Risk and Return

Risk & Return

Return
 Financial performance of an investment. The extra money that can be earned through
investment.
 The Capital Allocation Process
 The total gain or loss experienced on an investment over a given period of time; calculated
by dividing the asset’s cash distributions during the period, plus change in value, by its
beginning-of-period investment value.
Doller return= Amount received -Amount investment
Rate of return= (Amount received -Amount investment)/ Amount invested

 Types of Return
 Capital gains
 Dividends
 Interest
 Rental income
 Return from currency trading
 Risk
 The chance that some unfavorable event will occur.
 The chance of financial loss or,more formally, the variability of returns
 The Capital Allocation Process
associated with a given asset.
 Risk

 The Capital Allocation Process

• Financial risk involves the simultaneous existence of three
important elemnets in a risky situation-
a)that someone is adversely affected by the happening of
an event,
b) the assests or income is likely to be exposed to a
financial loss from the occurrence of the event and
c) the peril can cause the loss.

• When the possibility of a financial loss does not exist ,the

situation can be referred to an non-financial in nature.
 Risk

• Pure risk situation are those where there is a possibility of

loss or no [Link] is no gain to the individual or the
 The Capital Allocation Process
organization

• Speculative risk are those where there is possibility of gain as

well as [Link] element of gain in inherent or structuredin
such a situation
• Dynamic risks are those resulting from the changes in the economy
or the environment .These risk factors mainly refer to the macro
economic variables like inflation,income and output levels,and
technology changes.

• Static risks are more or less predictable and are not affected by the
economic conditions.
 Risk

 The Capital Allocation Process

 Risk Preference

Economists use three categories to describe how investors respond to risk.

1) Riskaverse- The attitude
The Capital Allocation Processtoward risk in which investors would require an
increased return as compensation for an increase in risk.

2) Risk neutral- The attitude toward risk in which investors choose the
investment with the higher return regardless of its risk.

3) Risk seeking- The attitude toward risk in which investors prefer investments
with greater risk even if they have lower expected returns.
 Risk Preference

 The Capital Allocation Process

 Risk

An asset’s risk can be analyzed in two ways:

(1) on
a stand-alone basis, where the asset is considered by itself
The Capital Allocation Process
and
(2) on a portfolio basis, where the asset is held as one of a number of assets
in a portfolio.
 Risk of single assest(Understanding of risk)
1. Risk assessment
a) Scenario Analysis-An approach for assessing risk that uses several possible
alternative

outcomes (scenarios) to obtain a sense of the variability among returns.
The Capital Allocation Process

b)Probability Distributions-Probability distributions provide a more quantitative

insight into an asset’s [Link] probability of a given outcome is its chance of occurring.
 Risk of single assest(Understanding of risk)

i. Bar chart-The simplest type of probability distribution; shows only a limited number of
outcomes and associated probabilities for a given event.
 The Capital
ii. Continuous Allocation
probability Process
distribution-A probability distribution showing all the possible
outcomes and associated probabilities for a given event.
 Risk of single assest(Understanding of risk)

2. Risk measurement
a) Standard deviation-The most common statistical indicator of an asset’s risk; it measures the
 around
dispersion theAllocation
The Capital expected Process
value.
 Risk & Return
b)coefficient of variation (CV)-A measure of relative dispersion that is useful in
comparing the risks of assets with differing expected returns.

 The Capital Allocation Process

Risk of a Portfolio
1. Portfolio return and SD-The return on a portfolio is a weighted average of the returns on
the individual assets from which it is formed.
 Risk & Return
2. Correlation-A statistical measure of the relationship between any two series of numbers.

 The Capital Allocation Process

3. Diversification- The concept of correlation is essential to developing an efficient portfolio. To

reduce overall risk, it is best to diversify by combining, or adding to the portfolio, assets that have the
lowest possible correlation.
 The capital asset pricing model (CAPM)

Capital asset pricing model(CAPM)-The basic theory that links risk and return for all
assets. 
The Capital Allocation Process
- (CAPM) links nondiversifiable risk to expected [Link] total risk of a security can
be viewed as consisting of two parts:
Total security risk = Nondiversifiable risk + Diversifiable risk

Total security risk -The combination of a security’s nondiversifiable risk and

diversifiable risk.
 The capital asset pricing model (CAPM)

diversifiable risk-The portion of an asset’s risk that is attributable to firm specific,

randomcauses; can be eliminated through diversification. Also called unsystematic
The Capital Allocation Process
risk.

Examples -A labor strike at a manufacturing plant, a major lawsuit against a drug

company, a product recall, a sudden change in company management.

nondiversifiable risk -The relevant portion of an asset’s risk attributable to market

factors that affect all firms; cannot be eliminated through diversification. Also called
systematic risk.

Examples A recession or economic downturn, a change in interest rates by the central

bank, a surge in inflation, or a new war or geopolitical crisis.
 The capital asset pricing model (CAPM)

 The Capital Allocation Process

 Risk & Return

Beta-the amount of risk in the market is called a single beta.

Beta coefficient (b)-A Allocation
 The Capital relative measure
Process of nondiversifiable risk. An index of the degree of movement of
an asset’s return in response to a change in the market return.
 Risk & Return
Practice problem
Problem-1
Security A and B have the following distribution
Year  The Capital
Return onAllocation Process Return on Security -A
Security -A
2014 25% 30%
2015 22% 25%
2016 19% 20%
a) Calculate Average return,standard daviation and covariation of varriance of two securities.
b) Which security is more risky?

Problem-2
Security X & Y have the following distribution
Probability - 10% 30% 40% 20%
X - 15% 20% 10% 5%
Y - 25% 30% 35% 40%
An investor seeks your opinion as to which security he should invest? Give your opinion on the basis of
CV.
 Risk & Return
Problem-3
The following information is available
Detail Stock -X Stock-Y
 The Capital Allocation Process
Expected return 16% 17%
Standard Deviation 8% 5%
Coefficient of correlation is 0.50
Required :
a) Co-variance between stock X and Y.
b) Expected return and Risk portfolio in which X and Y have an equal weight.

Problem-4
RFL company Ltd has a beta of 1.6. The risk free rate of return is 8% and risk premium is 6%. Determine
the cost of common stock of RFL Company Ltd using CAPM.
 Risk & Return
Problem-5
A firms risk free rate is 7% .The rate of return on the market is 14% and a beta is 0.65. What is the
expected return based on the CAPM. If another stock has an expected return on 24% ,what will be its
 The Capital Allocation Process
Beta?

Problem-6
At present ,Suppose the risk free rate is 12% and the expected returns on the market portfolio is 16%.
The expected returns for the four stock enlisted together with their expected beta:-
Portfolio Average return Beta
A 18% 1.35
B 15% 0.85
C 16% 1.20
D 20% 1.75
On the basis of these expectations which stocks are over valued and under valued?
 Thank
you