Module 2

Meaning and measurement of security

returns
Meaning and types of security risks
Systematic and
Non-systematic risk

Measurement of total risk.

RETURN
The gain or loss of a security in a particular period.
The return consists of the

Income and

Capital gains relative on an investment.

It is usually quoted as a percentage.

CAPITAL GAIN
An increase in the value of a capital asset (investment or real
estate) that gives it a higher worth than the purchase price.
The gain is not realized until the asset is sold. A capital gain
may be short term (one year or less) or long term (more than
one year) and must be claimed on income taxes.
A capital loss is incurred when there is a decrease in the
capital asset value compared to its purchase price.

Measurement of Return
Return=Income + Capital gain
P1-P0
D
R=
+
P0

P0

Where D= dividend
P0= Price at the beginning of the period i.e purchase price
P1= Price at the end of the period i.e selling price

Expected return and risk

Expected return on a portfolio is simply the
weighted average of the expected returns on
the individual securities in the portfolio:
E(Rp)= wiE(Ri)

Real Rate of Return

1+r
Real rate of return =

-1
1+IR

RISK
The chance that an investment's actual
return will be different than expected.

This includes the possibility of losing

some or all of the original investment.

It is usually measured by calculating the

standard deviation of the historical returns
or average returns of a specific investment.

Types of risk

Systematic Risk
Risk

that cannot be reduced or

predicted in any manner and it is
almost impossible to predict or
protect yourself against this type of
risk.
Examples of this type of risk
include interest rate increases or
government legislation changes.
The smartest way to account for
this risk, is to simply acknowledge
that this type of risk will occur and
plan for your investment to be
affected by it.

Unsystematic Risk

Risk that is specific to an assets

features and can usually be
eliminated through a process
called diversification .
Examples of this type of risk
include employee strikes or
management decision changes.

Risk of a Portfolio
Standard deviation of return or
Variance return
Measurements of co movements in security returns
Covariance is the statistical measure that indicates the interactive
risk of a security relative to others in a portfolios of securities.
It reflects the degree to which the returns of securities vary or change together.

Covariance between two securities X and Y may be calculated

using the formula:
N

Covxy = i=1

Pi

(RX-RX) (RY-RY)

The covariance is the absolute measure of interactive risk

between two securities

Covxy

=
i=1

[RX-RX] [RY-RY]
N

Covxy=covariance between x and y

Rx=return of security x
Ry=return of security y
Rx=expected return or mean return of security x
Ry=expected return or mean return of security y
N= no.of observations
If covariance is
+ve
Returns of two securities are in same direction
-ve
Returns of two securities are in opposite direction
zero
Returns are independent of each other

Coefficient of Correlation
It is a standardised measure
to facilitate comparison in returns
Covxy
rxy=
x y
Covxy= rxyx y

Can range from 1 to 1

-1= perfectly negative correlation or perfect co movement in the opposite direction

+1= perfectly positive correlation of perfect co movement in the same direction
0=returns are independent no correlation.

Variance of a portfolio(two securities)

p2 =x12 12+ x22 22 +2x1x2(r12 1 2)

p2=portfolio variance
x1 =proportion of funds invested in first security
x2= proportion of funds invested in second security
r12 =correlation coefficient between the returns of first and second security
1 =standard deviation of of first security
2 =standard deviation of of second security

Variance Covariance matrix

2p= xi xjij
i=1 j=1

ij= r iji j
ij= covariance between security I and j.
r ij= correlation coefficient between security I and j.
i= standard deviation of security i
j= standard deviation of security j
n

2p= xi xj rij ij
i=1 j=1

Beta (Calculation of Systematic Risk)

A measure of the volatility, or systematic risk,
of a security or
a portfolio
in comparison to the market as a whole.
Beta is used in the Capital Asset Pricing Model (CAPM),
a model that calculates the expected return of an asset based on
its beta and expected market returns.

Calculation of Beta

Correlation method
Regression method
Correlation method:
rimim
i= 2
m
rim= correlation coefficient between the returns of
stocks i and the returns of the market index
i= standard deviation of return of stock i.
m= standard deviation of returns of the market
index
2m= variance of the market returns.

Y= + X where Y=dependent variable

X= independent variable
and are constant

nXY- (X) Y)
nX2 ( X)2
=Y X
Y=Y/n
X=Y/n

n= no. of items
Y= mean value of the
dependent variable scores
X= mean value of
independent variable scores
X=independent variable
scores
Y= dependent variable
scores

CAPM model

Ri= Rf+ (Rm-Rf)

Where
Ri is the required return
Rf is the risk free return
Rm is the average market return
is the measure of systematic rick which is
non-diversifiable.