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RETURN
Why do people invest?
By investing (saving money now instead of spending
it), individuals can tradeoff present consumption for a
larger future consumption.
Realized vs Expected
Expected more relevant
but historical returns provides a base
Quantitative Measures of Return
Holding Period Returns
CFt (PE PB )
TR
PB
TR is Total Return
CFt is cash flows received as interest or dividend during a
given time period
PE is price at the end of the period or the sale price
PB is price at the beginning of the period or purchase price
An Example
100 shares of ACC was purchased at Rs. 1000 per
share and sold one year later at Rs. 1130 per share.
A dividend of Rs. 10 per share is paid by the
company. Find the Total Returns for the year.
14%
An investors bought 100 shares of Wipro a year back at the
prevailing market price of Rs. 500 per share. Assuming that
Wipro declared a dividend of Rs. 10 per share at the end of
the year and the share price of Wipro, end of the year, was
quoted at Rs.600 per share.
What is the return earned by the investor if he sells the
shares at the end of one year?
9.6%
Geometric average / mean
= [(1+R1)(1+R2)..(1+Rn)]1/n 1
Year Return
1 0.19
2 0.14
3 0.22
4 -0.12
5 0.05
Year Return Return Relative (1+R)
1 0.19 1.19
2 0.14 1.14
3 0.22 1.22
4 -0.12 0.88
5 0.05 1.05
[(1.19)*(1.14)*(1.22)*(0.88)*(1.05)]1/5 1
= 1.0887 1
=.0887 = 8.87%
Which is better? AM or GM
2013 50 100
2014 100 50
AM = 25%
GM = 0%
Arithmetic Versus Geometric
AM does not measure the compound growth rate
over time
Butit is suited for calculation of return in a single
period for various assets
Year Return
1 10% Geometric average return
2 -5% (1 Rg ) 4 (1 R1 ) (1 R2 ) (1 R3 ) (1 R4 )
3 20% Rg 4 (1.10) (.95) (1.20) (1.15) 1
4 15% .095844 9.58%
r1 r2 r3 r4
Arithmetic average return
4
10% 5% 20% 15%
10%
4
Expected Returns
n
E RAsset pi Ri p1 R1 p2 R2 .... pn Rn
i 1
Example
Expected rate of return on Bharat Food stock is:
The first symbol is the symbol for danger, while the second
is the symbol for opportunity, making risk a mix of danger
and opportunity.
RISK RETURN TRADE-OFF
Higher the risk, higher the expected return
List of securities with increasing risk
TreasuryBills (zero risk)
Corporate Bonds
Stocks
RISK RETURN TRADE-OFF
25%
20%
Expected Return
15%
10%
5%
0%
0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20%
Risk
Measurement of Risk
Standard Deviation
It is a measure of the total risk of an asset or a portfolio
Beta
It is a measure of the systematic risk of a security.
It is a relative measure of risk- the risk of an individual
stock relative to the market portfolio of all stocks.
Variance and Standard Deviation
R
n 2
1
2
R
n 1
t
t 1
( R1 R) 2 ( R2 R) 2 ( RT R) 2
SD VAR
n 1
n is used for population and n -1 for sample
Example
Period Return
1 0.15
2 0.12
3 0.20
4 -0.10
5 0.14
6 0.09
Solution
Square of
Period Return Deviation Deviation
1 0.15 0.05 0.00250
2 0.12 0.02 0.00040
3 0.20 0.10 0.01000
4 -0.10 -0.20 0.04000
5 0.14 0.04 0.00160
6 0.09 -0.01 0.00010
Variance ( )
n
2
(Pr obability ) x Possible Expected
( )
i 1
Return Return
n
Pi [ Ri E ( Ri )]2
i 1
Risk of Expected Return
Standard Deviation (): It is the square root of the
variance and measures the total risk
n
Pi [ Ri E ( Ri )]
i 1
2
Example
Returns in finance are assumed to have
a Normal Distribution
Completely characterized by 2 parameters: Expected
return and standard deviation of returns
B
Portfolio Risk and Return
n
E(R p ) w iE(R i )
i1
Portfolio return
Total 20,000,000
Return*Wt
20*0.05 1
5*0.20 1
10*0.75 7.5
Portfolio 9.5
return
Portfolio Risk
Portfolio risk is not the weighted average of the
risks of the individual securities in the portfolio
Standard Deviation of a Portfolio
The Formula
n 2 2 n n
port w i i w i w jCovij
i1 i1 j1
ij
where :
port the standard deviation of the portfolio
Wi the weights of the individual assets in the portfolio, where
weights are determined by the proportion of value in the portfolio
i2 the variance of rates of return for asset i
Cov ij the covariance between the rates of return for assets i and j,
where Cov ij ij i j
Risk of a two asset portfolio
Estimated Covariance
Returns on securities 1 and 2 under 5 possible
states:
State Probability Return 1 Return 2
1 0.1 -10% 5%
2 0.3 15 12
3 0.3 18 19
4 0.2 22 15
5 0.1 27 12
Estimated Covariance
Deviation Deviation
from from Prob*Dev
Prob Return 1 Product mean Return 2 Product mean 1*Dev2
0.1 -0.1 -0.01 -0.26 0.05 0.005 -0.09 0.00234
0.3 0.15 0.045 -0.01 0.12 0.036 -0.02 0.00006
0.3 0.18 0.054 0.02 0.19 0.057 0.05 0.0003
0.2 0.22 0.044 0.06 0.15 0.03 0.01 0.00012
0.1 0.27 0.027 0.11 0.12 0.012 -0.02 -0.00022
Sum =
ER 0.16 ER 0.14 0.0026
Covariance and Correlation
The correlation coefficient is obtained by standardizing the
covariance i.e. by dividing the covariance by the product of the
individual standard deviations
A measure that determines the degree to which two variable's
movements are associated.
Cov
12
12
1 2
0.00547 / (0.14363*0.05128)
=0.74 approx
10.74%
Correl SD
1 12.40%
0.5 10.74%
0 8.77%
-0.5 6.21%
-1 0.40%
= 0.16 /(0.1+0.16)
= 0.615384615
w2 = 1- 0.615384615
= 0.384615385
Systematic risk
arises on account of the economy-wide uncertainties and the
tendency of individual securities to move together with
changes in the market.
Cannot be reduced through diversification.
Sources: Inflation, interest rates, Political, Exchange rates, etc.
Systematic and Unsystematic Risk
Total Risk ()
im
2
m Covariance of stock
with the market
Beta 0.76125
How is beta interpreted?
Beta of the market = 1
If b = 1.0, stock has risk similar to the market.
If b > 1.0, stock is riskier than market.
If b < 1.0, stock is less risky than market.
Most stocks have betas in the range of 0.5 to 1.5.
Ri i i Rm ei
Security Returns
Slope = i
Return on
market %
Ri = i + iRm + ei
10-75
Beta for the data given in the example
0.3
Stock Returns
0.25
0.2
0.15
0.1
0.05
0
-0.1 -0.05 0 0.05 0.1 0.15 0.2 0.25 0.3 0.35
-0.04
-0.05
-0.1
Market Returns
Ways to calculate BETA in EXCEL
Function
slope 0.761252
linest 0.761252
Calculating Beta in Practice
Many analysts use the NSE or BSE 500 to find the
market return.
Analysts typically use four or five years of monthly
returns to establish the regression line.
Some analysts use 52 weeks of weekly returns.
Rf is taken from 91 day T Bills rate or 10 year GOI
Bonds rate
Portfolio Theory
Source: Investopedia
Sharpe took the Portfolio Theory further by adding
a risk free investment and came up with the Capital
Asset Pricing Model (CAPM)
Relationship between Risk and Expected Return
R i RF i ( R M RF )
Expected return
R
M
RF
1.0
Limitations of CAPM
Calculate
the market risk premium and other
components individually
MRP for India ranges between 8 to 13% according to a
study
Required return for a portfolio:
E(R n Asset Portfolio) = Rrf + n Asset Portfolio(E[Rm] Rrf)