FINANCIAL MANAGEMENT
RISK AND RETURN
It is a fundamental concept in finance that describes
the relationship between the two.
The risk and return analysis aim to help investors find
the best investments.
PRINCIPLES OF INVESTMENT
High Risk High Return
-------------
Low Risk INVESTMENT Low Return
-------------
TWO TYPES OF RISK
Systematic Risk
TWO TYPES
OF RISK
Unsystematic Risk
SYSTEMATIC RISK
ALSO KNOWN AS UNDIVERSIFIABLE RISK
• It is the risk that affects the entire market, not just specific
sectors or industries.
• It is caused by factors beyond individual investors' control,
and cannot be eliminated through diversification.
THREE TYPES OF SYSTEMATIC RISK
• Market Risk
• Interest Rate Risk
• Purchasing Power Risk
EXAMPLE: COVID-19 Pandemic
UNSYSTEMATIC RISK
ALSO KNOWN AS DIVERSIFIABLE RISK
• It is the risk that impacts only one sector or one business.
• This includes risks such as company bankruptcy, product
failure, and regulatory changes.
TWO TYPES OF UNSYSTEMATIC RISK
• Business Risk
• Financial Risk
EXAMPLE: Company bankruptcy
SUMMARY BETWEEN SYSTEMATIC
AND UNSYSTEMATIC RISK
SYSTEMATIC RISK UNSYSTEMATIC RISK
Can't be controlled Can be controlled
Caused by external factors Caused by internal factors
Cause chaos within an entire Only cause issues to a specific
economy organization or sector
RISK OF A SINGLE ASSET
• Standard deviation is a statistical measure of risk. It shows how much the returns
of an investment fluctuate around the mean return. A higher standard deviation
indicates a riskier investment.
RETURN OF A SINGLE ASSET
• Investment is driven by the expectation of return, which is the profit earned on top
of the investment made. It is the percentage of the growth of an investment.
• The return on an investment is the difference between the final value of the
investment and its initial cost. It can be expressed as a percentage or as a dollar
amount. The motivation to increase wealth is the most important reason for
investing. People invest to save for retirement, to buy a home, or to simply grow
their money over time.
Proceeds or Current Value of Investment − Investment
𝐑𝐞𝐭𝐮𝐫𝐧 (%) =
Investment
RISK AND RETURN OF PORTFOLIO
(ONLY TWO ASSET PORTFOLIO)
1. EXPECTED PORTFOLIO RETURN
It is the weighted average of the returns of the two assets in the portfolio. The
weight of each asset is its percentage allocation in the portfolio.
Expected Portfolio Return = (Weight of Asset 1 × Expected Return) +
(Weight of Asset 2 × Expected Return)
RISK AND RETURN OF PORTFOLIO
(ONLY TWO ASSET PORTFOLIO)
2. EXPECTED PORTFOLIO STANDARD DEVIATION
It is the standard deviation of the portfolio's returns. It is a measure of how
volatile the portfolio's returns are.
𝛔𝐏 = (𝑤12 × 𝜎12 + 𝑤22 × 𝜎22 + 2 × 𝑤1 × 𝑤2 × 𝜎1 × 𝜎2 × ρAB
Where:
σP = portfolio standard deviation σ1 = standard deviation of asset 1
w1 = weight of asset 1 in the portfolio σ2 = standard deviation of asset 2
w2 = weight of asset 2 in the portfolio ρAB = correlation of asset A and asset B
PORTFOLIO SELECTION
• The objective of every rational investor is to maximize his returns and
minimize the risk.
• Diversification is the method adopted for reducing risk.
• It essentially results in the construction of portfolios.
• The proper goal of portfolio construction would be to generate a portfolio
that provides the highest return and the lowest risk.
• Such a portfolio would be known as the optimal portfolio.
• The process of finding the optimal portfolio is described as portfolio selection.
NOTE: Portfolio selection is an important part of investing. By carefully
constructing a diversified portfolio, investors can reduce their risk and maximize
their chances of achieving their investment goals.
CAPM UNIT
• The Capital Asset Pricing Model (CAPM) is a theoretical model that
describes the relationship between risk and return.
𝑟 = 𝑟𝑓 + 𝛽 𝑟𝑚 − 𝑟𝑓
Expected Return = Risk-free Rate of Return + Beta (Market Risk Premium)
