Risk and Return

Prof. Sankersan Sarkar

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 Caselet 1
• The real estate companies in India face a wide range
of risks. Lack of liquidity in money markets leading to
tighter credit conditions affect the availability of
credit and hence the demand side. Poor or
inadequate transit and utility infrastructure
conditions affect the real estate sector growth.
Increasing competition in this sector affects growth
of the individual companies.
• While the costs are going up pricing and valuation
are still uncertain especially in the face of increasing
competition.
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 Caselet 1…
• Increasing pressure from the green revolution and
increasing need to build and operate in sustainable
ways are new factors affecting the industry. This
industry has strong backward linkages with the
cement ,iron and steel, power and energy industries.
Any volatility in these markets affect the costs and
profitability of the real estate companies.
• These risks affect the performance of these
companies and in turn the return realized by the
investors in these companies.

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 Key Financial Issues
• Risks faced by the firms and their returns
• Risks faced by investors and their returns

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 Why is it Important?
• A business is profitable when the returns from it are
commensurate with the risks involved
• The risk-return relationship of the business is
connected with the risk-return relationship desired
by the investor
• The risk-return relationship desired by the investor is
the risk adjusted rate of return required by the
investor
• Understanding the risk adjusted rate of return is
critical for knowing whether the investor’s
expectations are being fulfilled
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 Contents
• Single Period Return from a security
• How to Measure Return from a ‘Variable
Return Security’
• What is Risk and How to Measure it?
• Components of Risk
• What is a Portfolio?
• How to Measure Return and Risk of a Portfolio

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 Single Period Return from a
Security
Income  Ending Value - Beginning Value
Rate of Return 
Beginning Value

• Also called: Holding Period Return

• 1.Given the following information estimate
the rate of return from the security:
• Price at the beginning of the year : Rs. 120
• Dividend paid at the end of the year: Rs. 5
• Price at the end of the year: Rs. 145
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 Return from a Variable Return
Security
• Equity shares
• Generate different returns in different periods
• Multiple period & Multiple returns
• Representative returns are calculated using
mean
• Returns may be estimated using historical data
or projected data

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 Return from a Variable Return
Security…
• Estimating Returns from Historical Data:
n

R i
• Arithmetic Mean Return  i 1
n

2. Calculate mean return from for the shares of

Alpha Products Ltd. given the following data:
15%, -5%, 5%, 35%, 25%

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 Return from a Variable Return
Security…
• Estimating Returns from Projected Data:
n
• Expected Return E(R)  p R
i 1
i i

• 3.Calculate expected return from the

projected returns from the shares of Lotus
Cosmetics Ltd.
Return (%) -6 12 20 24
Probability(%) 15 50 20 15

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 Risk of a Variable Return Security
• Risk exists when the returns from a security
are variable
• Risk is measured by variability or dispersion of
returns
• Can be estimated using historical or projected
data
• Measure: Standard Deviation or Variance

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 Risk of a Variable Return Security…
• Estimating Risk From Historical Returns:
n

 i
(R - R ) 2

• Standard Deviation: σ i 1
N -1
• Variance = σ 2

4.Calculate risk of the shares of Alpha Products

given the following data:15%, -5%, 5%, 35%, 25%

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Risk of a Variable Return Security…
• Estimating Risk From Projected Returns:
n
• Standard Deviation: σ   pi R i - E(R) 
2

i 1
• Variance = σ 2

• 5.Calculate risk from the projected returns

from the shares of Lotus Cosmetics Ltd.

Return (%) -6 12 20 24
Probability(%) 15 50 20 15
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Risk of a Variable Return Security…
• Important Question:
• How can we compare risk-return combination
across multiple investments ?

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 Components of Risk
• Risk measured in terms of Variance of Returns
is a measure of the Total Risk of the security
• Total risk consists of two components:
• Systematic risk (Market risk)
• Unsystematic risk (Firm specific risk)
• Systematic risk arises out of economy wide
factors which affect every security
• Unsystematic risk arises out of firm specific
factors) 15
 Components of Risk…
• Unsystematic risk can be eliminated by investing in a
portfolio of securities instead of an individual
security. This process is called diversification.
• Systematic risk affects every security. Hence it cannot
be eliminated through diversification.
• Another measure of systematic risk is ‘beta’ (β)
• It measures the sensitivity of the returns from the
security to the variations in market returns
• Hence it can be used to compare systematic risk
between several securities

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 What is a Portfolio?
• A portfolio refers to a collection of securities.
• Instead of investing all his funds into a single
security the investor distributes his investible
funds among various securities
• A portfolio is also characterized along the two
dimensions of risk and return
• Intelligently chosen, the securities in a
portfolio can reduce its total risk

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 Measuring Return & Risk of a
Portfolio
• Both return & risk of a portfolio depend on
the following:
• Return & Risk of the individual securities in
the portfolio
• Proportion of the total investible funds
allocated to different securities (weights)
• Interrelationship between returns of different
securities (covariance or correlation of
returns)
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 Return of a Portfolio
• 2 Security Portfolio:
• E(Rp) = w1E(R1) + w2E(R2)
• w1 + w2 = 1
• n Security Portfolio:
• E(Rp) = w1E(R1) + w2E(R2) + … … + wnE(Rn)
n
  w i E(R i )
i 1

• w1 + w2 + … … + wn = 1
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 Risk of a Portfolio
• Can be calculated as Variance of portfolio
returns
• Simplified formula for 2 Security Portfolio:
σ  w σ  w σ  2w1w 2cov(1,2)
2
p
2
1
2
1
2
2
2
2

 w12σ12  w 22σ 22  2w1w 2ρ1,2 σ1σ 2

• w1 + w2 = 1

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 Risk of a Portfolio
• 6. Calculate the return and risk of a 2 security
• portfolio given the following details:
• w1 = 0.40 σ1 = 10 σ2 = 12 ρ1,2 = -0.30
• E(R1) = 20% E(R2) = 30%

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 Capital Asset Pricing Model
• A theory which explains the relationship
between the systematic risk (β) of a security
and its expected return
• Ri = Rf + βi(Rm – Rf )
• Expected return consists of two components:
• Risk free rate of return and risk premium
• The graph of CAPM is called Security Market
Line (SML)

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 Capital Asset Pricing Model
• 7. Calculate the expected return for a security
with β of 1.6 given the risk free rate 10% and
expected return on the market 15%

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• 8. The stocks of Co. A & Co. B are both selling for
Rs. 100 per share. The projected cash flows
(dividend + share price) from the shares are given
for the next year:
High Growth Low Growth Stagnation Recession
Probability 0.3 0.4 0.2 0.1
A: Return (Rs.) 100 110 120 140
B: Return (Rs.) 150 130 90 60

• Calculate the expected cash flow & risk (in terms

of Rupees) for the following investments: (a)
Rs.1000 in shares of Co. A (b) Rs.1000 in shares
of Co. B (c) Rs.500 each in shares of Cos. A & B
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 Home Work
• Text Book: Prasanna Chandra, Financial Mgt.
Theory & Practice, TMH
• Ch.8, p.225: Q. 8.1, Q. 8.2
• Ch.8, p.226: Q. 8.4 (except intrinsic value),
Q.8.5, Q. 8.6, Q. 8.7
• Ch.9, p.249: Q. 9.2(a & b)

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 Minimum Suggested Study Plan
• Text Book: Prasanna Chandra, Financial Mgt.
Theory & Practice, TMH
• Vital: Ch.8 (p.198-210), Unit 8.5 (p.215)
onwards to end (p.220); Ch.9 (p.227-231,
excluding Portfolio risk – n-security case)
• Desirable: Beta calculation (p.210) – Book
values or Market values (p.215); Ch.9
(covariance p.228, coefficient of correlation
p.229)
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THANK YOU

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