Interest Rate Risk
It is the risk caused by the variations in the market
interest rates.
Prices of debentures, bonds, etc. are mainly affected
by the interest rate risk.
The causes of interest rate risk are as follows:
Changes in the government’s monetary policy
Changes in the interest rate of treasury bills
Changes in the interest rate of government bonds
Purchasing Power Risk
Variations in returns are caused by the loss of
purchasing power of currency.
There are mainly two types of inflation:
Demand-pull inflation: The demand for goods and
services remains higher than the supply.
Cost-push inflation: There is a rise in price due to
the increase in the cost of production.
Nominal future value
Real future value = 1.0 Inflation Rate
1.0 r
Real Rate of Return = 1.0
1.0 IR
where r = rate of return
IR = Inflation Rate
Unsystematic Risk
It is a type of risk which is unique, specific
and related to a particular industry.
Managerial inefficiency, changes in
preferences of the consumers, availability of
raw material, labour problems, etc. are some of
the causes of unsystematic risk.
These are of two types:
Business risk
Financial risk
Business Risk
It is the risk that is caused by the inefficiency of a
company to manage its growth or stability of
earnings.
It can be classified as:
Internal business risk: It is the risk that is associated with
the operational efficiency of a company.
External business risk: It is the risk that is the result of
operating conditions imposed on the firm by the external
environment.
Financial Risk
It is associated with the capital structure of the
company, which consists of equity and borrowed
funds.
A financial risk can be avoided by analyzing the
capital structure of the company.
The financial risk considers the risk between EBIT
and EBT.
The payment of interest affects the eventual earnings
of the company.
Risk Measurement
An efficient measurement of risks provides an appropriate
quantification of risk.
Standard deviation is used as a tool for measuring the risk,
which is a measure of the variables around its mean.
The following formula is used to calculate standard
deviation:
N
P r -E(r)
2
σ= 1
i=1
Beta
Beta is the slope of the regression line.
Beta describes the relationship between the stock return and
index return.
Beta = +1.0. One per cent change in index return
causes one per cent change in stock return.
Beta = +0.5. One per cent change in index return
causes 0.5 per cent change in stock return.
Negative beta indicates that the stock return and the market
move in opposite directions.
Concept of Stock Return
It is a return which includes current income and
capital gain that is caused by increase in the price.
The current income and capital gain are expressed as
a percentage of the money invested in the beginning.
An investor before investing in securities must
properly analyze the returns associated with the
securities.
Current Income is also called Current Yield
Concept of Stock Return
Therefore Total Return =
Current Yield + Capital Appreciation
Example : X purchased a stock for Rs. 6,000. At the
end of the year the stock is worth Rs. 7,500. X
received dividend of Rs. 250 during the year.
Calculate the total return received by X.
Historical Return
It is the rate of return which an asset has given
historically.
Data of Annual returns of the asset is taken into
consideration over a period of years.
These returns are generally analyzed for 1 day, 1
month, 3 months, 6 months, 1 year to YTD.
These historical returns form basis for future
prediction of returns.
Historical Return
Price of shares of XYZ limited for the last 6 years is
given below. Find out the historical return of XYZ
for the last 5 years and average return for the last 5
years.
Year Price
1 125
2 136
3 128
4 140
5 143
6 150
Expected Return
It is the expected rate of return an investor will get in
future on his investments.
The anticipated rate of return can be calculated with
the help of probability.
Probability refers to the likelihood occurrence of an
event.
It can be calculated as:
N
E(R) = (Probability P ) (Return R )
t=1
t t
Expected Return
Suppose, if you knew a given investment had a 50%
chance of earning return of 10%, a 25% chance of
earning a return of 20% and there is a 25% chance of
bearing a loss of 10%.
What is your expected return?
Coefficient of Variation
CV is a measure of relative risk
It tells us the risk associated with each unit of money
invested.
CV = Standard Deviation
Expected Return
Coefficient of Variation
Stock A has an expected return of Rs. 15 and an
expected variation (S.D) of Rs. 4
Stock B has an expected return of Rs. 20 and an
expected variation (S.D) of Rs. 5.
Which stock is riskier?
Chapter Summary
By now, you should have:
Understood the concept of risk
Learnt about the types of risks
Comprehended the tools for measuring the risk
