Iind Session Ris-Return

RISK AND RETURN
Dr Pawan Gupta
Indian School of Petroleum

What is Risk?
■ The possibility that an actual return

will differ from our expected return.
■ Uncertainty in the distribution of
possible outcomes.

Sources of Risk in a Project
■ Project-Specific risk
■ Competitive risk
■ Industry-Specific risk
■ Market risk

Risk and Rates of
Return
Return
Risk
MEASURE OF RISK
■ Range
■ Standard deviation
■ Coefficient of Variance
■ Semi-Variance

For a Treasury security, what is the
required rate of return?
Required
rate of =
return

For a Treasury security, what is
the required rate of return?
Required Risk-free
rate of = rate of
return return
Since Treasury’s are essentially free of default

risk, the rate of return on a Treasury
security is considered the “risk-free” rate of
return.
For a corporate stock or bond, what
is the required rate of return?
Required
rate of =
return

Required Risk-free
rate of = rate of
return return

Required Risk-free
rate of = rate of
Risk
+
Premium
return return
How large of a risk premium should we

require to buy a corporate security?
Returns
■ Expected Return - the return that an

investor expects to earn on an asset,
given its price, growth potential, etc.
■ Required Return - the return that an

investor requires on an asset given
its risk.
Expected Return
State of Probability Return

Economy (P) ONGC IOC
Recession .20 4% -10%
Normal .50 10% 14%
Boom .30 14% 30%
For each firm, the expected return on the
stock is just a weighted average:

Expected Return

Normal .50 10% 14%
Boom .30 14% 30%
For each firm, the expected return on the
stock is just a weighted average:
k = P(k1)*k1 + P(k2)*k2 + ...+ P(kn)*kn
Expected Return

Economy (P) B ONGC IOC
Normal .50 10% 14%
Boom .30 14% 30%
k = P(k1)*k1 + P(k2)*k2 + ...+ P(kn)*kn

k (OU) = .2 (4%) + .5 (10%) + .3 (14%) = 10%
Expected Return

Normal .50 10% 14%
Boom .30 14% 30%
k = P(k1)*k1 + P(k2)*k2 + ...+ P(kn)*kn

k (OI) = .2 (-10%)+ .5 (14%) + .3 (30%) = 14%
Based only on your
expected return
calculations, which
stock would you
prefer?

Have you considered
RISK?

What is Risk?
possible outcomes.
0.5
Company A
0.45
0.4
0.35
0.3
0.25
0.2
0.15
0.1
0.05
0
4 8 12
return

What is Risk?
possible outcomes.
0.5
Company A Company B
0.2
0.45 0.18
0.4 0.16
0.35 0.14
0.3
0.12
0.25
0.1
0.2 0.08
0.15 0.06
0.1
0.04
0.05
0.02
0
4 8 12 0
-10 -5 0 5 10 15 20 25 30
return return
How do we Measure Risk?
■ To get a general idea of a stock’s

price variability, we could look at
the stock’s price range over the
past year.

How do we Measure Risk?
■ A more scientific approach is to examine
the stock’s STANDARD DEVIATION of
returns.
■ Standard deviation is a measure of the
dispersion of possible outcomes.
■ The greater the standard deviation, the
greater the uncertainty, and therefore ,
the greater the RISK.
Standard Deviation
σ = Σ (ki - k)
i=1
2
P(ki)

σ
n
Σ
2
= (ki - k) P(ki)
i=1
ONGC’S
( 4% - 10%)2 (.2) = 7.2
(10% - 10%)2 (.5) = 0
(14% - 10%)2 (.3) = 4.8
Variance = 12

σ
n
Σ
2
= (ki - k) P(ki)
i=1
ONGC’S
( 4% - 10%)2 (.2) = 7.2
(10% - 10%)2 (.5) = 0
(14% - 10%)2 (.3) = 4.8
Variance = 12
Stand. dev. = 12 = 3.46%
σ
n
Σ
2
= (ki - k) P(ki)
i=1
IOC’S
(-10% - 14%)2 (.2) = 115.2
(14% - 14%)2 (.5) = 0
(30% - 14%)2 (.3) = 76.8
Variance = 192

σ
n
Σ
2
= (ki - k) P(ki)
i=1
IOC’S
(-10% - 14%)2 (.2) = 115.2
(14% - 14%)2 (.5) = 0
(30% - 14%)2 (.3) = 76.8
Variance = 192
Stand. dev. = 192 = 13.86%
Which stock would you prefer?
How would you decide?

Which stock would you prefer?
How would you decide?

Summary
ONGC IOC
Expected Return 10% 14%
Standard Deviation 3.46% 13.86%

■ It depends on your tolerance for
risk!

It depends on your tolerance for risk!
Return
Risk
Remember there’s a tradeoff between risk and
return. Indian School of Petroleum
Portfolios
■ Combining several securities in a

portfolio can actually reduce overall
risk.
■ How does this work?

• Suppose we have stock A and stock
B. The returns on these stocks do
not tend to move together over time
(they are not perfectly correlated).
rate
of
return
Indian School of Petroleum time

rate kA
of
return

rate kA
of
return
kB

B. The returns on these stocks do not
tend to move together over time (they
are not perfectly correlated).
rate kA
of
return kp
kB

• What has happened to the variability
of returns for the portfolio?
rate kA
of
return kp
kB

Diversification
■ Investing in more than one security
to reduce risk.
■ If two stocks are perfectly
positively correlated,
diversification has no effect on risk.
■ If two stocks are perfectly
negatively correlated, the portfolio
is perfectly diversified.
Some risk can be diversified
away and some can not.
■ Market Risk is also called No

diversifiable risk. This type of risk
can not be diversified away.
■ Firm-Specific risk is also called
diversifiable risk. This type of risk
can be reduced through
diversification.
Market Risk
■ Unexpected changes in interest rates.

■ Unexpected changes in cash flows
due to tax rate changes, foreign
competition, and the overall business
cycle.

Firm-Specific Risk
■ A company’s labor force goes on

strike.
■ A company’s top management dies
in a plane crash.
■ A huge oil tank bursts and floods a
company’s production area.

As you add stocks to your
portfolio, firm-specific risk is
reduced.

reduced.
portfolio
risk
number of stocks
reduced.
portfolio
risk
Market risk
number of stocks
reduced.
portfolio
risk
Firm-
specific
risk
Market risk
number of stocks
Do some firms have more
market risk than others?
Yes. For example:

Interest rate changes affect all firms,
but which would be more affected:
a) Retail food chain

b) Commercial bank

Do some firms have more
market risk than others?
Yes. For example:
Interest rate changes affect all firms,
but which would be more affected:
a) Retail food chain

b) Commercial bank

■ Note
As we know, the market compensates
investors for accepting risk - but
only for market risk. Firm-specific
risk can and should be diversified
away.
So - we need to be able to measure

market risk.
This is why we have
BETA.
Beta: a measure of market risk.
Specifically, it is a measure of how an
individual stock’s returns vary with
market returns.
It’s a measure of the “sensitivity” of an

individual stock’s returns to changes in
the market.
The market’s beta is 1
■ A firm that has a beta = 1 has average

market risk. The stock is no more or
less volatile than the market.
■ A firm with a beta > 1 is more volatile
than the market (ex: computer firms).
■ A firm with a beta < 1 is less volatile
than the market (ex: utilities).
Summary:
■ We know how to measure risk, using

standard deviation for overall risk and beta
for market risk.
■ We know how to reduce overall risk to only
market risk through diversification.
■ We need to know how to price risk so we will
know how much extra return we should
require for accepting extra risk.

What is the Required Rate of
Return?
■ The return on an investment
required by an investor given the
investment’s risk.

Required
rate of =
return

Required Risk-free
rate of = rate of +
return return

Required Risk-free
rate of = rate of
Risk
+
Premium
return return

Required Risk-free Risk
rate of = rate of + Premium
return return
Market
Risk
Required Risk-free
rate of = rate of
Risk
+
Premium
return return
Market Firm-specific
Risk Risk
Required Risk-
= + Risk
rate of free
Premium
return rate of
return
Market Firm-specific
Risk Risk
Indian School of Petroleum can be diversified
Let’s try to graph this
Required
relationship!
rate of
return
Indian School of Petroleum Beta

Required
rate of
return
12% .
Risk-free
rate of
return
(6%)
1
Required security
rate of market
return line
12% . (SML)
Risk-free
rate of
return
(6%)
1
This linear relationship between risk
and required return is known as
the Capital Asset Pricing Model
(CAPM).

SML
Is there a riskless
Required
rate of
(zero beta) security?
return
12% .
Risk-free
rate of
return
(6%)
0 1
Required SML
rate of Is there a riskless
return (zero beta) security?
12% . Treasury
securities are
as close to riskless
Risk-free
rate of
as possible.
return
(6%)
0 1
Required SML
rate of Where does the Index
return fall on the SML?
12% .
The Index is
a good
Risk-free approximation
rate of for the market
return
(6%)
0 1
Required SML
rate of
return
Utility
Stocks
12% .
Risk-free
rate of
return
(6%)
0 1
Required High-tech SML
rate of
stocks
return
12% .
Risk-free
rate of
return
(6%)
0 1
The CAPM equation:
kj = krf + β j (km - krf)
where:
kj = the Required Return on security j,
krf = the risk-free rate of interest,
β j = the beta of security j, and
km = the return on the market index.

Example:
■ Suppose the Treasury bond rate is
6%, the average return on the
Index is 12%, and ONGC’s Stock
has a beta of 1.2.
■ According to the CAPM, what
should be the required rate of
return on ONGC’s stock?

kj = krfβ+ (km - krf)
kj = .06 + 1.2 (.12 - .06)

kj = .132 = 13.2%
According to the CAPM,

ONGC’s stock should be priced
to give a 13.2% return.
Required SML
rate of
Theoretically, every
return security should lie
on the SML
12% .
Risk-free
rate of
return
(6%)
0 1
Required SML
rate of
Theoretically, every
return security should lie
on the SML
12% .
If every stock
is on the SML,
investors are being fully
Risk-free compensated for risk.
rate of
return
(6%)
0 1
Required SML
rate of If a security is above
return the SML, it is
underpriced.
12% .
Risk-free
rate of
return
(6%)
0 1
Required SML
rate of If a security is above
return the SML, it is
underpriced.
12% .
If a security is
below the SML, it
Risk-free is overpriced.
rate of
return
(6%)
0 1

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RISK AND RETURN

Indian School of Petroleum

■ The possibility that an actual return

Indian School of Petroleum

Indian School of Petroleum

Indian School of Petroleum

Indian School of Petroleum

Since Treasury’s are essentially free of default

Indian School of Petroleum

Indian School of Petroleum

How large of a risk premium should we

■ Expected Return - the return that an

■ Required Return - the return that an

State of Probability Return

Indian School of Petroleum

State of Probability Return

State of Probability Return

k = P(k1)*k1 + P(k2)*k2 + ...+ P(kn)*kn

State of Probability Return

k = P(k1)*k1 + P(k2)*k2 + ...+ P(kn)*kn

Indian School of Petroleum

Indian School of Petroleum

Indian School of Petroleum

■ To get a general idea of a stock’s

Indian School of Petroleum

Indian School of Petroleum

Indian School of Petroleum

Indian School of Petroleum

Indian School of Petroleum

Indian School of Petroleum

Expected Return 10% 14%

Standard Deviation 3.46% 13.86%

Indian School of Petroleum

Indian School of Petroleum

■ Combining several securities in a

Indian School of Petroleum

Indian School of Petroleum time

Indian School of Petroleum time

Indian School of Petroleum time

Indian School of Petroleum time

Indian School of Petroleum time

■ Market Risk is also called No

■ Unexpected changes in interest rates.

Indian School of Petroleum

■ A company’s labor force goes on

Indian School of Petroleum

Indian School of Petroleum

Yes. For example:

a) Retail food chain

Indian School of Petroleum

a) Retail food chain

Indian School of Petroleum

So - we need to be able to measure

It’s a measure of the “sensitivity” of an

■ A firm that has a beta = 1 has average

■ We know how to measure risk, using

Indian School of Petroleum

Indian School of Petroleum

Indian School of Petroleum

Indian School of Petroleum

Indian School of Petroleum

Indian School of Petroleum Beta

k = P(k1)k1 + P(k2)k2 + ...+ P(kn)*kn

k = P(k1)k1 + P(k2)k2 + ...+ P(kn)*kn