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Contents
Risk and return go together
Probability distribution of all possible outcomes in terms of return
Measuring risk so as to expect adequate return – Weighted average return,
Standard deviation and the Co-efficient of variation
Risk in a portfolio context – introduction to a portfolio of securities
Types of risk associated with investment in a portfolio – systemic and non-
systemic
Concept of Beta and Capital Asset Pricing Model
Volatility and Risk
Some concerns about Beta and the CAPM
Numerical exercises in risk and return
♦ The enterprise pays the lender interest periodically. The owners on the contrary, get return in
the form of dividend. This is not certain.
♦ Besides interest, the enterprise should also have sufficient surplus after paying interest to
repay the loan amount
♦ Risk of project failure affects the owners more than the lenders for the same reason as
mentioned in the first bullet point
Thus we prove the point mentioned at commencing this chapter namely “risk and return go together”.
The question relevant here is that “can we define risk?’ Let us make an attempt here. We make an
investment in bank’s fixed deposit at 8% p.a. We have an agreement with the bank that if the market
rate comes down the rate of interest offered on the deposit would also come down. Is there a risk
here? Definitely, if the market rate comes down. What is this risk? The risk of not getting the expected
return of 8%. Thus the first definition of “risk” is the “uncertainty”. Uncertainty relating to what? In the
given example, uncertainty relates to “outcome” of an “activity”, i.e., investment. Is the “outcome”
stated? Yes. Right in the beginning when we contracted with the bank to get 8% return.
So, we build up the definition of “risk”. We can define risk in general as “uncertainty relating to a
stated outcome of a specific activity”. The activity could be anything and the outcome automatically
gets related to this. For example, undergoing a post graduation course in “Management” could be the
activity and the risk could be relating to the stated outcome of landing oneself in a well-paid job. In
finance terms, the “risk” obviously relates to the activity of investment and the stated outcome
relating to this would be the “return” on this investment. Thus going back to our example of
investment in a bank deposit, the activity is “investment in a bank deposit”. The risk relates to the
outcome of return on this investment namely interest not coming down from the expected rate of 8%.
Is risk related only to possible reduction in rate of return? Or in other words, is
there no risk in case the return is higher than the expected rate of return?
Suppose the bank deposit referred to above fetches us higher return than expected rate of 8%. Is
there no risk? There apparently is no risk from the point of view of the depositor. However this is not
the correct picture. The very fact that the return is higher than the expected rate due to
increase in market rate of interest could also bring the rate down in future any time. Thus
going by the accepted definition of “risk” relating to investment, it relates to uncertainty of the return
from the investment and not specifically to whether the deviation (fluctuation) is positive (return being
higher than expected) or negative (return being less than expected). In both the cases of deviation or
fluctuation from the expected rate of return, risk exists. Let us examine the following graph.
Return
On
investment
The above graph shows returns deviating from the expected rate of return both positively and
negatively. Does it mean that when it deviates positively there is no risk for us? There is a risk of
uncertainty that the returns could go down and be less than the expected rate of return.
Conclusion:
The higher the uncertainty the higher the risk. The higher the risk the higher the return expectation.
This is because the investors are risk averse and would expect a higher return in case the risk
increases. In terms of probability of return, the higher the probability, the less the uncertainty and less
the risk. Conversely the less the probability, the more the uncertainty and higher the risk.
In this chapter, we are going to study the return on investment in stock markets, i.e., in shares and
bonds and not any other investment as these are subject to market risk and fluctuations. This
enhances the risk associated with investment into equity market and bond market. We will examine as
to what kind of risk can be minimized and what cannot be minimized. We are also going to see how the
risk of an individual stock (share) can be minimized by including the same in a bunch of securities
(investment instruments) that is called “portfolio”.
The total return on investment = Amount received on sale of investment – Amount invested at T0
----------------------------------------------------------------------------------------------------------------
Amount invested at T0
Thus the return on our investment for a period of one year = 130/1000 = 13% p.a1.
Return on investment in shares = dividend + market appreciation during the period of holding the
security (difference between selling and purchase prices). Suppose the holding period is two years,
the return is determined cumulatively for a period of 2 years and divided by 2 to arrive at annual
return.
1
Return is always expressed on annual basis. For example if the return for holding a security is 13% for a period of
six months, the annualised return would be 26% = 2 x 13%
Standard deviation
Investment is about selection of one stock (share or bond) in preference over another, after due
consideration of the risks associated with them respectively. Let us say for example investment in
shares of two limited companies A and B. In this case we should understand the implication of
probability distribution of expected returns for a given period for both the stocks. Let us examine the
probability distribution and understand the concept of risk. We are examining below the expected
value of return and standard deviation of return for a chosen stock.
2
Total = 1.00 ∑ = .090 = R σ = 0.00703 and σ = 0.0838
th
Where Ri is the return for the i possibility, Pi is the probability of that return occurring and n is the
total number of possibilities. Thus the expected value of return is simply a weighted average of the
possible returns, with the weights being the probabilities of occurrences. For the above distribution of
possible returns, the expected weighted average return is 9% and the standard deviation of the return
is 0.0838 or 8.38%. We can easily see that the higher the standard deviation the higher the risk; the
higher the risk, the higher the expected rate of return in future. Thus the standard deviation is a
simple measure of risk based on the distribution of returns in the past by assigning probabilities to
them. The probabilities represent the % times the return has been so. In this case the probability is
10% for 20% return, this means that 10% of the times, the return has been 20%.
Coefficient of Variation
The standard deviation can at times be misleading in comparing the risk, or uncertainty relating to the
alternative returns, if they differ in size. Consider two alternative investment opportunities, A and B,
whose normal probability distributions of one-year returns have the following characteristics:
____________________________________
Investment
A B
____________________________________
Expected Return R 0.08 0.24
Standard deviation σ 0.06 0.08
Co-efficient of variation CV 0.75 0.33
We have mentioned earlier that higher the standard deviation, the higher the risk and vice-versa. Now
looking at the above table, can we say that since the standard deviation of stock B is more than that of
stock A, the risk associated with it is higher? Yes and No. Yes if the sizes of investment is the same in
both the stocks. This is best explained by taking two persons having widely different incomes
with the same standard deviation. Let us assume that the average monthly income of the first person
is Rs.10,000/- while that of the second person is Rs. 1,00,000/-. Both of them are having standard
deviation of say 3,000/-. We can very easily see that while this standard deviation would affect the first
person much more than it does the second person. This is what establishes the need for determining
the co-efficient of Variation. How does one do it?
To adjust for scale or size, the standard deviation can be divided by the expected value of return to
compute the coefficient of variation (CV). Co-efficient of variation (CV) = σ /R. This in the above table
gives us the values of 0.75 = 0.06/0.08 for stock A and 0.33 = 0.08/0.24 for stock B. Thus using the co-
efficient of variation (CV) we find that the riskiness of stock A is more than the riskiness of stock B
while by standard deviation method, we would have found stock B to be more risky than stock A.
Portfolio Return
The expected return of a portfolio is simply the weighted average of the expected returns of the
securities constituting that portfolio. The weights are equal to the proportion of total funds invested in
each security (the total of weights must equal to 100 percent). The general formula for the expected
return of a portfolio Rp is as follows:
m
Rp = ∑ Aj x Rj
J=1
Where Aj is the proportion of total funds invested in security j; Rj is the expected return for the security
j and m is the total number of different securities in the portfolio. The expected return and standard
deviation of the probability distribution of possible returns for two securities are shown below:
Security A Security B
2
For details of different markets and instruments, please refer to the chapter on “Financial Sources”
If equal amounts of money are invested in these two securities, the expected return of the portfolio
containing two securities namely A and B is 0.5 x 14% + 0.5 x 11.5% = 12.75%.
Portfolio Risk
The portfolio expected return is a straightforward weighted average of returns on the individual
securities; the portfolio standard deviation is not the weighted average of individual security standard
deviations. We should not ignore the relationship or correlation between the returns of two different
securities in a portfolio. This correlation however has no impact on the portfolio’s expected return. Let
us understand what we mean by “correlation” between securities.
Suppose we have two stocks “A” and “B” in our portfolio. During a given period the return of “A”
increases say by 1% while that of “B” increases by 0.5% in the same period. This means that both are
moving positively in the direction of increasing returns. This is described as “positive” correlation.
However the quantum of increase is not the same in both the cases. Hence this is imperfect but
positive correlation. In case the quantum of increase is 1% in both the cases, then the correlation is
said to be positive and perfect correlation.
If the returns move in the opposite direction, say one increasing and the other decreasing, then the
correlation is negative. Still the relationship could be perfect in the sense that the quantum of increase
in return say in the case of “A” is the same in the case of “B” but in the opposite direction. This means
that while stock “A” has increased its return, stock “B” has lost its return by the same percent. Let us
try to put these in the form of equations.
“Δ” represents the increase in return and (“Δ”) (within brackets indicate that the return is decreasing).
Keeping these in mind let us attempt the following:
Δ of stock A = 1% for a given period = Δ of stock B = perfect and positive correlation
Δ of stock A = 1% for a given period; Δ of stock B = greater than or less than 1% but the return has
increased and not decreased = positive but imperfect correlation
Δ of stock A = 1% for a given period; (“Δ”) of stock B = 1%. Then stock A and stock B are said to have
perfect but negative correlation.
Δ of stock A = 1% for a given period; (“Δ”) of stock B less than or more than 1%. Then stock A and
stock B are said to have imperfect and negative correlation.
We have consciously omitted the fifth possibility of both the stocks A and B losing to the same percent
during a given period. Any portfolio would avoid such stocks unless the future is going to be
completely different in which case the past is not the basis on which stock selection is being made.
We have also tried to present these concepts in as simple a manner as possible. The students are
advised to go through these repeatedly to grasp the essence of the underlying concept in correlation
between one stock and another. This is required because the concept of correlation is the fundamental
based on which the selection of stocks for a portfolio is done. The students will appreciate that positive
correlation between two stocks would mean increased risk especially if the relationship is perfect.
Negative correlation stocks are not desirable. What is then left is positive but imperfect correlation.
The risk-averse investors would invariably choose such stocks as show positive relationship between
them (or among them in view of the number of stocks in a portfolio being more than 2, which is usually
the case) but not perfect relationship. Then only the risk in a portfolio is reduced. For a given period,
same degree of movement in return on different stocks in the same direction only
increases the risk in a portfolio.
Now going back to the standard deviation of a portfolio, we will appreciate that it is not merely the
weighted average of the standard deviation numbers for each stock in the portfolio. Suppose there are
five stocks in a portfolio. We can appreciate that there are quite a few possible combinations of these
five stocks depending upon the proportion of investment in each of them; for each combination, the
weighted average of the standard deviation numbers has to be etermined first and then the ultimate
average standard deviation should be found out for all possible combinations. This involves a very
complicated calculation and hence not presented here. 3 However before we end this topic it should be
mentioned that the complicated calculation is worth the time invested in, as the ultimate result is
reduction in the total risk of the portfolio. This is the very objective of a portfolio.
3
This is better explained by any standard textbook on “Security Analysis and Portfolio Management”. Any student
interested on the topic of “Investment” is well advised to refer to any standard textbook on SAPM.
statement that they are totally risk-free. In the absence of any better alternative that is 100% risk free,
this has been accepted as “risk-free” investment. Suppose the average return from investment in
Govt. securities in India say, is 6.5% p.a. Risk-averse investors would be induced to invest in market
securities like shares or debentures or bonds only when they get what is known as “risk premium”. Let
us assume this to be 6%. This means that the market investment should fetch us 6.5% + 6% = 12.5%.
Unless we are sure of this return we will not invest in market securities.
Is there any readymade portfolio whose return represents the market return? Yes. The BSE sensex
represents the market portfolio and the return on this for a given period is the market rate of return.
The difference between this market rate of return (12.5%) and risk free rate (6.5%) represents the
market premium (6%). Is BSE sensex the only portfolio? No. NSE’s 50 stock index is another one.
However let us bear in mind that BSE sensex or NIFTY FIFTY does not include any debt instrument like
debenture or bond or short-term money market instruments. Hence the parameter of market premium
as applicable to BSE sensex etc. relates only to investment in equity shares.
Example no. 3
Let us say that the risk-free rate is 6.5% as assumed in the above paragraphs. Let us say that the
market premium is also 6% as assumed before. The Beta of a given stock is 1.2. Then the expected
rate of return from this stock is = Rj = Risk free rate + (Beta of selected stock x market premium) =
6.5% + 6% x 1.2 = 13.7%. This means that the expected rate of return from selected stock is 13.7%.
This equation is the famous equation called “Capital Asset Pricing Model (CAPM)”
The higher the Beta, the higher the risk and the higher the risk premium in comparison with the
market premium and vice-versa. In the preceding paragraph we saw that the Beta for RIL is less than
1. What does it mean? The risk associated with RIL stock is less than the risk associated with market
portfolio. It is safer. Beta is a true measure of the relative volatility of the return of a given
stock in comparison with the volatility of return of market portfolio.
4
Datum is singular and data is a plural of datum. Hence data and are should be used and not data and is.