Risk and Return – the two sides of
an investment coin…
Unit II
By :
Paayal D. Nanchahal
Return and Risk – The Basis
of Investment Decisions…
Return is the primary motivating force that drives investment
It represents the reward for undertaking investment.
In return, historical return is often used as an important input in
estimating future returns
Return
Current Return Capital Return
Return from the periodic It is the price appreciation (or
cash flow, such as depreciation) divided by the
dividend,interest etc beginning price of the asset
Total return = Current return + Capital return
Measuring Returns..
Total Returns
TR = (cash payments received + Price changes over the period )/
Price at which the asset is purchased
It is reflected as a percentage of original
investment
Although TR are useful but investment analysis
needs statistical tools to describe a series of
returns. They are known as Arithmetic
mean(AM) and Geometric mean (GM)
Arithmetic Mean (AM) is the sum of each of the
values being considered divided by the total
number of values n.
X mean = ∑Xi / n
where Xi is the Total return in one time period
Over ‘n’ time periods
Geometric Mean (GM) returns measure the
compound rate of growth over time.
X mean = [ (1 + X1) (1 + X2) (1 + X3)…..(1+Xn) ]1/n
The GM will always be less than the AM unless
the values being considered are identical.
Total
Year Sensex Returns AM = sum of TR/ 10
2000 5,209.54 = 211.98/ 10
2001 3,990.65 -23.40% = 21/19%
2002 3,262.01 -18.26% GM = (1-0.23)(1-0.1826)
2003 3,383.85 3.74% (1+.037)(1+.735)…….
2004 5,872.48 73.54% (1+.797)^1/10
2005 6,626.49 12.84%
= 1.13
2006 9,422.49 42.19%
= 13% return
2007 13,827.77 46.75%
2008 20,325.27 46.99%
2009 9,720.55 -52.18%
2010 17,473.45 79.76%
Risk
Risk is the uncertainty that an investment will
earn its expected rate of return.
Risk
Systematic
Unsystematic Risk
Risk
Risk that is directly associated Risk unique to a particular security
with overall moment in the and is associated with such factors
general market or economy as business, and financial risk, as
well as liquidity risk
Systematic Risk
Market Risk
The variability in returns resulting from fluctuations in overall market is
referred to as market risk.
Includes a range of factors like recession, wars, structural changes in the
economy, and changes in consumer preference.
Interest Rate Risk
The variability in a security return resulting from changes in the level of
interest rates is referred to as interest rate risk
Security price move inversely to interest rate
Purchasing Power Risk
Inflation is the reason for loss of PP
The change in the inflation rate also changes the consumption pattern
and hence investment return carries an additional risk.
This risk is related to interest rate risk
Unsystematic Risk
Unsystematic
Risk
Financial
Business Risk Risk
The changes that take place in an The risk of using of debt financing
industry and the environment causes by the company to finance a larger
risk for the company in earning the proportion of assets
operational revenue creates
business risk.
Unsystematic Risk
Business Risk (Internal)
Fluctuations in sales
Loss of customers will result in loss of operational
income
Research and development (R&D)
Scope for further expansion of product lines
Personnel Management
Higher labour costs affects margins
Fixed cost
Single Product
Unsystematic Risk
Business Risk (External)
Social and regulatory factors
Harsh regulatory climate can affect future profitability
Political Risk
Risk due to change in government policy
Exchange Rate risk
The change in the exchange rate causes a change in
the value of foreign holdings, foreign trade, and the
profitability of the firms
The exchange rate risk is applicable mainly to the
companies who operate overseas.
Business cycle
Unsystematic Risk
Financial Risk
The use of debt financing by the company to
finance a larger proportion of assets causes risk.
Debt financing enables the corporate to have
funds at low cost and financial leverage to
shareholders.
As long as Co. earnings are higher than cost of
capital, shareholders’ earnings are increased, but
when earnings are low,it may lead to bankruptcy
Measuring Risk
The weighted return for a portfolio is the weighted
average of the returns of the individual assets in the
portfolio.
n
E(R por i ) Wi R i
i 1
where :
Wi the percent of the portfolio in asset i
E(R i ) the expected rate of return for asset i
Example on weighted return
A portfolio consists of 50% common stocks,
40% bonds & 10% cash. If the return on
common stocks is 12%, the return on
bonds is 7%, and the return on cash is 3%,
what is the portfolio return?
Weight Return Net Return
Stocks 50% 12% 6%
Bonds 40% 7% 2.8%
Cash 10% 3% 0.3%
Total 9%
Expected Return
Why do we measure returns while considering a future
investment?
Expected returns are all based on probability which we have
to assign to each investment outcome
For an Individual risky asset
Sum of probability times possible rate of return
Portfolio
Weighted average of expected rates of return for the
individual investments in the portfolio
Expected Return of a
Portfolio
Possible
Weight Probability Expected Ret. Net Expected Ret.
Ret.
Stocks 60% 60% 9% 5.4%
15%
Bonds 30% 9% 100% 9% 2.7%
Mutual
Funds 10% 11% 50% 5.5% 0.6%
Total 8.7%
Variance of Returns for an
Individual Investment
Variance is a measure of the variation of
possible rates of return Ri, from the expected
rate of return [E(Ri)]
n
Variance ( ) [R i - E(R i )] Pi
2 2
i 1
[R
Standard
Deviation
( ) i
2
- E(R i )] Pi
i 1
Variance of Returns for an Individual
Investment
Possible Rate Expected
of Return (Ri) Return E(Ri) Ri - E(Ri) [Ri - E(Ri)]2 Pi [Ri - E(Ri)]2Pi
8% 11% 0.03 0.0009 25% 0.000225
10% 11% 0.01 0.0001 25% 0.000025
12% 11% 0.01 0.0001 25% 0.000025
14% 11% 0.03 0.0009 25% 0.000225
Total 0.000500
Variance = .00050
Standard Deviation = .02236
Variance of Returns for a
Portfolio When we evaluate a
sample of n from a
larger population
n
Variance ( ) [R i - E(R i )] /( n 1)
2 2
i 1
Standard Deviation
n
( ) [R
i 1
i - E(R i )] /( n 1)
2
Variance of Sample of Population
Monthly Closing Prices of SBI
Average Closing
Year Price (Ri ) % Return Ri - E(Ri) [Ri - E(Ri)]2
Dec-01 205.08
Dec-02 235.38 1.15 -0.194 0.0378
Dec-03 388.26 1.65 0.307 0.0945
Dec-04 525.63 1.35 0.012 0.0001
Dec-05 760.77 1.45 0.105 0.0111
Dec-06 968.99 1.27 -0.068 0.0047
Dec-07 1588.93 1.64 0.298 0.0886
Dec-08 1497.55 0.94 -0.400 0.1597
Dec-09 1715.50 1.15 -0.197 0.0386
Dec-10 2536.62 1.48 0.137 0.0187
Expected Return Variance
E(Ri) = 1.3421 =0.4537/(10-1) = 0.05041
Risk-return Tradeoff
A higher standard deviation means a higher risk and
higher possible return.
Covariance
A measure of the degree to which returns on two risky
assets move in tandem
Covariance is the absolute measure to the extent to
which two stocks move together
1
Covij
N 1
[ Ri E ( Ri )][ Rj E ( Rj )]
where :
Covij the covariance of stock i with stock j
E ( Ri ) the expected return on stock i
E ( R j ) the expected return on stock j
If Covariance of returns
is negative: it indicates an inverse relationship
between the two assets
is Zero: it indicates the two assets are
unrelated
is positive: it indicates an positive relationship
between the two assets
The covariance of a random asset with
itself is nothing but its variance
Example of Covariance
Year SBI(Ri) ITC (Rj)
Dec-01 205.08 742.69
Dec-02 235.38 659.17
Dec-03 388.26 759.83
Dec-04 525.63 1075.86
Dec-05 760.77 1052.71
Dec-06 968.99 180.85
Dec-07 1588.93 173.60
Dec-08 1497.55 190.95
Dec-09 1715.50 215.63
Dec-10 2536.62 230.38
Sum
Expected Return
E(R)
Covariance = 0.006679
Correlation
Correlation is a statistical measurement of the relationship
between two variables.
Correlation coefficient varies from -1 to +1
Cov ij
rij
i j
where :
r the correlation coefficient of returns
ij
Cov the covariance of stocks i & j
ij
the standard deviation
Beta
It is a historical measure of the risk an investor is
exposed to by holding a particular stock or
portfolio as compared to the market as a whole
Beta measures systematic risk
im
Cov im
m
2
where :
im Beta of the stock
Covim the Covariance of stock i with market index m
m the standard deviation of market R m
Interpretation of the Numerical Value
of Beta
Beta = 1.0 Stock's return has same
volatility as the market return
Beta > 1.0 Stock's return is more volatile
than the market return
Beta < 1.0 Stock's return is less volatile
than the market return
Significance of Beta
High Beta Stocks
More systematic market risk
May be appropriate for high-risk tolerant (aggressive) investors
Low Beta Stocks
Less systematic market risk
May be appropriate for low-risk tolerant (defensive) investors
Individual Stock Betas
May change over time
Tendency to move toward 1.0, the market beta
Portfolio Betas
Weighted average of the individual asset's betas
May be more stable than individual stock betas
Diversification of Risk
Diversification is a technique that reduces risk by allocating
investments among various financial instruments, industries and
other categories. It means reducing risk by investing in a variety
of assets
Effect of diversification on variance
Diversification can lower the variance of a portfolio's return below
what it would be if the entire portfolio were invested in the asset
with the lowest variance of return, even if the assets' returns are
uncorrelated
Ratio of Portfolio
An empirical example relating diversification
Average Standard Standard Deviation
to risk reduction Deviation of Annual
Number of Stocks in
to Standard
Portfolio
Portfolio ReturnsDeviation of a Single
In 1977 Elton and Gruber considered a population
Stock of 3290
securities1 available for possible
49.24% inclusion in a 1.00
portfolio,
and to consider
2 the average risk .Their results0.76
37.36 are
summarized4 in the following table.
29.69 0.60
It can be seen
6 that most of26.64
the gains from diversification
0.54
come for8n≤30. 24.98 0.51
10 23.93 0.49
20 21.68 0.44
30 20.87 0.42
40 20.46 0.42
50 20.20 0.41
400 19.29 0.39
500 19.27 0.39
1000 19.21 0.39
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