PF Chapter- 06.pdf wicjdnfdjfi dkjsfjijsfoij dsofjifj ifjidfj djfj

fjhdhjf hjuihdfuhu ihuidhf

1. RISK AND RATES OF RETURN
By Kaniz Fatema
Lecturer, Finance, AIBA

2. Risk and Rates of Return
Investment on a business project depends on…

Measuring
Risk
Return
Investment

3. What Is an Investment?

An investment is the current commitment of resources for a
period of time in the expectation of receiving future
resources greater than the current outlay.

Investors require compensation for investment:
▪the time resources are committed
▪the expected rate of inflation
▪the uncertainty of the future payments

4. Investment Returns
•

5. •

6. Types of Risk

Mainly two types of investment risk:

Stand- Alone risk Single asset

Portfolio risk Collection of bonds

7. Stand- Alone Risk
This risk an investor would face if he hold only one asset.
Some Statistical Way to Measure Stand-alone Risk:
❑Probability Distributions
❑ Expected Rate of Return
❑ Standard Deviation
❑ Coefficient of Variance

8. Probability Distributions

List of all possible outcomes and probability of each
occurrence.

Investment risk is related to earning low or negative actual
return.
Shows in graphically:



The tighter the graph the smaller the risk of investment.
Because, the actual return is more close to expected
return.

9. •

10. •

11. Coefficient of Variance

It’s a standardized measure of the risk per unit of return.

Formula:
Coefficient of Variance, CV =σ / E(R)

CV chance to actual return deviate significantly from
the average or expected return.

So, the lower the CV the better it is.

12. Example
Let see, analysis the riskiness of investment stock using these formula,


Investment A Investment B
Rate of RerunProbabilityRate of RerunProbability
-10 .1 30 .1
-5 .2 15 .2
5 .4 5 .4
15 .2 -10 .2
25 .1 -15 .1

13. •

14. Continued…
Coefficient of variance:

CV (A) = 10.11/5.5
= 1.8

CV (B) = 12.9/4.5
= 2.8

15. Summary of the result










Measuring Investment AInvestment B
E(R) 4.5
SD 12.9
CV 2.8
Here, Investment A has lower level risk with high
expected return. Should Invest in investment A.
1.8
10.11
5.5

16. A relative measure of Risk:

Calculation Investment A Investment B
E (R) 0.07 0.12
S.D 0.07
Which one is best? And Why?

Solution:

CV (A) = 0.05/0.07
= 0.714

CV (B) = 0.07/0.12

=


0.12
0.05
0.583

17. Activity # 1:
Calculate the riskiness of the investment :
Probability Rate of Return
.15 .20
.15 -.20
.70 .10
Calculate:
▪Expected rate of return
▪ Standard Deviation
▪ Coefficient of Variation

18. Portfolio Risk
•
Market Risk
Diversifiable
Risk

19. Rather than invest in a single asset invest in multiple assets
to ensure maximize the profit to minimize the level f risk
,diversification is the concept of portfolio.

Breaking down sources of risk:

20. ❑ Systematic Risk:
It is market risk. Portion of a security’s standalone risk that
cannot be eliminated through diversification. It is in general
and common risk. In respective of the nature of the
business all business are affected by common risk and
unavoidable circumstance. Like- Harte, inflation, interest
rate, tax etc.

❑ Unsystematic Risk:
It is firm specific risk. Portion of a security’s standalone risk
that can be eliminated through proper diversification. It
refers the specific type of risk that effect specific type of
business. Like- Frequent labor union movement in
garments sector, Government regulation for 5% interest on
different types of vehicles.
The purpose of portfolio manager is only to reduce the
unsystematic risk.

21. Portfolio Return
•

22. Example: Portfolio Return for multiple assets
Let assume , You have $100000 . Want to invest into 4
different stock by $25000 each. Then expected returns of
the portfolio of stock A, B, C & D companies are.
Investment Expected Return
A 12.0%
B 11.5%
C 10.0%
D 9.5%
E(P) = 0.25(12%) + 0.25( 11.5%) + 0.25( 10%) + 0.25
(9.5)
=10.75%

23. Measuring Coefficient of Correlation
•

24. It can vary only in the range +1 to -1. A value of +1 would
indicate perfect positive correlation. This means that
returns for the two assets move together in a completely
linear manner. A value of –1 would indicate perfect
negative correlation. This means that the returns for two
assets have the same percentage movement, but in
opposite directions.
As it has a maximum and minimum value, it can specify the
intensity of the relationship.

25. Example
Portfolio return of two perfectly negatively correlated stocks
& two perfectly positively correlated stocks are present in
graphs. (Assumption)

Rate of return distributions for two perfectly negatively correlated stocks
( r = -1) and for portfolio AB

Return of portfolio is changed as these are perfectly
negatively correlated.

26. Rate of return distributions for two perfectly positively
correlated stocks ( r = 1) and for portfolio CD

No change in return of portfolio as these are perfectly
positively correlated.

27. Capital Asset Pricing Model
•

28. Activity # 2:
Let security ACME has a beta of .75 while security KENT
has a beta of 1.45. Assuming that the risk –free rate is 5%
and the expected return of the market/risk premium is 14%.
Calculate the expected return of the securities.

29. Relevant Risk

Relevant Risk = Market Risk

Can not be diversified away but can be eliminated by the
contribution to the riskiness of well-diversified portfolio.

Can be measured by the degree to which a given stock to
move up or down with the market.

Example:
Mr. X has portfolio of 40 stocks makes the portfolio risky but
if he diversified it with other it can be eliminated.

30. The relationship between risk and rates of return
•

31. •

32. Market Risk Premium
•

33. The security market line (SML)
Security Market line the graphical presentation of the
relationship between risk as measured by beta and the
required rate of return for individual securities.

Consider the systematic/ market risk / partial risk.

34. Security Market line
Example

Rf = 7%
Rpm = 12%

Stock Beta E(Rp)
A 2 17%
B 1 12%
C .5 9.5%

36. Valuation of security through graph
Decision:
Underpriced: If the dots over the SML. Actual>Expected
Overpriced: If the dots below the SML . Actual<Expected
Fairly priced: If the dots is on the SML. Actual = Expected

37. Implications: (SML CAPM)
Let: Rf = 8%, Rm = 18%

InvestmentRp(%) E(Rp) Decision
A 30 1.75 25.5 Underpriced
B 28 1.68 24.8 Underpriced
C 20 1.20 20 Fairly priced
D 13 .78 15.8 Overpriced
E 10 .70 15 Overpriced

38. Activity # 3:
Security Rp(%)
A 30 2
B 25 1.5
C 20 1
D 11.5 0.8
E 10 0.5
Market-Index 15 1
Govt. Security 7 0
Q-1. In term of the security market line, which of the securities
listed above are under priced / over priced / fairly priced?

Q-2. assuming that a portfolio is constructed using equal
proportions of the five securities listed above, calculate the
expected return and systematic risk of such a portfolio?

39. Impact of Inflation and Risk Aversion on SML