Risk & Return
Financial Analytics Unit 4:Risk & Return 1
Return
Return of investment consist of two
components
Current Return
Capital Return
Total Return = Current Return + Capital
Return
Financial Analytics Unit 4:Risk & Return 2
Risk
Risk means the probability of having adverse
or low returns as compared to the expected
returns.
Risk can broadly classified into two types
Systematic risk [Market risk]
Unsystematic risk [Unique risk]
Total Risk = Systematic Risk +
Unsystematic Risk
Financial Analytics Unit 4:Risk & Return 3
Evaluation of various
investment avenues
Return Risk
Current return Capital return
Government Low Nil Nil
Securities
Post office Moderate Nil Nil
Instruments
Provident/ Nil Moderate Nil
Pension funds
Bank Products Moderate Nil Negligible
Debentures High Negligible Low
Shares Low High High
Mutual Fund Low Moderate High/low
Gold Nil Average Average
Real Estate Low High Negligible
Financial Analytics Unit 4:Risk & Return 4
Systematic Risk
Systematic risk is non diversifiable risk
because it can not be avoided.
It is inherent in almost all the investment
avenues.
Financial Analytics Unit 4:Risk & Return 5
Unsystematic Risk
Unsystematic risk is created due to
industry or company specific factors.
This risk can be diversifiable through
diversification.
Financial Analytics Unit 4:Risk & Return 6
Systematic Risk &
Unsystematic
Systematic Risk Risk Risk
Unsystematic
Inflation risk Business Risk
Interest rate risk Financial Risk
Political risk Risk due to industry-
Market risk
specific policies
Risk due to government
policies
Disputes
Natural Calamities
Scams & Malpractices
Monsoons
Industrial Growth
International Events
Financial Analytics Unit 4:Risk & Return 7
How to reduces the risk?
A portfolio is collection of different securities
“Do not put all your eggs in one basket”.
Investing in more than one share do not
reduces systematic risk, but unsystematic
risk can be reduced
As a result, total risk of portfolio get reduces
Financial Analytics Unit 6:Portfolio Management 8
How does portfolio reduces
the risk?
Financial Analytics Unit 4:Risk & Return 9
Measurement of Historical
return-Individual security
Current Return/yield
Dividend Capital Return
Current Return 100
Purchase Price
D1 (P1 - P0 )
Current Return 100
P0
Usually average [arithmetic mean] return
is considered when several years returns
are given.
Financial Analytics Unit 4:Risk & Return 10
Measurement of Historical
Risk-Individual security
Usually variance or standard deviation is considered for
measurement of risk.
Variance
( R R) 2
Standard Deviation
( R R ) 2
N N
The stock which has low variance/standard deviation is
considered as less risky one & vice versa.
Financial Analytics Unit 4:Risk & Return 11
Measurement of expected
risk & return-Individual
Security
Expected returns are calculated using
probability distribution of expected return.
Probability distribution of rate of return is
The possible outcome must be mutually exclusive
and collectively exhaustive.
The probability assigned an outcome may vary
between 0 to 1. [Impossible-0, Certain-1,
Uncertain-between 0 to 1]
The sum of the probabilities assigned to various
possible outcome is 1.
Financial Analytics Unit 4:Risk & Return 12
Measurement of expected
risk & return-Individual
Security
Expected rate of return is calculated as below
n
E (R) ( R R) 2
i 1
Expected risk is calculated as below
n
pi ( Ri E ( R)) 2
i 1
Financial Analytics Unit 4:Risk & Return 13
Covariation
Covariance reflects the degree to which the
returns of the two securities vary or change
together.
A positive covariance means that the returns
of the two securities move in the same
direction where as a negative covariance
implies that the returns of the two securities
move in opposite direction.
Coefficient of correlation
Correlation coefficient is simply covariance divided
by the product of the standard deviation.
Cov (1, 2)
12
1 2
Where.
. = Correlation of coefficient between returns of the
12
securities 1 & 2
.Cov (1, 2) = Correlation of coefficient between the
securities 1 & 2
. 1 2 = product of standard deviation of the securities 1 & 2.
Coefficient of correlation
The correlation of coefficient can vary between -
1 and +1.
A negative correlation implies two stocks move
in the opposite direction.
A value of 0 means no correlation
A positive correlation implies two stocks move in
the same direction.
The benefit of the diversification arises when the
correlation between the two securities is
negetive.
Calculation of portfolio
return & risk
2-Security case
Return
rp w 1r1 w 2 r2
Risk
2 2 2 2 2
p w 1 1 w 2 2 2w 1w 212 1 2
Where
o W1,W2 =Weight of security I & 2 in portfolio
o R1,R2 = mean return of security 1 & 2
o 1 2 = Standard deviation of security 1 &2.
Beta
Beta is a measure of a stock's volatility in
relation to the market.
Beta of individual stock is calculated by using
below formula
Cov (M, X)
x
2M
Where.
x = Beta of Stock X
.
Cov
. (M, X) = Covariance between market & stock X
.2
M = Variance of Market
Beta
By definition, the market has a beta of 1.0, and
individual stocks are ranked according to how
much they deviate from the market.
A stock has beta above 1.0 indicates stock's price
is more volatile than the market [riskier but provide
a potential for higher returns]-AGGRESSIVE stock
A stock has beta equal to 1.0 indicates stock's
price is as volatile as the market [safer but provide
a potential for market returns]-NEUTRAL stock
A stock has beta below 1.0 indicates stock's price
is less volatile than the market [less risk but also
lower returns.]-DEFENSIVE stock
Financial Analytics Unit 4:Risk & Return 19