21E00305a – INVESTMENT AND PORTFOLIO MANAGEMENT

UNIT - III

Measurement of Risk and Return: Revenue Return and Capital appreciation, holding period
–Calculation of expected return, Risk factors, risk classification – systematic risk –
unsystematic risk –standard deviation – variance– Beta.

Revenue Return and Capital Appreciation

There are two forms of returns on investments such as one is Revenue Returns and
Capital Appreciation.

1. Revenue Return: Interest or dividends received from an investment

periodically is called as Revenue Return. Interest is paid by the company to
the holders of debentures or bonds. A dividend is the distribution of a
company's profits to its shareholders.

2. Capital Appreciation: Capital appreciation is an increase in the value of

shares or bonds/debentures while the investor still holds them. Combinedly,
interest/dividend income and capital appreciation give the total return
delivered by investments.

A company’s stock is not redeemable until its closure. However, equity shares are
free to be traded in secondary markets, allowing investors to release their funds
from the company at their discretion. This ensures wealth creation in the hands of
equity shareholders in the form of capital appreciation which are changes in the
stock prices. It does not include any other forms of value, such as income generated
through dividends.

Capital appreciation in equity shares is passive and gradual. It can occur due to
macroeconomic and microeconomic factors such as:

• Strong economic growth

• Overall sectoral growth
• Demand and supply of the stocks in the market
• Speculative trading
• Improved financial performance of the company

Capital appreciation is the growth in the principal amount invested in a company's

stock. It is the ultimate goal of investors seeking long term growth. Investments
chosen for capital appreciation are well-suited for risk-tolerant investors. These
investments are riskier than assets selected for capital preservation or income
generation, such as government bonds or dividend-yielding shares.
For example, Mr D bought 10 shares of Company X for INR 100 each. After 6
months, Company declared and paid a dividend of Rs.2 on each of its shares issued
which were trading at INR 125 at that time.
Here,
Capital appreciation (in absolute terms) = (125-100) x 10 shares = Rs. 250
Dividend income (in absolute terms) = 2 x 10 shares = Rs. 20

Total return (in absolute terms) = Rs. 270

Holding Period:
A holding period is the total time that the investment is held by an investor,
or the period between the purchase and sale of a security. Any investments that
have a holding of less than one year will be short-term holds. A long-term holding
period is one year or more with no expiration.
Holding period return is the total return received from holding an asset or
portfolio of assets over a period of time, i.e the holding period. It is generally
expressed as a percentage and is particularly useful for comparing returns on
investments purchased at different periods in time.
Holding period return is important for several reasons. It considers not only
appreciation but also income payments and is a great way to compare the
performance of investments held over different timeframes.

Holding Period Return (HPR) can be calculated as follows:

Income + (End of Period Value − Initial Value)

Holding Period Return = ----------------------------------------------------------------
Initial Value

Expected Return

The term return refers to income from a security within a specified period
either in the form of interest, dividend, or market appreciation in security value. On
the other hand, risk refers to uncertainty over the future to get this return.
Expected return is the anticipated profit or loss an investor can predict for a
specific investment based on historical rate of return. Expected return may or may
not occur, since the investment market is highly volatile. It accounts for the
investment's historical performance. Keep in mind that since the expected return
uses past data, there's no guarantee of future outcomes.
The expected return refers to the anticipated return for some future period ,
and estimated on the basis of actual returns in the past periods. The realized return
is the net actual return earned by the investor over the holding period.
How to calculate expected return
Use the following formula and steps to calculate the expected return of investment:

• Determine the probability of each return that might occur

Refer to the historical data on past returns determine appropriate probabilities that
a return can occur for a specific asset. This is important because you need
approximate probabilities to find the expected return for an investment.

• Determine the expected return for each possible return

The expected return for each probability is also important. This value lets you
determine how valuable each return is. If you have three returns labeled A, B and
C, then you can find the expected returns of each.

• Multiply each expected return by its corresponding percentage (weight)

Find the absolute value of each return compared to other returns. This is valuable
because we can compare returns and determine which ones are the best for you.
We can also use the weight of each return to prioritize the calculations we make.
• Add each of the products together to find the weighted average expected
return
The weighted average expected return is the combination of expected returns for
each asset. This is the total expected returns average of every asset that generates
returns.

The expected return from a portfolio of two or more securities is equal to the
weighted average of the expected returns from the individual securities.
 Risk Factors

1. Business risk
Business risk is that portion of the unsystematic risk caused by the operating
environment of the business. Business risk arises from the inability of a firm to
maintain its competitive edge and the growth or stability of the earnings. Variation
that occurs in the operating environment is reflected on the operating income and
expected dividends. The variation in the expected operating income indicates the
business risk. Business risk can be divided into external business is and internal
business risk.
a) Internal Business Risk
Internal business risk is associated with the operational efficiency of the firm. The
operational efficiency differs from company to company. The efficiency of operation
is reflected on the company's achievement of its pre-set goals and the fulfillment of
the promises to its inventors.
(1) Fluctuations in the sales: It is common in business to lose customers
abruptly because of competition. Loss of customers will
lead to a loss in operational income. Hence, the company has to build a wide
customer base through various distribution channels. Diversified sales force may
help to tide over this problem.
(2) Lack of Research and development(R&D): Sometimes the product may
become obsolescent. It is the management, who has to overcome the problem of
obsolescence by concentrating on the in-house research and development program.
(3) Personnel management: The personnel management of the company also
contributes to the operational efficiency of the firm. Frequent strikes and lock outs
result in loss of production and high fixed capital cost. The labour productivity also
would suffer. The risk of labour management is present in all the firms.
(4) Fixed cost: The cost components also generate internal risk if the fixed cost is
higher in the cost component. During the period of recession or low demand for
product, the company cannot reduce the fixed cost. At the same time in the boom
period also the fixed factor cannot vary immediately. Thus, the high fixed cost
component in a firm would become a burden to the firm.
(5) Single product: The internal business risk is higher in the case of firm
producing a single product. The fall in the demand for a single product would be
fatal for the firm. Further, some products are more vulnerable to the business cycle
while sonic products resist and grow against the tide. Hence, the company has to
diversify the products if it has to face the competition and the business cycle
successfully.
b) External Risk
External risk is the result of operating conditions imposed on the firm by
circumstances beyond its control. The external factors are social and regulatory
factors, monetary and fiscal policies of the government, business cycle and the
general economic environment within which a firm or an industry operates. A
government policy that favors a particular industry could result in the rise in the
stock price of the particular industry.
1. Social and regulatory factors: Harsh regulatory climate and legislation
against the environmental degradation may impair the profitability of the industry.
2. Political risk: Political risk arises out of the change in the government policy.
With a change in the ruling party, the policy also changes. Political risk arises mainly
in the case of foreign investment.
3. Business cycle: The fluctuations of the business cycle lead to fluctuations in the
earnings of the company. Recession in the economy leads to a drop in the output of
many
2. Financial Risk
It refers to the variability of the income to the equity capital due to the debt capital.
Financial risk in a company is associated with the capital structure of the company.
Capital structure of the company consists of equity funds and borrowed funds. The
presence of debt and preference capital results in a commitment of paying interest
or pre fixed rate of dividend. The residual income alone would be available to the
equity holders.
The debt financing increases the variability of the returns to the common
stock holders and affects their expectations regarding the return. The use of debt
with the owned funds to increase the return to the shareholders is known as
financial leverage.

Risk Classification
Investors invest for anticipated future returns, but these returns can be rarely
predicted. The difference between the expected return and the realized return is
defined as risk. All investors generally prefer investment with higher returns, he has
to pay the price in terms of accepting higher risk too. Investors usually prefer less
risky investments than riskier investments.

Risk

Systematic Risk Unsystematic Risk

 Systematic Risk
It affects the entire market. It indicates that the entire market is moving in
particular direction. It affects the economic, political, sociological changes. This risk
is further
subdivided into:
1. Market risk
2. Interest rate risk
3. Purchasing power risk
1. Market risk:
Market risk is a “portion of total variability in return caused by the alternating forces
of bull and bear markets. When the security index moves upward for a significant
period of time, it is bull market and if the index declines from the peak to market
low point is called troughs i.e. bearish for significant period of time. The forces that
affect the stock market are tangible and intangible events. The tangible events such
as earthquake, war, political uncertainty and fall in the value of currency. Intangible
events are related to market psychology.
For example – In 1996, the political turmoil and recession in the economy resulted
in the fall of share prices and the small investors lost faith in market. There was a
rush to sell the shares and stocks that were floated in primary market were not
received well.
2. Interest rate risk:
It is the variation in single period rates of return caused by the fluctuations in the
market interest rate. Mostly it affects the price of the bonds, debentures and stocks.
The fluctuations in the interest rates are caused by the changes in the government
monetary policy and changes in treasury bills and the government bonds.
Interest rates not only affect the security traders but also the corporate
bodies who carry their business with borrowed funds. The cost of borrowing would
increase and a heavy outflow of profit would take place in the form of interest to the
capital borrowed. This would lead to reduction in earnings per share and consequent
fall in price of shares.
For example –In April 1996, most of the initial public offerings of many companies
remained under subscribed, but IDBI & IFC bonds were oversubscribed. The assured
rate of return attracted the investors from the stock market to the bond market
3. Purchasing power risk:
Variations in returns are due to loss of purchasing power of currency. Inflation is the
reason behind the loss of purchasing power. The inflation may be, “demand -pull or
cost-push “.
• Demand pull inflation, the demand for goods and services are in excess of
their supply. The supply cannot be increased unless there is an expansion of
labour force or machinery for production. The equilibrium between demand
and supply is attained at a higher price level.
 • Cost-push inflation, the rise in price is caused by the increase in the cost. The
increase in cost of raw material, labour, etc makes the cost of production high
and ends in high price level. The working force tries to make the corporate to
share the increase in the cost of living by demanding higher wages. Hence,
Cost-push inflation has a spiraling effect on price level
4. Regulation Risk: Some investments can be relatively attractive to other
investments because of certain regulations o tax laws that give them an advantage
of some of kind. Municipal bonds, for example, pay interest that is exempt from
local, state and federal taxation. The risk of regulatory change that adversely affect
the structure of an investment is a real danger.
5. Exchange Rate Risk: all investors who invest internationally in today’s global
investment arena face the prospect of uncertainty in the returns after they convert
the foreign gains back to their own currency.
Unsystematic Risk
Unsystematic risk stems from managerial inefficiency, technological change in
production process, availability of raw materials, change in consumer preference
and labour problems. All these factors form Unsystematic risk. They are
1. Business risk
2. Financial risk
1. Business risk:
It is caused by the operating environment of the business. It arises from the
inability of a firm to maintain its competitive edge and the growth or stability of the
earnings. The variation in the expected operating income indicates the business
risk. It is concerned with difference between revenue and earnings before interest
and tax. It can be further divided into:

• Internal business risk

• External business risk
Internal business risk - it is associated with the operational efficiency of the firm.
The efficiency of operation is reflected on the company’s achievement of its goals
and their promises to its investors. The internal business risks are:
• Fluctuation in sales
• Research and development
• Personal management
• Fixed cost
• Single product

External business risk –It is the result of operating conditions imposed on the
firm by circumstances beyond its control. The external business risk are,
• Social and regulatory factors
• Political risk
• Business cycle phase
2. Financial Risk
It is the variability of the income to the equity capital due to the debt capital.
Financial risk is associated with the capital structure of the firm. Capital structure of
firm consists of equity bonds and borrowed funds. The interest payment affects the
payments that are due to the equity investors. The use of debt with the owned
funds to increase the return to the shareholders is known as financial leverage. The
financial risk considers the difference between EBIT and EBT. The financial risk is an
avoidable risk because it is the management which has to decide how much has to
be funded with equity capital and borrowed capital.

Standard Deviation and Variance

The variance of return and standard deviation of return are alternative

statistical measures that are used for measuring risk in investment. These statistics
measure the extent to which returns are expected to vary around an average over a
period of time.
The variance or standard deviation of an individual security measures the
riskiness of a security in absolute sense. For calculating the risk of a portfolio of
securities, the riskiness of each security within the context of the overall portfolio
has to be considered. This depends on their interactive risk, i.e. how the returns of
a security move with the returns of other securities in the portfolio and contribute to
the overall risk of the portfolio.

The return and risk of a portfolio depends on two sets of factors

(a) The returns and risks of individual securities and the covariance
between securities in the portfolio,
(b) The proportion of investment in each security.

The first set of factors is parametric to the investor in the sense that he has no
control over the returns, risks and covariance of individual securities.

The second sets of factors are choice variables in the sense that the investor can
choose the proportions of each security in the portfolio.
 The portfolio risk is not simply a measure of its weighted average risk. The
securities that a portfolio contains are associated with each other. The portfolio risk
also considers the covariance between the returns of the investment. Covariance of
two securities is a measure of their co-movement; it expresses the degree to which
the securities vary together. The standard deviation of a two-share portfolio is
calculated by applying formula given below:
 Beta
Beta is a measure of the systematic risk of a security that cannot be avoided
through diversification. Beta is a relative measure of risk of an individual stock
relative to the market portfolio of all stocks.
It is important to note that beta measures a security's volatility, or
fluctuations in price, relative to a benchmark, the market portfolio of all stocks.
Beta effectively describes the activity of a security's returns as it responds to
swings in the market. The beta calculation is used to understand whether a stock
moves in the same direction as the rest of the market. It also provides insights into
how volatile or how risky a stock is relative to the rest of the market.

where: Re = the return on an individual stock

Rm = the return on the overall market
Covariance=how changes in a stock’s returns are related to changes in the
market’s returns
Variance=how far the market’s data points spread out from their average
value

Types of Beta Values

• Beta Value Equal to 1.0

If a stock has a beta of 1.0, it indicates that its price activity is strongly correlated
with the market. A stock with a beta of 1.0 has systematic risk.
• Beta Value Less Than One
A beta value that is less than 1.0 means that the security is theoretically less
volatile than the market. Including this stock in a portfolio makes it less risky than
the same portfolio without the stock.
 • Beta Value Greater Than One
A beta that is greater than 1.0 indicates that the security's price is
theoretically more volatile than the market. For example, if a stock's beta is 1.2, it
is assumed to be 20% more volatile than the market. Technology stocks and small
cap stocks tend to have higher betas than the market benchmark.
• Negative Beta Value
Some stocks have negative betas. A beta of -1.0 means that the stock is inversely
correlated to the market benchmark on a 1:1 basis. This stock could be thought of
as an opposite, mirror image of the benchmark’s trends.