Chapter-4

1. Concept of Risk and Return

Meaning of Return: - Return refers to the gain or loss an investor realizes from an investment
over a specific period. - It represents the reward for parting with liquidity and
undertaking risk. - Returns may come in two forms: - Current Income: Interest or dividends
received from investments. - Capital Gain (or Loss): Appreciation or depreciation in the
price of the investment.

Meaning of Risk: - Risk is the uncertainty associated with the expected returns of an
investment. - It reflects the possibility that the actual returns may deviate from the expected
returns. - Higher risk is generally associated with higher potential returns, and vice versa.

Risk-Return Relationship: - Investors expect to be compensated for assuming higher risk. -

The Risk- Return Trade-off implies that rational investors will take on higher risk only if they
expect higher returns. - This relationship is typically upward sloping when plotted graphically.

Types of Risk: 1. Systematic Risk: - Also called market risk. - Arises from external factors
affecting all securities, e.g., inflation, interest rate changes, political instability. - Cannot be
diversified away.

1. Unsystematic Risk:
2. Also known as specific or idiosyncratic risk.
3. Arises from factors unique to a company or industry, e.g., management inefficiency,
strikes, product failures.
4. Can be reduced through diversification.

5. Total Risk:

6. Combination of systematic and unsystematic risks.

7. Total variability in returns of an investment.

Key Takeaway:

The goal of the investor is to maximize return while minimizing risk through
effective portfolio selection.

2. Measuring Investment Returns

a) Holding Period Return (HPR): - Measures total return from an investment over the
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 holding period. - It includes both income and capital appreciation. - Useful for comparing
returns over short periods.

b) ReturnsOver Multiple Periods: - Investments held for multiple periods require compounding
or averaging. - Arithmetic Mean Return: Simple average of periodic returns. - Geometric
Mean Return: Reflects compounding and provides a more accurate measure over time.

c) Annualizing Rates of Return: - Converts periodic returns to annual terms for

comparison. - Important when comparing investments with different time horizons.

d) Expected Return: - The weighted average of all possible returns, considering their
probabilities of occurrence. - Represents the mean of the probability distribution of returns. -
Guides investor expectations and decision-making.

e) Time Series of Returns: - Historical record of an investment’s returns over time. - Helps
in assessing trends, consistency, and volatility.

At a Glance:

• Return = Reward for investing.

• Expected Return = Average anticipated outcome.
• Actual Return may vary due to market fluctuations.

3. Inflation and Real Rates of Return

Nominal Return: - The observed return on an investment without adjusting for inflation.

Real Return: - The return adjusted for inflation. - Indicates the true increase in purchasing power.

Relationship:

RealReturn = NominalReturn − InflationRate

Example Concept: - If an investor earns 10% nominal return and inflation is 6%, the real
return is 4%.

Importance: - Real returns reflect actual wealth growth. - Inflation reduces the purchasing
power of money and affects long-term investments. - Investors must focus on real returns for
effective portfolio planning.

Remember:
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 Inflation erodes the value of money; hence, nominal gains may not represent

4. Measuring Risk

Concept: - Risk is measured by the variability or volatility of returns. - It indicates the degree to
which actual returns deviate from expected [Link]: - Measures the dispersion of
returns around the mean (expected) return. - Higher variance means greater volatility and higher
risk.

a) Standard Deviation: - Square root of variance. - Expressed in the same unit as returns
(percentage). - Standard deviation is widely used as the key measure of total risk.

b) Coefficient
of Variation (CV): - Measures risk per unit of return. - Useful for comparing
investments with different mean returns. - Lower CV indicates more favorable risk-return
balance.

Interpretation: - A high standard deviation or variance implies higher uncertainty. - Investors

can compare CV values to select the more efficient investment option.

Key Point:

Risk measurement helps investors evaluate how much uncertainty they can tolerate for a
given expected return.

5. Portfolio Return and Risk

Concept of Portfolio: - A portfolio is a collection of investments held by an investor. - The

objective is to maximize returns and minimize risk through diversification.

Portfolio Return: - Weighted average of expected returns of all securities in the portfolio. -
a)
Weights represent the proportion of total investment in each security.

b)Portfolio Risk: - Not merely the weighted average of individual risks. - Depends on the
correlation between returns of the securities. - Covariance and Correlation: Measure the
degree to which two securities move together.

c) Diversification: - Reduces unsystematic risk by investing in uncorrelated or negatively

correlated assets.
- The overall risk of the portfolio may be lower than the risk of individual securities.

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 d) Portfolio of Risk-Free and Risky Assets: - Investors can combine a risk-free asset (like
government securities) with a risky portfolio. - Creates a linear relationship between expected
return and risk. - This is represented by the Capital Allocation Line (CAL).

e) Risk-Free Asset: - Asset with a certain return and zero risk. - Examples: Treasury bills,
government bonds.

f) CapitalAllocation Line (CAL): - Shows combinations of risk-free and risky assets. - The
slope represents the reward-to-variability ratio (Sharpe Ratio).

Sharpe Ratio (Conceptual):

SharpeRatio = (ExpectedPortfolioReturn − Risk − FreeRate)/PortfolioStandardDeviation

Indicates how much excess return an investor receives per unit of risk.

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