Return, Risk and Measuring Risk

Easy exam notes based on the provided slides and risk-measurement techniques

Main idea: in finance, investors compare return with risk. Return is what the
investor earns, and risk is the possibility that the actual return may be lower
than expected.

1. Meaning of Return
Return means the gain or loss from an investment over a period of time. When an investor
invests money in real assets or financial assets, the outcome of that investment is called
return.
• If the outcome gives profit, it is a positive return.
• If the outcome gives loss, it is a negative return.
• Return is calculated by comparing the gain or loss with the beginning investment value.

Return = (Cash income + Change in value) / Beginning investment

Example: If you buy a share for Tk. 1,000 and sell it for Tk. 1,100, your profit is Tk. 100 and
your rate of return is 10%.

Rate of return = (1,100 - 1,000) / 1,000 = 10%

2. Components of Return
A typical investment return has two important components: yield and capital gain.

Componen Easy Meaning Example

t
Yield Income received from the Dividend from shares, interest
investment. from bonds, rent from property.

Capital Gain Increase in the price or value Buying a share for Tk. 500 and
of the asset. selling it for Tk. 600 gives Tk. 100
capital gain.

Total Return = Yield + Capital Gain

3. Expected Return and Required Return

Expected return and required return are different but related concepts.

Expected Return: The return that an investor hopes or expects to earn from an asset. It
depends on price, growth potential and future prospects.

Required Return: The minimum return that an investor demands for accepting the risk of an
investment.

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 Exam line: Higher risk requires higher return. A risky investment must offer a
higher required return to attract investors.

4. Types of Return
Return can be classified into two main types: nominal return and real return.

Nominal Rate of Return: This shows how much more money the investor has at the end of the
year. It does not adjust for inflation.

Real Rate of Return: This shows how much more the investor can actually buy with that
money after considering inflation.

Approximate Real Return = Nominal Return - Inflation Rate

Example: If nominal return is 10% and inflation is 6%, approximate real return is 4%.

5. Methods of Measuring Returns

There are two important methods of measuring investment returns: dollar-weighted rate of
return and time-weighted rate of return.

5.1 Dollar-Weighted Rate of Return

The dollar-weighted rate of return is similar to the Internal Rate of Return (IRR). It is the rate
that makes the present value of all future cash flows equal to the cost of the investment.

Cost of investment = C1/(1+R)^1 + C2/(1+R)^2 + C3/(1+R)^3 + ... + Cn/(1+R)^n

• It considers both the amount of money invested and the timing of cash flows.
• It is affected by when investors deposit or withdraw money.
• It shows the investor's actual experience from the investment.

Easy example: If an investor invests a large amount just before the market falls,
dollar-weighted return will be low because it considers the timing and size of the investment.

5.2 Time-Weighted Rate of Return

The time-weighted rate of return measures the compound growth rate of an investment. It
removes the effect of cash inflows and outflows by calculating return for each period and
linking them together.

Time-weighted return = (1 + R1)(1 + R2)(1 + R3)(1 + R4) - 1

• It focuses on the performance of the investment itself.

• It eliminates the effect of deposits and withdrawals.
• It is preferred in the investment management industry because it gives a fair measure of an
investment manager's performance.

6. Dollar Return and Rate of Return

Dollar return is the total money received from the investment minus the amount invested.

Dollar Return = Amount Received - Amount Invested

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 Example: Amount received = Tk. 1,100 and amount invested = Tk. 1,000. So, dollar return =
Tk. 100.

But dollar return alone is not enough because it ignores two important things:
• Scale or size of investment: Tk. 100 return on Tk. 1,000 is good, but Tk. 100 return on Tk.
100,000 is very small.
• Timing of return: Tk. 100 return after one year is better than Tk. 100 return after twenty
years.

Therefore, return is usually expressed as a percentage rate of return.

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 7. Meaning of Risk
Risk means the possibility of loss or unfavorable outcome. In investment, risk means that the
actual return may be lower than the expected return, or the investor may face loss.
• Risk exists because the future is uncertain.
• Risk is connected with variability of possible outcomes.
• The greater the chance of low or negative return, the riskier the investment.

Exam definition: Risk is the possibility of an unfavorable deviation from

expected return.

8. Concepts of Risk
Risk can be understood in three simple ways.
• Possibility of loss: The investor may lose money.
• Unfavorable deviation from expectation: Actual return may be less than expected return.
• Measurable uncertainty: Risk can often be measured by probability, variance, standard
deviation and other tools.

Example: If expected return is 15% but actual return becomes 8%, the 7% unfavorable
difference shows risk.

9. Difference Between Risk and Uncertainty

The simplest difference is: risk is measurable, but uncertainty is not clearly measurable.

Basis Risk Uncertainty

Meaning Possibility of loss or unfavorable Future outcome is unknown or
result. unclear.

Measurement Can be measured Cannot be measured properly.

mathematically.

Database Based on historical data or past No proper past data is available.

experience.

Probability Probability can be assigned. Probability cannot be assigned

clearly.

Avoidability Can sometimes be reduced by Usually unavoidable.

techniques.

Possible results Possible outcomes are known. Possible outcomes are not
clearly known.

Frequency Can be converted into frequency Cannot be converted into

distribution or probability distribution. frequency distribution clearly.

Relation with Investors demand extra return Exact extra return cannot be
income for taking risk. calculated because it is not
measurable.

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 Basis Risk Uncertainty
Tools Standard deviation, variance, No exact tool is available.
coefficient of variation, range,
etc.

One-line exam answer: Risk is measurable uncertainty, but uncertainty is not

measurable.

10. Factors Creating Risk

Risk is created by many internal and external factors. The important factors are:
• General economic condition: Weak economy may reduce sales, profit and investment
return.
• Technological factor: New technology can make old technology or products less useful.
• Competition: More competition can reduce market share and profit.
• Political factor: Political instability and policy changes can create business risk.
• Inflation: Inflation reduces purchasing power and real return.
• Consumer preference: Changing customer taste can reduce demand.
• Internal business factors: Poor management, weak planning and inefficiency create risk.
• Financial risk: High debt, high interest cost and poor cash flow increase risk.
• Natural uncertainty: Flood, cyclone, drought, earthquake or pandemic can create risk.
• Human factor: Labor strike, employee mistakes, fraud and lack of skill create risk.

11. Bases of Risk

Investment risk can be considered in two ways: stand-alone risk and portfolio risk.

Stand-Alone Risk: The risk of an investment when it is held alone, not in combination with
other assets. The asset's cash flows are analyzed by themselves. It is measured by standard
deviation or coefficient of variation.

Example: Investing only in one company's share exposes the investor to the risk of that single
share.

Portfolio Risk: The risk of an investment when it is held together with other assets. Portfolio
risk is important because diversification can reduce risk.

Example: Investing in shares, bonds and mutual funds together creates a portfolio. If one
asset performs badly, another may perform well and reduce total risk.

12. Classification of Risk

On the basis of investment, risk is classified into two main types: systematic risk and
unsystematic risk.

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 12.1 Systematic Risk
Systematic risk is also called market-related risk or non-diversifiable risk. It arises from factors
that affect the entire market or economy. It is beyond the control of investors and cannot be
removed completely by diversification.
• It affects almost all companies and securities.
• It comes from outside the company.
• Examples include inflation, interest rate changes, taxation changes, political instability,
recession and global security threats.

Four types of systematic risk:

• Market Risk: Risk caused by changes in the overall stock market.
• Interest Rate Risk: Risk caused by changes in interest rates. For example, when interest
rates increase, bond prices usually fall.
• Purchasing Power Risk: Risk caused by inflation because inflation reduces the real value of
money.
• Default Risk: Risk that a borrower or company may fail to pay interest or principal on time.

12.2 Unsystematic Risk

Unsystematic risk is also called company-specific risk, avoidable risk, or diversifiable risk. It is
created by internal causes of a specific company and can be reduced by diversification.
• It affects only a particular company or industry.
• It comes from internal causes such as poor management, labor strike, production problem
and misuse of assets.
• Investors can reduce unsystematic risk by investing in many different securities.

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 13. Techniques of Measuring Risk
Risk means the possibility that the actual return will be different from the expected return. In
exams, the important techniques of measuring risk are sensitivity analysis, standard
deviation, coefficient of variation, beta coefficient and CAPM.
• Sensitivity Analysis
• Standard Deviation
• Coefficient of Variation
• Beta Coefficient
• Capital Asset Pricing Model (CAPM)

13.1 Sensitivity Analysis

Sensitivity analysis means checking how a project's result changes when important estimates
change. In simple words, it is a what-if analysis.

Example: What will happen to profit or cash flow if sales are low, normal or high?

Situation Meaning
Worst case Most pessimistic result. It shows what may happen if
conditions are bad.

Expected case Most likely result. It shows what is normally expected to

happen.

Best case Most optimistic result. It shows what may happen if

conditions are very favorable.

Exam definition: Sensitivity analysis is a risk-measuring technique that

evaluates a project under different estimated cash flows, such as worst,
expected and best outcomes, to understand the variability of results.

Why sensitivity analysis is useful:

• It helps the decision-maker understand how risky the project is.
• It shows how much the outcome may change if assumptions change.
• It identifies which factor affects the project most.
• It helps decide whether the project is safe or uncertain.

Memorize: Sensitivity analysis shows how sensitive a project's return is to

changes in assumptions.

13.2 Standard Deviation

Standard deviation measures how far possible returns may move away from the expected
return. If returns are very spread out, risk is high. If returns are close to expected return, risk
is low.

Important point: Standard deviation measures total risk or stand-alone risk. It measures the
full risk of one investment or project.

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 Exam definition: Standard deviation is a statistical measure of risk that shows
the dispersion or variation of possible returns around the expected return.

Variance = SUM[(Ri - ER)^2 x Pi]

Standard Deviation = Square root of Variance

Symbol Meaning
SD Standard deviation

Variance The average squared variation of returns

Ri Possible return

ER Expected return

Pi Probability of that return

Easy calculation steps:

• Find the expected return.
• Subtract expected return from each possible return.
• Square each deviation.
• Multiply each squared deviation by its probability.
• Add all values to get variance.
• Take the square root of variance to get standard deviation.

Standard Meaning
Deviation
Higher SD Higher risk because returns are more uncertain and
more spread out.

Lower SD Lower risk because returns are closer to expected

return.

Comments on standard deviation:

• Standard deviation measures total risk.
• Larger standard deviation means returns are more uncertain.
• Larger standard deviation means wider probability distribution.
• It is difficult to compare projects using only SD when their investment size or expected
return is different.

Memorize: Standard deviation is the square root of variance and measures total
risk.

13.3 Coefficient of Variation

Coefficient of Variation (CV) measures risk per unit of return. It is used when two projects have
different expected returns or different investment sizes.

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 CV = Standard Deviation / Expected Return

Exam definition: Coefficient of Variation is a relative measure of risk that shows

the risk per unit of expected return.

CV Meaning
Higher CV More risk per unit of return.

Lower CV Less risk per unit of return.

When to use SD and CV:

• Use standard deviation when projects have the same outlay or similar expected return
level.
• Use coefficient of variation when projects have different outlays or different expected
returns.

Memorize: CV is better than standard deviation when comparing projects with

different expected returns.

13.4 Beta Coefficient

Beta measures market risk or systematic risk. It shows how much a security's return moves
with the overall market return.

Systematic risk is caused by market-wide factors such as inflation, interest rate changes,
recession, political instability and economic crisis. This risk cannot be fully removed by
diversification.

Exam definition: Beta coefficient is a measure of systematic or market risk that

shows the sensitivity of a security's return to changes in the market return.

Beta Value Meaning

Beta = 1 Same risk as the market.

Beta > 1 More risky than the market.

Beta < 1 Less risky than the market.

Beta = 0 No relation with the market.

Beta < 0 Moves opposite to the market.

Example: If beta = 1.5, the stock is more risky than the market. If beta = 0.7, the stock is less
risky than the market.

Memorize: Beta measures only systematic risk, not total risk.

13.5 Capital Asset Pricing Model (CAPM)

CAPM links risk and return. It explains how much return an investor should require from an
asset based on its market risk.

Main idea: An investor should receive risk-free return plus an extra return for taking risk. This
extra return is called the risk premium.

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 Required Return = Risk-Free Rate + Beta x (Market Return - Risk-Free Rate)

Ri = Rf + Beta i x (Rm - Rf)

Symbol Meaning
Ri Required return on the asset

Rf Risk-free rate

Beta i Beta of the asset

Rm Market return

Rm - Rf Market risk premium

Exam definition: CAPM is a model that determines the required return on an

asset by adding a risk premium to the risk-free rate, based on the asset's beta.

Important points of CAPM:

• CAPM links risk and return.
• CAPM uses beta to measure risk.
• CAPM focuses on non-diversifiable or systematic risk.
• CAPM assumes a linear relationship between risk and expected return.

Memorize: According to CAPM, higher beta means higher required return.

13.6 Can Beta Be Negative?

Yes, beta can be negative, but it is very rare. Negative beta means the security moves in the
opposite direction of the market.
• If the market goes up, a negative-beta security goes down.
• If the market goes down, a negative-beta security goes up.
• Negative beta happens when the correlation between the stock and the market is negative.

Exam answer: Yes, beta of a security can be negative if the correlation between
the security and the market is negative. In that case, the regression line slopes
downward, and beta becomes negative. However, negative beta is highly
unlikely.

Memorize: Negative beta means the asset moves opposite to the market.

14. Final Exam Summary

• 1. Return is the gain or loss from an investment.
• 2. Return has two parts: yield and capital gain.
• 3. Expected return is what investors hope to earn.
• 4. Required return is the minimum return investors demand for risk.
• 5. Nominal return ignores inflation; real return considers inflation.

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 • 6. Dollar-weighted return is like IRR and is affected by the amount and timing of cash flows.
• 7. Time-weighted return removes the effect of deposits and withdrawals and is preferred for
judging investment managers.
• 8. Risk means the possibility of loss or unfavorable deviation from expected return.
• 9. Risk is measurable, but uncertainty is not measurable.
• 10. Stand-alone risk is the risk of one asset alone.
• 11. Portfolio risk is the risk of assets held together and can be reduced by diversification.
• 12. Systematic risk affects the whole market and cannot be diversified away.
• 13. Unsystematic risk affects a specific company and can be reduced through
diversification.
• 14. Sensitivity analysis is a what-if analysis using worst, expected and best outcomes.
• 15. Standard deviation measures total or stand-alone risk.
• 16. Coefficient of variation measures risk per unit of return.
• 17. Beta measures systematic or market risk only.
• 18. CAPM says required return equals risk-free return plus risk premium.
• 19. Negative beta means the asset moves opposite to the market.

Best exam line: An investor should not judge return alone; return must always
be analyzed with risk.

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