Module I

Introduction to Investment Avenues

Part II
Content:
1. Traditional v/s Alternate Investments
2. Introduction to stock markets
3. Concepts of Risk & Return
3. Concepts of Risk & Return:
• Real return, nominal return, historical and expected return, concept of
compounded returns
• Sources of risk, Calculation of Risk

• Cont.…
• Part II PPT.
 Risk and Return
Two Sides of Investment Coin
Return
• Investments are made with the primary objective of deriving
a return

• Represents the reward for making investment

• Two forms of return,

• Income (Current Return)
• The dividend or interest from investment is the yield.

• Capital Appreciation (Capital Return)

• Difference between sale price and the purchase price of the investment

Total Return = Current Return + Capital Return

Return
• Types of return
• Historical Return

• Return provided by the investment in past

• Also known as Holding Period Return (HPR)
• Used to predict the expected return
• Expected Return

• Return which the investment is expected to provide

in future
Measures of
Historical Rates of Return
Compounding Annual Growth Rate
CAGR = [(Ending value/Beginning Value) 1/𝑛 - 1]*100

• Example: 100 Rs. Stock in 2021 turns to 500 Rs. In 2024 than
Compounding Annual Growth Rate:
CAGR = [(Ending value/Beginning Value) 1/𝑛 - 1]*100
= [(500/100)1/3 - 1]*100
= (1.70998 – 1) *100
= 70.998%
 Total Return
Ω The total return on an investment for a given period is

Total Return = Current Return + Capital Return

Cash Payment received during the period + Price Change over the period
Total Return =
Price of Investment at the Beginning

C + ( PE − PB )
R=
PB

• It would give you return in decimal

• Decimal return can be converted into % return by multiplying it by 100
Total Return
Example – 1 :
❖ Price at the beginning of the year is Rs.60
❖ Divided paid at the end of the year is Rs. 2.4
❖ Price at the end of the year is Rs. 69.
❖ Find out total rate of return
C + ( PE − PB )
R=
PB
2.4 + (69 − 60)
R=
60
R = 0.19 or 19%
Total Return
Example – 2 :
❖ Mr. Anand invested Rs.100 in shares of ABC ltd.
Shares would worth Rs.110 after one year.
Dividend of Rs. 4 is expected during the year
What is the total rate of return
C + ( PE − PB )
R=
PB
4 + (110 − 100)
R=
100
R = 0.14 or 14%
Cumulative Wealth Index

• Cumulative Wealth Index (CWI) captures the cumulative

effect of the total return
• Shows the value addition in wealth of investor

CWI = (1 + R1 ) × (1 + 𝑅2 ) × (1 + 𝑅3 ). . . . (1 + 𝑅𝑛 )

R1, R2, R3….= total return in decimal

Cumulative Wealth Index
Example – 3
• Calculate Cumulative Wealth Index for the following
investment

Years Rate of Return

1 0.14
2 0.12
3 -0.08
4 0.25
5 0.02

CWI = (1 + R 1 )(1 + R2 )....(1 + Rn )

CWI = (1.14)(1.12)(0.92)(1.25)(1.02)
= 1.498
Summary Statistics

Mean Historical Rate of Return

Mean Historical Rate of Return
ΩComputing Mean Historical Return
γ Over a number of years an investment is likely to
give high rate of return during some years and low
or negative rate of returns during other years

γ Mean Rate of Return is the average of rates of

return earned during the different periods (years)
Mean Historical Rate of Return
ΩTypes of historical rate of return

Mean Rate of Return

Arithmetic Mean Geometric Mean

Return Return
Mean Historical Rate of Return
• Arithmetic Mean Return:
• When you want to know central tendency of a
series of returns the arithmetic mean is the
appropriate measure

AMR =
 R i

n
where :
R i = Sum of annual returns

n = Number of years
Mean Historical Rate of Return
• Geometric Mean Return:
• Calculated to know the average compound rate
of growth occurred during the multiple period
• Describes accurately the true average return

GM = (1 + R 1 )  (1 + R 2 )  (1 + R 3 )...(1 + R n ) n − 1
1

where :
R = total return in decimal term
n = Number of years
Mean Historical Rate of Return
Ω Example – 4:
γ Consider an investment with the following data:
Year Beginning Value Ending Value
1 100 115
2 115 138
3 138 110.4

γ Calculate,
ὸ Arithmetic Mean Return
ὸ Geometric Mean Return
Ω Arithmetic Mean Return

Year Beginning Ending Value Total Return

Value in Decimal (Ri)
1 100 115 0.15
2 115 138 0.20
3 138 110.4 - 0.20

ΩArithmetic Mean →

AMR =
 R i

n
(0.15) + (0.20) + ( −0.20)
AMR = = 0.05 = 5%
3
ΩCalculate Holding Period return and Holding Period Yield
Year Beginning Value Ending Value Total Return in
Decimal
(HPY)
1 100 115 0.15
2 115 138 0.20
3 138 110.4 - 0.20

ΩGeometric Mean →
GM = (1 + R 1 )  (1 + R 2 )  (1 + R 3 )...(1 + R n ) n − 1
1

GM = 1.15 1.20  0.80 − 1

1
3

1
= (1.104) − 1
3

= 1.03353 − 1
= 0.03353 = 3.353%
Mean Historical Rate of Return
ΩExample – 5:
Ő Consider an investment with the following data:

Year Beginning Value Ending Value

1 50 100
2 100 50

Ő Calculate,
ő Arithmetic Mean Return
ő Geometric Mean Return
ΩCalculate Holding Period return and Holding Period Yield

Year Beginning Ending Value Total Return

Value in Decimal
(HPY)
1 50 100 1
2 100 50 -0.50
ΩArithmetic Mean →

AMR =
 R i

n
(1.0) + ( −0.50)
AM = = 0.25 = 25%
2
ΩCalculate Holding Period return and Holding Period Yield

Year Beginning Ending Value HPY

Value
1 50 100 1
2 100 50 -0.50

ΩGeometric Mean →
GM = (1 + R 1 )  (1 + R 2 )  (1 + R 3 )...(1 + R n ) n − 1
1

GM = 2  0.5 − 1
1
2

= 1.00 − 1
= 0%
Measuring the Risk of Expected
Rates of Return
Measuring the Risk of Expected Rate of Return
• We can evaluate the expected return and risk of an
investment by identifying the range of possible returns
and by assigning probability to each of them
• Though it reflects the dispersion of returns, an investor
would like to quantify the degree of risk involved
• The following two statistical measures can be used to
quantify the degree of risk
• Variance
• Standard Deviation
• Risk can be calculated in two manners
• Historical risk
• Expected risk
Consider following two investments
A B
Years % Returns Years % Returns
1 10 1 11
2 6 2 9
3 10 3 10
4 3 4 11
5 17 5 9
6 5 6 8
7 8 7 9
8 21 8 12
9 13 9 13
10 7 10 8
Mean 10 Mean 10

Which investment has higher risk ???

 A B
Years % Returns Years % Returns
1 10 1 11
2 6 2 9
3 10 3 10
4 3 4 11
5 17 5 9
6 5 6 8
7 8 7 9
8 21 8 12
9 13 9 13
10 7 10 8
Mean 10 Mean 10

Range:
Range = Maximum - Minimum

21 – 3 = 18 13 – 8 = 5
 A
Years % Returns (X-X) (X –X)2
(X)
1 10 0 0
2 6 -4 16
3 10 0 0
4 3 -7 49
5 17 7 49
6 5 -5 25
7 8 -2 4
8 21 11 121
9 13 3 9
10 7 -3 9
Mean 10 282

Variance
 2
=
(X − X ) 2

n −1

282/9 = 31.33
 B
Years % Returns (X-X) (X –X)2

1 11 1 1
2 9 -1 1
3 10 0 0
4 11 1 1
5 9 -1 1
6 8 -2 4
7 9 -1 1
8 12 2 4
9 13 3 9
10 8 -2 4
Mean 10 26

Variance
 2
=
(X − X ) 2

n −1

26/9 = 2.88
• Standard Deviation
=  ( X − X ) 2

n −1

• Investment A
 = 31.33
= 5.59
• Investment B

 = 2.88
= 1.69
Measures of Risk
• Variance:
• It reveals the extent to which return from an
investment may vary from mean expected rate of
return
• Larger the variance greater the uncertainty or risk
• In case of perfect certainty there
is no variance of return
Measures of Risk
• Variance in case of historical return
(Historical Risk):

• When historical return is given

 =2  ( X − X ) 2

n −1
Measures of Risk
• Variance in case of expected return
(Expected Risk):
• When expected return is given

Variance( 2) =
n

 (Probabilit
i =1
y)  (Possible Return - Expected Return) 2

 (P )[R i i − E(R i )] 2
Measures of Risk
• An example – 12
• Calculate the Variance for the following investment
Economic Condition Probability Rate of Return
Strong Economy, No Inflation 0.15 0.20
Weak Economy, Above-average Inflation 0.15 -0.20
No Major Changes in Economy 0.70 0.10

• Expected rate of Return

E ( Ri ) = (0.15)(0.20) + (0.15)(−0.20) + (0.70)(0.10)

= 0.07 = 7%
Economic Condition Probability Rate of Return
Strong Economy, No Inflation 0.15 0.20
Weak Economy, Above-average Inflation 0.15 -0.20
No Major Changes in Economy 0.70 0.10

E ( Ri ) = 0.07
ΩCalculate Variance

 i i
(P )[R − E(R i )]2

= 0.15(0.20 − 0.07) 2 + 0.15(−0.20 − 0.07) 2

+ 0.70(0.10 − 0.07) 2

= 0.002535 + 0.010935 + 0.00063

= 0.0141
Measures of Risk
• Standard Deviation:
őStandard deviation is the square root of
variance
őStandard deviation measures the volatility of
investment returns

=  (P )[R
i i − E(R i )]
2

ő Calculate Standard deviation of return for previous problem

= 0.0141
= 0.11874 = 11.87%
 1 = 11.87% 1 = 11.87 1 = 68.27% Confidence Level
2 = 11.87%  2 = 23.75% 2 = 95.45% Confidence Level
3 = 11.87%  3 = 35.62% 3 = 99.73% Confidence Level

2 1 1 2
-16.75% -4.87% 7% 18.87% 30.75%

In any particular year in 68.27% cases the return would be within the range of -4.874%
to 18.874%
 Coefficient of variation
• While making the investment along with risk the relevant
return must also be considered
• High risk must be compensated by high return
• Coefficient of variation measures the degree of risk per
unit of return

Standard Devaition of Return

Coefficient of variation =
Expected Rate of Return

i
CV =
E(R i )
Lower the coefficient of variation, better the investment
 Coefficient of variation
• An example – 13
• Calculate Coefficient of Variation for the following
investment

Investment A Investment B

Expected Return 0.07 0.12

Standard Deviation 0.05 0.07

i
CV =
E(R)
0.05 0.07
CV A = = 0.714 CVB = = 0.583
0.07 0.12
Expected Return for Risky Investments
An example – 14

State of Probability of Rate of Return Rate of Return on

Economy Occurrence On Bharat Food Oriental Shipping
Boom 0.30 16 40
Normal 0.50 11 10
Recession 0.20 6 - 20

• For both the stocks calculate the followings

• Variance
• Standard Deviation
• Coefficient of Variation
ΩFor Bharat Food Ltd.

Pi (Ri − E ( Ri ) ) 
Economy Pi Ri Pi Ri Ri − E ( Ri ) Ri − E ( Ri )2 2

Boom 0.30 16 4.8 4.5 20.25 6.075

Normal 0.50 11 5.5 -0.5 0.25 0.125

Recession 0.20 6 1.2 -5.5 30.25 6.050

11.5 12.25

Expected Rate of Return E ( Ri ) =  (Pi )(R i ) = 11.5

= 12.25
Variance =  i i
(P )[R − E(R i )]2

Standard Deviation =
 i i
(P )[R − E(R i )]2
= 12.25 = 3.5%

i 3.5
Coefficient of Variation = = = 0.3043
E(R) 11.5
For Oriental Shipping Ltd.

Pi (Ri − E (R) ) 
Economy Pi Ri Pi Ri Ri − E (R) Ri − E (R)2 2

Boom 0.30 40 12 27 729 218.7

Normal 0.50 10 5 -3 9 4.5

Recession 0.20 -20 -4 -33 1089 217.8

13 441

Expected Rate of Return E(R) =  (P )(R ) = 13

i i

Variance =  i i
(P )[R − E(R i )]2
= 441

Standard Deviation =  i i
(P )[R − E(R i )]2
= 441 = 21%

i 21
Coefficient of Variation = = = 1.62
E(R) 13
 Determination of
Required Rate of Return
Determinants of Required Rates of
Return
• The minimum required rate of return must
compensate the investor for,
• Time value of money during the period of
investment
• Expected rate of inflation during the period
• Risk involved
Summation of these three components is called Required Rate of Return
Real v/s Nominal Return

• Real Return

• Real return is the return adjusted for the effect of inflation

• Nominal Return

• Nominal return is the rate of return without adjusting for the effect of inflation
 Adjusting For Inflation

How to convert nominal rate of return in real rate of return ?

 (1 + Nominal RFR) 
Real RFR =  (1 + Rate of Inflation)  − 1
 

Take nominal rate of return and inflation in decimal

 Adjusting for Inflation
Annual Rate of Inflation Nominal Return Real Return
4% 12% 7.69%
6% 12% 5.66%
8% 12% 3.70%
10% 12% 1.82%
12% 12% 0.00%

 (1 + Nominal RFR)  1 + 0.12

 (1 + Rate of Inflation)  − 1 1 + 0.04
− 1 = 7.69%
 
Sources of Risk
• Business risk/Company Risk

• Financial risk

• Liquidity risk

• Exchange rate risk

• Country risk

• Interest rate risk

• Inflation Risk

• Credit Risk
Business Risk/Company Risk
• Risk caused by the nature of a firm’s business

• Sales volatility determine the level of business risk

• Also depend upon the stability and size of business

• For e.g.
• A Company in FMCG Industry
• Low business risk

• A Company in Auto Industry

• High business risk
Financial Risk
• Uncertainty caused by the use of debt financing

• Borrowing requires fixed payments which must be

paid ahead of payments to stockholders.

• The use of debt increases uncertainty of

stockholder income and causes an increase in the
stock’s risk premium.
Liquidity Risk
• Risk caused by the lack of liquidity (Secondary
market)
• Factors to be considered while assessing
liquidity risk
• How long will it take to convert an investment
into cash?
• How certain is the price that will be received?
Exchange Rate Risk
• Uncertainty of return is introduced by acquiring
securities denominated in a currency different from
that of the investor.

• Changes in exchange rates affect the investors

return when converting an investment back into the
“home” currency.
Exchange Rate Risk

• Example:
• An Indian investor buys 50 shares of ABC Ltd. In USA at the price of $100.
When investment is made the rupee dollar exchange rate is 50Rs/$. Investor
sell the shares after one year @ $130 per share. At the time of sale rupee
dollar exchange rate is 45Rs/$.

• Calculate his rate of return in USA and in India

Exchange Rate Risk
• Beginning value of investment
• Dollar : 50 X 100$ = $ 5,000
• Rupee: $5,000 X 50 = Rs. 2,50,000
• Ending value of investment
• Dollar : 50 X 130$ = $ 6,500
• Rupee: $6,500 X 45 = Rs. 2,92,500
6500 - 5000
Return in USA = 100 = 30%
5000
2,92,500 - 2,50,000
Return in India = 100 = 17%
2,50,000
Country Risk/Political Risk
• Political risk is the uncertainty of returns caused by the
possibility of a major change in the political or economic
environment in a country.

• Individuals who invest in countries that have unstable

political-economic systems must include a country risk-
premium when determining their required rate of return
Inflation Risk
• Inflation risk surfaces when the inflation tends to

decrease the purchasing capacity of a currency

• Inflation leads to reduction in the value of money

irrespective of whether it is invested or not

Interest Rate Risk
• The risk that an investment's value will change due to
a change in the absolute level of interest rates

• Interest rate risk affects the value of bonds more

directly than stocks, and it is a major risk to all
bondholders.

• As interest rates rise, bond prices fall and vice versa.

Credit Risk
• The risk of loss of principal or loss of a financial reward

stemming from a borrower's failure to repay a loan or

otherwise meet a contractual obligation.

• The higher the perceived credit risk, the higher the rate of

interest that investors will demand for lending their capital.

• Credit risks are calculated based on the borrowers' overall

ability to repay.
Systematic v/s Unsystematic Risk

• Unsystematic Risk
• Risk caused by company specific factors

• Also known as fundamental or business risk

• Can be reduced by diversification

• Systematic Risk
• Risk Caused by market specific factors

• Can not be reduced by diversification

• Measured by Beta (β)

Example – 18
The probability distribution of the rate of return on a stock is
given below:
State of the Economy Probability Rate of Return
Boom 0.20 30%
Normal 0.50 18%
Recession 0.30 9%

What is the standard deviation of return?

 Solution:

Pi (Ri − E (R) ) 
Economy Pi Ri Pi Ri Ri − E (R) Ri − E (R)2 2

Boom 0.20 30 6 12.3 151.29 30.26

Normal 0.50 18 9 0.3 0.09 0.05

Recession 0.30 9 2.7 -8.7 75.69 22.71

17.7 53.01

 i i
(P )[R − E(R i )]2

Standard Deviation = 53.01 = 7.28%

Example -19
• During past five years the returns of the stock were
as follows
Year Return
1 0.07
2 0.03
3 -0.09
4 0.06
5 0.10
ΩCompute the followings
γ Cumulative Wealth Index
γ Arithmetic mean
γ Geometric Mean
γ Variance
γ Standard Deviation
Cumulative Wealth Index →
CWI = (1 + R 1 )(1 + R2 )....(1 + Rn )
CWI = (1.07)(1.03)(0.91)(1.06)(1.10)
= 1.169

Arithmetic Mean →

AMR =
 R i

n
(0.07) + (0.03) + (−0.09) + (0.06) + 0.10
AM = = 0.034 = 3.4%
5
Geometric Mean →

GM = (1 + R 1 )  (1 + R 2 )  (1 + R 3 )...(1 + R n ) n − 1
1

GM = 1.07 1.03  0.911.06 1.10 − 1

1
5

= 0.032
= 3.2%
Variance →
Period Return (X − X ) ( X − X )2
1 7 3.6 12.96
2 3 -0.4 0.16
3 -9 -12.4 153.76
4 6 2.6 6.76
5 10 6.6 43.56

 =
2 (X − X ) 2
X=
7 + 3 − 9 + 6 + 10
= 3.4
5
n −1
217.2
 = 2
= 54.3
5 −1
Standard Deviation →

=  ( X − X ) 2

n −1

217.2
= = 7.4%
5 −1
Example – 20
The probability distribution of the rate of return on a stock is
given below:

State of the Economy Probability Rate of Return

Boom 0.60 45%
Normal 0.20 16%
Recession 0.20 -20%

What is the standard deviation of return?

 Pi (Ri − E (R) ) 
Economy Pi Ri Pi Ri Ri − E (R) Ri − E (R)2 2

Boom 0.6 45 27 18.8 353.44 212.06

Normal 0.2 16 3.2 -10.2 104.04 20.81

Recession 0.2 -20 -4 -46.2 2134.44 426.888

26.2 659.76

 i i
(P )[R − E(R i )]2

Standard Deviation = 659.76 = 25.69%

Example – 21 →

Assume that during the past year the consumer price index increased
by 1.5 percent and the securities listed below returned the following
nominal rates of return.
U.S. Government T-bills 2.75%
U.S. Long-term bonds 4.75%

1. What are the real rates of return for each of these securities?

2. If next year the real rates all rise by 10 percent while inflation
climbs from 1.5 percent to 2.5 percent, what will be the nominal rate
of return on each security?
 1. What are the real rates of return for each
of these securities?
Real rate on T-bills →

 (1 + Nominal RFR)  1 + 0.0275

 (1 + Rate of Inflation)  − 1 − 1 = 1.23%
  1 + 0.015

Real rate on Bonds →

1 + 0.0475
− 1 = 3.2%
1 + 0.015
2. If next year the real rates all rise by 10 percent while inflation
climbs from 1.5 percent to 2.5 percent, what will be the nominal
rate of return on each security?

• Real rate on T-bills = 1.23 x 1.10 = 1.353%

• Real rate on bonds = 3.2 x 1.10 = 3.52%
Nominal RFR =
(1+Real RFR) x (1+Expected Rate of Inflation) - 1

Nominal rate on T-bills:

(1.01353)(1.025) - 1 = .03886 = 3.89%
Nominal rate on corporate bonds:
(1.0352)(1.025) - 1 = .06108 = 6.11%
Example – 22

You are provided with the following information

• Nominal return on risk-free asset = 4.5%
• Expected return for asset i = 12.75%
• Expected return on the market portfolio = 9.25%

1. Calculate the risk premium for asset i

2. Calculate the risk premium for the market portfolio
Risk Premium = Expected return – Risk Free Return

Risk premium for asset i = 12.75 – 4.5 = 8.25%

Risk premium market portfolio = 9.25 – 4.5 = 4.75%