Risk and Return

Basics of Return
The investors invest in any asset in anticipation of return
on the same. In case of financial assets, this can also be
termed as the financial results of the investment or
financial asset. As one of the foremost criteria, an
investor can distinguish different financial assets based
on return on such financial assets.
Returns can be classified as historical or expected i.e.
prospective. Returns can be in absolute value i.e. in
terms of currency and in relative terms i.e. in terms of %.
For example, if an investment purchased one year back
at K120 is sold for K132, the absolute return is K12 and
the relative return is 10% (i.e.12 / 120).
Return in a way represents total gain or loss on
investment. The total gain/ loss can comprise of
periodic return and change in the value of
investment at the end of the holding period.
Hence a basic formula used for calculation of return
can be as below:
Where
 rt is the actual, required or expected return during
period t,
 Pt is the current price,
 Pt-1 is the price during the previous time period, and
 Ct is any cash flow accruing from the investment.

Suppose one has bought a share of ABC Limited

at K300 one year back. Over the last year ABC
has distributed dividend of K5 per share. If the
share of ABC sells at K340 today, what is the
return?
The total return is K45 that comprises of K5 of dividend
and K40 (K340 – K300) in terms of appreciation in the
market price of the share. Hence the % return is K45/K300
i.e. 15%.

In case the share of ABC sells at K280 today what is the

return?

The absolute return (-ve) K15 (i.e. K5 dividend and loss of

K20 in terms of fall in price), which is -5% on original
investment of K300.
Holding Period Returns
The holding period return is the return that an investor
would get when holding an investment over a period of n
years, when the return during year i is given as ri:

Suppose an investment provides the following periodic

return over last five years:
The holding period return on the investment is computed
as below:

This can be interpreted as 56.70% return over five year

holding period. In case an asset does not provide any
periodic return – like annual return in the previous
example – the holding period return (HPR) can be
calculated as below:
Example: A financial asset was purchased at K300 and
it grew to K370 over five year period. The HPR over
three year period is:

This return can be converted to effective annual return

which can also be termed as annual holding period
return or yield as below:
Where, n is the number of years the investment is held.
In the previous example, the annual HPR is:
Expected Return
Unlike historical return, in case of expected returns are
predicted for the future with relevant values being
predicted. The prediction can be for different expected
outcomes. In such case probability is associated with
possible outcomes and expected return from an
investment is estimated.
Suppose there are two shares A and B and rate of returns
in different conditions are expected to be as below:
Risk:
Usually, investment returns are not known with
certainty. In the context of investment, risk is
defined as the chance of suffering a loss. Assets
(real or financial) which have a greater chance of
loss are considered more risky than those with a
lower chance of loss. Risk may be used
interchangeably with the term uncertainty to
refer to the variability of returns associated with
a given asset. The common sources of risk are as
below:
Firm Specific Risks
Business Risk: Investors can be subject to bad
performance of business or the firm due to several
reasons like weak demand for the products/
services, technological changes, supply related
problems, mismanagement.
Financial Risk: This emanates from the fact that the
particular firm has borrowings as its source of
finance. Higher the borrowing, higher is the interest
outflow. In good condition, borrowing helps better
return on shareholders’ funds – an implication of
financial leverage. However in bad condition, borrowing
can harm the firm. Borrowings also invite default risk.
Investor-Specific Risks
o Interest rate risk: Change in interest rates can
affect the value of interest bearing securities. There
is an inverse relationship between interest rate and
value of interest bearing securities like bonds,
debentures, etc. The equity shares are also affected
indirectly by the movement in interest rates.
o Liquidity risk: The investors can have problem in
converting the securities into cash because of
inadequate market or for the fact that the securities
are not listed. Sometimes, irrespective of listing, the
securities are not traded in the market.
Market risk: This is not related to the particular
firm’s performance, but depends upon the overall
market condition being pessimistic or optimistic
because of several underlying factors. During a
bullish period, prices of most of the equity shares
move up and vice versa in bearish period. Market
also moves in cycles.
Firm and Investor Risks
Event Risk: These are the risks caused due to unforeseen
events related to the company or a sector like ad
adverse court judgment, regulatory policy change,
sudden demise of key people of the organization.
Exchange Rate Risk: This risk is caused due to change in
currency rates. Companies having exports as major source
revenue or imports of supplies are vulnerable to this
risk. In the present era of globalization, it is difficult for any
company to be immune to this risk.
oPurchasing-power risk: These are caused by changes in
price level in the country.
Inflationary conditions can affect the firms adversely
because of decrease in demand.
Tax risk: Change in tax rates for companies and/ or
investors can have adverse impact. Sudden change in tax
rules may affect the companies favourably or unfavourably.
Tax being a major element of expense for any company,
adverse change in tax rates can be taxing for the company
concerned.
Unsystematic vs. Systematic Risk
The risks that can be controlled by diversifying the portfolio
of financial assets are known as unsystematic or
diversifiable risk. The risks that cannot be controlled by
investors are known as systematic risk. Market risks are
essentially systematic risk where as investor or firm related
risks can be diversified. Systematic risks affect the
companies across the system.
Risk Preferences: By default investors are risk averse, the
difference among investors is only with respect to the
relative risk averseness. However, based on the preferences
for risk, investors can be classified into three categories as
below:
Risk Neutral
Risk Averse
Risk Seeking

Risk of a Single Asset: Please refer Figure 1.

Which stock – A or B – is more risky compared to
the other? Do note that both the stocks have
same average rate of return of 15%. The return
distribution of Stock B is more flat than that of
Stock A, i.e. the range of possibilities of returns is
more compared to Stock A. From this figure one
can conclude that Stock B is more risky than
Stock A.
Consider the following Assets for which the returns under various
conditions of economy are given.
The G-sec has same return irrespective of the
economic outcome. This appears to be risk free.
Stock 1 moves along with the economy (positively
correlated) whereas Stock 2 moves in opposite
direction of the economy (negatively correlated).
Measuring Risk: the simplest measure of risk is
range which is defined as the difference between
the highest possible return and lowest possible
return. In the above table, the range for Stock 1 is
72.0% whereas for Stock 2 it is 48%. However
standard deviation is considered as one of the very
well accepted measure of risk. Standard deviation is
the square root of variance.
For Stock 1:
σ = ((-22 - 17.4)20.10 + (-2 - 17.4)20.20 + (20 - 17.4)20.40
+ (35 - 17.4)20.20 + (50 - 17.4)20.10))1/2 = 20.0%.