Risk & Return

In which security will you invest?

Security A gives annual expected return of 12% p.a.

Security B gives annual expected return of 18% p.a.

Option 1: Security A
Option 2: Security B
Option 3: Can not say
Elements in Return
Return on a typical investment consists of two components:
(1) Periodic cash receipts(or income) on investment in the form of
interest or dividends
(2) Change in price of asset called capital gain/loss

Total return = Income + Price change(+/-)

 RETURN OF A SINGLE ASSET

Rate of Return = Annual income + Ending price-Beginning price

Beginning price Beginning price

Current yield Capital gains /loss

yield
Return
Rate of return Dividend yield Capital gain yield
DIV1 P1 P0 DIV1 P1 P0
R1
P0 P0 P0
Year Dividend Share Price Return
(Rs.) (Rs.) (%)
2007 2 100 -
2008 2.5 108 =[2.5+(108-100)]/100 = 0.105 = 10.5%
2009 3 115 =[3+(115-108)]/108 = 0.0925 = 9.25%
2010 3 104 ??
2011 4 120 ??

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 AVERAGE ANNUAL RETURNS
The arithmetic mean is defined as:
n
R
R= i=1 i

n
Year Total return (%)
1 19
2 14
3 22
4 -12
5 5

The arithmetic mean return for stock A is: (19+14+22-12+5)/5 = 9.6%

Can you Calculate Average Return?
Year Price (Rs) Return

2013 50

2014 100 100%

2015 50 -50%
Geometric Average Return
Geometric average return measures compound , cumulative returns over time. It
is used in investments to reflect the realized change in wealth over multiple
periods.
Geometric Return = [(1+0.19)(1+0.14)(1+0.22)(1-0.12)(1+0.05)]1/5 -1 = 8.86%
 DATA ON THE NIFTY INDEX
Year ending NIFTY Annual return Year ending NIFTY Annual return
(%) (%)
1990 331 - 2002 1094 3.25
1991 559 68.84 2003 1880 71.90
1992 761 36.28 2004 2081 10.68
1993 1043 36.95 2005 2837 36.34
1994 1182 13.40 2006 3966 39.83
1995 909 -23.15 2007 6139 54.77
1996 899 -1.04 2008 2959 -51.79
1997 1079 20.05 2009 5201 75.76
1998 884 -18.08 2010 6135 17.95
1999 1480 67.42 2011 4624 -24.62
2000 1264 -14.65 2012 5905 27.70
2001 1059 -16.18 2013 6304 6.76
2014 8284 31.41

The return for the year ended 1991 is 559/331- 1 = 68.88 percent. The returns for other years have been calculated
the same way. The means of the returns are calculated as under:
Arithmetic Mean = ( 68.84 + 36.28 +-------------------+ 6.76 + 31.41)/ 24 = 19.57 %
Geometric Mean=(1.6884x1.3628----------x1.0676x1.3141)1/241 = (25.0378)1/24-1 =14.36 %
Expected Return based on Probability
Scenario Probability(P) Return(R) Expected return=
PxR

Boom 0.30 16% 0.30X16 =4.8%

Normal 0.50 12% 0.50x12 = 6%

Recession 0.20 8% 0.20x8 = 1.6%

TOTAL EXPECTED
RETURN =
4.8%+6%+1.6% =
12.4%

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RISK
Variability in the Rates of Return
Two types of Risk
Systematic Risk
Unsystematic Risk
Total Risk = Systematic Risk + Unsystematic Risk

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 Systematic Risk
Systematic risk refers to that portion of total variability in return
caused by factors affecting the prices of all securities.
Systematic risk arises on account of the economy-wide
uncertainties and the tendency of individual securities to move
together with changes in the market.
This part of risk cannot be reduced through diversification.
It is also known as market risk or undiversified risk.
Investors are exposed to market risk even when they hold well-
diversified portfolios of securities.

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 Examples of Systematic Risk

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 Unsystematic Risk

Unsystematic risk arises from the unique uncertainties of

individual securities.
These uncertainties are diversifiable if a large numbers of
securities are combined to form well-diversified portfolios.
Uncertainties of individual securities in a portfolio cancel out
each other.
Unsystematic risk can be totally reduced through diversification.
It is also called unique risk or diversified risk.

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 Examples of Unsystematic Risk

16
Systematic and unsystematic risk and
number of securities

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RISK
Variability in the Rates of Return

Risk or variability of rates of return may be defined as the extent of

deviation of individual rates of return from the average rates of
return.
Two measures of deviation:
Variance 2
Standard Deviation ()

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Normal distribution
 Risk of Rates of Return: Variance and
Standard Deviation
Formulae for calculating variance and standard
deviation:
Standard deviation = Variance

n 2
1
Variance 2
n 1 t 1
Rt R

20
Measure of Risk
1 n

2
Variance 2

n 1 t 1
Rt R

YEAR Return(%)

2010 13

2011 11

2012 10

2013 15

2014 13

2015 16

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PROBABILITY DISTRIBUTION AND EXPECTED
RATE OF RETURN
STANDARD DEVIATION
Covariance
YEAR Rt(%) Rm(%)

2011 14 11

2012 11 10

2013 10 12

2014 12 14

2015 13 18
Covariance
Scenario Probability Rt(%) Rm(%)

0.30 14 11

0.20 11 10

0.20 10 12

0.20 12 14

0.10 13 18
Risk in Contemporary Mode
Beta
Capital Asset Pricing Model
 Measurement of Systematic Risk: Beta
The sensitivity of a security to market movements is called beta .
Beta reflects the slope of a linear regression relationship between the return on the
security and the return on the portfolio

Relationship between Security Return and Market Return

Security
Return

Market return
 CALCULATION OF BETA
For calculating the beta of a security, the following market model is employed:
Rjt = aj + bjRMt ej
where Rjt = return of security j in period t
aj = intercept term alpha
bj = regression coefficient, beta
RMt = return on market portfolio in period t
ej = random error term
Beta reflects the slope of the above regression relationship. It is equal to:
Cov (Rj , RM)
bj =
2M
where Cov = covariance between the return on security j and the return on
market portfolio M. It is equal to:
n _ _
Rjt Rj)(RMt RM)/(n-1)
i=1
 CALCULATION OF BETA
Historical Market Data
_ _ _ _ _
Year Rjt RMt Rjt-Rj RMt-RM (Rjt - Rj)(RMt-RM) (RMt-RM)2

1 10 12 -2 -1 2 1
2 6 5 -6 -8 48 64
3 13 18 1 5 5 25
4 -4 -8 -16 -21 336 441
5 13 10 1 -3 -3 9
6 14 16 2 3 6 9
7 4 7 -8 -6 48 36
8 18 15 6 2 12 4
9 24 30 12 17 204 289
10 22 25 10 12 120 144
_ _ _
Rjt = 120 RMt = 130 (Rjt- Rj) (RMt - RM) = 778 (RMt - RM)2 = 1022
_ _
Rj = 12 RM = 13 Cov (Rjt , RMt) = 778/9= 86.4 M = 1022/9=113.6

Cov (Rjt , RMt) 86.4

Beta : j = = = 0.76
2 M 113.6
_ _
Alpha : aj = Rj j RM = 12 (0.76)(13) = 2.12%

Common Practice . . . 60 months

 CHARACTERISTIC LINE FOR SECURITY j

Rj
30
25

20
15

10

5

10 5 5 10 15 20 25 30 RM
5

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 The Capital Asset Pricing Model (CAPM)
Using Beta as the measure of Systematic( Non-diversifiable) Risk, the
CAPM model is used to define the required return on a security according
to following equation:
Rs R f ( Rm R f ) b j
The risk-free rate (Rf)
The market return (Rm )
The beta of the firms share (b)
Suppose in the year 2012, the risk-free rate is 6 per cent, the market
return is 12 per cent and beta of company`s share is 1.20.
As per CAPM, The return on security is
Rs= 0.06+1.2X(0.12-0.06) = 0.06+0.072=0.132
Rs = 13.2%
Security Market Line(SML)
Why Portfolios?
Portfolios perform the important function of providing hedge
against adverse environmental conditions.
Such a combination of the shares in a portfolio provides
protection of returns against unpredictable conditions.
The concept of hedging gets built automatically when large
number of securities forms the portfolio.
Portfolio Return
 Coefficient Of Correlation
Cov (Ri , Rj)
Cor (Ri , Rj) or ij =
ij
ij
=
i j
ij = ij . i . j
where ij = correlation coefficient between the returns on
securities i and j
ij = covariance between the returns on securities
i and j
i , j = standard deviation of the returns on securities
i and j
 Portfolio Risk : 2 Security Case

p = [w12 12 + w22 22 + 2w1w2 12 1 2]

Example : w1 = 0.6 , w2 = 0.4,

1 = 10%, 2 = 16%
12 = 0.5
p = [0.62 x 102 + 0.42 x 162 +2 x 0.6 x 0.4 x 0.5 x 10 x 16]
= 10.7%
 Portfolio Risk : 3 Security Case

p = [w12 12 + w22 22 + w32 32 + 2w1w2 12 1 2 + 2w2w3 23 2 3 +

2w1w3 13 1 3]
Example : w1 = 0.3 , w2 = 0.2, w3 = 0.5

1 = 10%, 2 = 16% , 3 = 12%

12 = 0.50 , 23 = 0.60 , 13 = 0.20

Find Portfolio Risk

What do you think?
Is it possible to reduce the risk of a portfolio by incorporating
a security whose risk is GREATER than that of any of
investments held initially?
Diversification and Portfolio Risk
Stock X Stock Y
Return(%) 7 or 11 13 or 5
Probability 0.5 each return 0.5 each return
Expected Return(%) (0.5)*(7)+(.5)*(11)= 9 (0.5)*(13)+(.5)*(5)= 9
Variance(%) 4 16
Standard Deviation(%) 2 4
Assume Weight 2/3 1/3
Correlation = -1.0 Standard Deviation = 0 Portfolio Return = 9%
Changing Proportion of X and Y
Stock X(%) Stock Y(%) Portfolio Standard Deviation

100 0 2.0

80 20 0.80

66 34 0

20 80 2.8

0 100 4.0

Correlation Portfolio Standard Deviation

-0.5 1.34

0 1.9

+0.5 2.3

+1.0 2.658
Beta Calculation through Excel