Return and Risk

Risk
Any investment involves some degree of
uncertainty about future returns
Risk arises out of variability in returns
If an asset has no variability in returns, the
assets is considered to be risk free like
one year T-bills

Sources of Risk
A. Interest rate risk = variability in returns
of securities resulting from changes in
interest rates
Securities prices move inversely with interest
rates [why]?

Interest rates and returns

1. Increase in interest rates increases the required rate
of return

RRR= Rf+Risk premium which reduces the prices of

the securities (intrinsic value)

Cashflow
Intrinsic.Value
1 RRR
2. It increases cost of borrowing
and hence cost capital
3. It reduces money supply which lower demand for
securities and resultantly prices fall-

Sources of Risk
Market risk : variability in returns due to
fluctuations in aggregate market
Recession, wars etc

Inflation risk
when purchasing power declines.
Inflation also leads to hike in interest rates because
lenders demand more to compensate themselves for
loss in purchasing power

Business risk = the risk of doing business in a

particular industry. Like OGDC has a unique risk
of falling oil prices

Sources of Risk
Financial risk = It is associated with the use of
debt financing by companies. The larger the
financial leverage, the larger will be the
variability in returns
Liquidity Risk = Whether a particular security
can be sold quickly and without price concession
in the secondary market.
Exchange risk = for international investors, a
source of risk come from exchange rate
fluctuation

Sources of Risk
Country Risk = For international investors,
economic and political stability, law and
order situation are important consideration
in the investment decision

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Measuring Risk

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The most commonly used measure of risk

for securities is standard deviation
SD measure the total risk of a security or a
portfolio
It measure deviations of each observation
from the arithmetic mean

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1
153
913495.89

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Standard Deviation

Interpretation
The 5.89 SD means that the security
return can fluctuate between +/-5.89 from
the mean value of 16%
More specifically, the return can fluctuate
between 16 - 5.89 = 10.11 or 16 + 5.89 =

21.89
Your return could fall to as low as
10.11% or could rise to 21.89 %

Realized Returns and risk from

Investing
Class of assets

Average

SD

S&P 500 Composite

9.21%

19.75%

S&P Industrial

9.66

21.57

S&P Utility

8.47

20.54

Small Cap Stock (S&P 600) 14.82

37.23

AAA 20-year Corp Bond

3.87

10.05

US 15-year Bond

3.25

10.22

T-Bills

1.569

4.65