Risk & Return analysis in investment decisions

Return

Risk
Ajay Kumar Chauhan

For a Treasury security, what is the required rate of return?

= Risk-free rate of return

Since Treasurys are essentially free of default risk, the rate of return on a Treasury security is considered the risk-free rate of return.

For a corporate stock or bond, what is the required rate of return?

Required rate of return

Risk-free rate of return

Risk Premium

How large of a risk premium should we require to buy a corporate security?

Returns

Expected Return - the return that an investor expects to earn on an asset, given its price, growth potential, etc. Required Return - the return that an investor requires on an asset given its risk.

Return Calculations
Returns = Selling price Buying price + CB Buying Price

Expected Return of a Portfolio is the weighted sum of the individual returns from the securities making up the portfolio:

Nominal & Real Rate of Return r = R i The exact relationship can be expressed as:

r = (R i) / (1 + i)

Arithmetic vs. Geometric Return

20%, -10%, 30%, -20%, 10%, 20%, -30% 20 10 + 30 - 20 + 10 + 20 30 7 = 3% Net Value of the portfolio = Rs 103 AM =

Discrete vs. Continously Compounded Return

DR = (P1-p0)/P0
CCR = ln (P1/p0)

Risk
Investors are willing to take some amount of risk since it is the only way to earn higher return. In Normal Life, Risk often means a negative return.

Three scenarios of Future investment

Certainty Uncertainty Risk

Risk : in holding the securities is generally associated

that realised returns will be less that the expected returns.

Risk

Systematic Risk
External to the firm Cannot be controlled => Known as non-diversifiable risk Affect large no of securities

Unsystematic Risk
=> internal to the firm => Controllable to large extent => also known as diversifiable risk

Market Risk

Interest rate risk

Purchasing power risk

Business risk

Financial risk

Market Risk
Stock variability due to the changes in investor's attitude and expectations. Caused by investors reaction towards

tangible and intangible events.

psychological basis

real basis

political events Social events International reasons Economic reasons

emotional instability fear of loss excessive selling pressure market sentiments

Interest rate risk

Refers to uncertainty of future markets values and of the size of future income caused by the fluctuations in the general level of interest rates. Increase in interest rates Increase in cost of capital ( cost of borrowed capital) Lower earnings , dividends Decline in the share prices

Purchasing power risk

Refers to the impact of inflation or deflation on an investment

Unsystematic risk
Is that portion of total risk that is unique to a firm or an industry and affecting securities market in general. Factors such as management capability, consumer preferences and labour strikes can cause unsystematic variability of returns for a cos stock Examined separately for each company

Two sources of unsystematic risk: Business risk Financial risk

Business Risk
Is a function of operating conditions faced by the firm and the variability these conditions injects into operating and income and expected dividends.

Internal business risk : wrong mgmt decisions, strikes

and lockouts, obsolete products, dependence on few large customers.

External business risk : Fiscal policy, monetary policy,

exchange rates, political environments.

Financial risk
Arises when the firm uses the debt in the capital structure Create problems in recessions or period of low demands. Spread of bad words/news in the market. Higher employee turn over Buyers dilemma.

Assigning risk premiums

R=I+p+b+f+m+o

Where

R = required rate of return I = risk free rate of return P = purchasing power allowance B = business risk allowance F = financial risk allowance O = allowance for other risk

Stating predictions scientifically

Analyst must try to quantify the risk that a given stock will fail to realize its expected return. Quantification of risk is necessary to ensure uniform interpretation and comparison.

Example : Consider two stocks A & B. Expected return of both the stocks is 10%. The security analyst assign probabilities to different returns to stock A & B. The probability distribution of stock A & B are as follows:
Stock A Stock B

Return
7 8 9 10 11 12 13 Total

Probability
0.05 0.10 0.20 0.30 0.20 0.10 0.05

R*P
0.35 0.80 1.80 3 2.20 1.20 0.65 10

Return

Probability

R*P

9 10 11

0.30 0.40 0.30

2.7 4 3.3

Total

10

Stocks A & B have identical expected average returns of 10%. But the spreads for stocks A & B are not the same. Range (A) = 7 to 13 % Range (B) = 9 to 11 % Higher the dispersion , higher the risk

Stock A
Return expected return 7-10 8-10 9-10 10-10 11-10 12-10 13-10 Variance S.D Square of the difference 9 4 1 0 1 4 9 Prob 2*3 Return expected return

Stock B
Square of the difference Prob 2*3

0.05 0.10 0.20 0.30 0.20 0.10 0.05

0.45 0.40 0.20 0 0.20 0.40 0.45 2.10 1.45

9-10 10-10 11-10

1 0 1

.3 .4 .3

.3 0 .3

Variance S.D

0.60 .77

Total Risk
Total risk of investment consists of two components: 1. Diversifiable risk 2. Non-diversifiable risk

Total risk = Diversifiable risk + Non-diversifiable risk

Can be eliminated by proper diversification Markowitz model

managed with the help of Beta

What Beta means

Beta is a risk measure comparing the volatility of a stock's price movement to the general market. Beta measures systematic risk. It shows how the price of a security responds to market forces. The beta of the market is one and other betas are viewed in relation to this value. Beta can be positive and negative.

Beta =

Covariace ( Xi, Yi) Variance (yi)

Where, Xi is the stock return Yi is the index return

Beta = n XY x y 2 y ny

Calculating Beta

bhel

Value At Risk
Quantile of a distribution

q is the value below which lie q% of the values.

ie with a prob of p% we can expect a loss equal to or greator than the VAR.

Conditional Tail Expectation

Assuming the terminal value of the portfolio falls in the bottom 5% of possible outcome , what is its expected value ?

Lower Partial Standard Deviation

Is an appropriate measure of risk for non-normal distributions Is the SD computed solely from values below the Expected Return measure of downside risk

Volatility
SD in the error terms

Where,
Error terms = Actual Return Expected return