Risk & Return

Return
Return : It is the primary motivating forces that drives investment. It represents the reward for undertaking the investment. In investment analysis we are primarily and particularly concerned with returns from investors perspective. The return of an investment consists two components : (i) Current return (ii) Capital return. (i) Current return: Periodic cash flow (income) such as dividend and interest. This can be zero or positive. (ii) Capital return: The price appreciation or price changes. This can be zero, positive and negative also. Thus Total Return = Current return + Capital return

Historical (ex-post) Return

Historical capital return excluding Dividend. Period : 0 1 2 3 4 Price : 100 110 108 130 115 Solution: R1 = (P1-P0)/P0 =(110 -100)/100 =0.10=10% R2 = -1.8% R3 = 20.37% R4 = -11.54% Average return = 4.26%

 Historical capital return including Dividend. Period : 0 1 2 3 4 Price : 100 110 108 130 115 Dividend: 5 7 8 3 Solution:R1 = [(P1-P0)+D1]/P0 =[(110 -100)+5]/100 =0.15=15% R2 = 4.5% R3 = 27.77% R4 = -9.23% Average return = 9.51% This return will give the investors an insight or the prediction about the future return.

Historical ( ex-post) Risk

The majority of investors tend to emphasize the return. They also tend to view the risk in subjective as well as comparative term. Suppose you are evaluating two shares A & B for investment. You have collected data of return earned for the last 5 years. Stock A: 30% 28% 34% 32% 31% Stock B: 26% 13% 48% 11% 57% You have to choose one stock among these two.

In this context , we interpret risk essentially in the terms of the variability of the security return. The most common measures of risk ness of security is SD and Variance of return. Given below returns of two stocks X and Y.
Period Return of stock X(%) Return of stockY(%)

1 -6 2 3 3 10 4 13 5 16 Calculate which stock is more risky ?

4 6 11 15 19

Period 1 2 3 4 5 Sum

X -6 3 10 13 16 36

Y 4 6 11 15 19 55

(X X) -13.2 -4.2 2.8 5.8 8.8

(Y Y) (X X)2 -7 -5 0 4 8 174.24 17.64 7.84 33.64 77.44 310.84

(Y Y)2 49 25 0 16 64 154

Mean of X = 36/5 = 7.2 =X Mean of Y = 55/5 =11=Y Variance of X = (X- X)2/(n -1)= 310.80/(5-1)= 77.7 and the S.D =77.7=8.815

Measuring Expected (ex-ante) Return

When we invest in a stock we try to anticipate the future streams return based on the past performance of the stock. It may be -5%, 15% or 35%. Further the likely hood of these possible returns can vary. Hence we should think in terms of probability distribution. The probability of an events represents the likelihood of its occurrence. For example there is a 70% chance that the price of the stock will increase and 30% chance that the price of the stock will not increase during the next fortnight.

Economic scenario

Probability of occurrence

Return from stock A(%)

Boom
Stagnation Recession

0.25
0.50 0.25

36
26 12

The expected return would be E(R) = (0.25*36)+(0.50*26)+(0.25*12) = 25% The risk of the stock : 2 =Pi *[Ri E(R)]2 =(36-25)2 *0.25 + (26-25)2 * 0.50 + (12-25)2 * 0.25 = 73% SD = 8.54%

Reduction of risk through Diversification

Investment Analysis: Measuring risk & return. Portfolio Mgt: minimize risk or maximize return.

Concept of Covariance: the degree to which the return of two securities vary or change together. Concept of Correlation: the degree of relationship between two variables.

Portfolio Risk & Return

The performance of the three stocks A, B and C for the four years are given below. If a portfolio is constructed such that the stock having lowest S.D accounts for 50% of the funds, the stock having next lowest S.D. accounting for 30% & the rest put in the last one. Compute the portfolio risk & return.
Period 1 2 3 4 A(%) 10 12 14 16 B(%) 11 9 13 17 C(%) 8 12 9 15

WA=50%, WB=20%, W C =30% _ _ _ Return of the portfolio = A*WA + B*WB +C*Wc Variance of portfolio(2) = 2A* W2A + 2B* W2 B + 2C* W2C + 2[ CovAB* WA* W B + CovBC* WB* W C + CovAC* WA* W C ]

Economic scenario
Boom

Probability of occurrence
0.40

A(%)
15

B(%)
11

C(%)
13

Stagnation
Recession

0.35
0.25

12
8

13
14

9
6

Construct a portfolio with 40% of the funds invested with lowest S.D. and the rest invested equally in other two stocks. Compute the risk & return of the portfolio.

A-E(A) 2.8 - 0.2 - 4.2 COV

B-E(B) -1.45 0.55 1.55

C-E(C) 3.15 - 0.85 - 3.85

1*2*P - 1.62 - 0.04 -1.63 -3.29

2*3*P - 1.83 -0.16 -1.49 -3.48

1*3*P 3.53 0.06 4.04 7.63

Portfolio Return = 11.59% Portfolio Variance = 1.39% Portfolio S.D. = 1.18%

Decomposition of Risk
Systematic risk : This risk refers to that portion of total variability of return caused by the factors affecting the price of all securities. This risk affects the market as a whole. The economic conditions, political situations and the sociological changes affect the security market. Example : A steep increase in the international oil prices is almost certain to affect the entire market adversely. Unsystematic risk : This risk is the portion of total risk that is unique to a firm or industry. This risk is also called diversifiable risk. Cont

Example : managerial inefficiency, technological changes, availability of raw materials, change in customer preferences, labor strikes, unexpected entry of new competitor. The nature and magnitude differ from industry to industry and company to company.

Systematic risk
Market risk : It refers to the investors attitude towards the market. The basis for this reaction is a set of real tangible events political, social or economic. Interest rate risk : This risk refers to the uncertainty of future market values and the size of the future income caused by fluctuation in the general level of interest rate. Purchasing power risk : the value of currency decreased & hence less surplus money to invest in the market.

Unsystematic risk
Business risk : This risk caused by the operating
environments of the business. This risk can be divided into two broad categories - external and internal business risk. (i) Internal business risk is largely associated with the efficiency with which a firm conducts its operations within the broad operating environment. (ii) External business risk is result of operating conditions imposed upon the firm by circumstances beyond its control.

Financial risk : This risk associated with the way in which a

company finance its activities. We usually gauge financial risk by looking at the capital structure of the firm.

Beta
It measures the securitys performance in relation to market. Beta shows how the price of a security responds to market forces, the more responsive the price of a security is to change in the market, the higher will be its beta. Beta measures how much the stock and market move together. Beta can be positive or negative. However nearly all betas are positive and most betas lie somewhere between 0.4 to 1.9.

Measurement of Beta = Covariance of security & the market return/ variance of market return.

Beta Estimation
The following Table gives the rate of return of X Ltd. and the market over a period of time. Calculate beta of X Ltd.
Month January February March April May June Return of X Ltd. 23% -14% 18% -9% 16% 7% Index return 21% -12% 13% -11% -19% 5%

Careful while calculating Beta

Daily, weekly or monthly Price. Period of analysis.

Portfolio Beta:
Company Beta Weightage Weighted Beta

Infosys
ICICI Ranbaxy TISCO GACL

1.37
0.99 0.91 1.19 0.95

35%
20% 20% 10% 15%

0.4795
0.1980 0.1820 0.1190 0.1425

Portfolio Beta

100%

1.2110

Capital Asset Pricing Model

CAPM: It is an equation that express the equilibrium relationship between securities required return & its systematic risk or beta. RA = Rf + Beta (Rm Rf) Expected rate of return: It is the rate of return from an asset that investors anticipate or expect to earn over some future time. Required rate of return: It is the minimum rate of return needed to induce to purchase a security.

CAPM
Basic assumptions : o Investors seek to maximize their risk-return trade off. o Investors are free to lend or borrow any amount of money at risk free rate. o All investors have homogenous expectation i.e. their future rate of return have identical probability distn. o All investors have same investment time horizon. o All investments are assumed to be infinitely divisible. o The market is perfect ; no taxes, no transaction costs and it is perfectly competitive.

Security Market Line

The SML represents the average or normal trade off between risk and return for a group of securities, where the risk is measured typically in terms of the security beta. So, we can say it is the graphical representation of the CAPM model.

Low Beta Sector

Pharmaceutical. FMCG.

High Beta Sector

Metal. Oil & Gas.

Apparel

Real Estate