Risk and Return Fundamentals

RAVI
 Risk and Return – I
Outline
• Basic Concepts of Return
• Basic Concepts of Risk
• Measuring Returns
• Sources of Risk
• Measuring Risk of a Single Asset
 Basics of Return
• The investors invest in any asset in
anticipation of return on the same.
• In case of financial assets, this can also be
termed as the financial results of the
investment or financial asset. As one of the
foremost criteria, an investor can distinguish
different financial assets based on return on
such financial assets.
 Basics of Return Contd.
• Returns can be classified as historical or expected i.e.
prospective.
• Returns can be in absolute value i.e. in terms of
currency and in relative terms i.e. in terms of %.
• For example, if an investment purchased one year back
at Rs.120 is sold for Rs.132, the absolute return is Rs.12
and the relative return is 10% (i.e.12 / 120). Return in a
way represents total gain or loss on investment. The
total gain/ loss can comprise of periodic return and
change in the value of investment at the end of the
holding period.
 Elements In Return
• Returns on a typical investment consists of
two components
1. Periodic Cash (Interest /dividend / income)
on the investment.
2. Change in Price of the asset (Capital gain or
loss) (Difference between the purchase price
and current market price or the price at
which can be asset sold)
Total Return == Income + Price Change (+/-)
Return Measurement
 Basics of Return
• The investors invest in any asset in
anticipation of return on the same. In case of
financial assets, this can also be termed as the
financial results of the investment or financial
asset.
• As one of the foremost criteria, an investor
can distinguish different financial assets based
on return on such financial assets
 Returns – Absolute / Relative
• Returns can be in absolute value i.e. in terms
of currency and in relative terms i.e. in terms
of %.
• For example, if an investment purchased one
year back at Rs.120 is sold for Rs.132, the
absolute return is Rs.12 and the relative
return is 10% (i.e.12 / 120).
• Return in a way represents total gain or loss
on investment
 Return Calculation
• Basic formula used for calculation of return
can be as below:
• Where rt is the actual, required or expected
return during period t, Pt is the current price,
Pt-1 is the price during the previous time
period, and Ct is any cash flow accruing from
the investment.
 Illustration
• Suppose one has bought a share of ABC Limited at Rs.300
one year back. Over the last year ABC has distributed
dividend of Rs.5 per share. If the share of ABC sells at
Rs.340 today, what is the return?
• The total return is Rs.45 that comprises of Rs.5 of dividend
and Rs.40 (Rs.340 – Rs.300) in terms of appreciation in the
market price of the share. Hence the % return is
Rs.45/Rs.300 i.e. 15%.
• In case the share of ABC sells at Rs.280 today what is the
return?
• The absolute return (-ve)Rs.15 (i.e. Rs.5 dividend and loss
of Rs.20 in terms of fall in price), which is -5% on original
investment of Rs.300.
 Holding Period Returns

• The holding period return is the return that an

investor would get when holding an
investment over a period of n years, when the
return during year i is given as ri:
 Holding Period Return
• In case an asset does not provide any periodic
return – like annual return in the previous
example – the holding period return (HPR)can
be calculated as below:
 Expected Return
• Unlike historical return, in case of expected
returns are predicted for the future with
relevant values being predicted.
• The prediction can be for different expected
outcomes.
• In such case probability is associated with
possible outcomes and expected return from
an investment is estimated.
• Suppose there are two shares A and B and
rate of returns in different conditions are
expected to be as below
Measuring Risk Example
 Measuring Risk:
The simplest measure of risk is range which is
defined as the difference between the highest
possible return and lowest possible return.
In the above table, the range for Stock 1 is
72.0% whereas for Stock 2 it is 48%.
However standard deviation is considered as
one of the very well accepted measure of risk.
Standard deviation is the square root of
variance.
 Standard Deviation as a Measure of
Risk
• The standard deviation is often used by
investors to measure the risk of a stock or a
stock portfolio.
• The basic idea is that the standard deviation is
a measure of volatility: the more a stock's
returns vary from the stock's average return,
the more volatile the stock
 Risk In a Traditional Sense
• Possibility that realized returns will be less
than the returns that were expected.
• Forces that contribute to variations in return
in price / dividend / interest constitute
elements of risk
• Influences of risk – can be internal or external
• External – Uncontrollable-Systematic risk
• Internal- Controllable – Unsystematic risk
 Systematic / Unsystematic Risk
Systematic risks
• Market risk
• Interest rate risk
• Purchasing Power risk
Unsystematic risks
• Business risk
• Financial risk
 Systematic risk
• Systematic risk refers to that portion of total
variability in return caused by factors affecting
prices of all securities.
• Systematic risks – Uncontrollable to a larger
degree & External
• Sources of systematic risk - Economic, political,
and sociological changes.
• Example : Impact due to fall in crude oil prices,
resulting in decrease in prices of shares of few oil
companies.
 Unsystematic risk
• Unsystematic risk refers to that portion of total risk
that is unique to a firm or industry.
• Unsystematic risks – Controllable & Internal
• Sources of Unsystematic risk –Management capability,
consumer preferences and labor strikes.
• Unsystematic factors are largely independent of factors
affecting securities markets in general and these
factors affect one firm and hence they must be
examined for one firm.
• Example : Maggie noodles issue – drastic drop in sales
resulting in loss and decline in prices of shares of
Nestle.
 Risk Fundamental
Facets of Fundamental Risk:
Risk is fundamentally inherent to investment. All
types of investments do not fit to the pattern of ‘no
risk, hence risk free return’.
Since the investors bear the risk i.e. the uncertainty
in future cash flows, they will be demanding a
premium for the risk borne.
Although, mathematically risk can involve upward
or downward swing in the return, practically it is
the downside that bothers the investor.
 Assigning risk allowance
(Risk Premium)
Definition of Risk Premium:
• The return in excess of the risk-free rate of return that an
investment is expected to yield.
• An asset's risk premium is a form of compensation for
investors who tolerate the extra risk - compared to that of a
risk-free asset - in a given investment.

• The formula for risk premium, sometimes referred to as

default risk premium, is the return on an investment minus
the return that would be earned on a risk free investment.

• The risk premium is the amount that an investor would like

to earn for the risk involved with a particular investment.
 Risk Premium
Risk Premium =
asset or investment return – risk free return
Risk Premium of the Market
• The risk premium of the market is the average
return on the market minus the risk free rate.
Risk Premium on a Stock Using CAPM
• The risk premium of a particular investment using
the capital asset pricing model is beta times the
difference between the return on the market and
the return on a risk free investment.
 Risk Premium formula
• RPi = E(Ri) - NRFR
• Where:
• RPi = risk premium for asset i
• E(Ri) = the expected return for asset i
• NRFR = the nominal return on a risk-free asset
• Risk premium:
• f(Business Risk, Financial Risk, Liquidity Risk,
Exchange Rate Risk, Country Risk); or
• f(Systematic Market Risk)
 Real Risk Free Rate (RFR)
The Real Risk Free Rate (RFR):
This is the return that has no risk the following
features:
● Assumes no inflation.
● Assumes no uncertainty about future cash flows.
● Influenced by time preference for consumption of
income and investment opportunities
in the economy.