CHAPTER 5: Risk and Return

 Concept of return and risk

 Types of return and risk
 Measures of return and risk
 Risk-return relationship
 Risk premium and sources of this
 Determinants of required rate of return

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 Return

 Return: Percentage form of earnings from

an investment or asset including normal
income and capital gain or loss is called
return. Return may be the following three
types:
1. Risk-free rate of return – rate of return
can be earned by making investment in
government securities of a country is
known as risk-free rate of return.
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 Return

2. Nominal rate of return – rate of return

calculated by ignoring existing level of
inflation is known as nominal rate of
return.
3. Real rate of return - rate of return
determined by considering/adjusting
existing level of inflation is known as real
rate of return.

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 Risk

 Risk is the concept of fluctuations. This fluctuations can

be
(i) a deviation of the actual return from the expected
return, or
(ii) a deviation of average return from the year to year
return. Higher the fluctuations, higher is the risk.
 Types of risk
i. Systematic risk – risk that can not be avoided or minimized and
that is out of control of an individual or a business enterprise.
ii. Unsystematic risk - risk that can not be avoided but can be
minimized by making intellectual decision and that is to some
extent under the control of an individual or a business
enterprise.
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 Risk
iii. Business risk – risk related to overall business activities of a
particular business enterprise that is mostly out of control of
that business enterprise.
iv. Financial risk - risk related to using of fund from debt sources
for forming and running business operations or making
investments by a particular party that is under the control of
that party.
Measures of risk
i. Standard Deviation – absolute measurement of total risk
ii. Coefficient of Variation - relative measurement of total risk
iii. Beta Coefficient - absolute measurement of systematic risk
iv. Covariance -is a measure of how much two random variables
change together
Correlation coefficient-is a measure of the strength and direction
of the linear relationship between two variables
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 Formula for calculating of Risk-Return

Expected Return  E ( R)  R 
 R
  (R * P )
i
i i
n

Risk   
 i
( R  R ) 2

( For time series data)

n 1
Risk     ( P )( R  R )
i i
2
( for probabilit y distribution)

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Calculation of Risk-Return (Historical Data)

Year Return (%) Dev. (Ri-E(R)) Dev. Square

1 20 7 49
2 5 -8 64
3 -5 -18 324
4 15 2 4
5 30 17 289
Mean Return= 13% Sum of Dev sq= 730
Stand.Deviation2   730/(5-1)= 182.5
Stand.Deviation=   Square root (182.5) 13.5%

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Calculation of Risk-Return (Probability Distribution)

Probability Return (Ri) Exp. Value Deviation Deviation

(Pi) (%) (Pi*Ri) (Ri-E(R)) Square Dev sq* Pi
(25-13.25) (11.25)2 (138*.25)
0.25 25 6.25 =11.75 =138.0625 =34.52
(14-13.25) (0.75)2 (.56*.5)
0.5 14 7 =0.75 =0.5625 =0.28
(0-13.25) (-13.25)2 (175*.25)
0.25 0 0 =-13.25 =175.5625 =43.89
  E(R)= 13.25%   Stand Dev2= 78.69
  Risk= 8.87%   Stand Dev 8.87

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Comments on standard deviation

 Standard deviation (σi) measures total, or

stand-alone, risk.
 The larger σi is, the lower the probability that
actual returns will be closer to expected
returns.
 Larger σi is associated with a wider probability
distribution of returns.
 It is difficult to compare standard deviations,
because return has not been accounted for.

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Coefficient of Variation (CV)

A standardized measure of dispersion about

the expected value, that shows the risk per
unit of return. When, both return and risk
increase then coefficient of variation (CV)
should be used.
Std dev 
CV   ^
Mean k

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 Use of coefficient of variance

 Example: We have 2 alternatives to invest. Security A

has a mean return of 10% and a standard deviation of
6%, and security B has a mean return of 13% with a
standard deviation of 8%. Which investment is better.
6%
CVA  *100  60%
10%
8%
CVB  *100  61.5%
13%
 So, security A is better as the Coefficient of variance
of A is less than the that of B.
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 Risk-return relationship i.e.
Security Market Line (SML)

Return [E(R)]
SML

E(Rj)

E(Rm)

Rf=5%

Systematic Risk (Beta)

βm=1 βj=1.9
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Comments on beta
 If beta = 1.0, the security is just as risky as
the average stock.
 If beta > 1.0, the security is riskier than
average.
 If beta < 1.0, the security is less risky than
average.
 Most stocks have betas in the range of 0.5 to
1.5.

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 Risk premium

The rate of return can be earned by making

investment in risk-free asset is called risk
free rate of return and the rate of return can
be earned by making investment in risky
asset is called nominal risky rate of return.
Generally the nominal risky rate of return is
higher that risk-free rate of return. The
increased required rate of return over risk-
free rate of return is called risk premium.
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 Sources of risk premium

1. Business risk- related to normal business operations.

2. Financial risk- related to capital structure or
financing decision.
3. Liquidity risk- related to convert the investment into
cash easily and quickly.
4. Foreign exchange rate risk- related to increase or
decrease foreign exchange rate.
5. Country risk- related to mainly overall political
situation of the country.
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 Determinants of required rate of return

1. The real risk-free rate: The rate of return can be

earned by making investment in risk-free sector in
absence of inflation is known as real risk-free rate.
The government sector of any country is
considered as risk-free sector.
2. Inflation premium: The rate of return can be earned
for compensating the loss for prevailing is known as
inflation premium.

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 Determinants of required rate of return:

3. Expected risk premium: The additional rate of

return to be required for compensating
additional level of risk for making investment
in risky asset or for doing risky business.
4. Conditions in the capital market: The impact
of the existing monetary and fiscal policies of
the government applicable within the country
and the probable change of these.
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Risk-Return relationship
 k=kRF + Risk Premium (RP)
 E(R) = Rf + RP
 RP=DRP+LP+MRP
Return

Rf


 Risk
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Capital asset pricing model (CAPM): The model
determines expected rate of return from an investment based
on risk-free rate of return and level of systematic risk that is
applied as discount rate for calculating intrinsic value of the
investment or asset that is used for ultimate investment
decision making is known as capital asset pricing model. It is
a set of predictions concerning equilibrium expected return
on risky assets. This was introduced by William Sharpe, Jhon
Lintner and Jan Mossin in 1964. The model is as follows:  
E(R) = R + (R – R )β, here E(R) = Expected rate of
f m f
return. Rf = Risk-free rate, Rm = Market rate, β = Beta
coefficient i.e. level of systematic risk.
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H.W.
Questions:
8-4, 8-5, 8-6, 8-10
Problems:
8-8, 8-9, 8-10, 8-11, 8-15.

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