Gains received b

y
u nc e r tainty Way of income
a r ia b ility or + increase in
V rns
Of retu Market value

Risk and Return

 Invest in
REALIZED RETURN & EXPECTED Equity or not
RETURN
Historic or realized return as in case of a
bank deposit at a fixed rate of interest.

EXPECTED RETURN
Have to be sufficiently high to offset the
risk or uncertainty.
 MEANING Of
Components OF Return
CASH

Periodic cash receipts by way of interest,

Dividends. Eg. Yield on a 10% bond of
Rs. 900 is 11.11%

The appreciation/depreciation in the

price of the asset. i.e. difference between
purchase & sale price of assets.
 Objectives :
How to calculate
Return ? Wha
Cap t is
What are its How d ital a
Prici
components o we ng m sset
Measu odel
re ?
risk

h a t is W
W i o? ha
t f o l
Por W t
Co ha is r
m t a isk
po re s
ne its ?
nt
s?
 Therefore RETURNS are
measured as -
• Shares of company A were
purchased for Rs.3580 and were
sold for Rs.3800 after one year
and dividend of Rs.35 was paid
for the year how much is rate of
return ?
ca sh Capital appreciation
gu lar
35 + (3800 −3580)
Re flow In value of security

=
3580
Initial capital
= 7.12% Invested.
 How to measure return?
Change in
Dividend
the value of
regular cash
stock over t
flow
-time

Dt + ( Pt − Pt − 1)
k=
Pt − 1
Value of stock in
beginning
PROBABILITIES & RULES
• A probability can never be larger
than 1
• The sum total of probability must be
equal to 1
• A probability can never be negative
• Certain to occur P=1 never occur P=0
• Probability should be mutually &
collectively exhaustive.
Let us take the case of HLL from
1991-1998
Year Share price Dividend per Capital gain Dividend Rate of
(Pt) share Pt -Pt-1 / Pt-1 Yield (%) return (%)

1991 24.75 -
1992 55.50 6.3 124.24 25.46 149.70
1993 86.25 8.4 55.41 15.14 70.54
1994 88.50 12.00 2.61 13.91 16.52
1995 93.60 15.00 5.76 16.95 22.71
1996 121.20 18.75 29.49 20.03 49.52
1997 207.60 25.50 ? 71.29 ? 21.04 92.33
1998 249.60 33 ?20.23 ?15.90 36.12
HLL’s Annual Rates of Return

160.00 149.70
140.00
Total Return (%)

120.00
100.00 92.33

80.00 70.54

60.00 49.52 52.64

36.13
40.00 22.71
16.52 12.95
20.00 7.29
0.00
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

Year
Expected returns
 The anticipated income over
some future period and may
be subject to certain risk or
uncertainty is expected return.
 Suppose in case of Alpha Ltd,
following information –
1. 20% chance of 50% return =(0.20 x 0.50)+(0.30 x
2. 30% chance of 40% return 0.40) +(0.25 x 0.30)+
3. 25% chance of 30% return (0.25 x 0.10)
4. 25% chance of 10% return
= 32%
 Uncertainty of
return is Risk components
Market risk

Business risk

Liquidity risk

Inflation
risk
k
Financial ris

Interest rate risk

inverse
 Calculation of risk
• Probability Distribution
• Range
• Variance
• Standard deviation
Probability distribution method – graphical
method
 Say if following data is
given to you ,of Alpha
ltd.,

PROBABILITY
Probability Rate of return
RETURN
0.1 50%
0.2 30% Since the dispersion is near
the y axis and not spread over
0.4 10% the risk in this company is very
low.
0.2 -10%
0.1 -30%
Probability distribution method – graphical
method
 Say if following data is
given to you ,of Beta
ltd.

PROBABILITY
Probability Rate of return
RETURN
0.1 70%
0.2 50% Since the dispersion is far from
the y axis and spread over the
0.4 10% risk in this company is very
high
0.2 -30%
0.1 -50%
 Range
 It is the difference between the highest and
the lowest value of rate of return
 It is based on only two extreme values.
 Range for Ala ltd = 50% –( -30%)
= 80%
 Range for Beta ltd= 70% - (-50%)
=120%
. So beta is more risky
 Variance
 It is the sum of the
n 2
squared deviation of
each possible rate of ∑ P (r − r )
i =1
i
i
return from the
expected rate of return
multiplied by the
probability that the
rate of return occurs.
 Standard Deviation
 It is the square root of variance of the rate of
return explained initially.
Standard deviation = Variance
n 2
σ= ∑ P (r − r )
i =1
i
i
 Sources Of Risk

• Interest Rate Risk-Security prices move

inversely to interest rates.
• Market Risk- Variability of returns due to
fluctuations in security markets. (Equity
most affected)
• Inflation Risk-Reduction in purchasing
power.
Directly related to interest rate risk.
Sources Of Risk
• Business Risk-Carrying on a business in a
particular environment. The risk is transferred
to the investors.
• Financial Risk- greater the debt financing,
greater the risk.
• Liquidity Risk- Security which can be bought or
sold easily, without significant price concession,
is considered liquid. The greater the uncertainty
about the time element & price concession, the
greater the liquidity risk.
Treasury bills have ready markets lesser
liquidity risks
 Calculate risk in Alpha ltd. -
Outcomes Return (ki%)
(ki − k ) ( ki − k ) 2 Pi Pi  k −k  2

1 50% 40 1600 0.1 160

2 30% 20 400 0.2 80
3 10% 0 0 0.4 0
4 -10% -20 400 0.2 80
5 -30% -40 1600 0.1 160

Total 480

n 2
=√ 480 = 21.9%
σ= ∑ Pi ( r i − r )
i =1
 How to reduce risk ?
• If I invest in a company trading in
sunglasses my normal observation would
be that I experience good profits in
summer and loss in rains
• If I invest in a company trading in
raincoats I would experience good profits
during rainy season and losses during
summers.
 p o f a s set so
Grou
t t he t o tal risk
tha
reduces Portfolio
■ Keep all types of assets like –
equity,
■ - bond, saving
account
■ - real estate
■ - bullions
■ - collectibles and
other
■ assets.
 I have to invest in two
companies
• There are two companies – Company A
and Company B .
• The return from Company A is 12% and
Company B is 18%
• The standard deviation of A is 16% and
24%
• Then how much will I invest in A and how
much in B ie. The weights assigned to
each will decide my total risk and return
factor
What will be the return and risk
if I invest 50:50 in company A
and company B

A . 15 % return and 20 % risk

B. 15 % return and 4 % risk
C. 15 % return and 14.42 % risk
The answer will depend on the
relationship between
Company A and Company B
 Formula to calculate risk in
portfolio is – standard deviation
of the portfolio
Standard
deviation of Relationship
The security of
The two
securities

   w   w  2 wx wy Co varxy
2
p
2
x
2
x
2
y
2
y

  w   w  2 wx wy x y Corxy
2
x
2
x
2
y
2
y
 Total Risk can be reduced
through diversification
■ Perfectly positively co-related – ex. Two
leading companies in pharmaceutical
industry.
■ Portfolio risk will be calculated as the
addition of the risk of the securities in the
portfolio.
 p2   x2 wx2   y2 wy2  2 wx wy Co varxy
■ Say, in given case
  x2 wx2   y2 wy2  2 wx wy x y Corxy

=(0.5*16)2 + (0.5*24)2 + 2
*0.5*16*0.5*24* 1
= 0.5*16 + 0.5*24
= 20%
No advantage of diversification
 Risk can be reduced
through diversification
■ Perfectly negatively co-related – ex. Two
companies in raincoat and sunglass industry.
■ Portfolio risk will be calculated as the
difference of the risk of the securities in the
portfolio.
■ Say, in given case
 2   2 w2   2 w2  2 w w Co var
p x x y y x y xy

  x2 wx2   y2 wy2  2 wx wy x y Corxy

=(0.5*16)2 + (0.5*24)2 - 2
*0.5*16*0.5*24* 1
= 0.5*16 - 0.5*24
= 4%
Huge advantage of diversification
 Risk can be reduced
through diversification
■ Perfectly not co-related – ex. Two
companies in steel and fertilizer industry.
■ Portfolio risk will be calculated by following
method.
■ Say, in given case
 p   x wx   y wy  2 wx wy Co varxy
2 2 2 2 2

  x2 wx2   y2 wy2  2 wx wy x y Corxy

=(0.5*16)2 + (0.5*24)2 + 2
*0.5*16*0.5*24* 0
=(0.5*16)2 + (0.5*24)2
= 14.42%
Advantage of diversification to some extent
 RISK
■ DIVERSIFIABLE/
unique risk

Strikes ■ NON –
Increase in competition DIVERSIFIABLE
Technical breakdown or
or systematic
obsolescence risk
Changes in government policies –
Inadequate raw material monetary policy, fiscal policy,
Change in management. foreign policy, corporate taxes

Loss of a big contract etc. War

Earthquake, floods, rains,
tsunamis etc.
Hence though initially the risk
gets diversified, due to some
systematic or market risk the
diversification cannot
completely negate the risk
 Risk Reduction
through
diversification.

The effect
reduces with

Diversifia
ble Risk

No change in
market risk
Non –
Risk

diversifiable Risk

Increase
Number in the portfolio
of securities size
in portfolio
Similarly if we calculate Return of Alpha–
12% and Beta – 18% and std. deviation –
Alpha -16% and Beta – 24%
Portfolio Risk, σp
Portfolio Correlation
Weight Return
Alpha Beta Rp σp σp σp σp σp
1.00 0.00 12.00 16.00 16.00 16.00 16.00 16.00
0.90 0.10 12.60 16.80 12.00 14.60 15.74 13.99
0.80 0.20 13.20 17.60 8.00 13.67 15.76 12.50
0.70 0.30 13.80 18.40 4.00 13.31 16.06 11.70
0.60 0.40 14.40 19.20 0.00 13.58 16.63 11.76
0.50 0.50 15.00 20.00 4.00 14.42 17.44 12.65
0.40 0.60 15.60 20.80 8.00 15.76 18.45 14.22
0.30 0.70 16.20 21.60 12.00 17.47 19.64 16.28
0.20 0.80 16.80 22.40 16.00 19.46 20.98 18.66
0.10 0.90 17.40 23.20 20.00 21.66 22.44 21.26
0.00 1.00 18.00 24.00 24.00 24.00 24.00 24.00
Minimum Variance Portfolio
wL 1.00 0.60 0.692 0.857 0.656
wR 0.00 0.40 0.308 0.143 0.344
σ2 256 0.00 177.23 246.86 135.00
σ (%) 16 0.00 13.31 15.71 11.62
If we plot the data on a graph
20
Cor = - 1.0 Cor = - 0.25
Efficient frontier
beta

Cor = + 0.50
15
Portfolio return, %

Cor = + 1.0

Cor = - 1.0 alfa

10
e f f ic i ent
In r
frontie
5

0
0 5 10 15 20 25 30
Porfolio risk (Stdev, %)
We will now try to analyze more
of diversifiable (market risk) and
non- diversifiable risk
• For this we will try to find relation between
market risk and specific risk of the security
• We try to analyse the responsiveness of
security to general market and measure
how extensively the return of security vary
with changes in market return.
 Calculation of risk of a stock/
portfolio with respect to market
• We try to fit a line to find the systematic
relationship (linear) between the return of
security and the return of market.
• As per model of William Sharpe it is
expressed as – Relation between the
market security and the
security k
Return on

kj = αj + βjkm
Security J

Return above
market at all
times
 Calculation of beta
• Beta refers to the regression co-efficient
between the market security and the
portfolio returns.
 Capital Asset Pricing Model
• The capital asset pricing model (CAPM) is a
model that provides a framework to determine
the required rate of return on an asset and
indicates the relationship between return and
risk of the asset.
• Assumptions of CAPM
– Market efficiency
– Risk aversion and mean-variance optimisation
– Homogeneous expectations
– Single time period
– Risk-free rate
Capital Asset Pricing Model

kj = kf + βj (km − kf )
 Security Market Line
• For a given amount of systematic risk (β),
SML shows the required rate of return
E(Rj)
E(R j ) = R f +  (R m ) – Rβf  j

SLM

Rm

Rf

β = (covarj,m/σ
0 1.0
m)
2
 SML
EXPECTED / REQUIRED RATE OF

RISK PREMIUM
FOR UNCERTAINTY
Km

Rf
RETURN ON Y AXIS

Defensive Beta Aggressive

securities securities
1.0
 X
SML
EXPECTED / REQUIRED RATE OF

RISK PREMIUM
FOR UNCERTAINTY
Km

Rf
Y
RETURN ON Y AXIS

Defensive Beta Aggressive

securities securities
1.0
 Types of investors – based on risk

• A risk-averse investor will choose among

investments with the equal rates of return, the
investment with lowest standard deviation.
Similarly, if investments have equal risk
(standard deviations), the investor would prefer
the one with higher return.
• A risk-neutral investor does not consider risk,
and would always prefer investments with higher
returns.
• A risk-seeking investor likes investments with
higher risk irrespective of the rates of return. In
reality, most (if not all) investors are risk-averse.