Risk and return in financial investments

Risk and return

1. Risk-Return
Analysis

2. WHAT IS RETURN?
Returnismeasuredbytakingtheincomeplusprice
change.Incomeiseitherdividendorinterestandprice
changeisthecapitalgain.
RateofReturn
=(Incomereceived+Pricechange)/Purchase
PriceofAsset
={D/I+(P
1-P
0)}/P
0

3. MEANING OF RISK
variability of return
• Security
•Governmentsecurity EquityStock
•Norisk Risky
•Why?
•Ifyoubuygovt.sec,youknowhowmuchyouwouldget
(Interest+endingvalue).
•Incaseofequity,youarenotsureabouttheending
price.
•Financialtheorydefinesriskasthepossibilitythatactual
returnswilldeviatefromexpectedreturns.

4. MEANING OF RISK
Variability of return
•ELEMENTS OF RISK
•Theessenceofriskinaninvestmentisthevariationin
return.Thisvariationinreturniscausedbyanumberof
factorsthatarecalledtheelementsofrisk.
•Letusconsidertheriskinholdingsecurities,suchas
shares,debenturesetc.Theelementsofriskmaybe
broadlyclassifiedintotwogroupsasfollows:

5. Elements of risk
(Risk factor)
Group I
External factors
which are
noncontrollable
Group II
Internal factors
which are
controllable
Produces
Systematic Risk
Produces
Unsystematic Risk

6. TOTAL RISK
•Thetotalvariabilityinreturnsofasecurity
representsthetotalriskofthatsecurity.
•Systematicriskandunsystematicriskare
thetwocomponentsoftotalrisk.Thus
•Totalrisk=Systematicrisk+Unsystematicrisk

7. SYSTEMATIC RISK
•Theportionofthevariabilityofreturnofa
securitythatiscausedbyexternalfactors,is
calledsystematicrisk.
•Economicandpoliticalinstability,
•Economicrecession,
•Macropolicyofthegovernment,etc.
•affectthepriceofallsharessystematically.
•Thusthevariationofreturninshares,whichis
causedbythesefactors,iscalledsystematic
risk.

8. UNSYSTEMATIC RISK
•Thesecurityreturnsometimesvariesbecauseof
certainfactorsaffectingonlythecompany
issuingsuchsecurity.
•Examplesare
•Rawmaterialscarcity,
•Labourstrike,
•Managementefficiencyetc.
•Whenvariabilityofreturnsoccursbecauseof
suchfirm-specificfactors,itisknownas
unsystematicrisk.

9. Components of systematic risk
• Systematic Risk
•
•
Market
Risk
Purchasing Power
risk
Exchange rate
risk
Interest rate risk

10. Interest Rate Risk
•INTEREST RATE RISK ON BOND
•COUPON RATE:
•A bond is normally issued with a coupon rate, which is
equal to the interest rate prevailing in the market at the
time of issue.
•Face Value = Rs.100
•Interest Rate = 10%
•Coupon Rate= 10%
•Maturity = 5 Years

11. Interest Rate Risk
•If the rate of interest is 10% ,Price of the bond is
If market rate of interest is 12.5%, Price of the bond is52
)1.1(
110
...............
)1.1(
10
1.01
10
100 

 096.91
493.55549.5242.6023.79012.7888.8
)125.1(
10
)125.1(
10
)125.1(
10
)125.1(
10
)125.1(
10
5432



V
V
V

12. Interest Rate Risk
•Marketpriceofbondsisinverselyrelatedtothemarket
rateofinterest.
•Thisvariationinbondpricescausedduetothevariation
ininterestrateisknownasinterestraterisk.
• Interestrate
Price

13. Interest Rate Risk
•Interest rate risk on share
•Margintradingonborrowedfund.
•Wheninterestratesmoveup,companiesusing
borrowedfundshavetomakehigherinterestpayment
lowerearningslowerdividendlowerprice.
•Variationsininterestratesmayindirectlyinfluencestock
prices.

14. MARKET RISK
•UpsandDownsinsharemarketswouldfollow
theexpansionandrecessionphaseofthe
economy.
•Political,economicorsocialchange,fallofa
government,drasticchangeinmonetarypolicy,
expectationchangeduetopolicychanges,etc.
affectsharepricesystematically.

15. PURCHASING POWER RISK:
•If refers to the variation in investor return
caused by inflation.
•Suppose a person lends Rs.100 @ 10%
interest.
•If Inflation is 0
•Return = 10%

16. PURCHASING POWER RISK:
•Ifduringtheyear,thepriceshave
increasedby8%,Rs110receivedatthe
endoftheyearwillhaveapurchasing
powerofonlyRs(110/108)x100=Rs
101.85.Thusrealreturnis1.85%.
•Thusinflationcausesavariationinthe
purchasingpowerofthereturnsfroman
investment.Thisisknownaspurchasing
powerrisk.

17. Exchange rate risk
•Ifrupeedepreciates,domesticgoodswill
becheaperinforeignmarket.
•Demandfordomesticgoodsmayincrease
inforeignmarket.
•Profitabilityoftheexportbusinessmay
increase.
•Itmayalsoincreasetheimportcost.
•Itmayalsoaffectinternationalportfolio.

18. Unsystematic risk
•Financial Risk
•Business risk

19. •EXPECTED RETURN
•Theexpectedreturnoftheinvestmentistheweightedaverageofall
possiblereturns.Ifthepossiblereturnsare10,15,20,25and30%
withequalprofitability,theexpectedreturnis
•X= X
i
•=1/5( 10+15+20+25+30) = 20% n
1 

n
i1

20. RISK
Themostpopularmeasureofriskisthevarianceorstandarddeviation
ofthepossiblereturns.TheS.D.oftheabovereturnseriesis
calculatedasfollows.
x
i x
i-x (x
i–x)
2
10
15
20
25
30
-10
-5
0
5
10
100
25
0
25
100
X
i=100 (X
i-X)
2
= 250 

n
i1 

n
i1

21. •S.D.= σ= [ (X
i–X)
2
] = [(1/5)250] = 7.12
•The σ measure is the total risk of the security
which comprises two components: systematic
variation and unsystematic variation.
•Total Risk
• = Systematic risk + Unsystematic risk

n
i1 n
1

22. •DIVERSIFICATION OF RISK
•Wehaveseenthattotalriskofanindividual
securityismeasuredbythestandarddeviation
(σ),whichcanbedividedintotwopartsi.e.,
systematicriskandunsystematicrisk
•TotalRisk(σ)
• =SystematicRisk+Unsystematicrisk

23. • σ
• Un systematic risk
•
• Systematic risk
•
• Number of shares
•Figure 1: Reduction of Risk through Diversification

24. •Onlytoincreasethenumberofsecuritiesintheportfoliowillnot
diversifytherisk.Securitiesaretobeselectedcarefully.Iftwo
securityreturnsarelessthanperfectlycorrelated,aninvestor
gainsthroughdiversification.
•If two securities M and N are perfectly negatively correlated, total
risk will reduce to zero.
•Suppose return are as follows:
t
1 t
2 t
3 t
4
M 10% 20% 10% 20%
N 20% 10% 20% 10%
Mean
Return
15% 15% 15% 15%

25. •20% M
•10% N
•Figure 2
•If r = -1 (perfectly negatively correlated), risk is completely
eliminated (σ = 0)
•If r = 1, risk can not be diversified away
•If r < 1 risk will be diversified away to some extent.

26. TWO IMPORTANT FINDINGS:
•Morenumberofsecuritieswillreduce
portfoliorisk.
•Securitiesshouldnotbeperfectly
correlated.