Chapter 4 : Fundamentals of Risk & Return.
Return - Return is the reward for investment
o Components of return
Current Income
o Income realized in cash periodically from an investment. Eg Dividend, Interest.
Capital Gain
o Arise due to difference in sales value and purchase value.
o Capital gain (loss) = Ending value – Beginning value.
o Total Return = Capital gain (loss) + Current Income
Capital gain yield Current yield
o Total rate of return(HPR)= + = X 100
P0 = Beginning value
P1 = Ending value
C1 = Current income (dividend)
HPR = Holding Period Return
Return and Risk(𝜎).
Historical Data (past years data) Data with probability(future data)
Average or Expected Return
E(Ra) (Higher is better)
Variance ̅̅̅̅
Std Deviation(𝜎 )- Risk ̅̅̅̅ √
𝜎=√ √
(Lower is better)
cannot be negative.
Covariance [Cov(Ra,Rb)] ̅̅̅̅ ̅̅̅̅
Correlation ρ=
(Negative correlation is better)
Coefficient of Variation CV = (It measures risk per unit of return).
(Lower is better)
-It is rate of return that would result in NPV of zero.
IRR for single cash flow IRR for a stream of cash flows
IRR = LR + (HR – LR)
IRR(yield)
or
IRR = LR + (HR – LR)
IRR = >Required rate of return -Accepting the project (increases shareholder wealth)
IRR < Required rate of return Do not accept project
Traditional approach of Portfolio Management.
o It is a method of managing portfolio that emphasizes on holding stocks of popular company to
reduce risk.
Modern Portfolio
o Portfolio: An investment into more than one asset
o Diversification : An investment into 2 or more risk class assets. Mix garera paisa sabai ma laune to reduce risk
Low risk investment Moderate risk invt High risk invt
Treasury Bills Long term bonds Stocks
Compiled by- Vishal Thapa
o Risk can be defined as probability of happening some unfavorable events in future. Higher
deviation(𝜎) higher will be risk. Std deviation is used to measure total risk of investment.
o Correlation
It shows strength of relationship between 2 stocks. It lies between (-1 to +1).
Types of correlation
o Perfect positive correlation (ρ = +1). (Return Move in same direction)
o 𝜎 p = (𝜎 a X wa) + (𝜎 b X wb).
o Perfect negative correlation(ρ = -1) . It eliminates risk. i.e. 𝜎 p = 0
o 𝜎 p = (𝜎 a X wa) - (𝜎 b X wb).
o Uncorrelated (ρ = 0)
o 𝜎p= 𝜎 𝜎
o Expected Return of Portfolio
E(Rp) = E(Ra) x Wa + E(Rb) x Wb
o Wa= Weight of stock A =
o Wb= Weight of stock B =
o Wa + Wb = 1
o Portfolio Standard Deviation
If 2 assets Remember formula
𝜎p=√ 𝜎 𝜎
or
𝜎p= √ 𝜎 𝜎
Capital Asset Pricing Model (CAPM)
o CAPM describes the relationship between risk & return for securities.
As per CAPM required rate of return (Rj / Ke) is Decision:
E(Rj) = Rf + (E(Rm) – Rf) βj If ER > Rj means Undervalued (sasto) - Buy
RP= Risk Premium If ER < Rj means Overvalued(mahango)- Don’t buy
Rf = Risk free rate(Treasury Bill) If ER = Rj - Indifferent.
E(Rm) = Market Return
(E(Rm) – Rf) = market risk premium ER means expected return.(pauchu)
Rj = Required return(chahiyo)
βj = Beta of asset j
o As per CAPM there are Total risk = Systematic Risk + Unsystematic Risk
Systematic Risk Unsystematic Risk
(Non diversifiable risk) (Diversifiable Risk)
Market related risk Company specific risk.
It can’t be avoided Can be avoided with help of diversification.
Eg: Interest rate, inflation. Eg: poor management, labor strike.
o Beta – it is a measure of systematic risk.
In CAPM, we find out relationship of each stock with market. Such relationship is called Beta.
How to calculate Beta
Case I : If only 2 years data are given Case 2: If more than 2 years data given
β= β=
or
β= Correlation of asset & market
Compiled by- Vishal Thapa
Beta of stock 2 means if market changes by 1% then stock return change by 2%.
Beta of market is 1.
If β = 1 (Average beta). Assets having average beta is called average asset.
If β > 1(Aggressive beta). Assets having aggressive beta is called aggressive asset.
If β < 1(Defensive asset). Assets having defensive beta is called defensive asset.
Direction of stock
If β > 0 (β is positive)- Assets return move in same direction of market.
If β < 0 (β is negative)- Assets return move in opposite direction of market.
Beta of portfolio (βp) = wa βa + wb βb
Security Market Line(SML)
o It is a visual representation of CAPM that plots expected return of asset against Beta.
o It helps to decide whether to include securities in portfolio
Buy Underpriced security & sell overpriced security.
Slope of SML = (Reward to Risk Ratio-Tells about Risk premium per unit of risk)
o Types of Investors
Risk averse investor: A risk-averse investor is someone who prefers to minimize risk and
avoid uncertainty when making investment decisions.
Risk Indifferent investor: A risk-indifferent investor is someone who is neither particularly
averse to nor enthusiastic about taking on risk.
Risk seeking investor: A risk-seeking investor is someone who actively seeks investments
with higher levels of risk, often in the hope of achieving higher returns.
Compiled by- Vishal Thapa