Risk - Return

-Prof.Suyash Bhatt

Types of Risk
1. Systematic Risk
Market Risk Interest Rate Risk Purchasing Power Risk. 2. Unsystematic Risk - Business Risk - Financial Risk.

Return of Single Asset

The typical object of investment is to make current income from investments in the form of dividends and interest income. The investments should earn reasonable and expected rate of return on investments. Certain investments like bank deposits, public deposits, debentures, bonds etc. will carry a fixed rate of return payable periodically. In case of investments in shares of companies, the periodical payments in the form of dividends are not assured, but it may ensure higher returns than fixed income investments. But the investments in equity shares of companies carry higher risk than fixed income instruments, Another form of return is in the form of capital appreciation. This element of return is the difference between the purchase price and the price at which the asset can be sold, it can be a capital gain or capital loss arising due to change in the price of the investment.

Risk of Single Asset

The concept of risk is more difficult to quantify. Statistically we can express risk in terms of standard deviation of return. For example, in case of gilt edged security or government bonds, the risk is nil since the return does not vary - it is fixed. But strictly speaking if we consider inflation and calculate real rate of return (inflation adjusted) we find that even government bonds have some amount of risk since the rate of inflation may vary. Return from unsecured fixed deposits appear to have zero variability and hence zero risk. But there is a risk of default of interest as well as the principal. In such case the rate of return can be negative. Hence, this investment has high risk though apparently it carries zero risk. For other investments like shares, business etc., where the rate of return is not fixed, there may be a schedule of return with associated probability for each rate of return.

Risk of Single Asset

The mean of the probable returns gives the expected rate of return and the standard deviation or variance which is square of standard deviation measures risk. Higher the range of the probable return, higher the standard deviation and hence higher the risk. A risk averse investor will look for return where the range is low. Hence, low standard deviation means low risk. The problem in portfolio management is to minimise the standard deviation without sacrificing expected rate of return. This is possible by diversification. Risk is measured in terms of variability of returns.

Problem 3
The rate of return of equity shares of Hill Top Ltd. for past six years are given below:
Year Rate of Retur n (%) 2000 12 2001 18 2002 -6 2003 20 2004 22 2006 24

 Calculation of Average Rate of Return

R 12 18 6 20 22 24 15 % R
N 6

( R R) 2 N

Year

Rate of Return (%)

(R R)

(R R)2

2000 2001 2002 2003 2004 2005

12 18 -6 20 22 24

-3 3 -21 5 7 9

9 9 441 25 49 81

2 Variance
102 .33 10 .12 %

Return of Portfolio (Two Assets)

(R ) W (R ) W (R )
p A A B B

Where Rp = Expected return from a portfolio of two securities WA = Proportion of funds invested in Security A WB = Proportion of funds invested in Security B RA = Expected return of Security A RB = Expected return of Security B WA +WA = 1

Problem 8 Mr. Amar's portfolio consists of six securities. The individual returns of each of the security in the portfolio is given below:
Security Proportion of Investment in the portfolio A B C X Y 10% 25 8% 30% 12% 18% 12% 22% 15% 6% Return

15%

8%

Risk of Portfolio (Two Assets)

The risk of a security is measured in terms of variance or standard deviation of its returns. The portfolio risk is not simply a measure of its weighted average risk. The securities consisting in a portfolio are associated with each other. The portfolio risk also considers the covariance between the returns of the investment, covariance of two securities is a measure of their co-movement, it expresses the degree to which the securities vary together.

Risk of Portfolio (Two Assets)

P 2 WA 2 A 2 WB 2 B 2 2WAWB AB A B
Where A = Standard deviation of portfolio consisting securities A and B WA and WB= Proportion of funds invested in Security A and Security B B = Standard deviation of returns of security A and security B AB= Correlation coefficient between returns of Security A and Security B The Correlation coefficient ( ) can be calculated as follows :

AB

Cov AB

A B

 The diversification of unsystematic risk, using two security portfolio, depends upon the correlation that exist between the returns of those two securities. The quantification of correlation is done through calculation of correlation coefficient of two securities
If =1 No unsystematic risk can be diversified If = -1 all unsystematic risk can be diversified If = 0 No correation exists between the returns of Security A and Security B

Problem 9 The returns of Security A and Security B for the past six years are given below
Year Security Security B

A
Return % 2001 9

Return %

10

2002
2003 2004 2005

5
3 12 16

-6
12 9 15

Calculation Mean Return and Standard Deviation of Security A

Year Return % (R R) (R-R)2

R
2001 2002 2003 2004 2005 9 5 3 12 16 45 0 -4 -6 3 7 0 16 36 9 49 110

 Mean Return ( ) = 45/5 = 9% Standard Deviation ( ) = = 10.49%

Calculation of Mean Return and Standard Deviation of Security B

Year Return (%) (R R) (R- R)2

R
2001 2002 2003 2004 2005 10 -6 12 9 15 40 2 -14 4 1 7 4 196 16 1 49 266

 Mean Return ( ) = 45/5 = 8% Standard Deviation ( ) = = 16.31%

 Analysis : Security A has a higher historic level of return and lower risk as compared to Security B Correlation Coefficient
N XY ( X )( y ) N X ( X )
2 2

N Y ( Y )
2

As return % X 9 X2 81 Y 11

Bs Return % Y2 100 XY 90

5
3 12 16

25
9 144 256

-6
12 9 15

36
144 81 225

-30
36 108 240

(5 X 444) (45 X 40) (5 X 515) (45) 2 (5 X 586z ) (40) 2