Risk and Return (Theory)

Risk and Return

Portfolio Analysis (Chapter - 4)

Assets pricing model (Chaper - 5)

1) Risk and return fundamentals 2) Risk aversion utility CML and CAL Risk and return fundamentals Investment Alternative use of saving or Rational use of saving or Best use of saving or sacrifice of person resources for sometimes Planning for future consumption Purchase of real or financial assets Why investment? To get additional financial benefit (capital gain and normal gain) To save the money from inflation To consume in future To maintain liquidity Excitement of interests To increase wealth position Main concerns of investments R Resources sacrifice today certain R Return expectation future uncertain R Risk involvement function during the period T Time time holding period duration E Environment factors and influences favorable and unfavorable Return analysis Return reward of investment Increment in value of wealth Additional financial benefit Cost of compensation paid for bearing risk and waiting time.

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Sources of return Return comes from two sources 1. Capital gain increment in price 2. Normal gain regular cash flow i.e interest and dividend Measurement of return Realized rate of return (past) and expected rate of return (future) are the two forms of return which are measured as under. 1. Holding period return (HPR) Example Date Price Dividend 1-1-2011 8000 31-12-2011 8100 500 31-12-2012 11000 100 31-12-2013

Find the HPR of Mr. A of his investment Stock NSO Po P1 A 10 100 115 B 20 200 220 D1 5 10 HPR 20% 15%

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AM and GM return For example I Year 1 2 3 Rj 6% 7 9

4 10

5 8

GM is the annualized return between FV and PV i.e with compounding concept Conclusion of AM and GM If there is no fluctuation in periodic returns then AM=GM If there is fluctuation in periodic returns then GMAM GM uses actual compounding effect but AM is biased GM is better for decision Effective rate of return Real rate of return That inflation adjusted actual rate of return which expresses the additional purchasing power of investor. where, q = inflation rate Expected rate of return Forecasted rate of return by using future date and respective probabilities is known as expected rate of return. Where,

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For example State V bad Bad Average Good V good

Rj 8 10 12 14 16

Pj 0.1 0.2 0.4 0.2 0.1

Rj*Pj 0.8 2 4.8 2.8 1.6 12%

For equal probability case

Or, Required rate of return (RRR) = cost = Rf + (Rm Rf) i Risk Uncertainties on future results or outcomes are known as risk. Fluctuation or variation or deviation in rate of return is known as risk. Higher the variation, higher the risk, lower the variation, lower the risk and if there is no variation there is no risk. For example: Year 1 2 3 4 5 Rj -2 22 -10 32 8 Rj = 50 High risk high variation Standard deviation Rp 8 9 10 11 12 Rp = 50 Low risk low variation Rt 10 10 10 10 10 Rt = 50 No risk no variation 144 144 400 484 4 4 1 0 1 4

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 Standard average volatility throughout the period. Standard dispersion around the mean.

Variance = square of S.D Co-variance between two assets It is a statistical tool which is used to Show the relationship between two stocks return whether positive or negative. To show whether they are moving in same direction or opposite direction.

Correlation coefficient Covariance only shows positive or negative relationship but is silent about the degree of relationship. So to find degree of relationship we calculate coefficient between A and B. rAB = AB = covAB/ A B

Portfolio What? Combination of more than one asset in investment. Why? To minimize the risk for stable return How? Possible loss from one will be covered by gain of others. Who? Harry M. Markowitz When? - 1952 What assumption? - Not put all eggs in a single basket. Expected return of portfolio It is simply the weighted average of return of individual assets which are included in portfolio. The expected return of portfolio depends upon following two factors.

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