Module 3
Risk and Return
Return
Return
Return is the primary motivating force that
drives investment
Return
Types of Return
Realized return – Already earned
Expected return –Expected in Future
Components of Return
Current return - Dividend
Capital return –Capital Appreciation
Return over time
Holding period return
Muti year return
Risk
Concept of Risk
Risk is expressed in terms of variability of
return.
There are two types of risks:
Systematic risk
Unsystematic risk
An investor before investing in securities
must properly analyze the risks associated
with these securities.
Risk
Systematic Risk Unsystematic Risk
Mark Interes Purchasin Business risk Financia
et t Rate g Power l Risk
Risk Risk Risk
Intern Exter
al nal
Risk Risk
Systematic Risk
It is the risk that is caused by external factors
such as economic, political and sociological
conditions.
It affects the functioning of the entire market.
They are of three types:
Market risk
Interest rate risk
Purchasing power risk
Market Risk
Jack Francis has defined market risk as that portion of the total variability
of returns that is caused by the alternating forces of bull and bear markets.
When the stock market moves upwards, it is known as bull market. On the
other hand, when the stock market moves downwards, then it is known as
bear market.
The two forces that affect the market are:
Tangible events: Earthquake, war, political uncertainty and
decrease in the value of money are some of the examples of
tangible events.
Intangible events: It is related to market psychology.
Political unrest or fall of government affects the market
sentiments.
Interest Rate Risk
It is the risk caused by the variations in the market interest
rates.
Prices of debentures, bonds, etc. are mainly affected by the
interest rate risk.
The causes of interest rate risk are as follows:
Changes in the government’s monetary policy
Changes in the interest rate of treasury bills
Changes in the interest rate of government bonds
Affects
Bond Returns
Firms with high borrowed funds
Equity market
Purchasing Power Risk
Variations in returns are caused by the loss of
purchasing power of currency.
There are mainly two types of inflation:
Demand-pull inflation: The demand for goods and
services remains higher than the supply.
Cost-push inflation: There is a rise in price due to
the increase in the cost of production.
Unsystematic Risk
It is a type of risk which is unique, specific
and related to a particular industry.
Managerial inefficiency, changes in
preferences of the consumers, availability of
raw material, labour problems, etc. are some of
the causes of unsystematic risk.
These are of two types:
Business risk
Financial risk
Business Risk
It is the risk that is caused by the inefficiency of a
company to manage its growth or stability of earnings.
It can be classified as:
Internal business risk: It is the risk that is
associated with the operational efficiency of a
company.
External business risk : It is the risk that is
the result of operating conditions imposed on
the firm by the external environment .
Financial Risk
It is associated with the capital structure of the
company, which consists of equity and borrowed
funds.
A financial risk can be avoided by analyzing the
capital structure of the company.
The financial risk considers the risk between EBIT
and EBT.
The payment of interest affects the eventual
earnings of the company.
Risk Measurement
An efficient measurement of risks provides an appropriate
quantification of risk.
Standard deviation is used as a tool for measuring the risk,
which is a measure of the variables around its mean.
Risk Measurement of Probability
distribution
The following formula is used to calculate standard
deviation:
N
P r -E(r)
2
σ= 1
i=1
Portfolio Risk Formula
Cov (X,Y) = ∑(Pi * RX*RY) - ∑(Pi*RX) ∑(Pi*RY)
Correlation formula
Difference between Covariance
and Correlation
The Investment Decision
Top-down process with 3 steps:
1. Capital allocation: risky portfolio and risk-free
asset
2. Asset allocation: across broad asset classes
3. Security selection: individual assets within asset
class
©2018 McGraw-Hill 7-32
Education
Diversification and Portfolio Risk
Market risk
Marketwide risk sources
Remains even after diversification
Also called: Systematic or Nondiversifiable
Firm-specific risk
Risk that can be eliminated by diversification
Also Called: Diversifiable or Nonsystematic
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Education
Portfolio Risk and
the Number of Stocks in the
Portfolio
Panel A: All risk is firm specific Panel B: Some risk is systematic
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Education
Portfolio Diversification
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Portfolios of Two Risky Assets
Expected Return:
Portfolio risk:
Covariance:
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Portfolios of Two Risky Assets:
Expected Return
Consider a Portfolio made up of Equity (stocks) and Debt (bonds)
rp wD rD wE rE
where wD
wE
rD
rE
E (rp ) w D E (rD ) wE E (rE )
©2018 McGraw-Hill 7-37
Education
Portfolios of Two Risky Assets:
Risk
Portfolio variance:
p wD D wE E 2wD wE Cov rD , rE
2 2 2 2 2
D2 = Bond variance
2
E
= Equity variance
Cov rD , rE
= Covariance of returns for bond
and equity
©2018 McGraw-Hill 7-38
Education
Portfolios of Two Risky Assets:
Covariance
Covariance of returns on bond and equity:
Cov(rD , rE ) rDE D E
D,E = Correlation coefficient of returns
D = Standard deviation of bond returns
E = Standard deviation of equity returns
©2018 McGraw-Hill 7-40
Education
Portfolios of Two Risky Assets:
Correlation Coefficients (1
of 2)
Range of values for 1,2
1.0 1.0
If = 1.0 perfectly positively correlated securities
If = 0 the securities are uncorrelated
If = - 1.0 perfectly negatively correlated
securities
©2018 McGraw-Hill 7-41
Education
Portfolios of Two Risky Assets:
Correlation Coefficients (2
of 2)
When ρDE = 1, there is no diversification
P wE E wD D
When ρDE = -1, a perfect hedge is possible
D
wE 1 wD
D E
©2018 McGraw-Hill 7-42
Education
Risk and Return of Three Stock
Portfolio
Beta
Beta is the slope of the regression line.
Beta describes the relationship between the stock
return and index return.
Beta
Beta = +1.0. One per cent change in index
return causes one per cent change in stock
return.
Beta = +0.5. One per cent change in index
return causes 0.5 per cent change in stock
return.
Negative beta indicates that the stock return
and the market move in opposite directions.
