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# RISK

RISK &
& RETURN
RETURN

Mr. Rohan S.
Ms. Shobhna M.
1
Defining
Defining Risk
Risk
The variability of returns from those
that are expected.

## The chance of financial loss or more

formally the variability of returns
associated with a given asset.

2
Defining
Defining Return
Return
plus any change in market price,
price
usually expressed as a percent of
the beginning market price of the
investment.
The total gain or loss experienced on
an investment over a given period of
3
time.
Calculation of Return
Ct + (Pt - Pt-1 )
Rt =
Pt-1

## Ct = Cash flow received from the asset

investment in the time period t-1 to t
Pt = Price (value) of asset at time t.
Pt-1 = Price (value) of asset at time t-1.
Rt = Actual, expected or required rate of
return during the period t
4
Return
Return Example
Example
The stock price for Stock A was \$10 per
share 1 year ago. The stock is currently
trading at \$9.50 per share, and
shareholders just received a \$1 dividend.
dividend
What return was earned over the past year?

5
Return
Return Example
Example
The stock price for Stock A was \$10 per
share 1 year ago. The stock is currently
trading at \$9.50 per share, and
shareholders just received a \$1 dividend.
dividend
What return was earned over the past year?

## \$1.00 + (\$9.50 - \$10.00 )

R= = 5%
\$10.00
6
Types of Risk

7
Firm Specific Risk
Business Risk: The chance that the firm
will be unable to cover its
OPERATING COSTS.

## Financial Risk: The chance that the firm

will be unable to cover its FINANCIAL
OBLIGATIONS.
8
Shareholder-Specific Risks

## Interest rate risk: The chance that the changes in

interest rates will adversely affect the value of an
investment. Most investments lose value when the
interest rate rises & increases in value when it falls.

## Liquidity risk: The chance that an investment cannot

be easily liquidated at a reasonable price. Liquidity is
significantly affected by the size & depth of the market
in which an investment is customarily traded.
9
Continued…
Market risk: The chance that the value of an
investment will decline because of market
factors that are independent of the
investment(such as economic, political &
social events). In general, the more a given
investment’s value responds to the market,
the greater its risk & vice versa.
10
Firm & Shareholder Risks
Event Risk: The chance that a totally
unexpected event will have a significant
effect on the value of the firm or a specific
investment. These infrequent events such as
Govt. mandated withdrawal of a popular
prescription drug, typically affect a small
group of firms or investments.

Continued…
11
Exchange rate risk: The exposure of future
expected cash flows to fluctuations in the
currency exchange rate. The greater the chance of
undesirable exchange rate fluctuations, the
greater the risk of the cash flows & therefore the
lower the value of the firm or investment.

Continued…
12
changing price levels caused by inflation or
deflation in the economy will adversely affect the
firm’s or investment’s cash flows & value.
Typically, firms or investments with cash
flows that move with general price levels have a
low purchasing-power risk & vice versa.
Continued…
13
Tax risk: The chance that unfavorable
changes in tax laws will occur. Firms &
investments with values that are sensitive
to tax changes are more risky.

14
Issuer Specific Risk
Default risk: The possibility that the issuer of debt will not
pay the contractual interest or principal as scheduled.

Maturity risk: The fact that the longer the maturity, the
more the value of the security will change in response to a
given change in interest rates.

## Contractual provision risk: Conditions that are often

included in a debt agreement or a stock issue.

15
Risk Preferences
managers/firms. Thus it is important to
specify a generally acceptable level of risk.
The 3 basic risk preference behaviors are:
(1) Risk-Indifferent
(2) Risk-Averse
(3) Risk-Seeking

16
◆ Risk-Indifferent:

## The attitude toward risk in which no change in return

would be required for an increase in risk.
◆ Risk-Averse:

## The attitude toward risk in which an increased return

would be required for an increase in risk.
◆ Risk-Seeking:

## The attitude toward risk in which a decreased return

would be required for an increase in risk.

17
Risk
Averse
Averse

Indifferent Risk
Indifferent

Seeking
Risk
Seeking

X1 X2
18 Risk
Types of Assets/Securities

Single Asset:
Assets are economic resources. Anything tangible or intangible that
is capable of being owned or controlled to produce value and that
is held to have positive economic value is considered an asset.
Simply stated, assets represent ownership of value that can be
converted into cash (although cash itself is also considered an
asset)

Portfolio:
A collection or group of assets created or developed to minimize risk
in order to maximize returns.
OR
19 A combination of two or more securities/assets.
Sensitivity Analysis:
An approach for assessing risk that uses several
possible return estimates to obtain a sense of
the variability[uncertainty] among outcomes.
RANGE:
A measure of an asset’s risk which is found
by subtracting the pessimistic(worst) outcome
from the optimistic(best) outcome.

20
Probability:

## The chance that a given outcome will occur.

Probability Distribution:
A model that relates probabilities to the
associated outcomes.

21
Probability Distribution

Discrete Continuous
0.4 0 .0 3 5
0.35 0 .0 3
0.3 0 .0 2 5
0.25 0 .0 2
0.2 0 .0 1 5
0.15 0 .0 1
0.1 0 .0 0 5
0.05
0
0

4%
-5%

13%

40%

67%
22%
31%

49%
58%
-50%
-41%

-23%
-14%
-32%
-15% -3% 9% 21% 33%

22 Returns
Determining
Determining Expected
Expected
Return
Return (Discrete
(Discrete Dist.)
Dist.)
n
R = Σ ( Ri )( Pi )
i=1

## R is the expected return for the asset,

Ri is the return for the ith possibility,
Pi is the probability of that return
occurring,
23 n is the total number of possibilities.
How
How to
to Determine
Determine the
the Expected
Expected
Return
Return and
and Standard
Standard Deviation
Deviation

Stock BW
Ri Pi (Ri)(Pi)
The
-.15 .10 -.015 expected
-.03 .20 -.006 return, R,
.09 .40 .036 for Stock
BW is .09
.21 .20 .042
or 9%
.33 .10 .033
Sum 1.00 Σ 0.090
24
Determining
Determining Standard
Standard
Deviation
Deviation (Risk
(Risk Measure)
Measure)
n
σ = Σ ( Ri - R )2( Pi )
i=1

Deviation σ , is a statistical
Standard Deviation,
measure of the variability of a distribution
around its expected return.
It is the square root of variance.
Note, this is for a Discrete Distribution.
25
Determining
Determining Expected
Expected
Return
Return (Continuous
(Continuous Dist.)
Dist.)
n
R=Σ
i=1
( Ri ) / ( n )
R is the expected return for the asset,
Ri is the return for the ith observation,
n is the total number of observations.
Probability is assumed to be equal
26
Determining
Determining Standard
Standard
Deviation
Deviation (Risk
(Risk Measure)
Measure)
n
σ = Σ ( R i - R )2
i=1
( n - 1)
Note, this is for a continuous distribution
where the distribution is for a population.
R represents the population mean in this
example.
Probability is assumed to be equal
27
How
How to
to Determine
Determine the
the Expected
Expected
Return
Return and
and Standard
Standard Deviation
Deviation

Stock BW
Ri Pi (Ri)(Pi) (Ri - R )2(Pi)
-.15 .10 -.015 .00576
-.03 .20 -.006 .00288
.09 .40 .036 .00000
.21 .20 .042 .00288
.33 .10 .033 .00576
Sum 1.00 .090 .01728
28
Determining
Determining Standard
Standard
Deviation
Deviation (Risk
(Risk Measure)
Measure)
n
σ = Σ
i=1
( Ri - R )2
( Pi )

σ = .01728

σ = .1315 or 13.15%
29
Coefficient
Coefficient of
of Variation
Variation [CV]
[CV]

## The ratio of the standard deviation of a

distribution to the Expected Rate of
Return of that distribution.
It is a measure of RELATIVE dispersion
that is used in comparing the risks of
assets with differing Expected Rate of
Return.
CV = σ / R
30
Coefficient
Coefficient of
of Variation
Variation [CV]
[CV]

## Higher CV, the greater the risk & therefore

the higher expected return of rate

## It is a measure of RELATIVE risk.

CV = σ / R
CV of BW = .1315 / .09 = 1.46
31
June 2010 Q7
Find out Expected Rate of Return [R] &
Standard Deviation [σ ]
SBI ICICI
Returns (Ri) Probability Returns (Ri) Probability
[%] (Pi) [%] [%] (Pi) [%]
22 0.05 12 0.05
16 0.15 8 0.08
12 0.25 6 0.10
6 0.45 -5 0.50
-8 0.10 - 10 0.27
32
Expected Rate of Return [R]
for SBI
Returns Probability Weighted Value
(Ri) [%] (Pi) [%] R = (Ri)(Pi)
22 0.05 1.1
16 0.15 2.4
12 0.25 3.0
6 0.45 2.7
-8 0.10 - 0.8
1.0 Σ R = 8.4%
33
Expected Rate of Return [R]
for ICICI
Returns Probability Weighted Value
(Ri) [%] (Pi) [%] R = (Ri)(Pi)
12 0.05 0.60
8 0.08 0.64
6 0.10 0.60
-5 0.50 - 2.50
- 10 0.27 - 2.70
1.0 Σ R = - 3.36%
34
Standard Deviation [σ ] of
SBI
Returns Expected (Ri - R ) (Ri - R )2 Probability (Ri - R )2 * (Pi)
(Ri) Return [R] (Pi)

## 22 8.4% 13.6 184.96 0.05 9.248

16 8.4% 7.6 57.76 0.15 8.664
12 8.4% 3.6 12.96 0.25 3.24
6 8.4% - 2.4 5.76 0.45 2.592
-8 8.4% - 16.4 268.96 0.10 26.896
1.0 Σ = 50.6
4
35 σ = 50.64 = 7.17%
Standard Deviation [σ ] of
ICICI
Returns Expected (Ri - R ) (Ri - R )2 Probability (Ri - R )2 * (Pi)
(Ri) Return [R] (Pi)

## 12 - 3.36% 15.36 235.93 0.05 11.79

8 - 3.36% 11.36 129.05 0.08 10.32
6 - 3.36% 9.36 87.61 0.10 8.76
-5 - 3.36% - 1.64 2.69 0.50 1.34
- 10 - 3.36% - 6.64 44.09 0.27 11.90
1.0 Σ = 44.1
1
36 σ = 44.11 = 6.64%
Continuous
Distribution Problem
◆ Assume that the following list represents the
continuous distribution of population returns
for a particular investment (even though there
are only 10 returns).
◆ 9.6%, -15.4%, 26.7%, -0.2%, 20.9%,
28.3%, -5.9%, 3.3%, 12.2%, 10.5%
◆ Calculate the Expected Return and
Standard Deviation for the population
assuming a continuous distribution.
37
◆ Expected rate of return is 9% for
the 10 observations.
◆ Population SD is 13.32%

38
Determining
Determining Portfolio
Portfolio
Expected
Expected Return
Return
m
RP = Σ ( Wj )( Rj )
j=1
RP is the expected return for the portfolio,
Wj is the weight (investment proportion) for
the jth asset in the portfolio,
Rj is the expected return of the jth asset,
m is the total number of assets in the
39 portfolio.
Determining
Determining Portfolio
Portfolio
Standard
Standard Deviation
Deviation

σ p= Wσ
1
2
2
1 + σ + 2W1 W2 r1σ
2 2
W2 2 ,2 1 σ 2
σ p is the SD for portfolio.
W1 is the weight (investment proportion) for the 1st asset in
the portfolio,.. W2
σ 1 is the SD for the 1st asset in the portfolio
r1,2 is the correlation coefficient between 2 assets

40
Portfolio
Portfolio Risk
Risk and
and
Expected
Expected Return
Return Example
Example
You are creating a portfolio of Stock D and Stock
BW (from earlier). You are investing \$2,000 in
Stock BW and \$3,000 in Stock D. D Remember that
the expected return and standard deviation of
Stock BW is 9% and 13.15%, respectively. The
expected return and standard deviation of Stock D
is 8% and 10.65%, respectively. The correlation
coefficient between BW and D is 0.75.
0.75
What is the expected return and standard
deviation of the portfolio?
41
Determining
Determining Portfolio
Portfolio
Expected
Expected Return
Return
WBW = \$2,000 / \$5,000 = .4
WD = \$3,000 / \$5,000 = .6

RP = (WBW)(RBW) + (WD)(RD)
RP = (.4)(9%) + (.6)(
.6 8%)
8%

42
RP = (3.6%) + (4.8%)
4.8% = 8.4%
Determining
Determining Portfolio
Portfolio
Standard
Standard Deviation
Deviation
σ P= 0.0028 + 0.0041 + (2)(.0025)
σ P = SQRT(.0119)
σ P = .1091 or 10.91%

## A weighted average of the individual

standard deviations is INCORRECT.
43
Determining
Determining Portfolio
Portfolio
Standard
Standard Deviation
Deviation
The WRONG way to calculate is a
weighted average like:
σ P = .4 (13.15%) + .6(10.65%)
σ P = 5.26 + 6.39 = 11.65%

10.91% = 11.65%
44 This is INCORRECT.
Summary
Summary of
of the
the Portfolio
Portfolio
Return
Return and
and Risk
Risk Calculation
Calculation
Stock C Stock D Portfolio
Return 9.00% 8.00% 8.64%
Stand.
Dev. 13.15% 10.65% 10.91%
CV 1.46 1.33 1.26

## The portfolio has the LOWEST coefficient

of variation due to diversification.
45
Correlation
Correlation Coefficient
Coefficient
A standardized statistical measure
of the linear relationship between
two variables.

## Its range is from -1.0 (perfect

negative correlation), through 0
(no correlation), to +1.0 (perfect
positive correlation).
46
INVESTMENT RETURN Perfectly Negatively Correlated

Series-P

Series-Q

47 TIME
INVESTMENT RETURN Perfectly Positively Correlated

Series-P

Series-Q

48 TIME
Diversification
Diversification and
and the
the
Correlation
Correlation Coefficient
Coefficient
Combination
SECURITY E SECURITY F E and F
INVESTMENT RETURN

## Combining securities that are not perfectly,

positively correlated reduces risk.
49
Total
Total Risk
Risk == Systematic
Systematic
Risk
Risk ++ Unsystematic
Unsystematic Risk
Risk
Total Risk = Systematic Risk +
Unsystematic Risk
Systematic Risk [nondiversifiable or unavoidable] is the
variability of return on stocks or portfolios associated
with changes in return on the market as a whole.
Unsystematic Risk [diversifiable or avoidable] is the
variability of return on stocks or portfolios not explained
by general market movements. It is avoidable through
diversification.

50
Total
Total Risk
Risk == Systematic
Systematic
Risk
Risk ++ Unsystematic
Unsystematic Risk
Risk
Factors such as changes in nation’s
STD DEV OF PORTFOLIO RETURN

## economy, tax reform by the Congress,

or a change in the world situation.

Unsystematic risk
Total
Risk
Systematic risk

## NUMBER OF SECURITIES IN THE PORTFOLIO

51
Total
Total Risk
Risk == Systematic
Systematic
Risk
Risk ++ Unsystematic
Unsystematic Risk
Risk
Factors unique to a particular company
STD DEV OF PORTFOLIO RETURN

## or industry. For example, the death of a

key executive or loss of a governmental
defense contract.

Unsystematic risk
Total
Risk
Systematic risk

## NUMBER OF SECURITIES IN THE PORTFOLIO

52
Capital
Capital Asset
Asset
Pricing
Pricing Model
Model (CAPM)
(CAPM)
William Sharpe in 1960
CAPM is a model that describes the
relationship between risk and expected
(required) return; in this model, a security’s
expected (required) return is the risk-free
rate plus a premium based on the
systematic risk of the security.

53
CAPM
CAPM Assumptions
Assumptions
1. Capital markets are efficient.
2. Homogeneous investor expectations
over a given period.
3. Risk-free asset return is certain
(use short- to intermediate-term
Treasuries as a proxy).
4. Market portfolio contains only
systematic risk (use BSE, NSE Index
or similar as a proxy).
54
What
What is
is Beta?
Beta?
An index of systematic risk
[nondiversifiable risk].
risk]
It measures the sensitivity of a stock’s
returns to changes in returns on the
market portfolio.
The beta for a portfolio is simply a
weighted average of the individual
stock betas in the portfolio.
55
Beta Coefficients & their
Interpretations
2.0 Twice as responsive as the market Move in same
Direction as
1.0 Same response as the market Market
0.5 Only half as responsive as the market
0 Unaffected by market movements
- 0.5 Only half as responsive as the market Move in opposite
Direction to
- 1.0 Same response as the market Market
- 2.0 Twice as responsive as the market

56
Characteristic
Characteristic Line
Line [a+bx]
[a+bx]
EXCESS RETURN is higher correlation
ON STOCK
∆ Y
Beta = ∆ X

EXCESS RETURN
ON MARKET PORTFOLIO

Characteristic Line

## Data Points > Dispersion

Wide Dispersion > Low Correlation > High Unsystematic risk
57 Narrow Dispersion > High Correlation > Low Unsystematic risk
Characteristic
Characteristic Lines
Lines
and
and Different
Different Betas
Betas
EXCESS RETURN Beta > 1
ON STOCK (Aggressive)
Beta = 1
Each characteristic
line has a Beta < 1
different slope. (Defensive)

EXCESS RETURN
ON MARKET PORTFOLIO
Beta > 1 = More Systematic risk
More proportion than MP

## Beta < 1 = Less systematic risk

Less proportion than MP
58
Security
Security Market
Market Line
Line

Rj = Rf + β j(RM - Rf)
Rj is the required rate of return for stock j,
Rf is the risk-free rate of return,
β j is the beta of stock j (measures systematic
risk of stock j),
RM is the expected return for the market
portfolio.
59
Security
Security Market
Market Line
Line

Rj = Rf + β j(RM - Rf)
Required Return

RM Risk
Rf
Risk-free
Return
β M = 1.0

60
Systematic Risk (Beta)
Determination
Determination of
of the
the
Required
Required Rate
Rate of
of Return
Return
Lisa Miller at Basket Wonders is attempting
to determine the rate of return required by
their stock investors. Lisa is using a 6% Rf
and a long-term market expected rate of
return of 10%.
10% A stock analyst following
the firm has calculated that the firm beta is
1.2.
1.2 What is the required rate of return on
61
BWs
BWs Required
Required
Rate
Rate of
of Return
Return
RBW = Rf + β j(RM - Rf)
RBW = 6% + 1.2(
1.2 10% - 6%)
6%
RBW = 10.8%
The required rate of return exceeds the
market rate of return as BW’s beta
exceeds the market beta (1.0).
62
June 2010 Q7
Using CAPM find out Required rate of
return [Rj ]
Situation Expected return on Risk Free Beta
Market portfolio Rate [%] [Rf] [bj]
[%] [RM]

1 15 10 1.00
2 18 14 0.70
3 15 8 1.20
4 17 11 0.80
5 16 10 1.90
63
Situation Required Rate of Return Rj = Rf + [bj(RM - Rf)]
1 R1 = 10 + [1*(15 – 10)]
= 10 + [1 * 5]
R1 = 15%
2 R2 = 14 + [0.70*(18 – 14)]
= 14 + [0.70 * 4]
R2 = 16.8%
3 R3 = 8 + [1.2*(15 – 8)]
= 8 + [1.2 * 7]
R3 = 16.4%
4 R4 = 11 + [0.80*(17 – 11)]
= 11 + [0.80 * 6]
R4 = 15.8%
5 R5 = 10 + [1.90*(16 – 10)]
64
= 10 + [1.90* 6]
June 2009 Q4
Using CAPM find out return [Rp ] &
risk [σ P]
◆ The common stocks of companies A & B have the
expected returns & SD given below; the expected
correlation coefficient between the 2 stocks is – 0.35
Company/Stock Rp σ P

A 0.10 0.05
B 0.06 0.04
Compute the risk & return for a portfolio comprising
60% invested in the stock A & 40% invested in stock B
65
Solution:-

## Rp = (0.60)(0.10) + (0.40) (0.06)

Rp = 8.4%

σ =
P
2 2 2 2
(0.60) (0.05) + (0.4) (0.04) + 2(0.60)(0.40)(- 0.35) (0.05)(0.04)

σ P= 0.00082 = 2.86%
66
Determination
Determination ofof the
the
Intrinsic
Intrinsic Value
Value
Intrinsic value of a security is the true Economic Value.

Value

## It is calculated by summing the future income generated

by the asset, and discounting it to the Present Value.

67
Div next period
Intrinsic
=
Value Rp - G

## Current Intrinsic Total Net

Market < Value = Current Assets
Price No. of O/S
of Common Common Shares
Share
68 Margin of Safety to Purchase Equity Shares
Determination
Determination ofof the
the
Intrinsic
Intrinsic Value
Value of
of BW
BW
Lisa Miller at BW is also attempting to
determine the intrinsic value of the stock. She
is using the constant growth model. Lisa
estimates that the dividend next period will be
\$0.50 and that BW will grow at a constant rate
of 5.8%.
5.8% The stock is currently selling for \$15.

## What is the intrinsic value of the stock?

Is the stock over or underpriced?
underpriced

69
Determination
Determination ofof the
the
Intrinsic
Intrinsic Value
Value of
of BW
BW
Intrinsic \$0.50
=
Value 10.8% - 5.8%

= \$10

## The stock is OVERVALUED as

the market price (\$15) exceeds
the intrinsic value (\$10).
\$10
70
◆ Rule No.1: Never Lose Money.
◆ Rule No.2: Never Forget Rule No.1. ...

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