Introduction to Risk and Return

Agenda:
The concepts of return measuring the rate of returnreturn risk Risk and expected and Return Concepts Sources of Risk Portfolios and riskthe Capital Asset Pricing Model (CAPM)

Risk and Return

What are investment returns?

Investment returns measure the financial results of an investment. Returns may be historical (Realized) or prospective (anticipated). Returns can be expressed in: zDollar (Rupee) terms. zPercentage terms.

What is the return on an investment that costs $1,000 and is sold after 1 year for $1,100? Dollar return: $ Received - $ Invested $1,100 $1,000 = $100.

Percentage return: $ Return/$ Invested $100/$1,000 = 0.10 = 10%.

How to measure return ?

Shares of company A Ltd. were purchased for Rs.3580 and were sold for Rs.3800 after one year and dividend of Rs.35 was paid for the year how much is rate of return ?

35 + (3800 3580 ) = 3580 Initial capital = 7 . 12 % Invested.

Capital appreciation In value of security

Therefore RETURNS are measured as Dividend / Interest regular cash flow Change in the value of stock over t -time

k=

Value of stock in beginning

Dt + ( Pt Pt 1) Pt 1

Expected returns
z

The anticipated income over some future period and may be subject to certain risk or uncertainty is expected return. K = P1K1 + P2 K2 + ---------------- + PnKn

Suppose in case of Alpha Ltd, following information Possible Outcomes (i) 1 2 3 4 5 Probabilities of Rate of Return Occurrence (Pi) (%) (Ki) 0.10 50 0.20 30 0.40 10 0.20 -10 0.10 -30 1.00

Expected Return =(0.1)(0.5) +(0.2)(0.3) +(0.4)(0.1)+ (0.2)(- 0.1)+(0.1)(-0.3) =0.05+0.06+0.04-0.02-0.03 =0.10 = 10%

Assume the Following Investment Alternatives

Economy Recession Below avg. Average Above avg. Boom Prob. T-Bill 0.10 0.20 0.40 0.20 0.10 1.00 Alta Repo 28.0% 14.7 0.0 -10.0 -20.0 Am F. MP

8.0% -22.0% 8.0 8.0 8.0 8.0 -2.0 20.0 35.0 50.0

10.0% -13.0% -10.0 7.0 45.0 30.0 1.0 15.0 29.0 43.0

Calculate the expected rate of return on each alternative. ^ r = expected rate of return.

r=

rP .
i i

i=1

^ = 0.10(-22%) + 0.20(-2%) r Alta + 0.40(20%) + 0.20(35%) + 0.10(50%) = 17.4%.

Alta Market Am. Foam T-bill Repo Men

^ r 17.4% 15.0 13.8 8.0 1.7

Alta has the highest rate of return. Does that make it best?

What is unique about the T-bill return?

The T-bill will return 8% regardless of the state of the economy. Is the T-bill riskless? Explain.

Do the returns of Alta Inds. and Repo Men move with or counter to the economy?
Alta Inds. moves with the economy, so it is positively correlated with the economy. This is the typical situation. situation Repo Men moves counter to the economy. Such negative correlation is unusual.

What is investment risk?

Typically, investment returns are not known with certainty. Investment risk pertains to the probability of earning a return less than that expected. The greater the chance of a return far below the expected return, the greater the risk.

Calculation of risk
Probability Distribution Range Variance Standard deviation

Probability distribution method graphical method

Probability

Rate of return

0.1 0.2 0.4 0.2 0.1

50% 30% 10% -10% -30%

PROBABILITY

Say if following data is given to you ,of Alpha ltd.,

RETURN

Since the dispersion is near the y axis and not spread over, hence, the risk in this company is very low.

Probability distribution method graphical method

Probability

Rate of return

0.1 0.2 0.4 0.2 0.1

70% 50% 10% -30% -50%

PROBABILITY

Say if following data is given to you ,of Beta ltd.

RETURN

Since the dispersion is far from the y axis and spread over the risk in this company is very high

Range
It is the difference between the highest and the lowest value of rate of return It is based on only two extreme values. ( -30%) 30%) Range for Alfa ltd = 50% ( = 80% Range for Beta ltd= 70% - (-50%) =120% . So beta is more risky

What is the standard deviation of returns for each alternative?

= Standard deviation = Variance =
= r r
i =1 i n
2

Pi .

Calculate risk in Alpha ltd. Outcomes Return (ri%)

(ri r )

( ri r ) 2

Pi

r r 2 Pi

1 2 3 4 5

50% 30% 10% -10% -30%

0.1 0.2 04 0.4 0.2 0.1 Total

P (r r)
i

i =1

r = 10 %

Calculate risk in Alpha ltd. Outcomes Return (ri%)

(ri r )

( ri r ) 2

Pi

r r 2 Pi

1 2 3 4 5

50% 30% 10% -10% -30%

40 20 0 -20 -40

1600 400 0 400 1600

0.1 0.2 04 0.4 0.2 0.1 Total

160 80 0 80 160 480

P (r r)
i

= 480 = 21.9%

i =1

r r
i =1 i

Pi .

Alta Inds: = ((-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%. T-bills = 0.0%. Alta = 20.0%. Repo = 13.4%. Am Foam= 18.8%. Market = 15.3%.

Expected Return versus Risk Security Alta Inds. M k t Market Am. Foam T-bills Repo Men Expected return 17.4% 15 0 15.0 13.8 8.0 1.7 Risk, 20.0% 15 3 15.3 18.8 0.0 13.4

 Standard deviation measures the stand-alone risk of an investment. The larger the standard deviation, the higher the probability that returns will be far below the expected return. Coefficient of variation is an alternative measure of stand-alone risk.

Coefficient of Variation: CV = Standard deviation/expected return

CVT-BILLS CVAlta Inds CVRepo Men CVAm. Foam CVM = 0.0%/8.0% = 20.0%/17.4% = 13.4%/1.7% 13 4%/1 7% = 18.8%/13.8% = 15.3%/15.0% = 0.0. = 1.1. = 7.9. 79 = 1.4. = 1.0.

Expected Return versus Coefficient of Variation Security Alta Inds Market Am. Foam T-bills Repo Men Expected return 17 4% 17.4% 15.0 13.8 8.0 1.7 Risk: 20 0% 20.0% 15.3 18.8 0.0 13.4 Risk: CV 11 1.1 1.0 1.4 0.0 7.9

Variance
It is the sum of the squared deviation of each possible rate of return from the expected rate of return multiplied by the probability that the rate of return occurs.

P (r r )
i

i =1

How to reduce risk ?

If I invest in a company trading in sunglasses my normal observation would be that I experience good profits in summer and loss in rains If I invest in a company trading in raincoats I would experience good profits during rainy season and losses during summers.

Portfolio
Keep all types of assets like equity,
- bond, saving account - real estate - bullions - collectibles and other assets.

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I have to invest in two companies

There are two companies Company A and Company B. The return from Company A is 12% and Company B is 18% The standard deviation of A is 16% and 24% Then how much will I invest in A and how much in B i.e. The weights assigned to each will decide my total risk and return factor.

What will be the return and risk if I invest 50:50 in company A and company B
A . 15 % return and 20 % risk B. 15 % return and 4 % risk C. 15 % return and 14.42 % risk The answer will depend on the relationship between Company A and Company B

Formula to calculate risk in portfolio is standard deviation of the portfolio

Standard deviation of The security Relationship of f The two securities

2 2 2 2 2 p =x wx + y wy + 2wx wy Co varxy 2 2 2 2 =x wx + y wy + 2wx wy x y Corxy

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Risk can be reduced through diversification

leading companies in pharmaceutical industry. Portfolio risk will be calculated as the addition of the risk of the securities in the portfolio. Say, in given case

2 p

Perfectly positively coco-related ex. Two

= =

2 x 2 x

2 wx + 2 wx +

2 y 2 y

w2 y + 2 w x w y C o v a rxy w2 y + 2 w x w y x
y

C o rxy

=(0.5*16)2

+ = 0.5*16 + 0.5*24

(0.5*24)2

+ 2 *0.5*16*0.5*24* 1

= 20%
No advantage of diversification

Risk can be reduced through diversification

companies in raincoat and sunglass industry. Portfolio risk will be calculated as the difference of the risk of the securities in the portfolio. Say, in given case

2 p

Perfectly negatively co co-related ex. Two

= =

2 x 2 x

2 wx + 2 wx +

2 y 2 y

w2 y + 2 w x w y C o v a rxy w2 y + 2 w x w y x
y

C o rxy

=(0.5*16)2

+ = 0.5*16 - 0.5*24

(0.5*24)2

- 2 *0.5*16*0.5*24* 1

= 4%
Huge advantage of diversification

Risk can be reduced through diversification

steel and fertilizer industry. Portfolio risk will be calculated by following method. Say, in given case

2 p

Perfectly not co co-related ex. Two companies in

= =

2 x 2 x

2 wx + 2 wx +

2 y 2 y

w2 y + 2 w x w y C o v a rxy w2 y + 2 w x w y x
y

C o rxy

=(0.5*16)2

+ + 2 *0.5*16*0.5*24* 0 =(0.5*16)2 + (0.5*24)2

(0.5*24)2

= 14.42%
Advantage of diversification to some extent

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RISK
DIVERSIFIABLE/ unique risk
Strikes Increase in competition Technical breakdown or obsolescence Inadequate raw material Change in management. Loss of a big contract etc.

NON DIVERSIFIABLE or systematic risk

Changes in government policies monetary policy, fiscal policy, foreign policy, corporate taxes War Earthquake, floods, rains, tsunamis etc.

Stand-alone = Market + Diversifiable . risk risk risk

Market risk is that part of a securitys stand-alone risk that cannot be eliminated by diversification.

Firm-specific, or diversifiable, risk is that part of a securitys stand-alone risk that can be eliminated by diversification.

Hence though initially the risk gets diversified, due to some systematic or market risk the diversification cannot completely negate the risk

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Risk Reduction through diversification. The effect reduces with Diversifia ble Risk

No change in market risk Non diversifiable Risk

Increase in the portfolio size Number of securities in portfolio

Calculation of risk of a stock/ portfolio with respect to market

We try to fit a line to find the systematic relationship (linear) between the return of security and the return of market. As p per model of William Sharpe p it is Relation between the expressed as
Return on Security J

market security and the security k

kj = j + jkm

How are betas calculated?

In addition to measuring a stocks contribution of risk to a portfolio, beta also which measures the stocks volatility relative to the market.

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How is beta interpreted?

If b = 1.0, stock has average risk. If b > 1.0, stock is riskier than average. If b < 1.0, stock is less risky than average. Most stocks have betas in the range of 0.5 to 1.5. Can a stock have a negative beta?

Capital Asset Pricing Model

The capital asset pricing model (CAPM) is a model that provides a framework to determine the required rate of return on an asset and indicates the relationship between return and risk of the asset asset. Assumptions of CAPM
Market efficiency Risk aversion and mean-variance optimisation Homogeneous expectations Single time period Risk-free rate

Capital Asset Pricing Model

kj = kf + j (km kf )

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Security Market Line

For a given amount of systematic risk (), SML shows the required rate of return
E(Rj)

E(R ( j ) = R f + [( (R m ) R f ] j
SML

Rm Rf

1.0

= (covarj,m/2m)

EXPECTED / REQUIRED RATE OF RETURN ON Y AXIS

Km

RISK PREMIUM FOR UNCERTAINTY

Rf

Defensive securities

Beta 1.0

Aggressive securities

Can an investor holding one stock earn a return commensurate with its risk? No. Rational investors will minimize risk by holding portfolios. They bear only market risk, so prices and returns reflect this lower risk. The one-stock investor bears higher (stand-alone) risk, so the return is less than that required by the risk.

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Calculating Beta in Practice

Many analysts use the S&P 500 to find the market return. Analysts y typically yp y use four or five y years of monthly y returns to establish the regression line. Some analysts use 52 weeks of weekly returns.

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