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Unit 2 Risk - Return

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7 views17 pages

Unit 2 Risk - Return

Uploaded by

Kashish Jain
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Risk and Return

By
Dr. Rishi Manrai
Associate Professor (Finance)
Amity Business school
Gurgaon
Concept of Return
Primary motivating force that drives investment,
the reward for undertaking investment.

Always expressed in terms of percentage

Having multiple connotations as


• ROCE – To measure the productivity of capital
• ROA – To measure the efficiency in use of assets
Single period & Multi – Period Returns

Single
• Calculation of returns for each period and
then taking average of all periodic returns
• ri = Pi – Pi-1 /Pi-1
period • r = Σri /n
• Caveat – not a suitable method if price
returns changes are erratic

Multi • Calculation of returns with the help of


price of first & last period only

period • Equivalent per period return P2 = P0 (1 +


r)2

Returns • Unadjusted annual return = r 0,n / n


Ex – Post (Historical) Returns
The return from investment includes two components
• Dividends (Current yield)
• Capital Gains

Returns represent the annual total income & capital gains


as a percentage of investment

In bond investment maturity is fixed & returns are


expressed in form of YTM

The maturity of common stock is not fixed so return will


be dividend yield + capital gain divided by initial price
Measurement of Historical Returns
Holding period returns on a stock is equal to the sum
of price change plus dividends received divided by
beginning price
• rit = (Pit – Pit-1) + Dit/ Pit-1

Average returns are calculated using arithmetic mean


• ri = Σrit /n

The majority of investors view the risk & return of


security in subjective terms
Expected Return
Being • E = ΣXiPi
calculated as • Where X is the rate of return in
total of particular period
expected • P is the probability of that
particular scenario adding up to 1
returns

• Weighted average of the return


Expected on individual securities in
portfolio
returns of • Ep = W1 E1 + W2 E2
portfolio
• Ep = ΣWiEi
Risk
• Share M : 30% 28% 34% 32% 31%
• Share N : 26% 13% 48% 11% 57%
Identification of • Average rate of return is equal in
risk both cases i.e. 31% but share N is
more risky

Risk means
variability in
returns being • σ2 = ΣPi (ri – E)2
measured in terms •
σ = √Variance
of Variance &
Standard
Deviation
Reduction of Risk Through Diversification
There are several sources of risk
• Some of which affect only one security
• Some affect both in opposite direction
• Some affect both in same direction

Statisticians use coefficient of correlation


to find out the strength of relationship &
magnitude of movement in both securities
Variance of Portfolio
Standard
deviation of • σ2p = W12σ12 +W22σ22 +
portfolio is not
the weighted 2W1W2σ12
average of
standard • Or σ2p = W12σ12 +W22σ22
deviations
because the + 2W1W2 r12 σ1 σ2
variance of • As r12 = σ12 /σ1 σ2
portfolio depends
on correlation • So σ12 = r12 σ1 σ2
coefficient
between returns
Measurement Of Risk In Portfolio Context
Unsystematic or Diversifiable Risk
• The firm specific risk factors like poor
management, productivity, cost structure of a
company
• Effect of such factors can be canceled by taking
sufficient number of securities in portfolio

Systematic or non – diversifiable risk


• Risk in a well diversified portfolio equals the
average co variance of securities in a portfolio
BETA
According to modern portfolio theory the riskiness of a security is its
vulnerability to market risk

This is measured as sensitivity of security return vis – a –vis market return


expressed as β

The Beta measures the systematic risk of security & also gives indication
of changes in security return due to changes in market return

The higher the riskiness the higher the Beta


• Beta > 1 » Aggressive Security
• Beta < 1 » Defensive Security
Estimating BETA
Beta is the slope of Characteristics regression
line

CRL represents linear relationship between


return on security & market returns
• rit = ai + βirmt + eit
• βi = Cov im /σ2m

Beta of Portfolio
• β = Σ β i Wi
Security Market Lines
SML simply represents the average or normal, trade
– off between risk & return for a group of securities
– where risk is measured, in terms of security betas

Ex – post SML – y – axis – average returns of


different securities, x – axis – Betas of different
securities

Alpha measures the difference between securities


average or expected return from its normal return
THANK YOU

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