Risk and Return

1. 2. 3. 4. 5.

What is risk? How is it measured? What is return? How is it measured? How are assets valued in capital markets? 6. How do investors make their investment decisions?

RETURN: The rate of return on an asset/investment for a given period, say a year, is the annual income received plus any change in market price, usually expressed as a per cent of the opening market price. Symbolically, the one period actual expected return R R = D1 + ( pt-pt-1) pt-1 Where D1 = annual income/cash dividend at the end of time period t. Pt = security price at time period, t(closing/ending security price) p security price at time period, t-

Risk : The variability of the actual return from the expected return associated with a given asset/investment is defined as risk. The greater the variability, the riskier the security (e.g.shares) is said to be. The more certain the return from an asset the less the variability and therefore the less the risk.

Measurement of Risk: The risk associated with a single asset is assessed from both behavioral and statistical point of view. Behavioral aspect of risk are measured by a. Sensitivity analysis b. Probability distribution The Statistical measures of risk of an asset 1. Standard deviation 2. Coefficient of variation.

Sensitivity Analysis: It takes into account a number of possible outcomes/return estimates while evaluating an asset. Estimates are made on the following modes 1. Pessimistic worst 2. Expected most likely 3. Optimistic best

Particulars Initial outlay Annual return Pessimistic Most likely Optimistic

Asset x 50 14 16 18

Asset y 50 8 16 24

Probability distribution: It represents the likelihood chance of occurrence of an event. Eg. If the expectation is that a given outcome will occur seven out of ten times, it can be said to have a 70% change of happening. If the event is certain to happen then the probability of happening is 100%. Based on the probability assigned to the return the expected value of the return can be calculated.

Rt = return for the ith possible outcome Pri = probability associated with its return N = number of outcomes considered.

The expected rate of return calculation using the returns for assets X and Y are presented in the table below

Expected rates of return

Possible outcomes 1 Asset X Pessimistic Most Likely Optimistic .20 .60 .20 14 16 18 2.8 9.6 3.6 16 Probability 2 Return 3 Expected return 4

The expected rate of return calculation using the returns for assets X and Y are presented in the table below

Expected rates of return

Possible outcomes 1 Asset Y Pessimistic Most Likely Optimistic .20 .60 .20 8 16 24 1.6 9.6 4.8 16 Probability 2 Return 3 Expected return 4

Standard Deviation of Return

Risk refers to the dispersion of returns around the expected value. The most common statistical measure of risk of an asset is the standard deviation from the mean/expected value of return. It represents the square root of the average squared deviations of the individual returns from the expected returns

where N = the number of states, pi = the probability of state i, Ri = the return on the stock in state i, and E[R] = the expected return on the stock. The standard deviation is calculated as the positive square root of the variance.

Standard deviation of returns Asset X

Return Ri

Expected return R

Ri - R

(Ri - R)2

Pri

5*6

1
1 2 3

2
14 16 18

3
16 16 16

4
-2 0 2

5
4 0 4

6
.20 .60 .20

7
.80 0 .80 1.6

 Variance = 1.6 Standard deviation = square root of variance Sd = Sd = 1.26

Standard deviation of returns Asset Y

Return Ri

Expected return R

Ri - R

(Ri - R)2

Pri

5*6

1
1 2 3

2
8 16 24

3
16 16 16

4
-8 0 8

5
64 0 64

6
.20 .60 .20

7
12.8 0 12.8 25.6

 Variance = 25.6 Standard deviation = square root of variance Sd = Sd = 5.06 The greater the SD of returns the greater the variability of returns and the greater the risk of the asset.

Co-efficient of variation
It is a measure of relative dispersion (risk) or a measure of risk per unit of expected return. It converts standard deviation of expected values into relative values to enable comparison of risks associated with assets having different expected values. The coefficient of variation (CV) is computed by dividing the standard deviation for an asset by its expected value.

The coefficient of variation for assets X and Y are respectively, 0.079(1.26 / 16) And .316(5.06/16) The larger the CV, the larger the relative risk of the asset. As a rule, the use of the coefficient of variation for computing asset risk is the best since it considers the relative size(expected value) of assets.

RISK AND RETURN OF PORTFOLIO

A portfolio means a combination of 2 or more assets. A large no of portfolios can be formed from a given set of assets. The portfolio theory was originally developed by

Harry Markowitz

 The Expected Return on a Portfolio is computed as the weighted average of the expected returns on the stocks which comprise the portfolio. The weights reflect the proportion of the portfolio invested in the stocks. This can be expressed as follows: E[Rp]= S wiE[Ri] i=1 Where:
E[Rp] = the expected return on the portfolio N = the number of stocks in the portfolio wi = the proportion of the portfolio invested in stock i E[Ri] = the expected return on stock i
N

 For a portfolio consisting of two assets, the above equation can be expressed as: E[Rp] = w1E[R1] + w2E[R2]

 The variance/standard deviation of a portfolio reflects not only the variance/standard deviation of the stocks that make up the portfolio but also how the returns on the stocks which comprise the portfolio vary together. Two measures of how the returns on a pair of stocks vary together are the covariance and the correlation coefficient.
Covariance is a measure that combines the variance of a stocks returns with the tendency of those returns to move up or down at the same time other stocks move up or down. Since it is difficult to interpret the magnitude of the covariance terms, a related statistic, the correlation coefficient, is often used to measure the degree of co-movement between two variables. The correlation coefficient simply standardizes the covariance.

 The Covariance between the returns on two stocks can be calculated as follows: Cov(RA,RB) = sA,B = S pi(RAi - E[RA])(RBi - E[RB])
i=1 N

Where:
sA,B = the covariance between the returns on stocks A and B N = the number pi = the probability RAi = the return on stock A E[RA] = the expected return on stock A RBi = the return on stock B E[RB] = the expected return on stock B

 The Correlation Coefficient between the returns on two stocks can be calculated as follows: sA,B Cov(RA,RB) Corr(RA,RB) = rA,B = sAsB = SD(RA)SD(RB) Where:
rA,B=the correlation coefficient between the returns on stocks A and sA,B=the covariance between the returns on stocks A and B, sA=the standard deviation on stock A, and sB=the standard deviation on stock B

Definition of 'Positive Correlation '

A relationship between two variables in which both variables move in tandem. A positive correlation exists when as one variable decreases, the other variable also decreases and vice versa. In statistics, a perfect positive correlation is represented by the value +1.00, while a 0.00 indicates no correlation and a -1.00 indicates a perfect negative correlation.

RISK DIVERSIFICATION
Can diversification reduce all risk of securities?
When more and more securities are included in a portfolio, the risk of individual securities in the portfolio is reduced. This risk totally vanishes when the no of securities is very large. The risk represented by the covariance remains. Thus, risk has two parts. Diversifiable (unsystematic) and non-diversifiable(systematic)

RISK DIVERSIFICATION
Systematic risk Non-diversifiable
This risk arises on account of the economy-wide uncertainties and the tendency of individual securities to move together with changes in the market. This part of risk cannot be reduced through diversification. It is also known as market risk. Investors are exposed to market risk even when they hold well diversified portfolios EXAMPLES OF SYSTEMATIC RISK The Government changes the interest rate policy The corporate tax rate is increased The Government resorts to massive deficit financing The RBI promulgates a restrictive credit policy The Government withdraws tax on dividend payments by companies The Government eliminates or reduces the capital gain tax rate. The Government relaxes the foreign exchange controls and announces full convertibility of the Indian rupee.

UnSystematic risk diversifiable

This risk arises from the unique uncertainties of individual securities. It is also called unique risk. These uncertainties are diversifiable. If a large numbers of securities are combined to form well-diversified portfolios. Uncertainties of individual securities in a portfolio cancel out each other. Thus unsystematic risk can be totally reduced through diversification. EXAMPLES OF SYSTEMATIC RISK

RISK DIVERSIFICATION

The company workers declare strike.

The R & D expert leave the company. Competitor enters the market The company loses a big contract in a bid.

The company makes a breakthrough in process innovation.

The Government increases custom duty on the material used by the company. The company is unable to obtain adequate quantity of raw material.

BETA
The beta of an asset is a measure of the variability of that asset relative to the variability of the market as a whole. Beta is an index of the systematic risk of an asset. B =1 ( a security of average risk) B >1 (more risky as the returns would be more valatile than the market risk. Eg. If market rises by 5% the stock price would move by 7.5%. B <1 = (below average risk. They are not directly affected by the market movements and so they are less risky.)

Total risk
Total risk of an individual security is the variance or standard deviation of its return. It consist of two parts. Total risk of a security = systematic risk + unsystematic risk. Total risk = variance attributable to macro economic factors + variance attributable to firm- specific factors.

CAPITAL ASSET PRICING MODEL

In finance, the capital asset pricing model (CAPM) is used to determine a theoretically appropriate required rate of return of an asset, if that asset is to be added to an already well-diversified portfolio, given that asset's nondiversifiable risk. The model takes into account the asset's sensitivity to non-diversifiable risk (also known as systematic risk or market risk), often represented by the quantity beta () in the financial industry, as well as the expected return of the market and the expected return of a theoretical riskfree asset. The model was introduced by Jack Treynor (1961, 1962), William Sharpe (1964), John Lintner (1965a,b) and Jan Mossin (1966) independently, building on the earlier work of Harry Markowitz on diversification and modern portfolio theory. Sharpe, Markowitz and Merton Miller jointly received the Nobel Memorial Prize in Economics for this contribution to the field of financial economics.

Capital Asset Pricing Model (CAPM)

The capital asset pricing model(CAPM) as the name suggests, is a theory that explains how asset prices are formed in the market place. It is a logical and major extension of the portfolio theory of Markowitz by William Sharpe(1964). John Lintner(1965) and Jan Mossin(1967) The capital asset pricing model provides the framework for determining the equilibrium expected return for risky assets. It uses the results of Capital market theory to derive the relationship between expected return and systematic risk of individual assets/ securities and portfolios. It is also referred to as asset pricing theories. It deals with how assets are priced if investors behave in the manner the Markowitz portfolio theory suggest.CAPM specifies a linear relationship between risk and required return. The equation used for CAPM is as follows:

Ki = Krf + bi(Km - Krf)

Where: Ki = the required return for the individual security Krf = the risk-free rate of return bi = the beta of the individual security Km = the expected return on the market portfolio (Km - Krf) is called the market risk premium

32

Calculate the required return for federal express assuming it has a beta of 1.25 the rate on ust bills is 5% and the expected return for the standard and poor is 15%. Ki = Krf + bi(Km - Krf)
Ki = 5% + 1.25(15% -5%)
= 17.5%

Security market line

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.

17.5
SECURITY MARKET LINE

EXPECTED RETURN

15

ASSET RISK PREMIUM

MARKET PREMIUM

1 BETA

1.25

Assumptions of CAPM All investors Are rational and risk-averse. Are broadly diversified across a range of investments. Are price takers, i.e., they cannot influence prices. Can lend and borrow unlimited amounts under the risk free rate of interest. Trade without transaction or taxation costs. Deal with securities that are all highly divisible into small parcels. Assume all information is available at the same time to all investors. Further, the model assumes that standard deviation of past returns is a perfect proxy for the future risk associated with a given security.