Risk and return

Return
• Income received over the investment made.
• It can be in form of regular income yield or changes in prices.
• Dividend yield = Dividend earned/ Original price
• Capital yield= (P1-Po)/Po*100
 RISK AND RETURN OF A SINGLE ASSET

Rate of Return = Annual income + Ending price-Beginning price

Beginning price Beginning price

Current yield Capital gains /loss

yield

Holding period yield

Measurement of return
• R= P1-P0 *100
• P0

• P1= Current year price

• Po= Original price
Risk
• The variability in actual returns from expected returns
• The greater the variability, greater will be the risk
• Measures
• Variance σ2
• Standard deviation σ
• Coefficient of variation (relative measure of risk)= SD/Mean*100(σ/R)*100
 VARIANCE OF RETURNS

n
∑ (Ri – R)2
σ2 = i=1

n-1
where σ2 is the variance of return, σ is the standard deviation of return,
Ri is the return from the stock in period i (i =1,…., n), R is the
arithmetic return, and n is the number of periods.
 PROBABILITY Method

n
E(R) = ∑ Ri *Pri
Σ
i=1

Here, R= Return; Pr= Probability of return

 Centre for Financial Management , Bangalore

 EXPECTED RETURN ON A PORTFOLIO

E(Rp) =  wi E(Ri)
 PORTFOLIO RISK
• Just as the risk of an individual security is measured by the variance (or
standard deviation) of its return, the risk of a portfolio too is measured by the
variance (or standard deviation) of its return.
• However, portfolio risk (measured by v variance or standard deviation) is not
the weighted average of the risks of the individual securities in the portfolio.
• In symbols,
n
E(Rp) =  wi E(Ri)
i=1
But
 p 2   wi 2  i 2
• The standard deviation of a two-security portfolio is:
 = √ [ w1212 + w2222 + 2 w1w2 P1212 ]
• The standard deviation of an n-security portfolio is:
 = √[ΣΣ w1wj Pij ij]

Here,

P1212 =Covariance between i and j

P12= Correlation coefficient between returns of i and j
 COMOVEMENTS IN SECURITY RETURNS
Covariance Covariance reflects the degree to which the returns of the two securities
vary or change together. A positive covariance means that the returns of the two
securities move in the same direction whereas a negative covariance implies that the
returns of the two securities move in opposite direction. The covariance between the
returns on any two securities i and j is calculated as follows:
Cov (Ri, Rj) or ij = p1 [Ri1 – E(Ri)] [Rj1 – E(Rj)]
+ p2 [Ri2 – E(Ri)] [Rj2 – E(Rj)]
+
+ pn [Rin – E(Ri)] [Rjn – E(Rj)]
where p1, p2 … pn are the probabilities associated with states 1, … n, Ri1, … Rin are
the returns on security i in states 1, … n, Rj1, … Rjn are the returns on security j in
states 1, … n, and E(Ri) and E(Rj) are the expected returns on securities i and j.

 Centre for Financial Management , Bangalore

 COEFFICIENT OF CORRELATION
Covariance and correlation are conceptually analogous in the sense that both of them
reflect the degree of comovement between two variables. Mathematically, they are
related as follows:
Cov (Ri, Rj) ij
Cor (Ri, Rj) or ij = or
s (Ri). s( Rj) i . j

ij = ij . i . j

where Cor (Ri, Rj) = ij is the correlation coefficient between the returns on securities i
and j , Cov (Ri, Rj) = ij is the covariance between the returns on securities i and j, and
s(Ri),s(Rj) = i , j are the standard deviations of the returns on securities i and j.

• The correlation coefficient can vary between –1.0 and +1.0.

• A value of -1.0 means perfect negative correlation or perfect comovement in the
opposite direction;
• a value of 0 means no correlation or comovement whatsoever;
• a value of 1.0 means perfect correlation or perfect comovement in the same
direction.
 Centre for Financial Management , Bangalore
 Types of risk
Systematic risk
 market risk/Non-diversifiable
Unsystematic risk
 Company related risk
 Can be diversified by enhancing number of securities in
portfolio
Portfolio risk
 Capital Asset Pricing model
 This theory explain the asset pricing in the market
 As per this theory, asset prices are the reflection of return
and risk expected from a security
 Expected return on asset =Rf+βeta* (Rf-Rm)
 Rf= Risk free rate of return
 Rm=Return on market
 Rm-Rf= Market risk premium
 βeta= Risk (volatility of asset relative to market)
 Beta
 Beta is covariance of security return with the market
portfolio’s return divided by variance of market
 βeta= im/ m^2
 Covariance of security and market return
Variance of market
= (Ri-R)*Rm-Rm)
m^2
Beta= 1; asset is risk-free
Beta>1; aggressive asset
Beta<1; Defensive assets
 Beta= N∑XY- (∑X)* (∑Y)
 N ∑X^2- (∑X)^2
 Here, X=Independent variable; Market return
 Y=Dependent variable; security returns
 To do
 Mr. Jain recently attended an investor’s meet in Mumbai
wherein he came across some brokers who advised him to
measure the systematic risk of shares using beta before
finally investing money in the same. Mr. Jain picked the
data of last few months of following securities Infotech Ltd
and Cantaxy Ltd and S&P CNX Nifty.
 Compute the beta of both security and comment which is
more risky
 Share prices Infotech Shareprices Cantaxy S&P CNX Nifty
Feb-28 ₹ 115.00 ₹ 28.00 976
Mar-31 ₹ 125.00 ₹ 26.00 985
Apr-30 ₹ 140.00 ₹ 21.00 991
May-31 ₹ 167.00 ₹ 20.00 1035
Jun-30 ₹ 189.00 ₹ 20.00 1049
Jul-31 ₹ 177.00 ₹ 15.00 989
Aug-30 ₹ 142.00 ₹ 19.00 977
Sep-30 ₹ 121.00 ₹ 21.00 965
Oct-31 ₹ 102.00 ₹ 32.00 956
Nov-29 ₹ 94.00 ₹ 29.00 951
Dec-31 ₹ 102.00 ₹ 31.00 957
Jan-31 ₹ 126.00 ₹ 28.00 962
Feb-28 ₹ 149.00 ₹ 39.00 975
 Test your knowledge
SD Beta
Asset A 40% 0.5
Asset B 20% 1.5

 Which security is more risky ?

 Which security will enjoy more premium?
 Compute expected return and risk associated with both the
assets on the basis of provided information

Returns
State of economy Probability A B
Recession 0.2 -0.15 0.2
Normal 0.5 0.2 0.3
Boom 0.3 0.6 0.4
 Expected
Returns Returns
State of economy Probability A B A B
Recession 0.2 -0.15 0.2 -0.03 0.04
Normal 0.5 0.2 0.3 0.1 0.15
Boom 0.3 0.6 0.4 0.18 0.12
0.25 0.31

Expected
Returns Risk
State of economy Probability A B A B
Recession 0.2 -0.15 0.2 0.032 0.00242
Normal 0.5 0.2 0.3 0.00125 5E-05
Boom 0.3 0.6 0.4 0.03675 0.00243
variance 0.07 0.0049
Standard Deviation 0.264575 0.07
 You hold a portfolio of Rs 200,000 with 75% of asset A and
rest with asset B. What will be your expected returns and
risk exposure.
 A B
Return expecetd 25 31
Weight 0.75 0.25 Portfolio Return
Weighted return 18.75 7.75 26.5

Covarince= Pr*(Ai-
Returns A)*(Bi-B)
State of economy Probability A B
Recession 0.2 -0.15 0.2 0.0088
Normal 0.5 0.2 0.3 0.00025
Boom 0.3 0.6 0.4 0.00945
Covariance 0.0185

Portfolio variance=
(W1*Sd1)^2+(W2*SD2)^2+
2W1*W2*Covariance 0.04526875Portfolio risk
SD 0.21276454
 Portfolio return= W1*R1+W2*R2

A B
Return expected 25 31
Weight 0.75 0.25 Portfolio return
Weighted return 18.75 7.75 26.5
 To do
 Hilt share is quoted at Rs 60. Nitin expects the company to
pay Rs 3 as dividend, one year from now. The price after 1
year is expected to be Rs 78.50.
 Compute the price yield, dividend yield and holding period
yield.
 If beta of this share is 1.5, market return is 16% and risk
free return is 6%. What is the required rate of return (Ke).
 What is the current MPS of this share?
 Dividend yield=3/60
 Price yield=(78.5-60)/60
 Holding period yield= (78.3+3-60)/60
 Required rate=Rf+B*(Rm-Rf)=21%
 Intrinsic value= (3+78.5)*1/(1+r); r=.21