Risk & Return

Return on a Single Asset

• Total return = Dividend + Capital gain

Rate of return  Dividend yield  Capital gain yield

DIV1 P1  P0 DIV1   P1  P0 
R1   
P0 P0 P0
 Return on a Single Asset

• Year-to-Year Total Returns on HUL Share

50
40.94
40 36.99

30
21.84
To tal Return (%)

20 15.65
12.83
10.81
10 2.93
0
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
-10 -6.73

-20 -16.43

-30 -27.45

-40
Ye ar
 Average Rate of Return

• The average rate of return is the sum of the

various one-period rates of return divided by
the number of period.
• Formula for the average rate of return is as
follows:
n
1 1
R = [ R1  R 2    R n] 
n n
 Rt
t =1
 What is Risk?
•RISK is the chance that an investment's actual return will be
different than expected.

•Risk means you have the possibility of losing some or even all of
your original investment.

•Low levels of uncertainty (low risk) are associated with low

potential returns. High levels of uncertainty (high risk) are
associated with high potential returns.

•The risk/return trade off is the balance between the desire for

the lowest possible risk and the highest possible return.
 Risk of Rates of Return:
Variance and Standard Deviation
• The fluctuations in returns were caused by the volatility of
the share prices. The changes in dividends also contributed to
the variability of company’s rates of return.
• The variability of rates of return may be defined as the extent
of the deviations (or dispersions) of individual rates of return
from the average rate of return.
• There are two measures of this dispersion: Variance and
Standard deviation.
• Formulae for calculating variance and standard deviation:

Standard deviation = Variance

 
n 2
1
Variance   2  
n  1 t 1
Rt  R
 7

Expected Return : Incorporating Probabilities in Estimates

• The expected rate of return [E (R)] is the sum of the product of each outcome
(return) and its associated probability: Risk & Return.xlsx
 Expected Return : Incorporating
8 Probabilities in Estimates
• The following formula can be used to
calculate the variance of returns:
 Expected Return : Incorporating
Probabilities in Estimates

Return (%) -20 -10 10 15 20 25 30

Probability 0.05 0.10 0.20 0.25 0.20 0.15 0.05
 Expected Risk and Preference
10

• A risk-averse investor will choose among investments with

the equal rates of return, the investment with lowest
standard deviation . Similarly, if investments have equal risk
(standard deviation), the investor would prefer the one with
higher return.

• A risk-neutral investor does not consider risk, and would

always prefer investments with higher returns.

• A risk-seeking investor likes investments with higher risk

irrespective of the rates of return.

In reality, most (if not all) investors are risk-averse.

 Historical Risk Premium
11

• This excess return is a compensation for the higher risk of the

return on the stock market; it is commonly referred to as risk
premium.

• The 28-year average return on the stock market is higher by

about 15 per cent in comparison with the average return on
the Treassury-bills.

• The 28-year average return on the stock market is higher by

about 12 per cent in comparison with the average return on the
long-term government bonds.
 Portfolio
• A portfolio is a grouping of financial assets such as stocks,
bonds and cash equivalents such as Commercial paper,
Marketable securities, Short-term government bonds, Treasury
bills, etc.
• 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 number of securities is very
large.
 RISK DIVERSIFICATION:
SYSTEMATIC AND UNSYSTEMATIC RISK
13

• Risk has two parts:

1. Systematic Risk
2. Unsystematic Risk
 Systematic Risk (Market Risk)
• Systematic 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 of
securities.
 Examples of Systematic Risk
15
 Unsystematic Risk (Unique risk)
16

• Unsystematic 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.
• Unsystematic risk can be totally reduced
through diversification.
Examples of Unsystematic Risk
 Total Risk
18
 Systematic and unsystematic risk and
number of securities
19
 Capital Asset Pricing Model (CAPM)

• In finance, the capital asset pricing

model (CAPM) is a model used to determine a
theoretically appropriate required rate of
return of an asset, to make decisions about
adding assets to a well-diversified portfolio.
• The Capital Asset Pricing Model (CAPM)
describes the relationship between systematic
risk and expected return for assets, particularly
stocks.
 Factor beta
21
• Beta is a standardized measure of a security’s systematic
risk.
• The beta of the market portfolio is the reference for
measuring the volatility of individual risky securities.
• Since a risk-free security has no volatility, it has zero
beta.
• The beta of the factor is the sensitivity of the asset’s
return to the changes in the factor.
• One can use regression approach to calculate the factor
beta.
• Beta is used in the Capital Asset Pricing Model (CAPM), which
calculates the expected return of an asset using beta and
expected market returns. 
 Factor beta
• A beta of 1 indicates that the security’s price tend to move with the
22
market.
• A beta of less than 1 means that the security will be less volatile than the
market.
• A beta of less than 1 means that the security is theoretically less volatile
than the market. A beta of greater than 1 indicates that the security's
price is theoretically more volatile than the market.
– For example, if a stock's beta is 1.2, it's theoretically 20% more
volatile than the market
– Say a company has a beta of 2; this means it is two times as volatile as
the overall market. If we expect the market to provide a return of 10%
on an investment, then we would expect the company to return 20%.
On the other hand, if the market were to decline and provide a return
of -6%, investors in that company could expect a return of -12% (a
loss of 12%).
– If a stock had a beta of 0.5, we would expect it to be half as volatile as
the market; a market return of 10% would mean a 5% gain for the
company.
 A basic guide to various betas
• Negative beta - A beta less than 0 - which would indicate an inverse relation to the market - is
possible but highly unlikely. Some investors used to believe that gold and gold stocks should have
negative betas, because they tended to do better when the stock market declined, but this hasn't
proved to be true over the long term.

Beta of 0 - Basically, cash has a beta of 0. In other words, regardless of which way the market
moves, the value of cash remains unchanged (given no inflation). 

Beta between 0 and 1 - Companies with volatilities lower than the market have a beta of less
than 1 (but more than 0). As we mentioned earlier, many utilities fall in this range.

Beta of 1 - A beta of 1 represents the volatility of the given index used to represent the overall
market, against which other stocks and their betas are measured. The S&P 500 is such an index. If
a stock has a beta of one, it will move the same amount and direction as the index. So, an index
fund that mirrors the S&P 500 will have a beta close to 1.

Beta greater than 1 - This denotes a volatility that is greater than the broad-based index. Again,
as we mentioned above, many technology companies on the Nasdaq have a beta higher than 1.

Beta greater than 100 - This is impossible, as it essentially denotes a volatility that is 100 times
greater than the market. If a stock had a beta of 100, it would be expected to go to 0 on any
decline in the stock market. If you ever see a beta of over 100 on a research site it is usually the
result of a statistical error, or the given stock has experienced large swings due to low liquidity,
such as an over-the-counter stock. For the most part, stocks of well-known companies rarely ever
have a beta higher than 4. 
 Factor beta

• Betas may not remain stable for a company

over time even if a company stays in the same
industry. - Over time, a company may witness
changes in its product mix, technology, competition
or market share.
 Risk and Cost of Equity
25
• From the firm’s point of view, the expected
rate of return from a security of equivalent
risk is the cost of equity.
• The expected rate of return or the cost of
equity in CAPM is given by the following
equation:

ERi /Ri /Ke = Expected return of investment/ Cost of Equity

Rf = Risk-free rate
ERm = Expected return of market
(ERm - Rf) = Market risk premium
βi = Beta of the investment
 Industry Beta Vs. Company Beta
26

• The use of the industry beta is preferable for those

companies whose operations match up with the industry
operations. The industry beta is less affected by random
variations.

• Those companies that have operations quite different from a

large number of companies in the industry, may stick to the
use of their own betas rather than the industry beta.

• Beta estimation and selection is an art as well, which one

learns with experience.
Thank You