Risk and Return

Name Roll no.

RISK
Risk in holding securities is generally associated with possibility that realized returns will be less than the expected returns. OR

Risk can be defined as the probability that the expected return from the security will not materialize.
Every investment involves uncertainties that make future investment returns risk-prone. Risk could be categorized depending on whether it affects the market as whole, or just a particular industry.

Types of Investment Risk

Unsystematic Risk Systematic Risk Risk is the potential for variability in returns. Total variability in returns of a security represents the total risk of that security.
Total Risk = Systematic Risk + Unsystematic Risk

Systematic Risk
Systematic risk refers to that portion of total variability in return caused by factors affecting the prices of all securities. Economic, political, and social changes are sources of systematic risk. Nearly all stocks listed on the National Stock Exchange (NSE) move in the same direction as the NSE Index. On an average, 50 percent of the variation in a stocks price can be explained by variation in the market index. In other words, about half of the total risk on an average common stock is systematic risk.

Systematic Risk is further subdivided into:

Market Risk:
Interest Rate Risk: Purchasing Power Risk:

Unsystematic Risk
Unsystematic risk is the portion of total risks that is unique to a firm or industry. Factors such as management capability, consumer preferences, raw material scarcity and labour strikes cause unsystematic variability of returns in a firm. Unsystematic factors are largely independent of factors affecting securities markets in general.

Unsystematic Risk is further subdivided into:

Business Risk:

Financial Risk:

The risk involved in investment depends on various factors such as:

The length of the maturity period: The credit-worthiness of the issuer of securities:

The nature of the instrument:

Equity shares are considered to be the most risky investment The liquidity of an investment

additional factors

Expected return
The expected rate of return on a stock represents the mean of a probability distribution of possible future returns on the stock.

E[R] = S (piRi)
i=1

Where:
E[R] = the expected return on the stock N = the number of states pi = the probability of state i Ri = the return on the stock in state i.

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EXPECTED RETURN
The table below provides a probability distribution for the returns on stocks A and B State Probability Return On Return On Stock A Stock B 1 20% 5% 50% 2 30% 10% 30% 3 30% 15% 10% 4 20% 20% -10% The state represents the state of the economy one period in the future i.e. state 1 could represent a recession and state 2 a growth economy. The probability reflects how likely it is that the state will occur. The sum of the probabilities must equal 100%. The last two columns present the returns or outcomes for stocks A and B that will occur in each of the four states.

Expected Return
In this example, the expected return for stock A would be calculated as follows:
E[R]A = .2(5%) + .3(10%) + .3(15%) + .2(20%) = 12.5%

Stock B E[R]B = .2(50%) + .3(30%) + .3(10%) + .2(-10%) = 20%

MEASURES OF RISK
Risk reflects the chance that the actual return on an investment may be different than the expected return. One way to measure risk is to calculate the variance and standard deviation of the distribution of returns. We will once again use a probability distribution in our calculations. The distribution used earlier is provided again for ease of use.

Given an asset's expected return, its variance can be calculated using the following equation:
Var(R) = s2 = i=1 S pi(Ri E[R])2 Where:
N = the number of states pi = the probability of state i Ri = the return on the stock in state i E[R] = the expected return on the stock
N

The standard deviation is calculated as the positive square root of the variance: SD(R) = s = s2 = (s2)1/2 = (s2)0.5

MEASURES OF RISK
Probability Distribution: State Probability Return On Stock A 5% 10% 15% 20% Return On Stock B 50% 30% 10% -10%

1 20% 2 30% 3 30% 4 20% E[R]A = 12.5% E[R]B = 20%

MEASURES OF RISK
The variance and standard deviation for stock A is calculated as follows:
s2A = .2(.05 -.125)2 + .3(.1 -.125)2 + .3(.15 -.125)2 + .2(.2 -.125)2 = .002625

sA = (.002625)0.5 = .0512 = 5.12%

Stock B: .042 and 20.49%