RISK AND RETURN Two Sides of the Investment Coin

RETURN
Return is the primary motivating force that investment. drives

The return of an investment consists of two components:

Current return Capital return

Elements in Return
Periodic cash receipts Change in the price of the asset

Total = Cash Payments + Price change Return Recd. over the period Purchase Price of the asset

Arithmetic return

X = x n

Security Return
In general, the return of a security can be calculated to be, Todays Price- Yesterdays Price 100 Yesterdays Price *

RISK
Risk refers to the possibility that the actual outcome of an investment will deviate from its expected outcome. Risk is defined as the deviation from the expected value It is measured by the variability of returns 2 types: Systematic and Unsystematic

Systematic Risk
Affects the market as a whole Non-Diversifiable It is that portion of total variability in returns caused by factors affecting the prices of all securities Caused due to economic, political and sociological changes Examples: (a) Wide spread economic recession-Great Depression of 1929 (b) A bullish rally (c) Inflation

Systematic Risk-Market risk

Change in investor expectations due to alternating forces of bull and the bear market These forces could be either tangible such as earth quake, war (or) Intangible such as the herd behavior

Systematic risk-Interest rate risk

Associated with fluctuation in interest rates Fluctuation in interest rates causes uncertainty of future income Interest rate fluctuations can occur because of changes in monetary policy

Implications of interest rate fluctuations

Affects Margin trading Allows investor to switch from debt to equity and vice-versa Companies like FIs ,banks are directly affected Affects companies that run on borrowed funds

Systematic risk-Purchasing power risk

Caused by the loss of purchasing power i.e. Inflation Variation in the returns Inflation may be because of 1)Demand Pull 2) Cost push

Unsystematic Risk
Unique to particular industry or company Diversifiable Caused due to inefficient management, efficient technology, change in consumer preferences, availability of raw materials, labor problem etc.

Unsystematic Risk-Business Risk

Caused by the operating environment of the business Arises from inability of the firm to maintain its competitive edge and the growth and stability of earnings Types: 1)Internal Business risk 2)External Business risk

Internal Business risk

Personnel management-Labor strike etc R & D-Product obsolescence and new product development Fixed cost Single product Fluctuation in the sales

External Business risk

Social and Regulatory factors Political risk Business Cycle Demographic conditions

Financial Risk

Associated with the debt-equity ratio of the company In the case of debt , interest paid is tax deductible

Default

risk Liquidity risk Forex risk

Measurement of Risk
Traditional approach through probability estimates: R= Pi O i 2= Pi (O i R)2 =2 i=1,2,n R=expected return 2=Variance of the expected return =Standard deviation of the expected return P=probability O=Outcome N=total number of different outcomes

MEASURING HISTORICAL RISK

n (Ri - R)2 1/2 t =1 = n -1
DEVIATAION SQUARE OF

PERIOD RETURN DEVIATION Ri (Ri - R) 1 15 5 2 12 2 3 20 10 4 -10 -20 5 14 4 6 9 -1 Ri = 60 R = 10 (Ri - R)2 2 =

(Ri - R)2 25 4 100 400 16 1 (Ri - R)2 = 536

= 107.2

= [107.2]1/2 = 10.4

Risk in a contemporary notation

Total Risk=DR+N-DR

is the measurement of Systematic or Non-diversifiable risk measures the sensitivity of a particular stock as compared to the market If =1,stock moves along with the market >1,Aggressive stock < 1, Defensive stock

Graphical Representation
Plot the corresponding Sensex and market price of the stock of a particular company say ABC Find the Line of Best Fit This line is called the Characteristic Regression Line (CRL) : The slope of CRL is

Graph

Mathematical Model
The equation of the CRL is Which can be equated to y=x+ Using the method of Least Squares, we get the values of and Where, = n x y- x y n x2 (x )2 and = y- x

MEASURING EXPECTED (EX ANTE) RETURN AND RISK

EXPECTED RATE OF RETURN n E (R) = pi Ri i=1 STANDARD DEVIATION OF RETURN = [ pi (Ri - E(R) )2] Bharat Foods Stock i. State of the Economy pi Ri piRi Ri-E(R) pi(Ri-E(R))2

(Ri-E(R))2

1. Boom 0.30 16 4.8 4.5 20.25 6.075 2. Normal 0.50 11 5.5 -0.5 0.25 0.125 3. Recession 0.20 6 1.2 -5.5 30.25 6.050 E(R ) = piRi = 11.5 pi(Ri E(R))2 =12.25