MODULE 2

RISK- RETURN

MOTIVE FOR INVESTMENT CAN BE

•Gain a sense of power or prestige

•Controlling corporate
•To earn a handsome return on investment

Investors wants to maximise expected returns subject to their tolerence for risk
Return is the motivating force and principal reward in the investment process.
It’s a key method available to investors in comparing alternative investments.

•EXPECTED RETURN:

•Expected return is the return from an asset that investors anticipate, they will earn over
some future period. It’s a predicted return which may or may not occur. Investors should
be willing to purchase the security if the expected return is adequate. But sometime
expected return may not materialise.

REALISED / HISTORICAL RETURN

It is the return which was earned on the investment by the investors.

COMPONENTS OF RETURN
Return in typical investment consists of two components. The basic component is
periodical cash receipt ( income) in form of interest or dividend. Another component is
the change in the price of the asset called as capital gain or loss. ( difference between
purchase and sale price)

YIELD

Yield refers to income component in relation to some price for a security.

In financial economics, the term yield indicates a rate of return that is based on
compounding, reinvestment, and/or the changing market value of a security.
•EG: Rs 1000, 6% coupon bond purchased for Rs 950
•Yield is 60
• 950
6.31%
Equity share paying Rs 4/year as dividend and purchased at Rs 100 Yield is 4%

Estimated yield
Expected cash income / current price of the asset./ Actual yield
cash income / amount invested.
 Yield is not a proper measure of return from a security. Capital gain or loss must
also be considered.
TOTAL RETURN

•Return across time or from different security can be measured and compared using total
return concept. Total return for a given holding period relates to all the cash flows
received by an investor during any designated time period.

ANTICIPATED RETURN

Although its difficult to calculate anticipate the return accurately, it can be done with the
help of the probability.Probability describes the likelihood occurrence of an event ie.,
likelihood of getting a certain rate of return.

RISK

Risk and uncertainty are integral part of an investment decision. Risk is the possibility of
a loss. In a financial sense it’s a possibility that realised return will be less then the return
that were expected.

Definitions and Concepts of risk

Risk Avoidance
Investment planning is almost impossible without a thorough understanding of risk.
There is a risk/return trade-off. That is, the greater risk accepted, the greater must be the
potential return as reward for committing one’s funds to an uncertain outcome.
Generally, as the level of risk rises, the rate of return should also rise, and vice versa.
Before we discuss risk in detail, we should first explain that risk can be perceived,
defined and handled in a multitude of ways. One way to handle risk is to avoid it. Risk
avoidance occurs when one chooses to completely avoid the activity the risk is
associated with. An example would be the risk of being injured while driving an
automobile. By choosing not to drive a person could avoid that risk altogether.
Obviously, life presents some risks that cannot be avoided. One may view a risk in
eating food that might be toxic. Complete avoidance, by refusing to eat at all, would
create the inevitable outcome of death, so in this case, avoidance is not a viable choice.
In the investment world, avoidance of some risk is deemed to be possible through the
act of investing in "risk-free" investments. Short-term maturity United States
government bonds are usually equated with a "risk-free" rate of return. Stock market
risk can be completely avoided by one choosing to have no exposure to it by not
investing in equity securities.

Risk Transfer

Another way to handle risk is to transfer the risk. An easy to understand example of risk
transfer is the concept of insurance. If one has the risk of becoming severely ill (and
 unfortunately we all do), then health insurance is advisable. An insurance company will
allow you to transfer the risk of large medical bills to them in exchange for a fee called
an insurance premium. The company knows that statistically, if they collect enough
premiums and have a large enough pool of insureds, they can pay the costs of the
minority who will require extensive medical treatment and have enough left over to
record a profit. Risk transfer can also occur in investing. One may choose to purchase a
municipal bond that is insured. One may purchase a put option on a stock which allows
that person to "put to" or sell to someone their stock at a set price, regardless of how
much lower the stock may drop. There are many examples of risk transfer in the area of
investing.

The Risk Averse Investor

Do investors dislike risk? In economics in general, and investments in particular, the

standard assumption is that investors are rational. Rational investors prefer certainty to
uncertainty. It is easy to say that investors dislike risk, but more precisely, we should
say that investors are risk averse. A risk-averse investor is one who will not assume risk
simply for its own sake and will not incur any given level of risk unless there is an
expectation of adequate compensation for having done so. Note carefully that it is not
irrational to assume risk, even very large risk, as long as we expect to be compensated
for it. In fact, investors cannot reasonably expect to earn larger returns without
assuming larger risks.
Investors deal with risk by choosing (implicitly or explicitly) the
amount of risk they are willing to incur. Some investors choose to incur high levels of
risk with the expectation of high levels of return. Other investors are unwilling to
assume much risk, and they should not expect to earn large returns.
We have said that investors would like to maximize their returns.
Can we also say that investors, in general, will choose to minimize their risks? No! The
reason is that there are costs to minimizing the risk, specifically a lower expected
return. Taken to its logical conclusion, the minimization of risk would result in
everyone holding risk-free assets such as savings accounts and Treasury bills. Thus, we
need to think in terms of the expected return/risk trade-off that results from the direct
relationship between the risk and the expected return of an investment.

RISK AND UNCERTINITY:

Both words can be used interchangeably. Risk is a situation where the possible
consequence of the decision that to be taken are known. Uncertainty generally defined
to apply to situations where the probabilities cannot be estimated

Some risks are external to the firm and cannot be controlled. But some risks are internal
to the firm and are controllable to large degree. These risks can be classified into two
categories, viz,
(a) Systematic or uncontrollable risk
 (b) Unsystematic or controllable risk

( A ) SYSTAMATIC RISK OR UNCONTROLLABLE RISK

These are the forces that are uncontrollable, external and broad in their effect.
These risks affect the entire market. It arises out of market, industry, and state of the
economy.

1) MARKET RISK:

The variability in a security’s returns resulting from fluctuations in

the aggregate market is known as market risk. All securities are exposed to market risk
including recessions, wars, structural changes in the economy, tax law changes, even
changes in consumer preferences. Market risk is sometimes used synonymously with
systematic risk.
Market risk is caused by investors reaction to tangible as well as intangible events.
Tangible events- political, social, or economical. Intangible events – market
psychology

( 2 ) INTEREST RATE RISK:

It refers to uncertainty of future market values and size of future income caused by
fluctuations in the general level of interest rates. Interest rate affects the prices of bonds,
debentures more severely. Affects not only investors but also companies borrowing.
In many cases fluctuations in interest rates is caused by govt monitory policy.
Indirectly affects equity market also.

( 3 ) PURCHASING POWER RISK / INFLATION RISK

A factor affecting all securities is purchasing power risk also

known as inflation risk. This is the chance that the purchasing power of invested dollars
will decline. With uncertain inflation, the real (inflation-adjusted) return involves risk
even if the nominal return is safe (e.g., a Treasury bond). This risk is related to interest
rate risk, since interest rates generally rise as inflation increases, because lenders
demand additional inflation premiums to compensate for the loss of purchasing power.

This risk arises out of change in prices of goods and services.

In india, purchasing power risk is associated with inflation and rising prices in the
economy.
(B) UNSYSTEMATIC RISK OR CONTROLLABLE RISK

Is that portion of total risk that is unique or peculiar to a firm or an industry.

Factors such as management capacity, consumer preference, labour strikes leads to
unsystematic risk Unsystematic risk is sometimes referred to as "specific risk". This kind
of risk affects a very small number of assets. An example is news that affects a specific
stock such as a sudden strike by employees. Diversification is the only way to protect
yourself from unsystematic risk. Different unsystematic risks are

(1) BUSINESS RISK:

Operating environment of the business causes it. It arises out of inability of a firm to
maintain its competitive position.
Internal business risk
It is associated with operational efficiency of the firm. Reasons for internal business
risks are.
(I) fluctuations in sales
(ii) R&D obsolescence
(iii) labour problem / attrition
(iv) higher fixed costs

External business risk

It result of operating conditions imposed on the firm by circumstances beyond its control.
(I) social or regulatory factors.
(ii) political risk
(iii) business cycle

( 2) FINANCIAL RISK:

Its associated with the way in which a company finances its activities. It can be
gauged by looking at the capital structure of a firm. It refers to the variability of income
to the equity capital due to debt capital.

There are few other risks which may affects the organization viz.

International Risk

International Risk can include both Country risk and Exchange Rate risk.
Exchange Rate Risk All investors who invest internationally in today's increasingly global
investment arena face the prospect of uncertainty in the returns after they convert the foreign
gains back to their own currency. Unlike the past when most U.S. investors ignored
international investing alternatives, investors today must recognize and understand exchange
rate risk, which can be defined as the variability in returns on securities caused by currency
fluctuations. Exchange rate risk is sometimes called currency risk.
 For example, a U.S. investor who buys a German stock denominated in
marks must ultimately convert the returns from this stock back to dollars. If the exchange rate
has moved against the investor, losses from these exchange rate movements can partially or
totally negate the original return earned.
Obviously, U.S. investors who invest only in U.S. stocks on U.S. markets
do not face this risk, but in today's global environment where investors increasingly consider
alternatives from other countries, this factor has become important. Currency risk affects
international mutual funds, global mutual funds, closed-end single country funds, American
Depository Receipts, foreign stocks, and foreign bonds.
Country Risk Country risk, also referred to as political risk, is an important risk for investors
today. With more investors investing internationally, both directly and indirectly, the political, and
therefore economic, stability and viability of a country's economy need to be considered. The
United States has the lowest country risk, and other countries can be judged on a relative basis
using the United States as a benchmark. Examples of countries that needed careful monitoring
in the 1990s because of country risk included the former Soviet Union and Yugoslavia, China,
Hong Kong, and South Africa.

Liquidity Risk

Liquidity risk is the risk associated with the particular secondary market in which a security
trades. An investment that can be bought or sold quickly and without significant price
concession is considered liquid. The more uncertainty about the time element and the price
concession, the greater the liquidity risk. A Treasury bill has little or no liquidity risk, whereas a
small OTC stock may have substantial liquidity risk.

MINIMISING RISK
Different risks discussed above can be minimized by adopting the following methods.

MARKET RISK can be minimized by,

Studying price behavior of the stock
Avoiding cyclical stock
Analyzing standard deviation and beta relating to stocks to avoid risk
Holding the stock for a long period.

INTEREST RATE RISK can be avoided by

Hold the investment till maturity
Buy short term instruments

INFLATION RISK can be avoided by

Investment diversification
Invest in ST securities and avoid LT securities

•BUSINESS AND FINANCE RISK can be minimized by,

•
SWOT analysis of industry and company.
•Analysis of profitability trend
•Analyzing capital structure and avoiding levered firm
RISK MEASUREMENT

One way of quantifying risk and building required rate of return is express a required rate
of risk less investment AND compensation for individual risk previously discussed.
r = I+p+b+f+m+o
where, I=risk less interest
p,b,f,m,o, = allowance for different risks.

variability of return ( r) around the expected return (er) is quantitative description of risk.
it include both systamatic and un systmatic risk. standard deviation helps us to measure
variability of retur.

TOTAL RISK OF A AN INVESTMENT CONSISTS OF TWO ELEMENTS

•Diversifiable or un systematic
•Non Diversifiable or systematic

Efforts are made to develop a measure of risk and system for using this measure in
assessing the return. Two components that have emerged are
a) Beta- a statistical measure of risk
b) CAPM- which links risk (beta) to the level of required return

BETA / BETA CO EFFICIENT

Beta measures non diversifiable or systematic risk. It shows how the price of a security
respond to market forces.
More responsive is the price of a security to market forces, higher will be its beta.
Beta is calculated by relating the returns on a security with the returns of the market.
It helps assessing systematic risk and understanding the impact of market movement on
return expected from a share.
•Beta for overall market is one and other betas are viewed in relations to this value.
•Betas can be +ve or negative. ( usually +ve and bet .4 to 1.9)
•For eg Market expected return is 10% Beta is 1.8 Stock expects an increase in return
app to 18%
•
If market expects a negative return of 10%, stock expects a 18% decrease in price.

•Beta = 1 --- security price will move with the market

•Beta less than 1 --- security price will be less volatile than the market(less risky)
•Beta more than 1 --- security price will be more volatile than the market(more
risky)
 CAPM ( CAPITAL ASSET PRICING MODEL )

CAPM was developed by financial economist william sharpe. Its based on idea that
investment includes systematic and un systematic risk. CAPM is evolved as a way to
measure systematic risk. General idea behind CAPM is that investors need to be
compensated in two ways.
•1) time value of money, that’s given by risk free rate of interest
•2) compensation for taking additional risk.

This compensation is calculated by taking a risk measure (beta) that compares the return
of the asset to the market over a period of time.

CAPM FORMULA

Rs = Rf + Bs (Rm – Rf )

Where,
Rs = return required on the investment
Rf = return on risk free investment
Bs = beta of the security (systematic risk)
Rm = average return on all the securities

CAPM reflects the mathematical relationship bet risk and return. Higher the risk (beta)
the higher is the required return.

ASSUMPTIONS UNDER CAPM

•A) all investors have rational expectations

•B) there are no arbitrage opportunities
•C) returns are distributed normally
•D) fixed quantity of assets
•E) perfect capital market
•F) risk free rates exists with time less borrowing capacity and universal access
•G) no inflation and no change in interest rates exists
.
Limitations of CAPM

•A) this model does not appear to adequately explain the variations in stock returns.
( many empirical studies shows that low beta stocks may offer higher return than what
expected in the model)
•B) this model assumes that all investors agree about the risk and expected return of all
assets ( homogeneous expectations assumptions)
•C) this model assumes no taxes and transactions cost
•D) this model assumes investors demand higher return in exchange of a higher risk. This
may not hold good always.

SECURITY MARKET LINE

•When CAPM is depicted graphically its called SML

The line that graphs the systematic, or market, risk versus return of the whole market at a
certain time and shows all risky marketable securities.
•The SML essentially graphs the results from the capital asset pricing model (CAPM)
formula. The X-axis represents the risk (beta), and the Y-axis represents the expected
return. The market risk premium is determined from the slope of the SML.
•It is a useful tool in determining if an asset being considered for a portfolio offers a
reasonable expected return for risk. Individual securities are plotted on the SML graph.

•CAPITAL MARKET LINE – CML

•A line used in the capital asset pricing model to illustrate the rates of return for efficient
portfolios depending on the risk-free rate of return and the level of risk
(standard deviation) for a particular portfolio
•The CML is derived by drawing a tangent line from the intercept point on the efficient
frontier to the point where the expected return equals the risk-free rate of return.

The CML is considered to be superior to the efficient frontier since it takes into account
the inclusion of a risk-free asset in the portfolio. The capital asset pricing model (CAPM)
demonstrates that the market portfolio is essentially the efficient frontier. This is achieved
visually through the security market line (SML).

ARBITRAGE PRICING THEORY – APT

An alternative to the CAPM, APT differs in its assumptions and explanation of risk
factors associated with the risk of an asset.
This is a relatively new theory that predicts a relationship between the returns of portfolio
and the returns of a single asset through a linear combination of variables. Sometimes
market theories can be as confusing as calculus. APT. An alternative asset pricing model
to the Capital Asset Pricing Model. Unlike the Capital Asset Pricing Model, which
specifies returns as a linear function of only systematic risk, Arbitrage Pricing Theory
may specify returns as a linear function of more than a single factor.
Arbitrage pricing theory (APT) holds that the expected return of a financial asset can
be modeled as a linear function of various macro-economic factors or theoretical market
indices, where sensitivity to changes in each factor is represented by a factor specific beta
coefficient. The model derived rate of return will then be used to price the asset correctly
- the asset price should equal the expected end of period price discounted at the rate
implied by model. If the price diverges, arbitrage should bring it back into line. The
theory was initiated by the economist Stephen Ross in 1976.
 Arbitrage mechanics
In the APT context, arbitrage consists of trading in two assets – with at least one being
mispriced. The arbitrageur sells the asset which is relatively too expensive and uses the
proceeds to buy one which is relatively too cheap.
Under the APT, an asset is mispriced if its current price diverges from the price predicted
by the model. The asset price today, should equal the sum of all future cash flows
discounted at the APT rate, where the expected return of the asset is a linear function of
various factors, and sensitivity to changes in each factor is represented by a factor
specific beta coefficient.
A correctly priced asset here, may be in fact, a synthetic asset - a portfolio consisting of
other correctly priced assets. This portfolio has the same exposure to each of the
macroeconomic factors as the mispriced asset. The arbitrageur creates the portfolio by
identifying x correctly priced assets (one per factor plus one) and then weighting the
assets such that portfolio beta per factor is the same as for the mispriced asset.
When the investor is long the asset and short the portfolio (or vice versa) he has created a
position which has a positive expected return (the difference between asset return and
portfolio return) and which has a net-zero exposure to any macroeconomic factor and is
therefore risk free (other than for firm specific risk). The arbitrageur is thus in a position
to make a risk free profit:
Relationship with the capital asset pricing model
The APT along with the capital asset pricing model (CAPM) is one of two influential
theories on asset pricing. The APT differs from the CAPM in that it is less restrictive in
its assumptions. It allows for an explanatory (as opposed to statistical) model of asset
returns. It assumes that each investor will hold a unique portfolio with its own particular
array of betas, as opposed to the identical "market portfolio". In some ways, the CAPM
can be considered a "special case" of the APT in that the securities market line represents
a single-factor model of the asset price, where Beta is exposure to changes in value of the
Market.
Additionally, the APT can be seen as a "supply side" model, since its beta coefficients
reflect the sensitivity of the underlying asset to economic factors. Thus, factor shocks
would cause structural changes in the asset's expected return, or in the case of stocks, in
the firm's profitability.
On the other side, the capital asset pricing model is considered a "demand side" model.
Its results, although similar to those in the APT, arise from a maximization problem of
each investor's utility function, and from the resulting market equilibrium (investors are
considered to be the "consumers" of the assets).