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◼ While making the decisions regarding investment and financing, the finance
manager seeks to achieve the right balance between risk and return, in order to
optimize the value of the firm.
◼ Everything an investor does it tied directly or indirectly to the return and risk.
The concepts of Return
◼ The objective of any investor is to maximize expected returns from
his investment, subject to various constraints, primarily risk.
◼ Return is the motivating force inspiring the investor in the form of
rewards for undertaking the investment.
◼ The importance of return in any investment can be traced to the
following factors:
1. It enables the investors to compare alternative investments in terms
of what they have to offer to the investors.
2. Measurement of historical (past) returns enables the investor to
assess how well they have done.
3. Measurement of historical returns helps in estimation of future
returns.
◼ This reveals that they are there are two types of return-Realized or
Historical Return and Expected Return.
◼ Realized Return :this is ex-post (after the fact) return, or the return that was
or could have been earned. For example, a deposit of Rs.1,000 in a bank on
1st Jan, at a stated annual interest rate of 10% will be worth Rs.1,100 exactly
in a year. The historical or realized return in this case is 10%
◼ Expected Return: this is the return from an asset that the investors
anticipate or expect to earn over some future period. The expected return is
subject to uncertainty, or risk and may or may not occur. The investor
compensates for the uncertainty in returns and the timing of those returns by
requiring an expected return that is sufficiently high to offset the risk or
uncertainty.
Pt-1 3,580
=7.12%
2 0.20 30
3 0.40 10
4 0.20 -10
5 0.10 -30
1.00
◼ k = (0.10) (0.50) +(0.20) (0.30) + (0.40) (0.10)+ (0.20) (-0.10)+ (0.10) (-0.30)
= 10%
Risk:
◼ Risk and return go hand- in hand in investments and finance.
◼ Risk can be defined as the chance that the actual outcome from an
investment will differ from the expected outcome.
◼ Sources of risk:
➢ Interest Rate Risk: is the variability in a security’s return resulting from
changes in level of interest rates. This risk affects bondholders more directly
than equity shareholders.
➢ Market risk: refers to the variability in returns due to the fluctuations in the
securities market. All securities are exposed to the market risk but equity
shares get most affected. This risk includes a wide range of factors
exogenous to securities themselves like depressions, wars, politics etc.
➢ Inflation risk: with rise in inflation there is reduction in purchasing power hence
this is also referred as purchasing power risk and affects all securities. This
risk is also directly related to interest rate risk, as interest rate go up with
inflation.
◼ Business Risk: risk of doing business in a particular industry or environment
and it gets transferred to the investors who invest in the business of the
company.
◼ Financial risk: arises when companies resort to financial leverage or the use
of debt financing. The more the company resorts to debt financing the
greater is the financial risk.
◼ Liquidity risk: associated with the secondary market in which the particular
security is traded. A security which can be bought or sold quickly without
significant price concession is considered liquid. The greater the uncertainty
about the time element and the price concession, the greater the liquidity
risk. Securities which have ready markets like T-bills have lesser liquidity
risk.
◼ While the return on each individual stock might vary quite a bit depending
on the weather, the return on your portfolio (50% Banlight and 50% Varsha
stocks) could be quite stable because the decline in one will be offset by the
increase in the other.
◼The table below gives the returns on the 2 stocks on the assumption that
rainy, normal and sunny weather are equally likely events (1/3 probability
each). Calculate the expected return and standard deviation of the two stocks
individually and of the portfolio of 50% Banlight and 50% Varsha stocks
Possible Probabilities RB RV RP
outcomes
Rainy 1/3 0 20 10
Normal 1/3 10 10 10
Sunny 1/3 20 0 10
Expected rate of 10% 10%
return k
S.D 66.67 = 8.16% 66.67 = 8.16% 0 = 0%
◼ The portfolio earns 10% no matter what the weather is. Hence through
diversification, 2 risky stocks have been combined to make a risk less
portfolio.
◼ For a diversified investor, the risk of the stock is only that portion of the total
risk that cannot be diversified away or its non-diversifiable risk.
◼ How is non diversifiable risk or market risk measured?. it is generally
measured by Beta (β) coefficient. Beta measures the relative risk
associated with any individual portfolio as measured in relation to the risk of
the market portfolio. The market portfolio represents the most diversified
portfolio of risky assets an investor could buy since it includes all risky
assets. This relative risk can be expressed as:
◼ In case of market portfolio , all the possible diversification is done- thus the
risk of the market portfolio is non-diversifiable which an investor cannot
avoid. Similarly as long as the asset’s return are not positively correlated
with returns from other assets, there will be some way to diversify away its
unsystematic risk. As a result beta depends only on non-diversifiable risks.
◼ The beta of a portfolio is the weighted average of the betas of the securities
that constitute the portfolio, the weights being the proportions of
investments in the respective securities. Ex: beta of security A is 1.5 and
that of security B is 0.9 and 60% and 40% of our portfolio is invested in the
2 securities respectively, the beta of our portfolio will be 1.26
(1.5*.60+0.9*0.40)
Measurement of Beta
◼ The systematic relationship between the return on security or a portfolio
and the return on the market can be described using a linear regression,
identifying the return on a security or portfolio as the dependent variable kj
and the return on market portfolio as the independent variable km, in the
single index model developed by William Sharpe.
kj = αj + βj km+ ej ------Characteristic Regression Line
◼ The beta parameter βj in the model represents the slope of the above
regression relationship and measures the responsiveness of the security
or portfolio or security will vary with changes in market return. The beta
coefficient of a security is defined as the ratio of the security’s covariance
of return with the market to the variance of the market.
βj = Cov (kj km)
Var (km)
◼ The alpha parameter is the intercept of the fitted line and indicates what the
security or portfolio will be when the market return is zero. Ex: if a security with
an α of +2 percent would earn 2 percent even when the market return was
zero and would earn an additional 2 percent at all levels of market return. The
converse is true if a security has α of -2 percent. The positive α thus
represents a sort of bonus return and would be highly desirable aspect of a
portfolio or security while a negative α represents a penalty to the investor.
◼ The third term ej is the unexpected return resulting from influences not
identified by the model. Frequently referred to as random or residual return, it
may take on any value but its generally found to average out to zero.
◼ What do the figures of β and α imply? When we say that the security has a β
of 1.54 we mean that if the return on the market portfolio rises by 10%, the
return on the security ‘j’ will rise by 15.4%. An α of 4.6% implies that the
security earns 4.6% over and above the market rate of return.
The Capital Asset Pricing Model
◼ The CAPM developed by William F Sharpe, John Lintner and Jan Mossin is
one of the major developments in financial theory. The CAPM establishes a
linear relationship between the required rate of return of a security and its
systematic or un diversifiable risk or beta.
◼ The CAPM is represented mathematically by
◼ This beta coefficient ‘Bj ‘ is the non-diversifiable risk of the asset relative to
the risk of the market. If the risk of the asset is greater than the market risk,
i.e. β exceeds 1.0, the investor assigns a higher risk premium to asset j than
to the market. Ex: suppose a fertilizer co. had a βj of 1.5 that is ROR on a
market (km) was 15 percent per year and that its risk free interest rate (Rf)
was 6 percent p.a. using the CAPM calculate the required rate of return.