Risk and Return-PART.

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PGDM- JAN. 2016

PROF. V. RAMACHANDRAN

FACULTY- SIESCOMS, NERUL,NAVI MUMBAI

 Risk and Return
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Operating Environment :
A business operates in an environment not in its
control.
It is exposed to dangers both internal and external
factors.
Stiff and cut throat competition.
Products in storage may : deteriorate or become obsolete
or suffer a fall in prices.
Properties may : be destroyed or stolen.
Customers may fail to pay their dues.
A Finance Manager has to keep all these risks in view and
maintain profitability and liquidity.
 Risk and Return
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Finance Manager has to maintain :

Right balance between Risk and Return to optimize
the value of the firm.

Return and risk go hand in hand in all

investments.
 Returns
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The objective of any investor is to maximize

expected Returns which is subject to various
constraints - primarily risks.

Return is that motivating force in the form of

rewards inducing the investor to undertake the
investment.
Returns on Investment Enables the investor to
Compare & select best alternative investments as to what
they have to offer.
Assess how well they have performed so far.
Helps in estimation of future returns.
 Types of Returns
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Returns are of two types:

Realized / Historical returns

Return that was or that could have been earned

Expected Returns
Anticipated or expected earnings from an asset over some
future period.
The expected return is subject to uncertainty or risk. And
may or may not occur.
 Returns -Components
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Components of Returns
Return basically is made up of two components
Income component
Periodic cash receipts in the form of interest or dividends etc.
includes yield derived from security in relation to its price. For
example: the yield on 10% bond at purchased price of 900(face
value Rs.1000) is 11.11%.
Capital gain or loss component
The appreciation (depreciation) in the price is referred to as
capital gain (or loss) which represents the difference between the
purchase and the sale price of the asset.
The primary objective of many investors is to expect a large
component of capital gain than income component.
 Measuring Rate of Return
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The income from security and

The difference in the price of security between the
beginning and end of holding period expressed as
percentage of purchase price of the beginning of the
holding period.
Illustration (A stock rate of return)
If share of ACC is purchased for Rs.3580 on 8th Feb, of last
year and sold for Rs.3800 on 9th Feb, this year, and the
company paid a dividend of Rs.35 for the year, the rate of
return will be calculated as under

ROR = 35+( 3800 -3580) x 100 = 7.12%

3580
 Measuring Rate of Return
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Illustration (Bond/debenture rate of return)

IF 14% Rs.1000 ICICI was purchased for Rs.1350, and the

price of the security rises to Rs.1500 by end of year, the rate of
return of debenture would be computed as
ROR = 140+ (1500-1350) x 100
1350
= 21.48
 Probabilities and Rates of Return
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Probability is a number which describes the chances of
occurrence of an event.
It is governed by Five Rules and ranges from 0 to 1.
Probability can never be larger than 1.(Maximum probability of
occurrence of an event is 100%)
The sum total of probabilities must be equal to 1.
Probability can never be a negative number.
IF the outcome of occurrence is assigned probability of 1 , the negative
outcomes are assigned a value of 0.
The possible outcome must be mutually exclusive and collectively
exhaustive.
The expected rate of return of an Asset rate of return from
each possible outcome and the probability of each rate
of return as weight.
The Expected rate of return k is calculated by summing the
products of the rate of return and their respective probabilities.
This can be shown as follows
Probabilities and Rates of Return
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Probability distribution of alphas Rate of Return

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X Axis : Return
Y Axis : Probability
 Risks
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Risk and return go hand in hand in

investments and finance.
All investment decisions always involve a
trade off between risk and return.
Risk may be defined as
The chance of a future loss or damagethat can be
foreseen.
In case of risk degree of happening of the loss
can be estimated the by assigning probabilities to the
risk on the basis of past data and probable trends.
 Risks
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Un-certainty
It may be defined as the chance of future loss or damage
that can not be foreseen e.g.
Investment in a foreign country may not foresee a coup
and taking over of govt. by an un friendly group.
Loss or destruction of plant on account of natural
calamities like earthquake etc.

The more variable, the possible outcomes that

can occur, the greater is the risk.

The wider the probability distribution, the

greater is the risk.
 Risks
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Sources of Risk
Interest rate risk
Resulting from changes in level of interest
rates.
Market Risk
Resulting from the variation due to
fluctuations in securities market. The equity
shares get most affected. The risk includes
depression, wars, politics etc.
Inflation Risk
Results from reduction of purchasing power,
affects all securities and also related to
interest rates.
 Risks
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Sources of Risk
Business Risk
Industry or environment related and its investors.
Financial Risk

Arises from companies use of debt financing and

related leverage.
Liquidity Risk

Associated with secondary market in which the

particular security is traded.
 Measurement Of Total Risk
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Measurement of Risk is Associated with Dispersion or

Variability in likely Outcomes
An Investor needs to know the extent of Variability of
Returns or Assets Total Risk
Three Methods of Measurement of Risk
1 Range Method
Difference between the highest possible Return and
lowest possible Return.
The Range based on only Two Extreme values
2 Variance Method
Sum of the Squared Deviation of each possible
Return (k )from Expected Return ( k ) multiplied by
the probability (pi )that the rate of Return occurs
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 Measurement Of Total Risk
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3 Standard Deviation Method

Most popular way of Measuring Variability of Returns is by Standard
Deviation.
It is Simply square root of the rates of return obtained under the
variance method.
Standard Deviation is preferred to other methods
due to
Considers every possible event and assigns weight equal to its
probability.
Familiar concept widely accepted in all calculations and computer
programs.
It is measure of Dispersion around the expected return and is in
absolute consensus with definition of Risk.
It facilitates Comparison of Risk and Expected Returns as both are
measured in the same parameter.
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Thank You