RISK AND

RETURN

Security analysis is built around the idea

that investors are concerned with two
principal properties inherent in securities.
The return that can be expected from
holding a security and the risk that, the
return that was achieved will be less than
the return that was expected

Risk
Risk in holding securities is generally
associated with the possibility that realized
returns will be less than the return that
was expected.
Risk is generally of two types Systematic Risk.
Unsystematic Risk

Systematic Risk
Systematic Risk is also known as
undiversified or uncontrollable risk. It
refers to that portion of total variability in
return caused by factors affecting the
prices of all securities. Economic, political
and sociological changes are sources of
systematic risk.

Unsystematic Risk

Unsystematic Risk is also known as diversified

or controllable risk. It is the portion of total risk
that is unique to a firm or industry .Factors such
as management capability ,Consumer
preferences, labour strikes cause variability of
returns in a firm .Unsystematic factors are
largely independent of factors affecting
securities markets in general. Because these
factors affect one firm, they must be examined
for each firm.

MARKET RISK_

Market risk refers to the variability of returns due to

fluctuation in the securities market. Market risk is caused
by investor reaction to tangible as well as intangible
events. Expectation of lower corporate profit in general
may cause the larger body of common stocks to fall in
price.
The basis for the reaction is a set of real, tangible events
like depression,war,politics.
Intangible events are related to market psychology The
initial decline In the market can cause the fear and all
investors make for the exit.

Interest Rate Risk

Interest Rate Risk refers to the uncertainty of

future market values and of the size of future
income, caused by fluctuations in the general
level of interest rates.
The root cause of interest rate risk lies in the fact
that, as the rate of interest paid on government
securities rises or falls .The rate of returns
demanded on alternative investment, such as
stocks and bonds issued in the private sector,
rise or fall.

PURCHASING _POWER RISK

Purchasing power risk refers to the impact of

inflation or deflation on an investment .Rising
prices on goods and services are normally
associated with what is referred to as inflation
Falling prices on goods and services are termed
deflation.
Rational investors should include in their
estimate of expected return an allowance for
purchasing power risk

BUSINESS RISK CAN BE

Internal Business Risk

External Business Risk.
Internal Business Risk is largely
associated with the efficiency with which a
firm conducts its operations within the
broader operating environment imposed upon
it.
External Business Risk is the result of
operating conditions imposes upon the firm
by circumstances beyond its control.

Financial Risk

Financial risk is associated with the way in which

a company finances its activities .We usually take
financial risk by looking at the capital structure of
a firm .The presence of borrowed money of debt
in the capital structure creates fixed payment in
the form of interest that must be sustained by the
firm. Financial risk is avoidable risk to the extent
that management have the freedom to decide to
borrow or not to borrow funds. A firm with no debt
financing has no financial risk.

Liquidity risk

Liquidity risk arises when an asset cannot

be liquidated easily in the secondary
market.

ASSIGNING RISK
ALLOWANCES

One way of Quantifying risk and building a required rate of return

would be to express the required rate as comprising risk less rate
plus compensation for individual risk factors.
R= I + P + B + F + M+O
Where,
I = Real interest rate (Risk less Rate)
P=Purchasing Power Risk Allowance.
B=Business Risk Allowance.
F= Financial Risk Allowance.
M= Market Risk Allowance.
O= Allowance for Other Risk.

Starting Predictions
Scientifically.

Security analysis can not be expected to predict with

certainty whether a stocks price will increase or
decrease or by how much. Analysist can not understand
political and socioeconomic forces completely enough to
permit predictions that are beyond doubt or error.
This existence of uncertainty does not mean that
analysis is value less. It does not mean that analysis
must strive to provide not only careful and reasonable
estimates of return but also some measure of the degree
of uncertainty associated with these estimates of return.

Suppose that stock A, in the opinion of the analysist, could provide

returns as follows.
Returns (%)
Likelihood
7
1 chance in 20.
8
2 chance in 20.
9
4 chance in 20.
10
6 chance in 20.
11
4 chance in 20.
12
2 chance in 20.
13
1 chance in 20.
A likelihood of four chances in twenty is 4/20 or .20. .The total of the
probabilities assigned to individual events in a group of events must
always equal 1.00.

Return (%)
Probability.
7
.05
8
.10
9
.20
10
.30
11
.20
12
.10
13
.05
Security analysis use the probability distribution of return to specify
expected return as well as risk .This expected return is the weighted
average of the returns .If we multiply each return by its associated
probability and add the results together, we get a weighted average
return or expected average return.

(1)
Return (%)
7
8
9
10
11
12
13

(2)
Probability
.05
.10
.20
.30
.20
.10
.05

1*2
.35
.80
1.80
3.00
2.20
1.20
.65
10.00%

The expected average return is 10%.The

expected return lies at the center of the
distribution .Most of the possible outcomes lie
either above or below it.
The spread of possible returns
about the expected return can be used to give
us a proxy of risk. Two stocks can have identical
expected returns but quite different spread or
dispersions and thus different risks.

Consider Stock B -:
(1)
Return (%)
9
10
11

(2)
Probability
1*2
.30
2.7
.40
4.0
.30
3.3
1.00
10.0
Stock A and B have identical expected average returns of 10%.But the
spreads for stocks A and B are not same .The range of outcome from high
to low return is wider for stock A than B .

The deviation of any outcome from the expected return

is:
outcome expected Return

Because outcomes do not have equal probabilities

of occurrence .We must weight each difference by its
probability.
Probability * (outcome Expected Return)
For the purpose of variance it is .
Probability * (Outcome Expected Return) 2

Stock A
Return minus
expected
return( 1

Differenc
e squared
(2

Stock B
Probability
(3)

2*3 (4)

Return
minus
expected
return (5)

9
4
1
0

.05
.10
.20
.30

.45
.40
.20
0

11-10=1

.20

.20

12-10=2

.10

.40

7-10= -3

8-10= -2
9-10=-1
10-10=0

9-10=1
10-10=0

11-10=1

Probability
(7)

6*7

1
0

.30
.40

.30
0

.30

.30

Difference
squared
(6)

Variance of A 2.10
Variance of B .60
Standard deviation of A 1.45
Standard deviation of B .77
The variability of return around the expected
average return is thus a quantitative descripition
of risk .The total variance is the rate of return on a
stock around the expected average return that
includes both systematic & unsystematic risk

Beta

Beta is a statistical measure of risk .and capital asset

pricing model (capm) links risk (beta) to the level of
required return.
Total risk=diversifiable risk + non diversifiable risk
Studies have shown that by carefully selecting as few as
15 securities for a portfolio diversifiable risk can be
almost entirely eliminated. non diversifiable risk is
unavoidable and each security possesses its own level
of non diversifiable risk ,measured using the beta
coefficient.

Beta measures non diversifiable risk. Beta shows how a price of a

security responds to market forces. The more responds to the price
of a security is to changes in the market, the higher will be its beta.
Beta is calculated by relating the returns on a security with the
returns of the market
Market return is measured by the average return of a large sample
of stocks such as BSE or NSE index. The beta for overall market is
equal to 1.00. Beta can be positive or negative. However all betas
are positive and most betas lie somewhere between .4 and 1.9.
Stocks having betas of less than 1 will of course be less responsive
to changing returns in the market and therefore are considered less
risky .

CAPITAL ASSET PRICING

MODEL(CAPM)

Capm uses beta to link formally the

notions of risk & return. CAPM can be
viewed both as a mathematical equation &
graphically, as the security market line,
(SML).

Assumptions of CAPM

Investors are risk averse. They take decision based upon risk and
return assessment.
The purchase or sale of a security can be undertaken in infinitely
divisible units.
Purchase and sale by a single investor can not affect prices.
There are no transaction costs.
There are no taxes.
Investor can borrow and lend freely at a risk less rate of interest.
Investors have homogeneous expectations - they have identical,
subjective estimate of the means, variances among returns.

Rs = Rf+ Bs(Rm-Rf)
Where,
Rs- The return required on the investment
Rf- The return that can be earned on a risk-free investment
Rm-The average return on all securities (BSE, NSE index)
Ex. Find the required rate of return when beta is1.2 , risk free rate
is 4% & the market return is expected to be 12 %.
Rs= 4 % + [1.20*(12%-4%)]
=4 % + [1.20 * 8%]
= 4% + 9.6 % = 13.6 %

The investor should therefore require 13.6% return on

this investment as compensation for the non diversifiable
risk assumed, given the securitys beta of 1.2 if the beta
were lower say 1.00, the required return would be 12%,
[4% +[1.00*(12%-4%)]]
And if the beta had been higher say 1.50 the required
return would be 16% {4% + [1.50*(12%-4%)]}.CAPM
reflects a positive mathematical relationship between risk
return since the higher the risk (BETA) the higher the
required return.

SECURITY MARKET LINE

When the capital asset pricing model (CAPM) is depicted

graphically, it is called the security Market Line (SML).Plotting
CAPM; we would find that the SML is a straight line. It tells us the
required return an investor should earn in the marketplace for any
level of unsystematic (beta) risk. The CAPM can be plotted by using
Equation. Make beta zero and the required return is 4% [4+0(12%4%)].Using a 4% risk-free rate and a 12% market return, the
required return is 13.6% when beta is 1.2.Increase the beta to 2.0, &
the required return equals 22% [4% +[2.0* (12%-4%)]] & so on. We
end up with the combinations of risk (beta) & required return.
Plotting these values on a graph (with beta on the horizontal axis &
required returns on the vertical axis); we would have a straight line.
The SML clearly indicates that as risk (beta) increases the required
return increases & vice versa.

EVALUATING RISK

In the end investors must some how relate the risk perceived in a
given security not only to return but also their own attitudes towards
risk. Thus, the evaluation process is not one in which we simply
calculate risk & compare it to a maximum risk level associated with
an investment offering a given return. The individual investor
typically tends to want to know of the amount of perceived risk is
worth taking in order to get the expected return & whether a higher
returns possible for the same level of risk. In the decision process
investors evaluate the risk-return behavior of each alternative
investment to ensure that the return expected is reasonable given
its level of risk. If other vehicles with lower levels of risk provide
greater returns, the investment would not be deemed acceptable.
An investor would select the opportunities that offer the highest
returns associated with the level of the risk they are willing to take.