After studying this chapter, you ‘Should be able to: ] Understand return 2 Know risk Analyse security return. Discuss systematic risk. Describe the risk in a contemporary mode 3 {ee 5 Explain unsystematic risk’. cS 6 i Understand the using beta in estimate return = Know alpha 2 q Discuss the measuring historical retum and risk ~ Describe the measuring expected return and risk feturn and risk Analyse the measuring historical risk: _ Understand the calculating expected”180 Financial Management INTRODUCTION ‘ lies somewhere bey ; ice, investing lies som Unllike natural science and like medicine, law and econo noelves toa scientific approach, » an art and a science. Certain aspects of investing pee ‘scientific methods. creation of computer skills has accelerated the use 0! vefore open to problems ASS ociy However, corporations are managed by people and tnensperate ina highly dynamic é with their faulty judgments. Moreover, the corporation’ ghd internationally. AS a res, & competitive environment, and many operate both nationally judgment factor still dominates investment decisions. aoabia, but Whether investing will ever be classified as a seen fine frieans a 8 experience have developed investing into a discipline. DiscipiTs and orderly process without rigidity in either concept or ™ research, training a structured, Consist! Financial Analysis , : ane i investing, It provides informatig Financial analysis is the informative and predictive function in ture. Capital budget, » about the past and present, and it quantifies expectations fot a Live for investment ey decisions, corporate financial polices, and informed selections 0! fs warposes include economa/ Products of financial analysis. Analytical resources mobilized for these p' ig, capital market, sector and specific security analyses. E Economic Analysis Economic analysis provides both near-term and longer-term projections for the total economy in terms of the nation’s output of goods and services, inflation, profits, monetary and fiscal policy, and productivity. It, thus, provides the foundation for capital market, sector, indust and company estimates of the future. Capital Market Analysis Capital market analysis examines the iridustries and securities of individual companies primarily to develop value and return expectations for securities and thus to°distinguish over-price: securities from under-priced ones. : wala) Between capital market analysis and: security analysis, incorporating some characteristics 0 = each are sector analysis. Broader than industry and company analysis, sector analysis may b. viewed as a bridge between capital market context; Sectors consist of major groupings of stock = (ie, according to economic sector, growth rate, or, cyclically in earnings) that either-cut across ¢ combine several industries. Comparative Selection of Securities Selection among alternative investment opportunities requires appraisal Of securities so thé their relative attractiveness in terms of retin’ and risk'can be judged at any tithe, This purpes can be accomplished only if consistent analytical procedures are employed and indusity al company forecasts are based on an internally consistent set of ecohomie and éapital mark projections. If Hindalco is considered for purchase, it must be considered more attractive than Nelo Indian Aluminium, or other issues with comparable investment characteres isolate Z i ena tistics, , isolatt 5 analysis and evaluation of an individual security are impractical and inapprcn etic tos coc cannot be effectively appraised apart from other securities, or apart front the genet investme climate.CHAPTER 6 Risk and Return 181 Consistency and comparability are so important:thi : c ia 7 at they should bx it investment analysis process, Consistency applies to data for on individual congas ee de: whereas comparability seeks ai lata on companies for each time period. Without consistency and comparability, the investor cannot exercise sound judgment in ident ing instances of soe compart er identifying instances of > qnvestment Decision-making Investment decision-making can best be viewed as an, inte; nent des can best be vi grated process to which securi i in eto orale sagen ace a economic, capital market and sector analysis to the definition of objectives and the measurement of performance. Security analysis serves the investment decision-maker by identifying the fairl ____ priced or under-priced securities that are most likely t6 produce the desired results. q Investment policies and asset allocation stratégi i curate ; ; ategies are’ developed based on the following @ Tocam a sufficient,"real” rate of return and maintain the purchading power of i adjusted for inflation in perpetuity. ‘i : 6 Pete a ae 4} . To control portfélio risk and volatility in order to provide as much year-to- i stability as possible and still meet. aoe se RISK DEFINED Risk can be defined as the probability that the expected return from the security will not ‘materialize. Every investment involves uncertainties that make future investment returns Hiskeprone. Uncertainties could be due to. the political, economic and industry factors. Risk could be systematic in future depending upon its source. Systematic risk is for the market as.a whole, while unsystematic risk is specific to an industry: or the company individually. The fist three risk factors discussed below are systematic in nature and the rest are unsystematic. Pataca tisk could be categorised depending on whether it affects the market as whole, or just a particular industry. : : Types of Investment Risk Z ‘Systematic versus Non-systematic Risk Modern investrhent analysis categorizes the traditional sources _ returns into two general types: those that are pervasive in nature, ‘fate risk, and those that are specific to a particular security issue, ‘se two categories of total risk. _ tisk, Therefore, we must consider the: introduces these terms, Dividing total risk into its two components, a general “and a specific Gseuer) component, we have systematic risk and non-systema additive: * of risk. causing variability. in such as market isk or interest such as business or financial The following discussion 1 (market) component tic risk, which are = General risk + Specific risk Market risk + Issuer risk Non-systematic risk ind eliminate part of the Total ris! = Systematic risk + iversified portfolio a ; c eat Sanat is let Pole non- diversifiable portion of a oe St is di i ‘th overall SC ce or oma Fue i dea se Movements in, the wneral market economy is called systematic (market) risk. Systematic Risk: An investor can182 Financial Management risk directly encompasses Inter this part of the risk because no mi market cannot be avoided. If the stock mar affected; if it rises strongly, value, These movements occur regar is critical to all investors. variability is called the non- systematic (non-mar! security’ and is associated with stich factors as busin Although all securities tend to have some non-sys! 0: stocks, i pee sk is attributal affecting all securities. Non-systematic frofmvariet tie risks ity. Dil s atic and unsystemat fn security. Different types 6f systematic and unsy: irae téaalting from fluctuations in the 1 » because system or stocks, ma a investor cannot ¢, ee re . Virtually all securities have some systemavt ME inflation TiBKS. 6 ‘the risk of the Over formatter ow wel oT at, ket declines 81 ost stocks will. appreciate of 1982, mi arly, market y as in the last fowy mani ate investor does. Clearly, market yy ‘dless of what a ll m, not related to overall may ty's total returns is unique to a particyly ot) risk. THis, Tvioke as well as liquiclty gt ‘inanci aera it is generally connected wig, a : Non-systematic Risk: The variability in a secur! ‘ple to broad-macro factor, Remember the difference: Systematic (market) aa atte putable to factors Unique fy are explained as under: Market Risk: The variability in.a security's retu aggregate market is known as market risk. All securities a recessions, wars, structural changes in the economy, tax consumer preferences, Market risk is sometimes used synonymousl " Interest Rate Risk: The variability in a security's return resulting from eee in the level | of interest rates is referred to as interest rate tisk. Such changes generally affect securities inversely; that is, other things being equal, security pricés mové inversely to interest rates, The reason for this movement is tied up with the Valuation of securities. Interest rate risk | affects bonds more directly than common stocks and is a thajor risk that.all bondholders face, As interest rates change, bond prices change in the opposite direction. Purchasing Power Risk: A factor affecting all securities. is purchasing power risk, also | known as inflation risk. This is the possibility that the purchasing power of invested dollars | will decline. With uncertain inflation, the real (inflation-adjusted) return involves risk even if the nominal return is safe (e.g., a Treasury bond). This risk is related to interest rate risk, since interest rates generally rise as inflation increases, because lenders demand additional inflation premiums to compensate for the'los§ of purchasing power, Regulation Risk: Some investments can be relatively attractive to dther investments because of certain regulations or tax laws that give them an advantage of some kind ‘Municipal bonds, for example, pay interest that is exempt from local, state and federal taxation, As 4 Tesult of that special tax exemption, municipals can price bonds to. yield a lower interest rate since the net after-tax yield may still make them attractive to investors. ‘The risk of a} regulatory change that could adversely affect the statute of an investment is a real danger. | In 1987, tax law changes dramatically lessened the attractiveness of many existing limited} Partnerships that relied upon special tax considerations as part of thelr tial on, ores for many limited partnerships tumbled when investors were left with different securities,) in effect, than what they originally bargained for. To make matters worse there was no| extensive secondary market for these liquid securltie aid many investors trent eee unable to sell those securities at anything but 'firesale' prices if at all, Business Risk: The risk of doing business in a particular industry or environment is called} ” business risk For example, as one of the largest steel producers, US, Steet faces untquell problems, Similarly, General Motors faces unique problems as a result of such developments} as the global oil situation and Japanese imports. ane Reinvestment Risk: Tne YTM calculation assumes that the investor rej inv ns| received from a bond at a rate equal to the computed YTM on that bona theta conan re exposéd to market risk including law changes and even changes in ly with systematic risk, e eeCHAPTER 6 Risk and Return 183 on interest over the life of the bond at the computed YTM rate. In effect, this interest on qgsumes that the reinvestment rate is the yield to maturity. caleulati If the investor spends the coupons, OF Feinvests them at a rate different fr 5 ; 8, OF Te orn th IF the tment rate of 10% the realized. yield that will actually be earned at the termi rnination ment in the bond will differ from the is of the ways will be reinvested at rates higher or liste egies Siri eee almost zed yield that differs from the promised yield. This gives tise to relnestment ae risk. This interest-on-interest concept significantly affects the potential total dollar return. sk Tey mpact isa function of coupon and time to maturity, with reinvestment becoming Is emimportant as either coupon oF time fo maturity, or both, rise. Specifically: (@) Holding everything else constant, the longer the maturit reinvestment. risks. a rity of a bond, the greater the (b) Holding everything else constant, the higher the ‘coupon rate, the greater the dependence of the total dollar returns from the bond on the reinvestment of ihe coupon ‘payment Let's look at realized yield’ under different assumed reinvestment rates for a 10% non- Uifable 20-year bond purchased at face value. If the reinvestment rate exactly equals the FIM of 10%, the investor would realize a 10% compound return when the bond is Held to maturity, with $4,040 of the total dollar return from the bond attributable to interest on interest, At a 12% reinvestment rate, the investor ‘would realize an 11.14% Compound return, interest (65,738/87,738). With infh almost 75% of the total return. coming from interes! |. no reinvestment of coupons (spending them ae received), the investor would achieve only 57% return. In all cases, the bond Js held to maturity: Clearly, the reinvestment portion of the YTM concep is critical. In fact, for long-term bonds the interest-on-interest component of the total realized yield may account for more than thiee-fourths of the bond's total.dollar return. >. Bull-Bear Market Risk: This tisk atises from the variability in the market returns resulting from alternating bull.and bear market ‘forces. When security index rises fairly consistently = from a low point, called a trough, over. a period of time, this upward trend is called a bull votket, The bull market ends when the market index reaches a peak and starts a downward trend. The period during which the “narket declines to the next trough is called a bear market. : Management Risk: Management, all said and done, is made up of people who are mortal, fallible and capable of making a mistake or a poor, decision. Eitors made by the management can harm those who invested in their firms. Forecasting errors is difficult work and may not be worth the effort and, as a result, imparts @ ‘needlessly sceptical outlook. ers delegate the day-to- ‘An agent-principal relationship exists when the shareholder own Saal i" ‘who are hired employees rather than substantial e value of.the day decision-making authority to managers W l owners, This theory suggests that owners, will work harder to maximize the company than employees will. Various researches in the field indicate that investors can teduce their losses to difficult-to-analyse management errors by buying shares in those corporations in which the executives have significant equity investments. : Default Risk: It is that portion of an investment's total risk that results from changes in the financial integrity of the investment. For example, when a company that tamues sec ies ‘moves either further away from pankruptcy OF closer to it, these ee a x financial integrity will be reflected in the market price of its securities Se vara of _ Tetum that investors experience, asa result of chanBe® in the credit worthiness Which they invested, is their default risk: of the invest184 Financial Management Almost all the losses suffered by investors as a result of default risk Te not the sectaye efaults and/or bankruptcies, Investor losses from default risk usy, ly security pri . See eee joration’s weakness . > "ey; ty prices falling as the financial integrity of a corp Marka Of the troubled firm's securities will already have declined to near zero. Ho eve Pi Rot always the case - ‘creative’ accounting practices in firms like Enron, Worlgco™ Anderson and Computer Associates may maintain quoted prices of stock. oven company's net worth Bets completely eroded. Thus, the bankruptcy losses wou Small part of the total losses resulting from the process of financial deterioratign °°) 10. International Risk International risk can include both country risk and exchange ra Exchange Rate Risk: All investors who invest internationally in today's increasing ny investment arena face the Prospect of uncertainty in the returns after they egy? 8 foreign gains back to their own Currency. Unlike the past, when most US investons international investing alternatives, investors today must recognize and understand ey, ch ate risk, which can be defined as the variability in returns on securities caused by, Huctuations. Exchange rate risk is sometimes called currency risk. ° For example, a US investor who Bo = sountry funds, American Depo: Country Risk: Country risk, also referred to'as Political risk, is an important risk for inves today. With more investors investing internationally, both directly and indirectly, } Political, and therefore economic stability and viability of a country's economy need to considered. The United States has the lowest country tisk, and other countries can | judged on a relative basis using the United States ae - benchmark. Examples of coun! that needed careful monitoring in the 1990s because of country risk included he fo Soviet Union and Yugoslavia, China, Hong Kong, arid South Africa, Liquidity Risk: Liquidity risk is the tisk associated with the particular secondary mari in which a security trades. An investment that can be bought or sold Quickly and with Significant price concession is considered liquid. There is ore uncertainty about the ti element and the price concession, the greater the liquidity risk. A ill has little no liquidity risk, whereas a small OTC stock may have substantial liquidity risk Liquid Assets Risk: It is that portion of an asset's total Variability of return which rest from price discounts given or sales concessions paid in order yo sell the asset with] delay. Perfectly liquid assets are highly marketable and suffer no liquidation costs Il assets are not readily marketable and suffer no liquidation costs. Eithe, price disco must be given or sales commissions must be paid, or the seller must incur both the costs order t6 find a new investor for an illiquid asset. The more illiquid the asset is, the la the price discounts or the commissions that must be paid to dispose of the assets. ae ce 5 itation of a politically weak the benefit litical Risk: It arises from the exploitation of a pc Seep for the Dea a strong group, with the efforts of vatious groups to improve weir lett? citi Evescasing hs eociab ty of return from the affected assets. Regardless of whe 1 the changes that cause polltial risk are sought by political or by economic nee resulting variability of return is called political risk if itis accomplished through legis) judicial or administrative branches of the government.CHAPTER 6 Risk and Return 185 pomestc political riskarises from changes in environmental regulations, zoningrequ zoniny Doméfeenses, and most frequently, taxes. Taxes could be Ein direct and Gndvect. Some fet NG securities and certain categories of investors enjoy a privileged tax status ee International political risk takes the form of expropriation of non-residents’ a: fore : i ssets, f Inigange controls that won't let forelgn investore withdraw their funds, isadvantageous end tariff treatments, requirements that non-residents investors give partial ownership to local residents, and un-reimbursed destruction of foreign- i ie jdents of the foreign country. reign-owned assets by hostile industry Risk: An industry may be viewed as group of companies thal i Inausy Ferfe a hornogencous product. Indy risk that secon ofan nvesunent’ total variability of return ‘caused by events that affect the products and firms that make up ‘an industry. For example, commodity prices going up or down will affect all the commodity producers, though not equally. : ‘the stage of the industry's life cycle, international tariffs and/or quotas on the products E produced, by.an industry, product /industry related taxes (e.g. cigarettes), industry-wide jabour union ‘problems, environmental restrictions, ‘aw material availability, and similar factors interact with and affect all the firms in an industry simultaneously: As a result of these common features, the prices of the secutities’isstied by the competing firms tend to rive and fall together. tT EE : ‘These risk factors do not make up an éxhiaustive list, but.are merely representative of the major classifications involved. All the uncertainties taken’ together make up the total risk, or the total variability of return. a : MEASUREMENT OF RISK - Volatility Of sll the ways to describe risk, the simplest and, possibly most accurate is "the uncertainty ofa future outcome." ‘The anticlpated return for some future period 1s known as the expected return. ‘The actual return over some past period ls known as the realized return. The simple fact that dominates Investing, io that the realized return on an asset.with any.risk attached to it may be Asfferent from what was expected, Volatility, may be, described as the range of movement (or price fluctuation) from thg expected Jevel of return. For example, the more.a stock goes UP and down in price, the more volatile that stock ls. Because wide price swings create more uncertainty of an eventual outcome, Increased volatility can be equated with increased risk. Being able to meavure and determine the past volatility of gocurily is Important in that it provides some Inilght tnto the riukinewo of that security a8 an investinent. Standard Deviation Investors and analyots should be at lenst jomewhat familiar with the study of Peo lotrHbutions, Since the return an Investor will earn from investing Is ol i mio MD Aa See Citinaied, An investor may expect the TR (otal volun) on a particular security Cotntny, yonn, but In truth this 4a only a "point cutimate.” » MohobLitty Distributions ity's ih a secur | [pent with the uncertainty of return inventors neeet to think explo altiough they tbution of probable ‘Ra, In other ry veators need 10 Keep HEN re oft entre “Hwy oxpeet'n peeulty to retin 10%, for exemple ths Is only « oneP i186 Financial Management 5 must deal with the uncertain future, a ny i range of possibilities. Given that investor possible returns can, and will, occur. In the case of a treasury bond payin made with 100 per cent certainty, barring a is i occurrence is 1.0, because no other outcome i ‘i eeroas x dutcomes, which is the norm for common stocks, each possible likely out be cont ¢ Mt i cI The result of considering these outcomes an, and a probability ofits occurrence assessed. The result of consicetiag are ot nes = a Saar, i ion Probabilities together is a probability distribution consisting & Bh i tr returns that may occur and the probabilities associ: ‘ clihood of various outcomes and are typically expresseg , Probabilities represent the lik ia 7 decimal (sometimes fractions are used). The sum of the probabilities of all Possible outeon must be 1.0, because they must completely describe all the (perceived) likely occurrences, 4, s obtained? In the final analysis, investing | interest payme, a fixed rate of interest, the inl men 5S & rinancial collapse of the economy. The Probage 's possible. With the possibility of tw gp are these probabilities and associated outcome: eae some future period involves uncertainty, and therefore subjective es! + Although 5, occurrences (frequencies) may be relied on heavily to estimate the probabilities, the past mus modified for any change’ expected in the future. Probability distributions can be either qi or continuous. With a discrete probability distribution, a probability is assigned to each poss outcome. With a continuous probability distribution, an infinite number of possible outcon, ” exists, The most familiar continuous distribution is the normal distribution depicted by, well-known bell-shaped curve often used in statistics. It is a two-parameter distribution in the mean and the variance fully describe it. To describe the single-most likely outcome from a particular probability distribution, i¢ necessary to calculate its expected value. The expected value is the average of all possible ret. outcomes, where each outcome is weighted by its respective probability of occurrence, | _ investors, this can be described as the expected return. x We-have mentioned that it's important for investors to be able to quantify and measure To calculate the total risk associated with the expected return, the variance or standard deviat is used. This is a measure of the spread or dispersion in the probability distribution; that i - measurement of the dispersion of a random variable around its thean. Without going into furl » details, just be aware that the larger this dispersion, the larger the variance or standard deviat Since variance, volatility and risk can, in this context, be used synonymously, remember that larger the standard deviation, the more uncertain the outcome. i Calculating a standard deviation using probability distributions involves making subjeq__ estimates of the probabilities and the likely returns. However, we cannot avoid such estim because future returns are uncertain. The prices of securities are based on investors’ expectath z about the future. The relevant standard deviation in this situation is the ex anfestandard devia and not the ex post based on realized returns, Although standard deviations based on realized returns are often used as proxies for ex standard deviations, investors should be careful to remember that the past carinot alway, extrapolated into the future without modifications, Ex post standard deviations ma’ convenient, but they are subject to errors. One important point about the estimation of stal deviation is the distinction between individual securities and portfolios, Standard devial for well-diversified portfolios are reasonably steady across time, and therefore histol calculations may be fairly reliable in projecting the future. Moving from well-diversified port! to individual securities, however, makes historical calculations much less reliable. Fortunq” the number one rule of portfolio management ‘s to diversify and hold a portfolio of sect and the standard deviations of well-diversified portfolios may be more stable. Something very important to remember about standard deviation is that it is a measure 4 total risk of an assct or a portfolio, including, therefore, both systematic and unsystematicCHAPTER 6 Risk and Return 187 It captures the total variability in the asset's or portfolio’ oes of that 1 Gee ity, In summary, the standard deviation Sree mene mato tisk of one sorutly variably leak of a portfolio of securities, The historical standard ieviation can be calcula oF the dual securities oF portfolios of securities using total returns for some Specified period one Tis ex post value is useful in evaluating the total risk for a particular Fistorical period and in estimating the total risk that is expected to prevail over some future period. bee ‘The standard deviation, combined with the normal distribution, can provide some useful -- informations about the'dispersion or variation in returns. In a normal distribution, the probability iis particular outcome will be above (or below) specified value can ‘be determined. With one standard deviation on either side of the arithmetic mean of the distribution, 68.3% of the outcomes stat pe encompassed: that is, there is a 68.3% probability that the actual outcome will be within tne (plus oF minus) standard deviation of the arithmetic mean. The probabilities are 95% and Sov that the actual outcome will be within two or three standard deviations, respectively, of the arithmetic mean. Beta ~ Beta is a measure of the systematic risk of a security that cannot be avoided through = Giversification. Beta is a relative measure of risk the ‘risk of an individual stock relative to the airsket portfolio of all stocks. Ifthe security's retturns move more (less) than the market's returns rene latter changes, the security's returns have more (less) ‘volaiility (fluctuations in price) than those of the market. It is important to note that beta measures 2 security's volatility, or fluctuations in price, relative toa. benchmark, the market portfolio of all stocks. Securities with different slopés have. different sensitivities to the returns of the market index. If the slope of this relationship for a particular security # ‘a 45-degree angle, the beta is 1.0. This means that for every one per cent change in the market's return, on average this security's returns change 1%. The market portfolio has a beta, ‘of 1.0. A security with a beta of 1.5 indicates that, on average, security returns are 1.5 times as volatile as market returns, ‘both up and down. ‘This would be considered. an aggressive security because ‘when the overall market return rises or falls 10%, this security, on average, would rise oF fall 15%. Stocks having a beta of less than S10 would be considered more conservative investments than the overall market. = tisk of different stocks and, in. practice, is Beta is useful for comparing the relative systematic used by investors to judge a stock's riskiness. Stocks can be ranked by their betas. Because the variance of the market is constant across all securities for a particular period, ranking stocks by beta is the same as ranking them by their absolute. systematic tisk. Stocks with high betas are said to be high-risk securities. “RISK AND EXPECTED RETURN nvestment decision. Risk, in simple ‘Risk and expected key determinants of an i pected return are the two key : z __ terms, is associated with the variability of the rates of return from an investment; hove such de individual outcomes deviate from the expected value? Statistically, risk is measured A by y a f the measures of dispersion such as co-efficient of range, variance, standard deviation of The tisk involved in investment depends on various factors such as: oe i) The length of the maturity period - longer maturity periods impart greater risk to investments. sil The credit-worthiness of the issuer of securities - the al lity periodical interest payments and pay ‘back the principal amoun' investment and this reduces risk. of the borrower to make will impart safety to the188 Fi ancial Management isk. Generall swrmines the risk. Generally, goyery, Gil) The nature of the instrument or security also determ 5s or least risky; corporaye NE ies and fixed deposits with banks tend to be riskless OF TEM Cao) a owas eb instruments like debentures tend to be riskier than Sie relative ranking of instr Se instruments like equity shares tend to be the riskiest. The To" men, by tisk is once again connected to the safety of the investmene a oe (iv) Equity shares are considered to be the most risky iver bankruptcy has to be peels of the rates of returns ane also because the residual risk o} ome the equity holders. : i invi ; (v) The liquidity of an investment also determines the risk involved - Hate ree of an asset refers to its quick salenbility without a loss or with © BELT ol loss, (vi) Jn addition to the aforesaid factors, there are also various at ee detailed ee industry and firm specific factors that affect the risk an investment. analysis, | these risk factors will be taken up in the next chapter. ces Another major factor determining the investment decision is the rate Of t vay Ported the investor. The rate of return expected by the investor consists of the yield and capiy| appreciation. r - | Before we look at the methods of computing the rate of return from an investment, i, | pecessary to understand the concept of the return on investinent, We have noted earlier that | investment is a postponed consumption. Postponement of consumption is synonymous with concept of ‘time preference for money’. Other things, remaining the same, individuals pre current consumption to future consumption. Therefore, in order to inditce individuals to postp,| current consumption they have to be paid certain compensation, which is the time preference consumption. The comperssation paid should be a positive real fate of return. The real rat” return is generally equal to’ the rate of return expected by an investor from a risk-free cape asset assuming a world without inflation. However, in real life, inflation is a common featun a capitalist econoniy. If the investo: 3 hot compensated for the effects of inflation, the real: of return may turn out to be cither zero or negative, Therefore, the investors, generally, : expected inflation rate to the real rate of return to arrive at the nominal rate of return. ; For example, assume that the present value of an investment is Rs. 100; the investor expe real time rate of 3% per annum and the expected inflation rate is 3% per annum. If the inve was to receive only the real time rate, he would get back Rs. 103 at the end of one year. The rate of return received by the investor would be equal to-zero because the time preference of 3% per annum is matched by the inflation of 3% per annum. If the actual iiflation ré greater than 3% per annum, the invéstor would suffer negative returns. : Thus, nominal rate of return on a risk-free asset i8 equal to the time preference real rate expected inflation rate. : If the investment is in capital assets other than government obligations, such assets woul associated with a degree of risk that ig idiosyncratic to the investment. For an individ invest. in such assets, an additional compensation, called thé risk premium will have to be over and above the nominal rate of return. ‘ 'quidit Determinants of the rate of return Therefore, three major determinants of the rate Of return expected by the investor are: G)_ The time preference Gi) The expected rate of inflation : ii) The risk associated with the investment, which is unique to the investment. isk-free real rate Hence, Required return = Risk-free real rate + Inflation premium + Risk premiumCHAPTER 6 Risk and Return 189 Tt was stated earlier that the rate of return from an inv: i 4 ‘estment consists of the it spp ye ference br he ep ae pcan poe se pl appreciation and the interest or dividend divided by the purchase price is the yield. eae “A+R, -Pal ”, p Rate of return (R) a Where R,= Rate of return per time period ‘t J, = Income for the period ‘t' Initial price, i.e,, price at the beginning of the period 't. In the above equation ‘t’ can be a day or a week or a'month or a year or years and i 1 di daily, weekly, monthly or annual rates of return could be computed for most eal ‘The above equation can be split in to two components. Viz., a (1.2) 2 ope and in'yield.*\ 5? 2 Rees st : : ~~ Or ROR’ current yield + capital gain yield... “Mastration 1: The, following information is given for a ‘corporate bond. Price ‘of the bond at the beginning of the year: Rs, 90, Price ofthe, bond at the end gf the year: Rs, 95.40, Interest received forthe year:. Rs. 13.50. Compute the rate of return." - s Solution: : ‘The rate of feturn can be computed.as follows: .o06 5.4 135026540-20 = 0.21.0r'21%. per annum The return of 21% consists of 15% current yield a There is always a direct association between the Fr theory stipulates that the price of any asset is equal to th which the capital asset owner would receive, Accordingly, can be expected, symbolically, as : SEC), Pa (1.3) Po ary en nd 6% capital gain yield, ‘ates of retuin and the asset prices. Finance .e-sum of the discounted. cash flows, the current price of any capital asset Where E (R) = Expected income to be received in year 't Current price of the capital asset Price of the asset on redemption or on liquidation ors expect given the risk inherentin that capital R = Thevate of return invest ital asset asset. oo Thus, i sch the investors require in order to invest in @ ¢@P! ¥ is the rate or return, which the ner rom that capital asset _ that is used to discount the expected future cas: Re. 10 each of Kinetic Ltd. in agg, “ t f 4 100 shares of RS: © "ine year 2006-07. The ond @ 40% fo . Calculate the ake 2007 was Rs: 128 late the anna 190 Financial Management 1n has purchase Jlustration 2: Mr. Ari Rs. 78 per share. The company has declared 4 12 price of share as on 1-4-2006 was Rs. 104 and on 3 sar 2006-07. return on the investment for the ye | Dividend received for 2004 ~ 05 = Rs. 10 * 40/100 = Solution: | ne year 2006-07 | Calculation of annual rate of return on investment for u ee SGP) _ 44028100 _ 9.9692 oF 26.92% P 104 RISK-RETURN RELATIONSHIP The most fundamental tenet of finance lite! return. The risk-return relationship requires # with its riskiness, If the capital markets are operal Should provide a rate or return that is consistent with the risks and return are direetly’ variable, i.c., an investment with high return. i The risk/return trade-off could easily be called the ‘ability-to-sleep-at-night test." While so eople can handle the equivalent of financial skydiving without batting 2° eye, others are territ Prchimb the financial ladder without a sécure harhess: Deciding what amount of risk youc take while remaining comfortable with your investments is very important. In the investing world; the dictionary definition of risk isthe possibility that an investme: actual return will be different than expected. Technically, this is measured in statistics by stanc: Geviation. Risk means’ you have the possibility of losing some, or even all, of your orig investment. : ns Low levels of uncertainty (low risk) are associate uncertainty (high risk) are associated with high’ potential returns. The risk/return trade-ct the balance between the desire for the lowest possible risk and the highest possible return. is demonstrated graphically in the chart below. A higher standard deviation means a higher! and higher possible return. The figure below réprescnts the relationship between risk and reb ere is a trade-off between risk a ‘a security should be commensurs, Honally efficient, then all investment asi 9 associated with them. The rj er risk should produce high’ rature is that thé hat the return/on .d with low potential returns. High lever Return Low risk | Average risk | High risk Slope indicaies required Return per unit of risk Risk-free return R(f) Risk and Return Relationship