Dr. Rajinder S.
Aurora
Concept of Return
Reward expected by an investor from an investment Rate of return helps make investment decisions Analysis of Historical returns gives a feel of how the
investment is doing
Historical returns also help in estimating future returns
Types of Returns
Realized Return:
Return that was or could have been earned Also known as Ex-post For Example: An investor takes a FD with HDFC Bank
for Rs.1,00,000/- with one year duration. On maturity he gets back Rs.1,08,000/-. The realized return in this case is Rs.8,000/- or 8%
Types of Returns
Expected Return:
Return anticipated from an investment over some
future period
May be earned or not due to risk or uncertainty
involved
Investor seeks compensation for the uncertainty by
expecting higher returns to off-set the risk
Difficulty to precisely determine the rate of return
Components of Returns
Periodic cash receipts or income in the form of
interest or dividends known as Yield
Appreciation / Depreciation in the value of the asset
over a period of time known as Capital Gain / Loss
General expectation is latter should be greater than
the former
Measuring Rate of Return
Rate of Return represents the total return received by the
investor during the holding period of the investment
Difference between the price of the security at the
beginning and end of the holding period
Expressed as a percentage of the purchase price of the
investment at the beginning of the holding period
Calculating Rate of Return
Rate of return is calculated as:
Dt + Pt Pt-1 k = -----------------Pt-1
Where, k = Rate of Return Pt = Price of the Security at time t at the end of the holding period or purchase price Pt-1 = Price of the security at time t-1at the beginning of the holding period or purchase price Dt = Income or cash flows receivable from the security at time t
Securitys Rate of Return
Return of Shares:
Income by way of dividend Appreciation or Depreciation
Return on Bond/Debt Security:
Income by way of interest based on coupon rate
Appreciation or Depreciation
Probabilities and Rates of Return
Can never be greater than 1 Sum of all probabilities should be equal to 1 Probability can never be negative Possible outcomes are assigned probability of 1 and
impossible outcomes are assigned probability of 0 Possible outcomes must be mutually exclusive and collectively exhaustive
Risk and Expected Rate of Return
Chance that the actual outcome of the event shall differ
from the expected outcome
Wider the probability greater the risk or greater the
variability of returns
Sources of Risk
Interest Rate Risk
Market Risk Inflation Risk Business Risk Financial Risk
Liquidity Risk
Types of Risk
Non - Diversifiable Risk or Market Risk Factors Diversifiable Risk or Specific Risk Factors
Major Changes in tax rates War and other calamities Changes in Inflation rates Change in Economic Policy Industrial Recession Changes in Oil prices
Company Strike Bankruptcy of Suppliers Death of Key Company
Officer
Unexpected entry of a new
competitor
Risk Reduction through Diversification
Total Risk of the Portfolio Risk
Diversifiable Risk
Non Diversifiable Risk
Number of Securities in the Portfolio
Beta
Measure of the non diversifiable risk of an asset relative
to that of the market portfolio
Beta 1 indicates an asset of average risk Beta greater than 1 indicates above average risk Beta lesser than 1 indicates below average risk
Beta of a portfolio is weighted average of the betas of
securities that constitute the portfolio
Measurement of Risk
Relationship between return of a security and return on
the market described using Linear Regression
Slope of the Regression reflects responsiveness of the
security to the general market and indicates securitys behavior vis--vis the market return
Beta Coefficient is the ratio of the securitys covariance
of return with the market to the variance of the market
Capital Asset Pricing Model (CAPM)
Developed by William Sharpe, John Lintner and Jan
Mossin
Establishes a linear relationship between the required rate
of return of a security and it systematic or un -
diversifiable risk or beta
Assumptions
Investors are risk averse and use expected rate of return
and standard deviation of return as appropriate measures of risk and return for their portfolio Greater the perceived risk the higher is the return expected by the investor Decision based on single-period horizon i.e. immediate time period Transactions costs are low and hence ignored Assets can be bought and sold in any unit desired Taxes do not affect the choice of buying assets Assets can be bought at the going market price
Relevance of CAPM
Helps precisely define risk-return trade-offs
Expected rate can also be thought of as a required rate of
return because market is assumed to be in equilibrium Expected rate is anticipated return and required rate is rate expected to induce investors' to invest Investors can invest in risk free securities like treasury bills Risk averse nature makes them expect compensation for risk taken CAPM provides measure for risk premium
Security Market Line
Developed by Modern Portfolio theory SML provides framework for evaluating whether high-risk stocks are
offering returns more or less in proportion to their risk and vice versa
Risk measured using beta values
Ex-post (after the fact) used to evaluate performance of Portfolio
Manager, Test theories such as CAPM and test market efficiency
Ex ante SML used to identify undervalued security and price of risk
implicit in the current market prices.
Contd.
Helps determine whether security is under priced or over
priced using the value of alpha
Alpha is the intercept of the fitted line and indicates what
the return of the security will be when the market return
is zero.
For Example if alpha of a security is + 5 %, it implies
that the security return would be 5% even when market return is zero.