RISK AND RETURN

LEARNING OBJEVTIVE Understand the meaning of return and risk. Know how the return and risk are computed and measured Understand the difference between various averages and which one is useful at which time Learn about the different measures of risk Understand why standard deviation is most appropriate to measure risk Know how to find expected return and standard deviation from the historical data of financial assets.

RISK AND RETURN

Investment decision by individuals and firms alike are done with diverse motive. For firms the decision to invest in business opportunities can be motivated by factors such as desire for control, expansion, status etc. Individual also make investments with several motives ranging from providing for rainy days, speculation, to increase personal wealth. In a nut shell everybody is looking for some return. Investors always wish to earn a return on the funds invested in assets.

RISK AND RETURN

Reason: There is always an opportunity cost of funds. Return helps the investor to realize the opportunity cost. Return may be revenue return (dividend/interest) or Capital return (Capital appreciation) The net return is the sum of revenue return and capital return. The return can be classified into two categories EXPECTED RETURN: Anticipated return in future. Expected return is estimated on the basis of past. Return in the past provide good basis for estimates. In case of fixed interest investments, expected return is fixed interest plus capital change, if any.

RISK AND RETURN

REALIZED RETURN: is the net actual return earned by the investor over the holding period. Initially investors invest for future in the light of expected return, and when the investment period is over, they are left with the realized return. The difference between the expected and realized risk give rise to risk attached with the investment. While identifying expected return, investors think of risk also. THIS IS THE ESSENCE OF INVESTMENT PROCESS The variability in returns from an investment is referred to as RISK. For example, bank deposit is considered risk-less. In equity the return may be 10, 20 or 100% or may be negative. The govt. bonds are known as risk free but other investments are risky. Investors are rational and prefer less risky investments to riskier.

RISK AND RETURN

Some investors are ready to take even higher risk but only with the expectation of higher returns. Investors select the level of risk they are ready to assume. Investors always like to maximize returns but always want to minimize risk. Maximization of returns and minimization of risk are two opposite forces working in the investment decisions. This is known as risk return trade-off
RETURN Return on financial consist of dividend i.e. the benefit of holding the security and capital gain i.e. the difference between prices at the beginning and end of the holding period.

RISK AND RETURN

Consider an initial investment in the stock of Reliance currently selling a price of Rs 500 by an investor. An investor buys 100 shares making an initial investment of Rs 50000. Assume that this investment is being made for a period of one year after which the investor would make an exist by selling the shares. How do we calculate the returns of the investor? To answer this , the returns on the investment must be broken in two parts: The reward the investor gets by owning this asset over the holding period, one year in this case, referred as dividend yield and The gain the investor makes upon selling the asset after the holding period of one year, referred to as capital gain.

RISK AND RETURN

Assume that Reliance declares a dividend of Rs 10 per share during this period of one year. Further, at the end of one year the share price of Reliance is Rs 600 per share. For convenience let us assume that the disinvestment and receipt of dividend are simultaneous and happen exactly after one year. We make this assumption to eliminate the impact of time value of money. The funds received by the investor after one year are: = dividend received + Amount realized through sale = 100 x 10 + 100 x 600 = 1000 + 60000 = 61000 The absolute return of the investor would be = Amount realized Amount invested = 61000 50000 = 11000 %age return = 61000 50000/50000 x 100 = 22%

RISK AND RETURN

Total %age return = Dividend + Capital Gain / Initial Investment = D 1 + (P1 P 0) /Po = D 1 / Po + P 1 P o/P o Where D 1 is the dividend received during the holding period. P 1 is the market price after the holding period and P o is the price paid for buying the security. In this analysis: Time value of money is ignored Made no adjustment for inflation and the returns calculated are in nominal terms, and Not provided for taxes that may be payable on dividend and capital gains that are taxed at different rates.

RISK AND RETURN

CALCULATION OF DIVIDEND YIELD AND CAPITAL GAIN The current market price of the share is Rs 300. An investor buys 100 shares. After one year he sells these shares at a price of Rs 360 and also receives the dividend of Rs 15 per share. Find out his total return, %age return, dividend yield and capital gains. Initial Investment = 300 x 100 = 30000 Dividend Earned = 15 x 100 = 1500 Capital Gains = (360 300) x 100 = 6000 Total Return = 1500 + 6000 = 7500 Total %age return = (7500 / 30000) x 100 = 25% Dividend Yield = 15/300 = 0.05 = 5% Capital Gains = 60 /300 = 0.20 = 20%

MEASURING EXPECTED RETURN

In the previous example, the prices at the time of investment as well as at the time of disinvestment were assumed as known. However, in practice only the current price is known. The investor does not the future price of the financial asset. At best only an estimate can be made bout the future price, which generates expectations of the return. In the absence of availability of a future price, the investor acts on the expectations of some return while initiating a position either buying or selling the financial assets. Investor is rewarded positively when he buys first at a lower price and expects to sell later when price increase, or when he sells first at higher price and expects to buy later when price decreases.

ARITHMATIC MEAN
There are several ways one can estimate the expected return. One of the simplest ways of finding the same is to directly address the question to the investor and seek the %age profit expected. A more complicated approach could be to develop a valuation model and forecast the price a year later or for any other time borazon as considered appropriate by the investor. Yet another way of finding the expected return is to use some standard models such as capital asset pricing model, arbitrage pricing model, etc. another simple time tested approach to find out the expected return is based on historical returns the financial asset has offered in the past. AIRTHMATIC MEAN (AVERAGE) Let us assume the price data of a share for the last six years:

GEOMETRIC RETURN
Arithmetic Return = R = 1/n (R1+R2+R3+..Rn) Arithmetic Return = 20 + 18.18 -6.66 +2.00 +57.78) = 91.30 / 6 = 15.22% GEOMETRIC RETURN Another popular statistics that is very popular as a measure of return is the geometric mean. Let us consider an example. A buys a share in 2001 which trading at Rs 100. A year later in 2002 the price jumps by 100% and becomes Rs 200. Two years after the investment in 2003, the share falls by 50% and again quotes at Rs 100. Assuming that no dividend was paid in the two year period, we may compute the average return for A by taking the average of the returns over the years 2002 and 2003 Return in the first year = 200-100/100= 100% Return in the second years = 100-200/200= -50% Arithmetic average return = 100 + (-50) = 50/2= 25%

GEOMETRIC RETURN
The geometric mean reflects the holding period return and takes compounding into account. If we take R g to be the annual rate of return in a holding period of two years in this case, it is different a year. The first year return is 100% and second year return is -50%, we can calculate the GM, (1+R g) n = (1+R1) x(1+R1) x(1+R1)x (1+Rn) (1+R g) n = (1+1) x (1- 0.5) = 2 x 0.5 = 1 R g = 1 -1 =0 ARITHMETIC MEAN VS GEOMETRIC MEAN The relationship between the geometric mean an arithmetic mean is approximated by equation where R g is geometric mean and R a is the arithmetic mean, and is the standard deviation of the return. R g = R a - 2

RISK
DEFINITION OF RISK Risk can be defined as the probability that the expected return from the security will not materialize. Every investment involves uncertainties that make future investment returns risk-prone. Uncertainties could be due to the political, economic and industry factors. Risk could be systematic in future depending upon its source. Systematic risk is for the market as a whole, while unsystematic risk is specific to an industry or the company individually. TYPES OF INVESTMENT RISK Modern investment analysis categorizes the traditional sources of risk causing variability in returns into two general types.

RISK
Those that are pervasive (present everywhere in something) in nature, such as market risk or interest rate risk, and those that are specific to a particular security issue, such as business or financial risk. Therefore, we must consider these two categories of total risk. Dividing total risk into its two components, a general (market) component and a specific (issuer) component; we have systematic risk and non-systematic risk. Total risk = General risk + Specific risk = Market risk + Issuer risk = Systematic risk + Non-systematic risk SYSTEMATIC RISK An investor can construct a diversified portfolio and eliminate part of the total risk, that is, the diversifiable or non-market part.

RISK
What is left is the non-diversifiable portion or the market risk. Variability in a securitys total returns that is directly associated with overall movements in the general market or economy is called systematic (market) risk. Virtually all securities have some systematic risk, whether bonds or stock, because systematic risk directly encompasses interest rate, market, and inflation risks. The investor cannot escape this part of the risk because know to all investors.

RISK
These movements occur regardless of what any single investor does. Clearly, market risk is critical to all investors. NON SYSTEMATIC RISK matter how well he or she diversifies, the risk of the overall market cannot be avoided. If the stock market declines sharply, most stocks will be adversely affected, if it rises strongly, as in the last few months of 2008 and 2009, most stocks will appreciate in value. These movements occur regardless of what any single investor does. Clearly, market risk is critical to all investors.

RISK
The variability in a securitys total returns not related to overall market variability is called the non-systematic (non-market) risk. This risk is unique to a particular security and is associated with such factors as business and financial risk as well as liquidity risk. Although all securities tend to have some non-systematic risk, it is generally connected with common stock. Systematic risks are market risk, Interest rate risk and purchasing power risk or inflation risk. Market risk is recession, war, structural changes in economy, tax law changes and eve Interest rate risk and purchasing power risk or inflation risk and changes in consumer preferences etc. Unsystematic risks are Regulation risk, Business risk, Reinvestment risk, Bull-bear market risk, Management risk, Default risk.

MEASUREMENT OF RISK
MEASUREMENT RISK Volatility: Of all the ways to describe risk, the simplest and possible most accurate is the uncertainty of a future outcome. As we know that the anticipated return for some future period is known as the expected return. The actual return over some part period is known as the realized return. The simple fact that dominates investing is that the realized return on an asset with any risk attached to it may be different from what was expected.

MEASUREMENT OF RISK
Volatility may be described as the range of movement (or price fluctuations) from the expected level of return. For example, the more a stock goes up and down in prices the more volatile that stock is. Because wide price swings crate more uncertainty of an eventual outcome, increased volatility can be equated with increased risk. Being able to measure and determine the past volatility of a security is important in that it provides some insight into riskiness of that security as an investment. PROBABILITY DISTRIBUTION We defined the average return as the sum of observations divided by the number of observations.

MEASUREMENT OF RISK
What meaning do we assign to this value? Does this represent the more likely value? Not really. In fact it was assumed that all observations are equally likely. It implies that if sufficiently large observations were made one would end up with the return equal to the average computed. In fact the returns on the assets are not equally likely. Some values of return occur more often while some values occur fewer times when some extraordinary events happen. In such situations the returns are not evenly distributed. There is a greater chance that some values will occur more often than others. A graphical plot of the values of the return on the horizontal axis and the frequency of occurrence on the vertical axis is referred as frequency distribution. An example would illustrate the point. Consider the data of returns for 150 observations on a security as given in the table.

MEASUREMENT OF RISK
Frequency of occurrence Values of returns in % Probability of occurrence Probability x Return (%) 26 10 17% 1.73 34 15 23% 3.40 50 20 33% 6.67 18 25 12% 3.00 12 30 8% 2.40 10 35 7% 2.33

26 x10/150
Expected Returns (%) 19.53

MEASUREMENT OF RISK
A total of 150 observations are made. The table lists the frequency of observed returns ranging from 10% to 35%. For example, the value of 20% returns occurs 50 times out of the total 150 observations. In the above example, the likelihood of a 20% return occurring is 33%. In a scenario where the frequency of occurrence is not same, the average will not be given by arithmetic return which considers all values equal. One has to take into consideration the likelihood of occurrence of each value. The average referred as expected value is the product of probability and the value of the variable. The expected value can be calculated as: Expected values = Sum of product of probabilities and value. E (R) = pi x Ri

MEASUREMENT OF RISK
Pi = probability of occurrence of ith outcome Ri = Return for the ith outcome. N = Nos of possible outcome. AVERAGE DEVIATION Another way of measuring risk is to find out the deviation of returns from a reference value such as an expected return. It must also include the probability of such deviations. For an aggregate risk one can add the product of deviations. For example let us consider the data in the below mentioned table.

MEASUREMENT OF RISK
Probability p Return % R P x R Deviation R-E) P x [(R-E)]

O.2 O.3 O.3 O.2 Expected Return E) Sum of deviation as measure of risk

15 20 30 40

3 6 9 8 26

-11 -6 +4 +14

- 2.2 - 1.8 +1.2 +2.8 o

MEASUREMENT OF RISK
With the possible value of returns of 15, 20, 30 and 40% with probability of .2, .3, .3, .2, the expected return works out to 26%. The risk measured as a sum of deviations in the last column of the table is Nil or O. this happens because positive and negative deviations cancel out each other. Clearly this too cannot be a dependable and authentic measure of risk. VARIANCE AND STANDARD DEVIATION