Concept of Risk & Return

Session Objective
 The concept of Return
 Measuring rate of Return
 Concept of Risk
 Sources of risk
 Summary
 Qs…….

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 Return
When an asset is bought the gain or loss in
the investment is called as the return.
It is the major factor that motivates an investor
to invest. It helps in:
 Comparison between alternatives
 Analyzing past performance
 Forecasting the future return
Types of return:
 Realized return – Have been earned (ex-post)
 Expected Return – Anticipate to earn over some
future period (may or may not materialize) 3
 Components of Return
Periodic return (Income/Yield): The cash an
investor receives while he owns an investment. (i.e.,
during holding period- dividend, interest etc.)

e.g. The dividend that an equity share-holders get

when they own a company’s share constitutes
income component.
Dt
It is measured as = P
t-1
Dt = Dividend,
Pt-1= The price of the stock at the beginning 4
 Contd….
Capital Gain: The value of the asset that
an investor has, will often change; and
depending upon the increase (or decrees)
in the value of an asset there will be a
capital gain (or loss)
(Pt – Pt-1)
Measured as =
Pt-1
where Pt is the price of the stock at the
end of the year.
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 Example
Suppose a stock had an initial price of Rs.54 per
share, and a dividend of Rs.1.75 per share is paid
during the year, and has an ending share price of
Rs.46, then what is the dividend yield and capital
gain yield from the share?
Solution:
Dt
The dividend yield = = 1.75/54 = 0.0324 = 3.24%
Pt-1
(Pt – Pt-1)
The capital gain (or loss) =
Pt-1
= (46-54)/54 = - 0.1481 6
 Measuring the Rate of Return
 The rate of return is the total return the
investor receives during the holding period
stated as a percentage of the purchase price
of the investment at the beginning of the
holding period.
 The income from the security in the form of
cash flows and the difference in price of the
security between the beginning and end of
the holding period expressed as a
percentage of the purchase price of the at
the beginning of the holding period. 7
 Contd….
Dt
 The dividend component is measured as
Pt-1
 The capital gain or yield is measured as
(Pt – Pt-1)

Pt-1
 The total return is measured as the sum of
income component and the capital gain
Dt + (Pt – Pt-1)
Pt-1 8
 Example
Vishal bought the stock of Globe Ltd. for
Rs.25 per share. At the end of the year the
price is Rs.35 per share. During the year he
received a dividend of Rs.2 per share. If his
total investment was Rs.1,000, how much did
Vishal have at the end of the year?
Solution: The total percentage return =
Dt + (Pt – Pt-1)
Pt-1
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 Contd…..

2 + (35 – 25)
= = 0.48 = 48%
25
 Hence an investment of Rs.1,000 would
become 1000 (1+0.48) = Rs.1,480 at he
end of the year.

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Expected Return or Average Return

 The average rate of return is the sum of

various one-period rates of return divided
by the number of periods.
n

i=1

 Where R = Average rate of return, n = total

number of periods, Ri = Observed or
realized rates of return in periods 1,2,….n
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 Probability and Rate of Return
 The future returns are characterized by
uncertainty. Whenever the probabilities
associated with various possible returns
are known, then the expected return can
be computed as the weighted average of
the various returns, the weights being the
probabilities associated with the returns.

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 Contd….
 Expected rate of return
n
R = Σ PiRi
i=1

Where Pi is the probability associated with

the ith outcome and Ri is the rate of return
from the ith possible outcome.

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 Example
The probability distribution of the possible returns
from the shares of Star Ltd. for 1-year holding period
is given below:

Probability of
0.05 0.10 0.20 0.30 0.20 0.10 0.05
occurrence
Possible
-10% -2% 4% 9% 14% 20% 28%
return (in %)
Compute the expected return? n
Solution: The expected rate of return = R = Σ PiRi
i=1

= (.05)(-0.10)+(.10)(-0.20)+(.20)(0.14)+(.10)(0.20)
+ (0.05)(0.28) = 0.09 = 9% 14
 Expected Return : Incorporating

Probabilities in Estimates
The expected rate of return [E (R)] is the sum of the product of each
outcome (return) and its associated probability:
Rates of Returns Under Various Economic Conditions

Returns and Probabilities

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 Sensex 1997-2015
35000

30000

25000

20000

15000

10000

5000

0
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Which stock would you prefer?
How would you decide?

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 Concept Risk
 Risk can be defined as the variability in the
actual return emanating from the project in
future over its working life, in relation to
the estimated return that was forecasted at
the time of selecting the project. The
greater the variability between the actual
and estimated return, the more risky is the
project.

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 Contd....
 The relationship between return and risk can
be simply expressed as:
Return = Risk free rate + Risk premium
 A proper balance between return and risk
should be maintained to maximize the wealth
of the share-holders. Such balance is known
as risk-return trade off. The finance manager,
in a bid to maximize the shareholder’s wealth
should strive to maximize returns in relation
to the given risk and should seek courses of
action that avoid unnecessary risks.
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 Measurement of risk

The degree of variability can be measured by

using measures of dispersion:
1. Range – Difference between the highest
value and the lowest value
2. Standard deviation – is an absolute measure
of deviation. It is defined as the square root
of the mean deviations where the deviation is
the difference between an outcome and the
expected mean value of all outcomes.
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Ri = the rate of return associated with the ith possible outcome, Pi
=corresponding probability and R = Expected return, then the
standard deviation is:
Standard deviation = Variance
If probabilities are not given:

The greater the standard deviation of a probability distribution,

the greater is the dispersion or the variability of the outcomes
around the expected (mean) value. Graphically, a distribution
having a wider normal distribution indicates greater risk.

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If probabilities are given

Standard deviation = Variance

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23
 Coefficient of Variation

• The standard deviation is misleading when

comparison is to be made of two series or two
projects or portfolios, if they differ in size and
mean.
σ
C.V. = x 100
Ri

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 Example
State of Probability Return (%)
Economy Security (X) Security (Y)
A 0.10 -8 14
B 0.20 10 -4
C 0.40 8 6
D 0.20 5 15
E 0.10 -4 20

Find out which of the securities is best for investment

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 Sources of Risk
 Interest rate of risk – Fluctuations in interest
 Market risk – Depression, Recession etc.,
 Inflation risk – Reduction in purchasing power
 Business risk – Industry specific risk
 Financial risk – Huge debt burden on firms
 Liquidity risk – Risk of secondary market

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 Types of Risk
 Systematic risk: - It constitutes interest
rate, inflation risk, etc., related to general
economy or stock market and hence
cannot be avoided or eliminated. Also
known as non-avoidable risk
 Un-systematic risk: - Specific to the
company or industry and hence can be
avoided or eliminated.

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 Factors of Systematic risk

 Major changes in tax rates

 War and other calamities
 An increase or decrease in inflation rates
 A change in economic policy
 Industrial recession
 An increase in international oil prices etc.

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 Factors of Unsystematic risk

 Company strike

 Bankruptcy of a major supplier

 Death of a key company officer

 Unexpired entry of new competitor into the

market etc.
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 Risk Preference
 A risk-averse investor will choose among
investments with the equal rates of return, the
investment with lowest standard deviation and
among investments with equal risk she 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.
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Risk preferences

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 Summary
 The gain over and above the investment is
known as return
 Two components periodic income and
capital gain. Types: expected and realized
return.
 Variability in the return is known as risk.
Standard dev. measures the risk.
 Two types of risk: systematic and
unsystematic risk

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 Qs
 What is return? Explain the components of
(total) return?
 What is risk? How can risk of a security be
calculated?
 What is a risk-free security? What is risk
premium?
 Who are the different types of investors
based on risk preference?
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Thank You

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